Financial Post, April 15
Amid the regulatory investigations into Nortel Networks Corp.'s accounting troubles, there has been little attention paid to the telecom equipment maker's business and the modest improvement happening in an industry recovering from a severe three-year slump.
Granted, it is difficult to seriously look at Nortel's fundamentals when there are U.S. Securities & Exchange Commission and Ontario Securities Commission investigators looking to interview the company's executives and sift through the books.
With little information available, it is difficult for investors to tell whether Nortel is about to be engulfed in a complex accounting scandal or whether the company's independent audit committee and regulators will discover minor issues that could see it receive a slap on the wrist and be sent to a corner for a corporate time-out.
For anyone considering an investment in Nortel or trying to figure out what to do with shares they own, April 29 will be a crucial date when the company reports first-quarter results.
Nortel chief executive Frank Dunn, who has been invisible since the company disclosed last month it will likely need to re-state financial results from 2000 to the third quarter of 2003, will be available to analysts on a conference call.
There is a distinct likelihood Mr. Dunn will attempt to bob and weave around questions about the accounting problems and the regulatory investigations. This will frustrate analysts looking for insight into issues such as why chief financial officer Doug Beatty and controller Michael Gollogly were placed on paid leave last month.
With this in mind, investors with a healthy appetite for risk will have to examine Nortel's business. Investors who pursue this exercise will discover Nortel is well-positioned to capitalize on growing demand by carriers for new equipment to roll out wireless and Internet-based services.
“Their industry is improving, their competitive position is strong and continues to get better, and gross margins are historically higher than they have ever been,” said Duncan Stewart, a partner with Tera Capital. “The products Nortel seems to be best at seem to be the ones likely to grow faster than overall market, and have higher margins. From a fundamental perspective, the company is very well positioned.”
Mr. Stewart said the challenge facing investors is balancing Nortel's improved prospects with the regulatory and financial uncertainties looming over it. He said Nortel stock is worth $10 to $12 but it should trade at a 25% discount to fair value to account for the regulatory risk.
“If everything comes up roses, it goes back to $10,” he said. “If everything comes to a likely level of badness, it goes to $5. I do not see the SEC and OSC investigations culminating in the company going bankrupt. The scenario is they go into the penalty box, the stock could go to $5. I believe it is much more likely that if it goes to $5, it won't stay there long, and if it goes to $10, it will go higher.”
Nortel shares closed down 17 cents to $7.70 in Toronto yesterday. According to Bloomberg News, 20 analysts rate Nortel a “buy,” 11 a “hold” and two a “sell.”
From a business perspective, Nortel is poised to do well because of its strength in the wireless and Internet Protocol markets. In 2003, wireless sales accounted for 44% of Nortel's US$9.8-billion in revenue.
During the past couple of years, the company's willingness to aggressively invest in research and development has played a key role in helping it produce leading-edge wireless technology at a time when carriers are looking to boost the speed of their networks to launch new revenue-generating services.
This has given Nortel a competitive lead over rivals such as Ericsson Telephone Co., Siemens SA, Nokia Oyj and Lucent Technologies Inc. A big advantage is Nortel's strength in different wireless technology sectors, compared with Lucent, which has pinned its wireless hopes on a single standard called code-division multiple access.
Nortel is also benefiting from the growing interest in Internet-based technologies as carriers look to migrate their networks from older circuit-based systems. Carriers are buying Internet equipment because they can reduce costs by putting voice, video and data traffic on a single network. This makes these networks less expensive to operate and maintain.
An important driver is Internet telephony, otherwise known as Voice over Internet Protocol. Nortel should see healthy sales as carriers look to reduce operating expenses, and cable companies move into the telephony market.
Mr. Stewart said VoIP is an attractive business because it is software-intensive, which creates a large barrier to entry. It also requires high standards before the technology is adopted by carriers, which is something Nortel has established as a long-time industry supplier.
Mr. Stewart said another important issue is Nortel's ability to attract business by offering carriers new Internet telephony features such as call-waiting and 911 that can generate additional revenue.
“As Nortel comes up with solutions, it tends to lock the customers in more than selling them a photonics part,” he said. “This [business] is unlikely to be commoditized as quickly.”
While Nortel has an attractive product portfolio at a time when industry conditions are starting to rebound, its accounting and regulatory woes cannot be brushed aside.
Kevin Mitchell, directing analyst with Infonetics Research Inc., said these problems may deter customers from entering large, long-term deals until the investigations are completed.
“I don't think anyone thinks they will go out of business but one of the chief concerns is financial stability of technology suppliers, and it will be a question mark and a red flag for a while until it's resolved,” he said. “Nortel has been clicking and doing pretty well. [The accounting and regulatory investigations] are an unfortunate stain on their record. These things can drag on for quite some time, and it can hurt larger three- to five-year deals service providers would sign.”
Nortel Beyond the Accounting Woes