12 March 2009

NT: Financial Analysis through December 2008

On 2 March 2009, bankrupt Nortel Networks (TSE: NT) announced its results for the fourth quarter and full year of 2008.  The company simultaneously filed a 10-K report for the year with the SEC. 

This post provides the GCFR analysis of the financial statements.  These statements are prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP) and are expressed in U.S. dollars.

Nortel Networks Corp. is the Toronto-based supplier of products and services to telecom carriers, other networking enterprises, and businesses.  Nortel succumbed to bankruptcy after experiencing losses for most of this decade, resulting in an unfathomable accumulated deficit (i.e., negative retained earnings) of $40 billion (U.S.).

Shortfalls in the company's internal financial controls were revealed over the years, resulting in numerous restatements and 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.

Speculation has increased that the company's restructuring plan for emerging from bankruptcy will involve the sale of major business units.

We begin by comparing the latest quarterly Income Statement to the model we prepared prior to the creditor-protection filing.

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.


Revenue was 14.9 percent less than in the December 2007 quarter.  However, it was only 1.0 percent below our target, which was based on the company's guidance to expect Revenue in all of 2008 to be 4 percent less than Revenue in 2007.  In actuality, annual Revenue dropped by 4.8 percent.

Nortel management reported that many of its customers, but especially those in North America, "responded to increasingly worsening macroeconomic and industry conditions and uncertainty by suspending, delaying and reducing their capital expenditures."

The Cost of Goods Sold was 59.6 percent of Revenue in the quarter, which translates into a Gross Margin of 40.4 percent.  We had expected a more profitable margin of 43.8 percent.  For the year, the Gross Margin was 41.1 percent, which compares unfavorably to management's guidance of 42 percent.

Research and Development (R&D) expenses in the quarter were 12.3 percent of Revenue, significantly less than our 14.5 percent estimate.  For the year, R&D expenses totaled 15.1 percent of Revenue.

Sales, General, and Administrative expenses were 17.2 percent of Revenue, much less than our 20 percent estimate for the quarter. 

Alas, less-than-projected R&D and SG&A costs was for naught.  A gargantuan, but non-cash, $1.237 billion operating charge for Goodwill Impairment made all other numbers seem small. 

The Goodwill Impairment charge sunk Operating Income to a $1 billion loss.  If special charges are ignored, Operating Income would have been almost $300 million.  Out estimate, on this basis, was $255 million.

Negative pre-tax income didn't preclude a $967 million provision for Income Taxes, which pushed the Net Loss over $2 billion. Nortel stated "The tax expense ... included an increase to the valuation allowance against the deferred tax assets due to the uncertainties resulting from the global economic downturn and the Company’s creditor protection proceedings."

In 2008 as a whole, Nortel's lost $2.6 billion before tax.  While most companies might have claimed a tax credit, Nortel's Provision for Income Taxes equaled $3.2 billion. 

Cash ManagementDecember 20083 months prior12 months prior
Current Ratio1.51.51.4
LTD/Equity N/AN/A138%
Inventory/CGS 104 days110 days115 days
Finished Goods/Inventory 48.8%50.1%40.0%
Days of Sales Outstanding (DSO)83.0 days75.2 days89.5 days
Working Capital/Market Capitalization  46.9%41.2%19.7%
Cash Conversion Cycle Time (CCCT)
115 days120 days138 days
Gauge Score (0 to 25)

Neither Shareholder's Equity, nor Cash Flow from Operations, are available for debt payments because both are negative.

The decrease in the total Inventory is mildly positive, but the high proportion of Finished Goods indicates slowing sales.  In addition, the Inventory level is too high for an industry where frequent innovation necessitates short product cycle times. 

For Market Capitalization, we add the Market Value of the common shares to the company's long-term and maturing debt.  The former is essentially zero.  This explains the rise in the Working Capital/Market Capitalization ratio.

GrowthDecember 20083 months prior12 months prior
Revenue growth-4.8%-1.6%-4.1%
Revenue/Assets 81%74%61%
CFO growthN/AN/AN/A
Net Income growth N/AN/AN/A
Gauge Score (0 to 25)0
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 contracting, but write-downs have reduced the carrying value of Assets even more.

ProfitabilityDecember 20083 months prior12 months prior
Operating Expenses/Revenue 94.6%95.4%96.3%
Accrual Ratio-56%-33%-5.6%
Gauge Score (0 to 25)7

When special charges are excluded, as in the Operating Expense ratio above, there are is shimmer of improving profitability. 

ValueDecember 20083 months prior12 months prior
P/E to S&P 500 average P/E N/AN/AN/A
Price/Revenue N/A0.10.7
Enterprise Value/Cash Flow (EV/CFO)N/AN/AN/A
Gauge Score (0 to 25)N/A10

In bankruptcy, Nortel's shares have essentially no value.

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