Number Crunching on NT

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By Mark Evans | April 4, 2008

All About Nortel is a one-man show. I write it, produce it, script it, sweep the floors, etc.

That said, there are some really smart people who read ANN, and whose knowledge of Nortel and the investment landscape leave me in the proverbial dust. One of these people is Frank Burch, who, from time to time, sends along valuable tips and insight. It got me thinking that maybe it was time for the first guest post on ANN so without further ado, here it is:

Nortel: Some Valuation Points

The recently announced split of MOT yields some interesting valuation discussions…even with MOT trading near a five-year low. Of note recently is a Bank Of America piece that says the non-handset business has gross margins of 35% and operating margins of 8.6%. BofA values the business at 1X 2008 sales.

In comparison, Nortel had gross margins in Q4 of 43.7%, and will average around 43% for 2008. This is almost 25% better than Motorola’s non-handset business gross margin of 35% and 66% better than Motorola’s total GM of 26.3%. NT expects operating margin of 6.5% for the year, but had operating margin of 7.4% in the fourth quarter.

Under this valuation scenario, NT is today worth $11.3 billion. Divide that by 498 million shares and that yields $22.70. Take out $2 for NT’s debt, if you like, and the stock is still worth over $20, even under the current turnaround numbers. If NT management can improve operating margins by a little more and get some more 40G, LTE and other wins, maybe we even get some revenue growth. Then, things get interesting.

Need more evidence that NT should trade at over $20 now? Simple. Companies in much worse shape are trading at vastly higher valuations. Nortel’s business metrics are getting better…and other company’s metrics are not! NT’s most recent quarter’s gross margins were more than 1000 basis points above MOT, ALU, TLAB, ARRS and 700 basis points above ERIC and ADCT. And yet, NT is trading at a deep discount to all of these names by several measures that are used in turnaround investing.

In addition, the change in operating margin for NT (measured in basis points) was better than almost all of its competitors…even CSCO. So, they are making progress.

Basis point change in operating margin for the most recent quarter for selected companies:

NT +338

MOT -330

ALU +296

TLAB -614

ARRS -540

ERIC -895

CSCO -79 (admittedly hard to improve)

ADCT +383

FFIV -765

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Now, I’m not comparing NT to CSCO right now and claiming it is worth $88 per share. CSCO has gross margins in excess of 62%. Its customers care nothing about price, because they love the products and it’s a safe purchase. Great. Another World. NT will get there.

Instead of saying that NT should be valued like CSCO, let’s compare NT to a couple of companies that, like NT, have had their share of troubles and are working to get back to normalcy. Let’s look at ADCT, TLAB and ERIC.

ADCT has much lower gross margins than NT, but a higher operating margin. NT is investing far more in the selling organization and R&D to increase sales in 2008 and beyond. ADCT is doing some good things and has made better progress than NT on cost cutting and sales growth. However, ADCT has benefitted in recent quarters from the Verizon FTTP program which is not sustainable over the long term.

TLAB is 1000 basis points below NT in gross margin and more than 700 basis points behind in operating margin as they are negative for operating profit. Like NT, they are barely growing sales. They are in far worse shape principally because of their dependence on legacy products

ERIC has seen huge reductions in its margins recently, both gross and operating…and sales growth is less than NT in the latest quarter. Margin issues stem from its exposure to low margin GSM business in emerging markets.

First, a comparison of some operational metrics:

And here are some valuation measures:

Extrapolating NT to a 1.11x sales multiple yields a price in excess of $20. I think NT is worth far more than that, but they have to show operating margin improvement to get there. In my next piece, I will talk Operating Earning and EPS and the potential for NT in the short, medium and long term. In the meantime, start buying.

Finally, don’t you hate how some Wall Street analysts downgrade a stock before the market opens…when they know it’s opening down 20 points…and then they tell their clients they downgraded it at the higher price?

In the spirit of the bull of The Street, let’s just say I recommended NT at $5.73.