TO CHEAP TO IGNORE
By James B. Stewart
May 4, 2004
AS AN INVESTOR, I love a "special situation," an investment opportunity that I believe will pay off regardless of the overall direction of the market. I've described several of these in previous columns, such as Tyco (TYC) and Time Warner (TWX), and now there's a new one on the horizon: Nortel Networks (NT).
Special situations can come in many varieties, but recently they've been spawned by corporate scandal. The question isn't whether something bad has happened to the company in question — it has. The question is whether the possibly illegal, fraudulent or scandalous (or all three) activity goes to the heart of the company's business and earnings. In other words, is it another Enron, or have investors panicked and overreacted?
In the cases of Tyco and Time Warner, it's safe to say the market has rendered its verdict, even if a jury couldn't reach a decision in the Tyco criminal case. Tyco shares, after hitting $8.25 in July 2002, have been nearing $30, a more than 300% gain. Time Warner also hit its low that same month (it traded then under the symbol AOL), $9.64, and has recently traded near $17. Time Warner reported excellent results last week, surpassing analysts' expectations and even showing some modest improvement at its troubled AOL unit. Early Tuesday, Tyco also reported stellar numbers, including a sixfold profit increase in a year's time that beat analysts' expectations handily.
Both of these situations, which I addressed in my columns of July 30, 2002, and Oct. 29, 2002, have paid off handsomely, with far bigger gains than the overall market. It takes only a few scores like these for a portfolio to far outperform the market averages. And the issues that sent the companies reeling in the first place still haven't been resolved. The SEC continues to investigate both companies, and the Tyco executives will be retried on criminal charges. So there's still a cloud over the stocks. I continue to own positions, though I've taken many of my profits off the table by selling my deep-in-the-money options and buying new ones closer to the stocks' current prices. I still maintain that Time Warner is worth at least $25 a share and probably more. Tyco strikes me as more fully valued, but it should continue to benefit from the economic expansion.
Which brings me to Nortel. Last week the stock plunged nearly 30% on news that the telecommunications equipment company had fired its CEO and other top executives because of accounting irregularities. Readers may recall that I'd already bought some Nortel the week before, when it announced the accounting problems — but not the executive firings — and the stock dropped about 20%. The market reaction last week made no sense to me, since Nortel had already disclosed the accounting issues. The only news was the dismissal of the CEO and other executives, to which I say, good riddance. I see that as a positive development. Recall that Tyco and Time Warner both replaced their chief executives, which helped stabilize those situations.
Then there are the accounting issues themselves. These are not Enron-scale disclosures. In a meeting last week with analysts, Nortel's new management stressed that it has uncovered nothing that would seriously change revenue. Rather, it's likely that substantial profits booked in 2003 will be shifted back to 2002. The dismissed Nortel executives had financial incentives to realize a profit in 2003, which may have induced them to delay revenue recognition in order to depress profit in 2002, and raise it in 2003. This may be fraud, and it may warrant their dismissal, but it is of primarily historical interest to investors. What matters is how Nortel's business is doing now, and how it's likely to perform in the future.
That's hard to assess, since Nortel is delaying the release of its financial results until the accounting mess is cleared up. But when it last reported, its businesses were faring quite well, especially its fast-growing voice-over-internet protocol unit and its cellular unit. On the strength of those results, Nortel's stock rose to above $8 a share as recently as February.
Of course there are risks. That's what makes this a special situation, and why potential returns are high. But I feel strongly that this recent sell-off represents an excellent opportunity. I believe Nortel is a fundamentally sound company, better positioned than its chief rival, Lucent (LU).
So I'm buying more Nortel at the recent bargain price of under $3.50 a share (at that low price, I didn't bother with options). No doubt there will be some more bad news before this is over, but I'm prepared to be patient. I'd love to see Nortel's stock get back to $8. And if the beleaguered telecommunications sector finally starts to recover, it could go much higher.
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