20 December 2008

NT: Look Ahead to December 2008 Quarterly Results

The GCFR Overall Gauge of Nortel Networks (NYSE: NT) registered 35 of the 100 possible points in the third quarter of 2008, which ended on 30 September.  Our analysis report explained the score in some detail.

While 35 points is not an especially good score, the number is clearly much too high given Nortel's diminished financial stature and future prospects.  The GCFR gauges produce inflated results, as we've seen with Nortel, when evaluating a company with Net Losses, negative Cash Flow from Operations, and massive "special" charges.  We've made some minor adjustments to the underlying algorithms to correct the problem, but we're proceeding cautiously.  We want to the gauges to retain sufficient sensitivity to detect the early signs of a turnaround in a troubled company.

The September 2008 quarter included a $1.1 billion, non-cash charge for "Goodwill Impairment."  To add salt to the wound, negative pretax income was accompanied by a jaw-dropping $2.2 billion Provision for Income Taxes.  The bottom-line Net Loss was $3.4 billion.  The tax situation is complicated, but Nortel reported "it will not be able to use all of its net deferred tax assets within a reasonable timeframe."

We've wondered, in jest, if Nortel's raison d'être is to pay income taxes on non-existent profits.  In the last 10 quarters, tax provisions were $3.375 billion on a cumulative pretax loss of $1.285 billion.

On 11 December 2008, the NYSE notified Nortel that the persistent share price below $1.00 violates one of the exchange's listing standards.  It was, amazingly enough, only two years ago that Nortel implemented a 1-for-10 reverse stock split to boost the share price.  Nortel has 6 months to rectify the current problem.  However, a bankruptcy filing, which is under consideration, would render the listing qualifications moot. 

To look ahead, we've modeled Nortel's Income Statement for the December 2008 quarter. The intent of this exercise was to produce a baseline for identifying any deviations, positive or negative, in the actual data that the company will announce in late February 2009.  GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

First, we will take a step back.

Nortel Networks Corp. (NYSE: NT) is the Canadian-based supplier of products and services to telecom carriers, other networking enterprises, and businesses.   Losses have been the norm at Nortel for most of this decade, resulting in an unfathomable accumulated deficit (i.e., negative retained earnings) of $40 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 charged a former Nortel CEO and two other executives with fraud for errors for errors in the company's financial statements. 

Nortel, on 17 September 2008, announced that sales in certain markets were under "significant pressure."  The warning was accompanied by an announcement that the company intends "to explore a divestiture of its Metro Ethernet Networks (MEN) business," which it refers to as "a premium asset."

When it announced third quarter results, Nortel also updated its outlook for the full year of 2008.

Nortel [the company stated] revised its revenue and management operating margin financial outlook for the full year 2008 to around the low end of the previously announced ranges primarily due to the further deteriorating economic conditions and the unfavourable impact of foreign exchange and now expects revenue to decline by around four percent compared to 2007 (versus the previous range of a decline of two to four percent), gross margin to be about 42 percent of revenue, and management operating margin(a) to improve about 125 basis points compared to 2007 (versus the previous range of an improvement of 125 to 175 basis points). In light of the economic conditions noted above, and continuing foreign exchange volatility, Nortel’s actual results may be lower than these current expectations.

As previously announced, the full year outlook includes the expected completion of wireless contracts in the fourth quarter representing about $320 million of previously deferred revenue. These contracts are progressing towards completion and the Company currently expects to meet the conditions to recognize the previously deferred revenue in the fourth quarter.

Guidance for the fourth quarter can be derived easily from the full year outlook and the reported data for the first nine months of the year.

Nortel's Revenue in 2007 was $10.95 billion.  By trimming four percent from this figure, we get management's 2008 target of $10.5 billion.  Subtracting year-to-date Revenue of $7.7 billion yields guidance for the fourth quarter of $2.8 billion.  The GCFR target is $2.75 billion because we suspect conditions worsened over the course of the quarter.

For the Gross Margin to be 42 percent for the full year, in accordance with the guidance, the Cost of Goods Sold during the year would have to be (1 - 0.42) * $10.5 billion = $6.1 billion.  CGS in the first three quarters was about $4.5 billion, which leaves $1.5 billion for the fourth quarter.  Our precise target is $1.545 billion.

In 2007, Operating Expenses (CGS + R&D + SG&A) were 96.34 percent of Revenue.  Management indicated that the equivalent figure for 2008 would be about 1.25 percent less, or 95.1 percent.  Using our Revenue and CGS estimates, it can easily be determined that Research and Development and Sales, General, and Administrative in the fourth quarter would have to sum to no more than $950 million to achieve the 95.1 percent implied guidance.  For the record, we have allocated $400 million of the $950 million to R&D and the remaining $550 million to SG&A.

Nortel's quarterly results usually include other operating expenses such as Amortization of Intangibles, In-process R&D, and Special Charges.  These items were not mentioned in the company's guidance, and the figures fluctuate so much from quarter to quarter that we can't predict them with any confidence.  We made our $66 million estimate by taking the average charge over the last 10 quarters, ignoring the highest and lowest values.

The Revenue and expense numbers identified above would lead to an Operating Income, as we define it, of $189 million in the quarter.  This value is 5 percent less than in the comparable year-earlier quarter.

Gains and losses from Non-operating activities (minority interests, equity in associated companies, asset sales, an interest expense) are also volatile from quarter to quarter.  If (as above) we take 10-quarter average values for these figures, but throw out the high and low values, the total expected non-operating expense is $50 million.

This assumption results in pretax income at $139 million.

Nortel's quarterly effective income tax rate defies prediction.  For example, in the December 2007 quarter, Nortel recorded a non-cash charge over $1 billion to increase the valuation allowance associated with Canadian deferred tax assets.  This tax charge turned a modest gain into a huge loss.

Admitting our inability to make sense of Nortel's tax situation, we have arbitrarily assumed a +30 percent tax rate for the fourth quarter. 

This would yield Net Income of $97 million ($0.19 per share), compared to a loss of $844 million in the December 2007 quarter.  Given the number of substantial estimates we had to make to come up with the income projection, our confidence in it is not very high.

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.

($M) December 2008
December 2007
Revenue (1) 2,750 3,198
Operating expenses
CGS (1,545) (1,801)
R&D (400) (475)
SG&A (550) (678)
Other (2) (66)
189 199
Other income
Investments (3) (32) (39)
Asset sales723
Interest, etc. (4) (25) 13
Pretax income 139 196
Income tax (42) (1,040)
Net Income 97 (844)
$0.19/sh ($1.69)/sh
Shares outstanding 500 498
1. Total revenues include 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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