Nortel: You Must Be Joking
When a new management team commits to driving a money-losing behemoth back
to profitability, it's something any investor would want to hear. In
Nortel's case, though, there wasn't much weight behind its vaunted
recovery in 2003. The elements that made it profitable were rainy-day
reserves the company had set aside years before. What's needed at Nortel
is a change of culture. Email this page Format for printing Become a Fool!
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By Bill Mann (TMF Otter)July 7, 2004
Typical question in my inbox:
"Hi. I own Nortel (NYSE: NT). What do you think of this company?"
How I answer: "The company used the words 'terminated for cause' when they
fired the CEO, Frank Dunn, in April. There are many things that need to
happen before I'd be willing to even work on a valuation of Nortel."
How I'd prefer to answer:
"Frankly, there aren't enough controlled substances in the world to make
me find owning Nortel's stock desirable."
Let's be frank. I adore nasty situations where shareholders abandon a
company due to horrible news. This one is beyond the pale, though. A
litany of events at Nortel reads like a wayward version of How to Win
Friends and Influence People. Let's call it How to Win Friends and Cause
Them to Lose Tons of Money.
In May my colleague Ben McClure witheringly noted that investors had best
pay attention when a Canadian CEO is terminated, noting that his homeland
is a place "where bungling CEOs are normally punished by way of big pay
raises." That's pretty good comedy, right there. Even so, people were
piling into Nortel based on the presumption that the bad news had punished
the price down below where it deserved to be. Ben rightly noted that the
bad news was likely nowhere near its end. And while people could get
excited about a potential rebound in telecom spending (which is possible),
they also need to recognize that this is a company upon which no
trustworthy analysis can be made, because trustworthy financial statements
for the last three years do not exist.
Here are the greatest hits on what Nortel is facing:Nortel is currently
working on restatements of its financial statements from 2001 to the
present; Nortel is under investigation by the Securities and Exchange
Commission, the U.S. Justice Department and the Ontario Securities
Commission; Nortel is facing criminal investigations in Texas, while
Canadian authorities consider similar action; Its reported earnings from
2003 will be halved after the restatement; This is still at its essence a
telecommunications equipment company, and telecommunications hasn't turned
around; Nortel is in technical default with some of its creditors.
There's plenty more. Perhaps most disconcerting is the recent report in
the Wall Street Journal that Nortel's board discovered scores of
individual transactions that all conspired to make the company suddenly
seem profitable in 2003, when in fact it was not. Some of these
transactions were of such small amounts that they were almost impossible
to detect. That the deception took the perverse form of profitability by a
thousand adjustments suggests to me that the problems are quite systemic
in nature. Nortel's got some real cleaning up to do. As recently as
mid-2000 the public perception of Nortel rivaled that of Cisco (Nasdaq:
CSCO). Now it's not even Lucent (NYSE: LU). At least Lucent seems to have
cleaned up its mess.
Who stole cookies from the cookie jar?
Nortel's core business sank like a stone following the collapse of the
telecommunications buildout bubble. Nortel flew higher than most, sporting
a market capitalization well over $200 billion for most of 2000. The
company's business had grown threefold in the previous five years, to more
than $30 billion in revenues. Nortel spent aggressively to build out its
capacity to meet the anticipated ongoing demand, which failed to
materialize. A massive $19.2 billion quarterly loss in the second quarter
of 2001, exacerbated by massive writedowns of acquisitions, signaled that
the good times had come to a crashing halt.
There are two points in a company's life cycle where there seem to be a
higher than normal occurrence of financial chicanery: at a point of great
financial distress and at a point where a fast grower sees its growth
rates first begin to decline. In a matter of three years, Nortel has
encountered each of these conditions, and failed both tests.
As Nortel's new CEO Bill Owens noted in an April conference call (accessed
courtesy of CCBN), most of the company's focus for its 2003 restatement is
on an accounting convention known as accrued liabilities. These are
liabilities that a company believes it has generated but has yet to pay.
In Nortel's case, the majority of these liabilities were contractual in
nature -- they could be warranties, for example, or take-or-pay contracts.
Whatever they were, they started happening constantly at Nortel. Even as
revenues spiraled in the late 1990s, Nortel kept reporting accounting
losses as the company consistently took non-cash charges related to
reserves it set up for accrued liabilities. In an environment where pro
forma accounting was king, companies could easily wave these charges off
as being inconsequential -- green eyeshade stuff that investors should
ignore.
As with any company, some of these reserves served a legitimate purpose --
to placehold for money the company expected to have to spend to satisfy an
obligation. But Nortel also used these reserves for another purpose -- to
be able to bring earnings back from the dead should the company not be
able to live up to analyst projections. So Nortel might find itself a
penny short of expectations one quarter, but lo, it had a $100 million
reserve related to some pervious acquisition. The company simply reversed
the reserve and could count those $100 million as profits. Voila! Found
the penny!
Funds that were ignored when they were subtracted below the line were
plowed into operating results, where they weren't ignored at all. This
worked until it didn't -- when the fiber optics market became so putrid
that there wasn't any way to dress up the fact that Nortel's business had
collapsed. An internal audit in 2002 that was not disclosed to the public
found that Nortel had in excess of $300 million in inappropriately booked
reserves. These findings were never disclosed to investors, and some
executives at the company believe these amounts were simply added to
earnings in late 2002.
Mr. Dunn had pledged to drive Nortel back to profitability, and his
executive team had substantial financial incentives to succeed. But in
2003, these goals were impeded by the small fact that Nortel's customer
base was in horrible financial shape. In early 2003, however, the company
stunned investors by reporting a small profit. Two more positive quarterly
reports in the year helped drive Nortel's stock from well below a buck to
as high as $7.86. In these quarters the company released more than $380
million in reserves, giving its reported results the burst of oxygen
required to go from a reported loss to a reported profit. And wouldn't you
know it: the board determined that at least $160 million of that was
released improperly.
Systemic Audacity
The Wall Street Journal story paints a picture of a Nortel where diddling
reserves has been standard operating procedure for years, not only on the
corporate level (i.e., what's reported to shareholders), but also on a
division level. In April, William Kerr, the company's newly named CFO,
noted that all areas of the company's reported performance "could possibly
be affected in the restatement, including research & development, gross
margins, and general & administrative." They weren't just bleeding
reserves into the bottom line -- it was showing up everywhere.
There's something about the timeline I find mindblowing, though. In 2002,
investors complained about the company's deferred liability accounts.
Nortel did the audits and found $300 million in improperly booked
reserves. But this didn't stop the practice, as the company continued
monkeying with reserves. Its results in 2003 included another $380
million, enough to push the company's reported numbers into the black,
enough to trigger big fat bonuses for management and thousands of
employees. What is simply unbelievable about this, though, is that in May
of 2003, Nortel's board demanded that company executives clean up its
balance sheet and do an audit on years' worth of reserve accounting. So
even while the company was auditing itself, it was hitting the reserve
sauce at the exact same time. When the board received an external report
in April, it immediately moved to fire three top executives, including
Frank Dunn.
We can hope this is the end. In the meantime, people investing in Nortel
should know they don't have firm numbers upon which to base a valuation of
the firm. More to the point, Nortel will have to undergo a complete change
of culture before its business-as-usual becomes something that conforms
with accounting principles. This was a company that simply debased itself
to "make the number." That being the case, there may be more pain to come
as the restatement process continues.
Bill Mann owns none of the companies mentioned in this story. Come take a
look at the latest income bearing stock idea from Mathew Emmert! Take a
free trial subscription to Motley Fool Income Investor today! The Motley
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