Think the Bad News at Nortel Is Over? Think Again
You'd think projecting a $19.2 billion loss for the June quarter would mean
Nortel
(NT)
had put all the bad news behind it, especially given that the June 15 announcement marked the third time the company has warned this year about lower-than-expected earnings and revenue.
No way. Nortel's own numbers argue that the company has at least one more dose of bad news in store for investors. And that, I think, pretty much tells us how the stock market, and the market for technology stocks in particular, is going to behave over the next two to three months.
Let me start by telling you how I see Nortel's numbers adding up. Then I'll give you the three stock-market lessons I see in the company's figures.
"Kitchen-Sink" Accounting
On Wall Street it's known as a "kitchen-sink quarter." In order to clear the decks of all the bad news -- and, cynics would say, to make the present look so bad that the future must look better -- a company will report an operating loss for the period and then pile on all the special charges it can think of.
Nortel's June 15 warning certainly resembles that kind of "all-the-bad-news-we-can-think-of" approach. Revenue for the quarter that ends on June 30 will come in at about $4.5 billion, way short of the $5.7 billion to $6.2 billion expected by Wall Street analysts. That would result in an operating loss of about $1.5 billion. In addition, the company said it would take two one-time charges against earnings -- one of $650 million to write off excess or obsolete inventory and another of $300 million to write off bad debts and other investments.
But that was just the start of the bad news. For the quarter, Nortel was planning to write down $12.3 billion in goodwill -- that intangible asset put on the books after an acquisition that represents the difference between the book value of the acquired company and the price the acquiring company actually paid -- from deals such as the purchases of
Xros
and
Qtera
. Another $2.6 billion charge would account for the cost of closing some existing businesses and writing down some more goodwill. Then there's almost $1 billion in "restructuring" charges to account for the 20,000 job cuts Nortel had announced earlier.
Add in a few odds and ends and the total comes to $19.2 billion.
Now the purpose of all this, plus the new round of 10,000 job cuts that Nortel announced as part of this bad-news package, is to reduce the company's cost structure to a point where it can make money even at a lower level of sales. That's imperative because Nortel will watch $2 billion in cash flow out the door in the June quarter with the current cost structure. After all the cuts and asset sales, the company says it will have reduced its break-even point to $20 billion in annual revenue, or $5 billion in revenue a quarter.
That's great, except that Nortel isn't going to see a $5 billion quarter for quite a while if current trends keep up. Certainly not in June, when revenue is expected to top at $4.5 billion. And not for the rest of 2001, either. Analysts and Nortel itself say that spending on telecommunications equipment continues to fall. In its warning, Nortel said it doesn't expect a meaningful improvement in telecom carrier spending until the second half of 2002.
That may be wishful thinking, because even a relatively optimistic Wall Street investment firm such as
Robertson Stephens
is projecting a 12% decline in carrier capital spending in 2002, and a 6% decline in 2003. If you believe those projections, Nortel isn't likely to see a quarter of $5 billion in revenue until the fourth quarter of 2002.
By its own figures, and even after the current round of cost-cutting, Nortel is looking at six straight quarters -- including the current June 2001 period -- of sub-$5 billion in revenue. That means six straight quarters of operating losses.
Now, Nortel is a rich company --
Goldman Sachs
calculates that Nortel has access to $7.4 billion in cash or credit -- so it's not in any danger of running out of money. But like any big company, it depends on the short-term commercial paper market to fund its day-to-day cash needs. Continued operating losses increase the cost of rolling over that debt.
Already,
Standard & Poor's
has put Nortel on credit watch, a step that's often followed by a downgrade. Nortel's creditors are going to find it very hard to find any enthusiasm for a restructuring plan that shows six more quarters of operating losses.
So rather than a draconian bite-the-bullet plan to put the company into the black as fast as possible and at any cost, Nortel's June 15 announcement is just another step on the road to the eventual "right-sizing" of the company. Unless you believe that the telecommunications-equipment market is headed for an earlier-than-expected turnaround -- and I don't -- it's reasonable to expect at least one more warning and one more round of restructuring from Nortel before the end of the September quarter. The company will have to present a plan, on the basis of current market trends, to get to break-even on $4.5 billion, or even $4 billion, in quarterly revenue.
Learning From Nortel's Troubles
It's tough for a company to roll back its cost structure to the level of 1998, but that's what Nortel is in the process of doing. That year the company took in revenue of $17.6 billion -- about the $17.3 billion level that Robertson Stephens forecasts for Nortel's revenue in 2002 -- and showed a loss of $90 million before special charges. In 2000, revenue at Nortel came to $30.3 billion. But that year the company's selling and general administrative expenses were 77% higher than they were in 1998. See why this process is so hard and why it's taking Nortel so many tries to get it right?
So what are the stock market lessons in Nortel's numbers?
1. June redux in September:
Investors can expect another round of warnings, restructuring plans, job cuts and asset sales from technology companies in the run-up to the announcement of September-quarter earnings in October. If we're lucky and the rate of revenue decline in capital equipment spending has started to moderate, that set of restructurings might be the last major wave.
But judging from the shortfall between what Nortel has announced and what it has to achieve, come September we can count on at least one more period of bad news much like the one that investors are suffering through now.
2. April redux in July:
Just as we saw in April, investors can expect a rally in July on actual earnings as we get over our shock and realize that as bad as losses being announced right now are, they don't signal the end of the world. Look at Nortel as an example. As amazing as a loss of $19.2 billion in a single quarter may be -- and I find it breathtaking -- Nortel isn't likely to go bust. But at a recent price of $8 a share, it's certainly being priced as if its long-term future as one of the two or three dominant telecom-equipment makers were in doubt.
In 1998, Nortel traded in this range during the Asian financial crisis; I think you can make a good argument that $8 was a panic price then and that $8 is a panic price now. At least I expect to hear analysts and strategists make that argument this July. I can see Nortel getting as high as $10 or even $12 on this logic, pretty much where it bounced to after the crisis passed in 1998. Of course, once the
Federal Reserve rode to the rescue in 1998, the crisis was over and the market began a huge, sustained rally.
This time around, however, the financial markets aren't likely to get any such instant fix. For the reasons noted in Lesson No. 1 above, I think the rally is likely to be temporary, although I hope it continues the slow process of healing the wounds left by the bear market. It's certainly tradable, but watch out for the correction on the next batch of bad news.
3. Future winners:
Some new long-term winners will emerge from this period of "right-sizing." Leading the list, I think, will be those companies that didn't gorge on high-priced acquisitions and are now sitting on enough cash to pick up a solid business at a discount.
Nortel is, for example, discontinuing its entire broadband and narrowband access solutions business. Will a competitor step up to buy that business, which accounted for about $500 million in quarterly revenue, at a bargain price? Good chance, I'd say. Who? Too early to tell. So far, potential acquirers of the technology businesses that are on the block haven't announced themselves, preferring to let cash-strapped sellers dangle nervously in the wind. But you can bet that when the dust has settled, a few clever CEOs will have managed to snap up key assets for a song, or even to piece together enough discarded businesses to dominate a niche.
We're still in the destructive stage of this economic cycle, but I think we're getting close to the point -- no more than six months or so -- where the farsighted start to build for the future.
To get to that constructive stage, we've got to put up with some destruction, I'm afraid. But there's no reason that an investor can't occasionally profit from this destructive, reorganizing, downsizing part of the cycle.
A number of times in this column I've mentioned the possibility that Nortel could go bust, which is a very outside chance, at best, in my opinion. In my next column, I'll write about why an investor never wants to see a stock he or she owns go into bankruptcy, but why owning one coming out can be very profitable.
At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column.