Goldman on Nortel
NT (OP/N): Business Update; Cash &
Margin Analysis
Understanding that a significant amount of risk related to the overhanging accounting
issues and uncertainty on the timing and resolution remains, we continue to recommend
Nortel for 4 reasons: 1) the business is not being negatively impacted by the accounting
issue, 2) valuation discounts much of the risk at hand and is attractive relative to peers and
historical levels - fair value of $5.50 to $6, we see 18-20% downside and 35-50% upside,
3) our cash flow analysis suggests that profitability is intact, 4) our gross margin analysis
supports margins of 45% in 2004. NT is rating Outperform within a Neutral coverage
view. We view this as a higher risk recommendation compared to our other Outperform
rated stocks such as Cisco, Juniper, and Ericsson, and requires a longer-term view.
#1 Business is not being impacted. - Our contacts with major customers confirm that
Nortel is not being impacted. - Meeting with major wireless competitor Ericsson confirms
that Nortel remains a strong competitor. - VoIP: Recent wins with Telenet (Belgium),
Comcast (US) and Cable & Wireless IDC (Japan) demonstrates continued traction in
VoIP, important because a) this is a key growth market for Nortel's wireline business, and
b) VoIP equipment sales should benefit margins. - WIRELESS: Verizon Wireless
EV-DO build remains on track and comments from Lucent would indicate that revenue recognition
from this contract is still to come. Announced contract wins in 1Q04 include the Telekom Baltija
450 networks (sole provider), China Mobile GSM expansion contract, and the Alaska
Communications' EV-DO network, expected to launch in May 2004 (sole provider). -
FOODCHAIN: 1Q04 earnings reports of major suppliers reveal strong demand from NT
particularly in areas such as wireless. - We understand that Nortel is taking steps to strengthen its
channel/ partner operations, particularly in key areas such as India (into B and C cities - Nortel
currently has branches in Mumbai, Delhi and Bangalore). This is important because Nortel's
traction in this market is currently lagging competitors such as Ericsson, Nokia and Motorola.
#2 VALUATION IS ATTRACTIVE; $5.50 - 6.00 FAIR VALUE. Compelling valuation can be
supported by sales and cash levels that are not materially impacted by accounting issues. In our
view, downside risk is 18-20%, or just above 1x EV/Sales which has historically been a good
buying point for the shares. Upside potential is 35-50% as we believe shares should trade at 2x
EV/Sales based on our belief that mid-40% gross margins are in tact. Further, we believe that the
company's current valuation reflects much of the risk surrounding the accounting issues. - NT is
currently trading at 1.4X '05 sales vs. Lucent at 1.8x sales. - 2001-to-date average sales multiple for
Nortel is 1.8x, in-line with the company's 10 year historical average. - We believe Nortel should
trade closer to 2x sales given the company's greater revenue visibility and favorable product
positioning in high growth markets such as 3G wireless and VoIP. At 2x our 2005 revenue estimate
of $12.0B, this would imply a price of $5.50. - Operating cash flow yield of 10% in 4Q03 is also a
number that will remain unchanged in our view, a solid indicator that a healthy level of profitability
remains intact. - Currently NT trades at 16x our 2005 EPS forecast of $0.25, a discount to the
market and its historic 20x average. We continue to believe that Nortel should trade at a premium
to histric levels given its historic gross margins were 40% and going forward will be 45%.
#3 CASH IN INTACT - OUR CASH FLOW ANALYSIS SUGGESTS PROFITABILITY IS
INTACT. We do not expect the company's cash balance or operating cash flow level to be
impacted materially in any given quartery by the accounting restatments. Given that revenues will
also be left unchanged, we believe this is a good indicator that much of the profitability in Nortel's
underlying business remains healthy. 4Q03E operating cash flow yield of 10% suggests that the
profitability of the underlying business is more in tact than the share price currently reflects.
Further, we believe the company's operating cash flow metrics are set to continue to improve in
2004 and 2005.
#4 GROSS MARGIN ANALYSIS SHOWS MID-40% IS ACHEIVABLE. Our blended gross
margin analysis for Nortel supports our $0.25 05' EPS and mid-40% gross margins in the
near-term.
'04E % of Reasonable NT Peer Key
Sales '04 Rev GM Est. Est. GM Assump.
Wireless $4,926 46% 45%-50% 46% 45% A
Wireline $2,136 20% 49% 48% 34% B
Enterprise $2,491 23%
~ 75% PBX $1,868 17% 45%-48% 47% 48% C
~ 25% data net $467 4% 55%-60% 55% 62% D
Optical $1,204 11% 33%-38% 33% 29% E
NT TOTAL $10,757 45% |
