Nortel News: MEN Stats, Is the Board to Blame?, Shades of Desperation

MEN Stats

For those of you looking for more information about the profitable Metro Ethernet Network business, here are some facts from Nortel’s Q2 results

Optical networking Sales
Q2: $300M vs. $285M in Q2 2007
Six-months: $547M vs. $548M

Data networking and Security
Q2: $78M vs. $78M
Six-months: $158M vs. $188M

MEN revenues decreased to $705M in the first half of 2008 from $736M in the first half of 2007, a decrease of $31M or 4%. The decrease was primarily due to a decrease in the data networking and security solutions business of $30, while the optical network solutions business remained essentially flat.

MEN gross profit increased to $252M in the first half of 2008 from $242M in the first half of 2007, while gross margin increased to 35.8% from 32.9%.

The increase in gross profit was primarily due to higher volume, the favorable impact of foreign exchange fluctuations and lower costs due to our cost reduction program initiative.

This increase was partially offset by unfavorable product mix, royalty costs, charges related to certain inventory revaluation and the completion of two significant customer contract obligations resulting in the recognition of previously deferred revenues in the first half of 2007 that was not repeated in the first half of 2008 and increased costs due to a settlement with one of our vendors.

Is the Board to Blame?

In the wake of Nortel’s accounting scandal, the company went through an extensive restructuring.

There was a lot of change - a new management team headed by CEO Mike Zafirovski, a new auditor to replace Deloitte, and an overhauled board of directors.

With Nortel’s decision to sell its $1.5-billion Metro Ethernet Network business, it’s clear the company’s in a strategic crisis. If it abandons MEN, then Nortel is making a huge bet on the enterprise space where it has been, at best, a second-tier player.

As much as Zafirovski and his senior executives have put together the strategic plan to resuscitate Nortel, a key question is what role did the board play, and how much of the blame should the 11 directors get for Nortel’s current situation.

Ultimately, the board represents the interests of shareholders so if Nortel has been headed down the wrong strategic direction over the past three years, shouldn’t they share the blame?

Shades of Desperation

Neil Sedaka once crooned “Breaking Up is Hard to Do” but you have to wonder if that’s the scenario facing Nortel CEO Mike Zafirovski.

In the cold, harsh reality of yesterday’s announcement of even more restructuring and the contemplated sale of the Metro Ethernet Network business, Nortel’s future seems more uncertain than it has since the end of the telecom boom seven years ago.

In many respects, the potential MEN sale appears like Nortel is throwing in the towel. MEN is a fast-growing (10%/year), highly profitable business with revenue this year of about $1.5-billion that sells technology that helps make the Internet faster.

Why sell it other than the fact it’s an attractive business that, in theory, will be worth a lot? Heck, if there was a private equity firm with some cash and chutzpah, it would probably thrive away from Nortel.

To me, this decision smacks of desperation. Selling the UMTS business to Alcatel-Lucent  (ALU) made sense because it was a money-loser in a ultra-competitive landscape in which Nortel had single-digit market share. But MEN is one of Nortel’s best assets at a time when it needs all the strong horses it can in the stable.

BusinessWeek wonders whether the MEN sale is a harbinger of a breakup. The story includes this quote from long-time Nortel watch Duncan Stewart:

Nortel has entered a very difficult period that’s not likely to get better. “It’s going to be sold or dramatically restructured before Christmas.

In any event, the next two months before the Q3 results are released will be fascinating as Nortel puts together its restructuring plan.

Will thousands of more employees will slashed? Will MEN attract a buyer? Will other business units be turfed? Can Nortel compete in the services market against players such as IBM? Will the Canadian government let Nortel be chopped up?

Nortel’s decision to sell its Metro Ethernet Network business is a real puzzler to pretty much everyone it seems except Nortel’s executives.

In a research note, TD Securities analyst Chris Umiastowski said he was “shocked” by Nortel’s decision given MEN is seen as the company “crown jewel” and its 40GB optical transport technology has been a big success since its launch last quarter.

The MEN business does about $1.5 billion in sales per year, and we are told it is operating at approximately break-even. We’ve been bullish on this business unit and believe Nortel has been taking back market share. Selling the business now is a bad move, in our view. It won’t significantly alter the company’s profitability, and it hurts future growth. Unless Nortel can get close to 1 times sales for the business, we are not convinced it will help the valuation much to sell it. We would rather see the company divest its Enterprise business and focus solely on carriers.

Umiastowski has downgraded Nortel to a “hold” and slashed his target price to $3.50 from $10.

Two major holes have been shot in our bull thesis. They both relate to revenue growth. First, the change in outlook really takes the wind out of the sails on near-term growth. Without stable to slightly growing revenue it is very difficult for SG&A cuts to turn into EPS growth. Second, the sale of MEN takes away longer term growth potential that we feel the company needs to fight the weakening wireless business. We are not left with a catalyst that we feel can strongly support a buy recommendation.

Comments

[User 265329:]

It is hard to understand what the investment bankers are talking about with respect to Nortel, assuming they actually are saying sensible things. It does not seem reasonable that the price target shoud be revised from $10 to $ 3 because of a 4% shortfall in revenue, in an enterprise with 40% gross margin. It seems that the market reaction is being overdone, since if costs are cut Nortel can be profitable even without substantial growth, which is what I understand the CEO is saying.

2008 Sep 18 04:32 PM