What is Nortel’s Investment Thesis? 9 comments
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Last week on February 27, Nortel Networks Corporation (NT) reported fourth quarter net loss of $844 million, or $1.70 per share. Added to the economic slowdown and low North American carrier spending, Nortel also had to deal with a change in Canadian tax profile with a $1.1 billion tax write-down.
Following 2900 job cuts in 2007, it plans to save $300 million in 2008 by cutting 2100 more jobs and moving 1000 positions to high-growth, low-cost locations. Earlier coverage is available here and here.
Revenue in Q4 was $3.2 billion, down 3.6% y-o-y and up 18.5% sequentially. Excluding the impact of the UMTS Access divestiture, revenue grew by 2% y-o-y. Gross margin was 43.7%, up from 39.8% last year and 43% in Q3.
For 2007, revenues were $10.95 billion, down 4% and up 2% excluding impact of UMTS Access divestiture. Net loss was $957 million, or $1.98 per share, compared to net earnings of $28 million, or $0.06 per share in 2006.
Segment-wise, Q4 Carrier Networks [CN] revenue was $1,346 million, down 9% y-o-y and up 25% sequentially, affected by the UMTS Access divestiture, partially offset by growth in CDMA and VoIP. Excluding the impact of the UMTS Access divestiture, CN revenue declined by 2% y-o-y.
Enterprise Solutions [ES] revenue was $762 million, down 3% y-o-y and up 14% sequentially, affected by lower y-o-y revenues from the LG-Nortel joint venture, partially offset by growth in voice, data and applications businesses.
Global Services [GS] Q4 revenue was $605 million, up 12% y-o-y and 12% sequentially driven by strong growth in network implementation services, support services and managed services. Excluding the impact of the UMTS Access divestiture, GS revenue grew by 32% y-o-y.
Metro Ethernet Networks [MEN] revenue in Q4 was $429 million, down 4% y-o-y and up 19% sequentially. The y-o-y decline was mainly due to decreases in long-haul optical revenue and legacy data, partially offset by increases in metro optical.
For 2008, Nortel expects revenue to grow in the low single digits. Gross margin is expected to be about 43% of revenue. There are rumors of a possible merger of the wireless infrastructure divisions of Motorola and Nortel. President and CEO Mike Zafirovski was formerly the president and chief operating officer of Motorola. Its stock is currently trading around $7.71, hitting a new 52-week low. Market cap is around $3.4 billion, close to its Q4 revenue.
Pretty ugly situation. How the company gets turned around, is difficult to assess. There doesn’t seem to be any strategic guidance from the management, besides continued drastic cost-cutting. In contrast, at least 3Com (COMS) has an investment thesis, even though they have their own headaches with the government.
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This article has 9 comments:
Jack Welch had one principle which said that if a business was not number 1 or 2 in its market then you must fix it, shut it down, or sell it. Mike Z did that with the UMTS access business that will contribute to margin growth by getting rid of a loser. Doing these with 3 or 4 of the big losers will contribute to overall margin growth.
After 5 years of no hiring of new graduates, Nortel has once again started to hire new graduates. This influx of fresh blood will allow the company to continue to develop and deliver products in about 10 years. Without the fresh blood, they would have been dead in 10 years.
Nortel has started to use open-source software to leverage research and development. For example it uses Linux in its BCM products, and other products. It also contributes back to the "carrier-grade Linux" core. As it does so, it will gain progressively more R&D leverage.
Nortel has outsourced software development indiscriminately. Sustaining and evolution work are great for outsourcing, but new product development needs to be kept close to the business leaders. Nortel needs to eliminate the practice of keeping the business and technology leaders in North America while developing software in India and China. If they want to leverage the low-cost labour of those countries, they should set up P&L units in India and China with the business leaders co-located with the R&D teams.
Nortel is trying to bring in process excellence because it worked at GE. Process excellence worked at GE because GE's businesses have extremely high natural barriers to entry. Nortel has no such luxury, and as a result investments in process excellence often have high opportunity costs that manifest themselves in increased time-to-market, high non-recurring engineering costs, and high product costs. They need to tread carefully with this one.
With the successive layoffs and bad news of the last 7 years, Nortel has severely crippled its culture of technology and product innovation. Today, you just don't see technology leaders take chances on key new core technologies as they did in the past (e.g. advanced codecs, Protel programming language, SOS operating system, PLS source code control, credit-based flow control, DSL, etc.). They stick to "industry standard" technologies, and as a result, get "industry standard" R&D. Nortel also used to innovate in products. DigitalWorld turned Nortel from a technology backwater in Canada to a leading telecomms equipment firm. FiberWorld continued on that. The Meridian/Norstar products utterly transformed the Small-Medium Enterprise market by bringing them phone features normally reserved for very large companies. Not having great innovation in products and technologies will hinder them from growing their top line beyond population growth rates. Of course, those great products and technologies came from BNR which was the separate R&D unit. Nortel needs to bring back BNR if it wants to develop innovative new products.
Nortel will become profitable under Mike Z, but top line growth can only come from innovation in products and technology.
You ask a great question. The strange part is Nortel hasn't answered it all amid all of its restructuring activity.
Mark
other thoughts:WHY INVESTORS SHOULD PILE INTO Nortel NOW
1. You have skipped the first 2 years of a tough turnaround. The 3rd year is key…Jack Welch will tell you that.
2. Much has been accomplished, despite stock selloff. Every operational metric is in better shape.
3. Margin improvement was better at NT than at any competitor over the last year.
4. Key investments have also been made. NT’s market cap about equals what it has spent in the last two years on R&D. This should bear fruit soon.
5. Numerous potential catalysts.
This story gets really good quickly, or someone acquires the Company and all associated revenue, intellectual property, a great North American installed base, a senior management team, AND they eliminate a competitor in the emerging enterprise business and other areas.
For a strategic buyer, it is a no brainer. For CSCO in particular, it is a no brainer. This is not a large acquisition for them. They could pick the locales and employees they wish to retain and shutter the rest. With almost no NT R&D, they would make huge and immediate profits in the remaining businesses, and be able to keep those businesses competitive through ongoing CSCO R&D. Eliminating NT as a possible enterprise competitor forever is worth billions of loonies alone.
A financial buyer also makes sense. Everything is working but the stock price. NT is set to be massively profitable, but the distraction to management and key employees of a diving stock price can hinder the underlying performance. As a private company, the proper cuts could be made…the Canadian press be damned. Certain operations could be sold off for quicker financial results. Management could also focus on bolt on acquisitions and such things rather than an embarrassing stock price decline.
Activist investors could help facilitate quicker management action or a sale.
The opportunity
In short, NT management is managing the company for a long-term turnaround. They are making the tough decisions to build a “great company”. CEO Zafirovski said it would take 3 to 5 years…it looks like 4 to 5 years. Along the way a number of key changes have occurred which call into question this strategy. First, the telecom service providers have undergone a massive consolidation and new entrants have not materialized since the bubble of the late 1990’s. Second, a number of NT‘s competitors have merged (ALU) or formed joint ventures (Nokia-Siemens). Third, competition from Asian competitors has increased significantly particularly in the higher margin more technically challenging areas (WIMAX).
Now 2 years into the turnaround and despite a tough environment much has been accomplished:
1) The Businesss Transformation Plan has substantially reduced costs; improved NT’s market position in key product areas ; better aligned NT’s strengths with customers needs and focused R&D spending on growth technologies.
2) The Q4 gross margin of 43.7% was the highest in five years.
3) Operating Margins are up 350bps year over year.
4) Zafirovski has replaced virtually the entire senior management team with seasoned executives with proven leadership and business skills.
5) NT has resolved its legal and regulatory issues thus eliminating an important overhang and potential liability.
6) NT has completed a complete overhaul of its finance department including the implementation of a world class IT reporting system from SAP.
7) Cash flow from operations has steadily improved due to increased focus on working capital management and savings associated with the BT program.
8) NT has successfully re-financed its outstanding debt maturities and does not need to raise capital to implement its turnaround. Net debt is under $1 billion and there are no significant debt maturities coming due.
They have over $11 billion in Sales…could make $1.40 operating earnings next year. Stripped down, NT could make a lot more than that. NT spends $1.6 billion per year on R&D. That is $3.20 per share per year in R&D. R&D is important, but they are overspending in anticipation of being a 13% OM business. RIMM spends $250 million per year, for example, less than $0.50 per share which is 8% of revenues versus NT’s 14.8%
NT has accomplished a lot, but not enough. If a turnaround stock remains stable or trends up, then a turnaround management team has the luxury of plugging along in their grand plan. But, NT’s stock price has been destroyed…down from $32 to 7.70 in 12 months. In this time, a lot at the Company has improved. Gross margin has been up in each of the last six quarters and is significantly better than its competitors.
So progress has been made, but the market has pulled the rug out from under them. They are out of time. Now, they need to drastically increase their efforts to get dollars to the bottom line. They have lost the luxury of taking their time, and now are an easy target for CSCO and others.
Their mistake… a little arrogance and small misses that hurt BIG
After a good Q3 in terms of revenue and gross margin, management committed to meaningful opex improvement and mid single digit sales improvement. At the “fireside chat” in mid November, Zafirovski reiterated the guidance including the operating margin of high single digits. After decent top performance in Q4 from NT’s key competitors, investors had every reason to expect a strong Q4 with no surprises. Instead, NT missed guidance. They compounded the failure by not pre-releasing and thereby hanging key analysts out to dry.
The extreme market reaction demonstrates the loss of confidence and management lack of understanding regarding the patience of the investor base. You can spend $1.6 billion in R&D and go on your merry way of restructuring…buy you have to show broad, consistent improvement.
In particular, they have been slow to cut costs in the finance area so as to be conservative and extra cautious with their accounting. Now, with the 3rd closing of the books under the newly installed SAP system, we hear that an easy $200 million can come out of the finance area alone. The company must also start to show fruit for its expensive R&D efforts or do a better job of explaining how $1 invested in R&D yields a consistent $0.13 operating profit. In short, NT must prove that it can and will be paid by customers for its efforts
With any progress at all, NT will have $11.3 billion in revenue this year and close to $12 billion in 2009 with new products from R&D coming online strong. $12 Billion multiplied by a 13% operating margin yields a $3.12 per share run rate exiting 2009.
Valuation ridiculously low by any measure versus peers
In this analysis, I use price to sales, because we know that by the right cuts, NT can easily get to industry profit margins. NT will get to 13% operating margin by 2009…or sooner if they get more aggressive. The last quarter WAS 7.41%, up 340 basis points year over year..
So, to summarize, why get involved?
1. Underlying business value when restructuring and R&D yield 13% om
2. Strong acquisition potential
The fact is that Nortel has great direction with it's executive management and it has great products. If the media gets on board and begins promoting Nortels very very strong solution portfolio, the turn around many have been waiting for will happen.
A breakup or major pruning is needed to focus on fewer offers.
A tough choice for this company's culture to swallow.
Cut this bad boy up into pieces and sell anything that is worth anything. I'm out of this stock permanently.
They don't seem to have updated their high-end routers since 2000 or their layer 4-7 switches since 2001. Market share in both markets seems to be in single digits and dropping. Are they dropping out of data all together?