04 May 2007

NT: Financial Analysis through March 2007

Nortel Networks (NT), the Canadian supplier of telecom products and services, filed a 10-Q with the SEC for the quarter ending on 31 March 2007. We updated our analysis to address certain details (e.g., an inventory breakout) in this formal submittal that were not available in the original press release. Our results, adjusted to account for the new information, are reported in this post.

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, resulting in numerous restatements, and allegations of fraud. The restatements complicate any financial analysis of Nortel. For our purposes, we have assumed that the financial statements for 2004-2006 included in the company's most recent 10-K filing are accurate and consistent. We have also employed data from earlier periods -- some of which had been restated previously -- to establish a baseline to which current results can be compared. Comparisons between recent and historical data might be partially or completely invalid because of differences in presentation. Nevertheless, we felt that there was more to be gained by having a baseline, even if imperfect, than not having one. Readers are cautioned to consider the data uncertainties when reviewing the analysis results.

Cash Management. The Current Ratio is now 1.7. While we would prefer to see it higher, the recent upward trend has lifted the Current Ratio from a worrisome 1.1 one year ago. Long-Term Debt/Equity is a highly leveraged 207 percent; this almost seems good considering that the debt ratio was 397 percent in December and 382 percent in March 2006. However, the drop was not due to the company paying off debt, just the opposite. The debt ratio declined because stockholders equity, beaten down to near zero, increased by a greater proportion due to small (in absolute terms) increase in paid-in capital. Inventory/Cost of Goods Sold increased a little to 107 days from 104 days three months ago, but the current inventory level is much less than the 133 days it was in March 2006. The percentage of Inventory that is product ready for sale is 34 percent, which is a few percent less than the average Finished Goods ratio during the last year of 37 percent. Taken together, the two inventory ratios hint that sales met expectations. Accounts Receivable are 75 days of Revenue. This is much less than the 89-day value one year earlier. It might be indicating the company is finding it less difficult to get its customers to pay their bills.

Growth. Revenue growth is now 9 percent year over year, up a little from 8 percent a year ago. Net Income growth is N/A because the company lost money in both twelve-month periods. CFO was positive over the last year, if we ignore a large charge for a class action settlement. It was negative the previous year. Revenue/Assets is 61 percent; it has been stable, showing neither increased, nor decreased, efficiency at generating sales.

Profitability. ROIC is a weak 6 percent, but it was positive unlike previous periods it was positive. By coincidence, FCF/Equity is also 6 percent after a recent stretch of negative values. Operating Expenses/Revenue has been between 99 and 101 percent for the last couple of years. The company has to get costs down if it ever hopes to be profitable on a sustained basis. The Accrual Ratio, which we like to be both negative and declining, moved in the right direction from +1 percent to -2 percent. Since we excluded a large cash action settlement charge, we're not going to get too excited by this change.

Value. Nortel's stock price fell over the course of the quarter from $26.73 to $24.05. Since the company's earnings were negative, neither the P/E, nor the PEG ratio, are presently meaningful. For the record, the average P/E for the Communications Equipment industry is 26.5. The Price/Revenue ratio, which is less affected by the one-time factors that cause wide swings in earnings, has been stable at 0.9 for the last year. But, it's much less than Nortel's 1.3 average and the 5.0 average for the Communications Equipment industry.

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.) 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. Stubbornly high Operating Expenses are blocking profits, and the company has too much Long-Term Debt. We are also concerned that allegations of fraud could keep the black cloud above the company firmly in place.

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