03 August 2008

NT: Financial Analysis through June 2008

We have analyzed Nortel's 10-Q financial statements for the quarter that ended on 30 June 2008. These statements of this company based in Canada are prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP) and are expressed in U.S. dollars.

Nortel Networks Corp. (NT) is a 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 $36.8 billion (U.S.).

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

When we analyzed Nortel's first quarter financial statements, the GCFR Overall Gauge rose to 37, of 100 possible, from 32 points three months earlier. However, we were concerned that the particulars of our analytical methodology might have produced over-optimistic results for a company in Nortel's circumstances. 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. Of the four individual gauges that fed into the composite result, the Cash Management gauge was weakest at 7 (of 25) points. The three other gauges were tied at 10 points.

Now, with the available data from the March 2008 quarter, our gauges display the following scores:

Before we examine the factors that affected each gauge, we will compare the latest quarterly Income Statement to our previously communicated expectations.

Please note that the tabular 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 2008
June 2007
Revenue (1)

Operating expenses

CGS (1492)

R&D (441)

SG&A (575)

Other (2) (71)

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

Revenue was 2.3 percent more than in the June 2007 quarter, but it was also 4.9 percent below that in the March 2008 quarter. Since we anticipated sequential growth, Revenue in the recent quarter also fell short of our projection by 6.4 percent.

Nortel had indicated in their guidance for 2008 that they expected to achieve a Gross Margin of about 43 percent. We assumed, with some doubt, that management would be proven correct. In the second quarter, the guidance was quite accurate since the actual Gross Margin was 43.1 percent. The Cost of Goods Sold was 56.9 percent of Revenue.

Research and Development (R&D) expenses were 16.8 percent of Revenue, compared to our forecast of 15.5 percent of Revenue. This result is more a consequence of declining Revenue than a sign of growing R&D expenses.

On the other hand, we expected that Sales, General, and Administrative expenses would be 22.5 percent of Revenue, and the actual figure was 21.9 percent. Perhaps some overhead expenses have been scaled back to fit a smaller company.

Nortel's quarterly results always include other operating expenses such as Amortization of intangibles, In-process R&D, and "Special charges." Special charges are related to workforce reductions, consolidation of real estate, and other restructuring actions. There were $71 million of these other operating expenses in the recent quarter, which surpassed our $60 million estimate.

Lower-than-expected Revenue was the main reason Operating Income, as we define it, fell short of our prediction. However, it was nonetheless positive, which cannot be said about the year-earlier quarter.

Alas, net Non-Operating expenses of $95 million exceeded the Operating Income by a wide margin. The non-operating factors include Interest Expenses and Minority Interests.

Negative pre-tax income didn't preclude a $61 million provision for Income Taxes, which exacerbated the loss. Net Income was substantially in the red. [In the last 10 quarters, provisions for Income Taxes totaled $1.27 billion, and Pre-tax Income totaled a loss of $137 million. This is, to say the least, puzzling.]

Cash Management. This gauge increased from 7 points in March to 12 points now.

3 mos.
12 mos.
Current Ratio1.5
Finished Goods/Inventory
Days of Sales Outstanding (DSO)73.7 days
76.4 days
83.9 days
Working Capital/Market Capitalization 33.2%
Cash Conversion Cycle Time (CCCT)
122 days
123 days
146 days

The rise in the gauge score is a result of several of the metrics in the table above showing some improvement from either the previous quarter or the previous year. It may be a greater concern that there is no Cash Flow from Operations to cover the rather high level of Long-Term Debt, and that Inventory levels are so high in an industry where frequent innovation necessitates short product cycle times. The high ratio of Working Capital to Market Capitalization is surprising for a company that has been bleeding cash for years. However, Nortel's rapidly diminishing Market Value, not a significant improvement in Liquidity, is the reason the ratio increased.

Growth. This gauge didn't change from 10 points in March.

3 mos.
12 mos.
Revenue growth-0.1%
Revenue/Assets 71%
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 weight it more than the other ratios when computing the Growth score.

Profitability. This gauge decreased from 10 points in March to 9 points now.

3 mos.
12 mos.
Operating Expenses/Revenue 94.5%
ROIC 9.5%
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, but this could be misleading. The numerator doesn't include the crushing Income Taxes Nortel shows on its Income Statement, and the denominator includes Stockholders Equity, which has been diminishing.

Value. Nortel's stock price increased during the June quarter from $6.69 to $8.22, although the gain has already been erased. The Value gauge, based on the quarter-end closing price, stayed at 10 points.

3 mos.
12 mos.
P/E to S&P 500 average P/E N/AN/AN/A
Price/Revenue 0.4
Enterprise Value/Cash Flow (EV/CFO)
Nortel's valuation ratios can be compared with other companies in the Technology Processing Systems & Products industry. (It's not pretty.)

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

Nortel Networks Corp. is both an interesting and frustrating company to follow. In an era when the weak dollar is boosting reported Revenues for multinational companies, Nortel's Revenue in the last four quarters is almost exactly identical to Revenue in the four earlier quarters. The company has made progress cutting its core operating expenses (CGS, R&D, and SG&A) as a percentage of Revenue, and it even makes money on an operating basis from time to time. However, debt, taxes, and other expenses outweigh any Operating Income, often by a wide margin.

The 10-Q provides details on restructuring plans dated 2001, 2004, 2006, 2007, and 2008.

As best we can tell, Cash Flow from Operations has been positive in exactly two four-quarter periods (sliding window) since the high-tech boom came to end at the decade's beginning.

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