21 June 2008

NT: Look Ahead to June 2008 Results

When we analyzed Nortel's financial statements for the first quarter of 2008, our Overall Gauge rose to 37, of 100 possible, from 32 points three months earlier. However, we felt that the increase might have overstated the company's financial condition. Reductions in Assets and Market Value -- the latter caused by a plunging stock price -- had perversely improved some of the ratios we use to track growth and profitability.

First quarter Operating Income was a mere $16 million. It was dragged down by miscellaneous operating expenses that include amortization of intangible assets and charges related to workforce reductions, consolidation of real estate, other restructuring actions, and litigation.

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 $36.7 billion (U.S.).

Tougher times also revealed shortfalls in the company's internal financial controls, resulting in numerous restatements, and, sadly, allegations of misdeeds. Just recently, the RCMP charged a former Nortel CEO and two other executives with fraud for errors for errors in the company's financial statements.

The restatements complicate any financial analysis of Nortel.

On 31 July 2008, Nortel is scheduled to announce its results for the second 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.

Nortel recently re-affirmed its outlook for 2008. The company expects:

Revenue to grow in the low single digits compared to 2007
Gross Margin to be about the business model target of 43 percent of revenue
Operating Margin as a percentage of revenue to increase by about 300 basis points compared to 2007

With this guidance in mind, we expect Nortel's Revenue to be about $2.8 billion in the June 2008 quarter. While this figure is a seemingly too high 9 percent more than Revenue in the June 2007 quarter, it is essentially the same as Revenue in the March 2008 quarter. It equates to a 1 percent year-over-year (i.e., trailing four quarters) growth rate.

The company's Gross Margin target is consistent with historical results, although a percentage point more optimistic than we would have assumed if left to our own devices. Given Nortel's Gross Margin guidance and our Revenue estimate, our prediction for Cost of Goods Sold is (1 - 0.43) * $2.8 billion = $1.6 billion.

Research and Development expenses have, in recent quarters, been trimmed a couple of percentage points to about 15.5 percent of Revenue. We would, therefore, expect R&D to be 0.155 * $2.8 billion = $434 million in the second quarter.

Similarly, historical trends suggest that a good estimate for Sales, General, and Administrative expenses is about 22.5 percent of Revenue. In the June 2008 period, our SG&A prediction turns out to be 0.225 * $2.8 billion = $630 million.

Nortel's quarterly results usually include other operating expenses such as Amortization of intangibles, In-process R&D, and Special charges. 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 June 2008 quarter.

Rolling up the estimates described above would lead to Operating Income, as we define it, of $80 million in the quarter. This would certainly be a nice improvement over the $50 million loss in the year-earlier 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 $38 million.

This would bring pre-tax income down to $42 million.

Nortel's quarterly effective income tax rate defies prediction from historical results. There have been many quarters where the amount of income tax far exceeds the amount of income. Oddly enough, there have also been quarters where the company had negative provisions for income taxes despite a positive income value. Admitting our inability to make sense of Nortel's tax situation, we have arbitrarily assumed a 40 percent tax rate for the second quarter.

This would yield Net Income of $25 million ($0.05 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.


June 2008
June 2007
Revenue (1)

Operating expenses

CGS (1596)

R&D (434)

SG&A (630)

Other (2) (60)

80 (50)
Other income

Investments (3)

Asset sales

Interest, etc. (4)
(16) 24
Pretax income

42 (26)
Income tax

Net Income
25 (37)

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

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