Guest Post: Duncan Stewart

Nortel’s Q3 results are out, and they are just about as rough as I expected in terms of how the company did and what the immediate future looks like. On the other hand, the company was far more tentative than I expected in terms of strategy, divisions for sale, JVs, etc.

Let’s start with the financials and operating results – and I will just hit the highlights (…or lowlights!)

Operating Loss – Headlines aside, they didn’t REALLY lose US$6.85 a share. Most of that was goodwill and tax write-downs, and doesn’t matter much in the short or even long term. These are non-cash charges. If you back all that stuff out they lost somewhere between $0.30-$0.40 per share.

(A dime of the losses Nortel classifies as ‘special charges’ and should not be counted. I say that any charge that re-occurs on every quarter for the last 4 years and into the foreseeable future is a real loss!)

Cash Flow – Some heroic work by CFO Pavi Binning on working capital meant that cash loss from operations in Q3 was ‘only’ $144 million. Given how tough the quarter was it could have been much worse.

Cash Balance – Nortel had guided that cash balance would about $2.6B, and it was $2.3B. It ain’t a happy thing, but they had about $360 million in The Reserve Primary Fund which recently broke the buck and froze redemptions due to Lehman and the ongoing crisis.

I am not going to get too fussed by that – they will get most of that money back by 2011 when they need to start repaying the debt.

2009 Cash Use – We didn’t get full clarity, but it looks like Nortel will need to spend about $1.2B in cash for various things (restructuring, pension, debt payments, capex, cash taxes.) Which means that in order for their cash balances not to go down, they would need to generate more than that in other ways. Leaving aside asset sales, I don’t see how that is possible.

CDMA – This is (in my view) the killer. In the past few years Nortel’s CDMA division has been kicking out almost a billion per year in operating profits – it was the division that kept the company afloat. It wasn’t the ‘future’ of Nortel, but it was a cash cow. In June I asked management what would happen if CDMA revenues declined abruptly, and they said they saw it declining at 3% per year.

In Q3, those revenues dropped 30% yoy – or about 10x as rapidly. Eek. Some of that is due to the “one time” effect of the global financial crisis, but a lot of it is due to CDMA becoming the Hydrox of the chocolate cookie with vanilla icing world.

Strategy – None of it matters. The reorg is classic “rearrangement of deck chairs on the Titanic”, the staff cuts are modest and won’t get the company to profitability, the four execs thrown over the side will neither help nor hurt the company before 2011 debt repayments come due, putting services into the operating divisions will make them easier to sell piecemeal (but in this market no one is buying), we have no visibility on an MEN sale (or price), no insight on a possible wireless JV, and a takeaway that management doesn’t know how bad Q4 and 2009 might get. I am not bitching at them for that – no one knows how bad 2009 will be. But Nortel is in a tough spot and of all the telecom equipment OEM’s they are the weakest horse in the field.

Bottom Line – The company (and its industry) are facing headwinds that are as bad or even worse than 2000/2001.They will save some money from restructuring and cost controls – but in my view Nortel will see its cash balances decline by about roughly $1B in 2009 (it could be even worse.)

I also think the company will lose money at the EPS and operating margin lines – maybe a $250 million op margin loss for the whole year? (they have not given guidance so this is purely and educated guess with a bucket of assumptions.)

If they can sell MEN for a decent amount or come up with a creative way of handling wireless, they may be able to be a weak enterprise only player. If they do not do something on the M&A front the death spiral will intensify and customers will begin to defect at an increasing space, making losses even worse, cash flow more negative, etc.

Which is not to say that investors might not make money on the thing. Trading at roughly US$1, it could be broken up and might yield a decent return. In 1981 in West Vancouver my neighbour up the street had a cool-looking 1972 Super Beetle. It was under a tarp, and hadn’t run for 5 years. I offered him a bottle of single malt (Glenfiddich, $28) and my dad and I dragged it (the wheels didn’t rotate) 100 yards down the hill to our driveway.

It never ran again, but I took it to pieces and sold the various bits for a cumulative $800. Which, if I ignore the cost of the VW manual, various tools, hundreds of hours of my (and my Dad’s) time and the scratched cornea I got when a chunk of metal fell in my eye – is about a 2800% return!