Nortel to Sell Metro Ethernet Networks: Throwing Off Weight to Stay Afloat

| About: Nortel Networks (NT)

You know the situation is not good when a press release starts with this kind of sentence:

With a sustained and expanding economic downturn, the Company is experiencing significant pressure as Carrier customers cut back their capital expenditures further than previously expected and certain Enterprise and Metro Ethernet customers defer new IT and optical investments.

Translation: Nortel (NT) needs to aggressively reduce costs to deal with a rough economic and competitive environment.

In addition to likely job cuts, this means Nortel is looking to sell its Metro Ethernet Networks business, which includes its optical and carrier Ethernet portfolios. Nortel believes that it can “monetize this asset” given its strong customer base and technology, which includes 40G/100G optical networking products.

“Monetization of this asset is in line with the further consolidation necessary in the industry and will provide MEN customers and employees with a clear path forward,” Nortel CEO Mike Zafirovski said in a statement. “Throughout the process, Nortel will maintain MEN R&D investments, new product introduction timelines and all customer commitments.”

Over the first six months of 2008, the MEN business had management operating loss of $8-million on sales of $736-million, compared with a loss of $10-million on revenue of $736-million a year earlier.

If/when MEN business is sold, Nortel said it could use the proceeds to make investments to enhance its enterprise business, which has seen three small but strategic acquisitions recently.

Nortel also updated its Q3 and 2008 results. It nows expects Q3 revenue to be about $2.3 billion with gross margins of about 39%, most due to “a product delivery delay into the fourth quarter and customer mix within the Carrier business”. Operating expenses in Q3 (SG&A and R&D) will be $60 million less than the second quarter.

According to Yahoo Finance, analysts had expected Nortel to have revenue of $2.66-billion in Q3 and profits of six cents a share. For 2008, they were looking for profits of 38 cents a share on revenue of $11.2-billion.

Nortel’s revised 2008 outlook is:

- Revenue to decline between two and four percent compared to 2007, compared with an earlier projection of a single-digit increase.

- Gross Margin of approximately 42%

- Management Operating Margin(b) as a percentage of revenue to improve 125 to 175 basis points compared to 2007

- As well, cash balances at the end of Q3 and Q4 are expected be between $2.6 billion and $2.9 billion.

In many respects, Nortel’s  press release is a major harbinger of a completely different Nortel.

If you read between the lines of the press release and listen closely to the conference call, you’ll appreciate why CEO Mike Zafirovski describes it as a “pivotal” moment for Nortel, adding that “We clearly understand the status quo is not an option for Nortel”.

The most significant message is that Nortel has officially - and finally - decided it can’t be all things to all people. It can no longer remain competitive and viable by developing and selling a broad technology portfolio that meets the needs of a wide variety of carrier and enterprise customers. In the end, Nortel will be a small entity focused on two key business - Enterprise and Carrier VOIP.

“There is a challenge in being highly relevant in multiple areas of business,” Zafirovski said during the conference call. “We are realistic in today’s environment with our balance sheet as much as a number of us believe we can be successful in various segments, the view is that it will be very advantageous to take some decisions and focus on fewer areas.”

One of the key questions involving the sale of the Metro Ethernet Network business is who will acquire it and what they might be willing to pay - a key consideration given Nortel is looking for the deal to strengthen its balance sheet.

UBS analyst Nikos Theodosopoulos hit the nail on the head when he asked this question:

The logical buyers in the market are also suffering from similar macro issues and it could cause limited amount of interested parties to buy it given the desire to maintain cash. Have you seen interest expressed recently in that business by motivated buyers willing to pay cash for this business? Or are you entertaining the thought process that it is a valuable asset and buyers will emerge?

Zafirovski’s responded by saying:

We will not provide details of context in terms of discussions. We have gone through broad level discussions internally and with the board. We have used an investment banker from the outside, and gone through various options in respect to growth and opportunities to monetize.