03 May 2008

NT: Financial Analysis through March 2008

We have analyzed Nortel's 10-Q financial statements for the quarter that ended on 31 March 2008. Nortel submitted the 10-Q to the SEC when they announced their results publicly, which gave us early access to a full set of financial statements and notes.

Nortel Networks Corp. (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. 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 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 December 2007 quarter, the Overall gauge score was a modest 32 points. Of the four individual gauges that fed into this composite result, Value was strongest at 9 points. Cash Management was weakest at 5 points.

Now, with the available data from the March 2008 quarter, our gauges display the following scores:
As will be explained below, these numbers do not necessarily represent an improving situation.

Before we examine the factors that affected each gauge, let's examine the Income Statements for the March 2008 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.


March 2008
March 2007
Revenue (1)

Operating expenses

CGS (1612)

R&D (420)

SG&A (597)

Other (2) (113)

16 (39)
Other income

Investments (3)

Asset sales

Interest, etc. (4)
(43) (30)
Pretax income

(102) (90)
Income tax

Net Income
(128) (103)

Shares outstanding

1. Total revenues includes products and services.
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

Revenue was 11.1 percent more than in the year-earlier quarter. On a year-over-year basis, Revenue was down 2.5 percent. Gross Margin for the quarter increased by 1.2 percentage points because the Cost of Goods Sold dropped from 59.6 to 58.4 percent of Revenue. Research and Development (R&D) expenses were trimmed from 16.5 to 15.2 percent of Revenue. Sales, General, and Administrative (SG&A) expenses were reduced from 24.3 to 21.6 percent of Revenue.

This good news about lower core operating costs is nullified, or nearly so, by a significant $85 million increase in a category of miscellaneous, theoretically non-recurring, operating expenses we simply label as "Other." This category includes Amortization of intangible assets, "Special Charges," and other expenses. Special charges are related to workforce reductions, consolidation of real estate, and other restructuring actions. Some other expenses are related to litigation.

The bite of these charges cut quarterly Operating Income to a mere $16 million. This might be considered progress, since Operating Income was a loss in the year-earlier quarter. However, the tiny value dampens the optimism that Nortel's troubles might be abating that was kindled by an Operating Income surge in 2007's final quarter.

Net Non-Operating Charges of $118 million in the latest quarter outweighed the Operating Income by a wide margin. The non-operating factors include Minority Interests and Net Interest Expense.

Negative pre-tax income didn't preclude a provision for Income Taxes, which exacerbated the loss. Net Income was substantially in the red.

Cash Management. This gauge increased from 5 points in December to 7 points now.

3 mos.
12 mos.
Current Ratio1.4
Finished Goods/Inventory
Days of Sales Outstanding (DSO)76.4 days
89.5 days
78.1 days
Working Capital/Market Capitalization 28.4%
Cash Conversion Cycle Time (CCCT)
123 days
138 days
134 days

The high ratio of Working Capital to Market Capitalization is intriguing and almost surprising for a company that has been bleeding cash for years. However, Nortel's rapidly diminishing Market Value, not an increase in Current Assets, is the reason the ratio increased.

The CCCT reduction is a sign of greater Cash Management efficiency.

Growth. This gauge increased from 8 points in December to 10 points now.

3 mos.
12 mos.
Revenue growth-2.5%
Revenue/Assets 69%
CFO growth
Net Income growth N/AN/AN/A
Growth rates are trailing four quarters compared to four previous quarters.

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 not as fast as Assets. This explains the Revenue/Assets increase. We consider Revenue/Assets to be an important metric, and we give it greater weight than most other ratios. However, the Nortel case suggests that we need to trim the weight because the company clearly doesn't deserve a Growth score of 10 points. [An advantage to analyzing companies under stress is that it can reveal aberrations and strengthen the methodology.]

Profitability. This gauge increased from 8 points in December to 10 points now.

3 mos.
12 mos.
Operating Expenses/Revenue 95.2%
ROIC 8.3%
Accrual Ratio

In the Operating Expense ratio, we exclude the special and non-recurring expenses discussed above. On this basis, Nortel's progress in cutting costs is encouraging.

The ROIC results also appear encouraging. However, we need to keep in mind that the denominator of this return-on-investment metric includes Stockholders Equity, which has been diminishing.

Value. Nortel's stock price plunged during the March quarter from $15.09 to $6.69 (it later bounced back a little). The Value gauge, based on the quarter-end closing price, moved up from 9 to 10 points.

3 mos.
12 mos.
P/E to S&P 500 average P/E N/AN/AN/A
Price/Revenue 0.3
Enterprise Value/Cash Flow (EV/CFO)
The average P/E for the Communication Equipment industry is 24.3, and the average Price/Sales is 5.2.

The Value gauge score is driven entirely by the Price/Revenue ratio.

Nortel is both an interesting and frustrating company to follow. Revenue increased nicely in the first quarter, relative to the same quarter in 2007. However, Revenue in the trailing four quarters still declined when compared to the four previous quarters. Core operating expenses (CGS, R&D, & SG&A) have declined, but the company repeatedly incurs restructuring charges that erase any minuscule profits.

The share price has fallen so dramatically that a return to even modestly positive earnings and cash flow would make the company appealing across the board. However, this happy day has been postponed time after time to address new problems.

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