18 March 2007

NT: Financial Analysis through December 2006

Nortel Networks (NT) is a Canadian-based supplier of products and services to telecom carriers, networking operators, and businesses.

Although it has been in business for over 110 years -- the first century as Northern Electric -- Nortel is one of the most spectacular casualties of the dot-com bust. Its stock price plunged from over $80 to $2, before a 1:10 reverse split late last year made the current price seem more respectable. Nortel has somehow managed to stay in business and even independent, unlike fellow fallen telecom Lucent. For most of this decade, huge losses have been the norm at Nortel, resulting in an unfathomable accumulated earnings deficit of $35 billion (U.S.). Tougher times also revealed shortfalls in the company's financial controls, and allegations of fraud, resulting in numerous restatements.

Nortel's recent 10-K provides current data and restated results for each quarter of 2006 and 2005. The auditors have expressed an opinion that the data fairly represent, in all material respects, the financial position of the company for these two years. Data for 2004 has also been restated; however, full quarter-by-quarter results were not included in 10-K. For our analysis of Nortel, we have warily used the financial statements included in some earlier (but not too much earlier) filings. Given the murkiness of historical data, we're not including numeric scores in the analysis summary below. Instead, we merely summarize the financial results that drive our gauges.

Cash Management. Given the extent of its losses, a Current Ratio just below 1.5 doesn't seem too bad. The recent upward trend in this parameter signifies improved credit-worthiness; however, it's only getting back a level attained a couple of years ago. Long-Term Debt/Equity is an extremely leveraged 397 percent, up from 345 percent in September and 320 percent one year ago. Inventory/Cost of Goods Sold dropped nicely to 104 days, from 114 days at the end of the prior quarter and 122 days at the end of December 2005. The percentage of Inventory that is product ready for sale (i.e., Finished Goods) is 37 percent, which is 2 percentage points fewer than a year ago. We don't trust the historical inventory breakout data, so we can't put this in historical perspective. However, the lower inventory figures seem to be suggesting that sales met, or even exceeded, expectations. Accounts Receivable/Revenue equals 89 days, which is a little less (a good thing) than recent levels. It might indicate the company is finding it easier to get its customers to pay their bills.

Growth. Revenue growth was 9 percent year over year, up from 7 percent a year ago. Net Income appears to have increased, but it declined if we ignore the last year's huge litigation charge. CFO, encouragingly, switched from a loss to gain, mostly because the final quarter generated a lot cash. Revenue/Assets seems to have stabilized at around 60 percent. It will be interesting to see how this indication of efficiency at generating sales changes in the next year or two.

Profitability. Since operating profit was slightly negative (i.e., a loss), ROIC was a little bit less than zero percent. FCF/Equity jumped up, if you can call it that, to minus 7 percent, from minus 57 percent a year ago. Operating Expenses/Revenue continue to hover around 100 percent, which tells us that core operating profitability is still lacking. There are some traces of pressure on Gross Margin, which are being compensated for by cutbacks in R&D expenses and, to a lesser extent, SG&A expenses. The Accrual Ratio, which we like to be both negative and declining, did both by moving from +2 percent to -1 percent. This tells us that more of the company's Net Income (Loss) is due to CFO, and, therefore, less is due to changes in non-operational balance sheet accruals.

Value. The stock price at the end of the year was $26.73. With negative earnings, the P/E and the PEG are not applicable. Therefore, our only measure of value is the Price/Revenue ratio. It was 1.02 at the end of the year, down form 1.26 in December 2005. It's ironic to say this about a company that has lost so much money, but the decrease suggests the shares have become less expensive. The average Price/Sales for the Communications Equipment industry is over 5.0.

In summary, an optimist can find some favorable aspects to Nortel's recent performance. Cash levels are reasonable, and Inventory control seems to be getting better. Revenue is increasing, indicating that the company's products are still succeeding in a very competitive marketplace. (Of 225 Communications Equipment firms, Nortel had the sixth-most sales in the last year.) A strong fourth quarter pushed CFO for the whole of last year into the black. And, the company is cheap compared to its competitors on a Price/Revenue basis. However, a pessimist won't have any trouble finding red flags. Long-Term Debt is too high: $2.7 billion of debt was rolled over into $3.3 billion of new debt in 2006. In an era of generally low long-term interest rates, the company has to pay 10.75 percent for senior fixed rate notes due in 2016. Even if the all non-recurring charges are ignored, Nortel's core operations generate small profits, at best, and often losses. The most recent quarter was good, but there have been other good quarters since the bubble burst. In addition, the company has said before that the restatements were complete, only to find additional errors that erased any remaining vestiges of credibility it had with the investment community. To top it off, new allegations of fraud could keep the black cloud above the company firmly in place.

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