We didn't consider the score to be especially credible, as discussed below, but the underlying analysis was still revealing.
At GCFR, we try to discern when a company's financial performance is improving or worsening compared to normal conditions as reflected in the historical accounting record. [We then look to see if the changes are reflected in the stock price.] Nortel hasn't achieved what we would deem stability in many years, and this gives us fits. Net Income and Cash Flow from Operations are often negative, and too-frequent special charges obscure the situation. Occasionally, however, some positive data appears and hints at a turnaround. We're fairly certain that our gauges give too much weight to these evanescent upswings, and yet we don't want to stop looking for them.We've wondered if Nortel's raison d'être is to pay income taxes on non-existent profits. In the last 10 quarters, Provisions for Income Taxes totaled $1.27 billion. During this period the cumulative Pretax loss was $137 million.
Tougher times also revealed shortfalls in the company's internal financial controls, resulting in numerous restatements, and, sadly, allegations of misdeeds. The RCMP charged a former Nortel CEO and two other executives with fraud for errors for errors in the company's financial statements.
We will now turn our attention to the third quarter. 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 business," which it refers to as "a premium asset."
Nortel Networks Corp. (NYSE: NT) 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 -- now part of Alcatel-Lucent (NYSE: ALU). Losses have been the norm at Nortel for most of this decade, resulting in an unfathomable accumulated deficit (i.e., negative retained earnings) of $36.7 billion (U.S.).
On 6 November 2008, Nortel is scheduled to announce its results for the third quarter. In anticipation of this report, we've modeled Nortel's Income Statement for the quarter. The intent of this exercise was to produce a baseline for identifying any deviations, positive or negative, in the actual data. GCFR estimates are derived from trends in the company's historical financial results and guidance provided by company management.
In the recent earnings warning, Nortel explicitly stated that it expects Revenue of about $2.3 billion in the third quarter. This figure is 15 percent below September 2007's quarterly sales of $2.7 billion. The revised guidance is also 12.3 percent less than Revenue in the June 2008 quarter.
Nortel also told investors to expect the Gross Margin to be approximately 39 percent of Revenue. The margin had been more like 42 to 43 percent in recent quarters, although 39 percent would not represent a new low. The company's guidance translates into an estimate for Cost of Goods Sold of (1 - 0.39) * $2.3 billion = $1.4 billion.
Management also took the trouble to report that "Third quarter operating expense (SG&A and R&D) is currently expected to be $60 million less than the second quarter 2008 level." (Do they enjoy forcing analysts to do arithmetic?) Research and Development and Sales, General, and Administrative expenses in the second quarter totaled $1.016 billion, so the guidance for the third quarter is obviously $956 million. Not that it really matters, but we have allocated this value as $397 million for R&D and $559 million for SG&A.
Nortel's quarterly results usually include other operating expenses such as Amortization of Intangibles, In-process R&D, and Special Charges. These items were not mentioned in the company's guidance, and it's possible they included these items with operating expenses. The average over the previous eight quarters for these miscellaneous expenses has been $60 million. We will use this figure as our target for the September quarter.
Rolling up the estimates described above would lead to an Operating Loss, as we define it, of $119 million in the quarter.
Gains and losses from Non-operating activities (minority interests, equity in associated companies, asset sales, an interest expense) are extremely volatile at Nortel from quarter to quarter. If we take two-year average values for these figures, but throw out the high and low values, the aggregate expected non-operating loss is $50 million.
This would increase the pretax loss to $169 million.
Nortel's quarterly effective income tax rate defies prediction. There have been many quarters where the income tax far exceeds income. Oddly enough, there have also been quarters where the company had negative Provisions for Income Taxes despite positive earnings. Admitting our inability to make sense of Nortel's tax situation, we have arbitrarily assumed a +40 percent tax rate for the third quarter. Given the pretax loss, the company would get a tax credit of $67 million.
This would yield a Net Loss of $101 million ($0.20 per share).
Please note that the table format below, which we use for all analyses, can and often does differ in material respects from company-used formats. A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.
| ($M) | | September 2008 (predicted) | September 2007 (actual) |
| Revenue (1) | | 2,300 | 2,705 |
| Operating expenses | | | |
| | CGS | (1,403) | (1,542) |
| | R&D | (397) | (416) |
| | SG&A | (559) | (613) |
| | Other (2) | (60) | (68) |
| Operating Income | | (119) | 66 |
| Other income | | | |
| | Investments (3) | (37) | (42) |
| Asset sales | 9 | (3) | |
| | Interest, etc. (4) | (21) | 56 |
| Pretax income | | (169) | 77 |
| Income tax | | 67 | (50) |
| Net Income | | (101) | 27 |
| | | ($0.20)/sh | $0.05/sh |
| Shares outstanding | | 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
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