Before I get to that, though, there is one point that I'd like to clear up. When I discussed Nortel's place in the optical market and who it views as its competitors, I mentioned that the company representative I met with does not view Cisco Systems (Nasdaq: CSCO) as a competitor in optical at this time. Personally, I disagree with that statement. If I didn't, it's quite possible that I wouldn't own shares of Cisco in my personal portfolio.
Based on the information that I've heard on Cisco's conference calls, as of last quarter Cisco's annualized rate of optical sales was $640 million. It's expected that figure will rise to $1 billion this quarter. While that number is much smaller than Nortel's expected sales of $10-11 billion for the current year, it's certainly nothing to sneeze at. When I met with them, Nortel did also mention to me that it expects Cisco to become more of a competitor in optical in the future.
I closed last Friday's report by saying that based upon its business and competitive position, Nortel could be a Rule Maker, but we have to look at the numbers to see whether it can join Cisco as the second networking infrastructure Rule Maker company. One thing to keep in mind here is that Nortel is a Canadian-based company. As such, it wasn't until the end of last year that Nortel started reporting its financial statements under U.S. Generally Accepted Accounting Principles (GAAP).
I got all the numbers I used for my analysis directly from Nortel's website, which has a wealth of information for investors. I compiled a lot more Rule Maker numbers for the company than I'll talk about in tonight's report. If you're interested in seeing some of them you can also check this discussion board post.
Okay let's move on to the numbers. While parsing through financial statements is viewed by some as a chore, I consider it an important and quite revealing exercise. The financials allow us to make some objective assessments of how a company is performing. These numbers can also be used to help us draw conclusions about how a company stacks up against its competition.
- Sales Growth > 10% -- In the first quarter of this year, Nortel had sales of $6.3 billion, which was an impressive 48% increase over the first quarter of 1999. Demand for Nortel's products has really picked up over the past few years. The last time Nortel had year-over-year sales growth for a quarter of less than 10% was in the first quarter of 1998. The last time that it failed to grow sales by more than 10% on an annual basis was in 1994, which completed a three-year stretch of pretty anemic sales growth.
- Gross Margins > 50% -- I looked at Nortel's quarterly numbers going back all the way to 1997. For the first quarter of this year, Nortel's gross margin came in at 41%. The company has never had gross margins above our target level of 50%. Part of that certainly relates to the greater price sensitivity that's found in Nortel's traditional telephony business. I would expect that Nortel's recent efforts to outsource some of its manufacturing processes as well as other supply chain initiatives may boost its gross margins a bit in the future.
Nortel's gross margins may also get a boost due to some recent accounting technicalities. According to some reading I've done, Nortel has been expensing wireless equipment that it has sold to AT&T Wireless (NYSE: AWE) without recognizing the related revenue. From what I've read, this revenue won't be recognized until the third quarter of this year. Such accounting is certainly conservative, and I'd much rather see this approach than learn that the company is overstating revenue. Since the expenses have already been recorded, we shouldn't be surprised if Nortel's gross margin improves in the third quarter when this revenue is recognized.
- Net Margins > 7% -- Nortel's net margin of 12.6% in the first quarter was its best performance over the entire period for which I compiled the numbers. As Nortel converts some of its ways from those of an "Old Economy" company to those of a "New Economy" company, it's not surprising to see that its net margins are improving. Much like Cisco, Nortel is also "eating its own cooking" by using many of its products to run its business more efficiently.
(Sidenote: I should point out that I made a couple of adjustments to calculate Nortel's net income. I eliminated the following amounts from net income: acquired in-process research and development, acquired technology, goodwill amortization, special charges, and gain on sale of businesses. You should note that I did not modify income taxes based on my adjustments. Since I generally added non-cash expenses back to income, it is likely that the amount of Nortel's tax provision would also have been different without these items. I don't know the exact result here, so I chose to just ignore the income tax effect of my adjustments as they're not likely to have had a material effect on my analysis.)
- Cash-to-Debt Ratio > 1.5 -- Nortel has built up its cash level over the past year and kept its debt level relatively flat. The end result is that its cash-to-debt ratio has increased to 0.87 as of the first quarter of this year (it was as low as 0.20 in 1998). That's a nice improvement for Nortel, but it still falls short of our benchmark.
One thing to keep in mind here is that Nortel has issued preferred stock, which can be thought of as a debt equivalent. Consequently, when I calculate a company's ratio of cash-to-debt, I treat preferred stock as debt. A look at Nortel's income statement should shed some light on why I've chosen to do this. If you take a look, you'll see that there is a line called "dividends on preferred shares" that appears between the net income (or loss) line and the net income (or loss) applicable to common shares. When I calculated Nortel's net margin, I used the income applicable to common shares as a starting point. Since the preferred dividends represent amounts that aren't available to common stockholders, I view these dividends as being akin to interest expense and treat the underlying preferred stock like long-term debt.
- Flow Ratio -- Nortel's Flow Ratio currently sits at 1.68. That's not a terrible result, but it's not a Rule Maker performance either. When a company's Flow is outside the Rule Maker range, one thing that I like to look at is the cash conversion cycle (CCC), as this helps give me some more insights in to the ways that a company can improve its Flowie.
Here's what I found for Nortel: It currently takes the company 100 days to collect revenue from its customers, 88 days to turn over its inventory, and 62 days to pay its non-interest bearing bills. That leads to a cash conversion cycle of 126 days, a result that's not out of line with its historical performance. This can be contrasted to Rule Maker Cisco, which has had an average CCC over the last three years of 57 days. Clearly, Nortel could do a much better job of making its customers pay their bills. It's encouraging to note that Nortel has taken some initiatives directed towards improving its supply chain management which should help shorten its inventory turnover cycle.
- Cash King Margin (CKM) > 10% -- On a quarterly basis Nortel's CKM is really all over the map. In the first quarter of this year it was an awful -113%. It's actually not unusual for Nortel to have negative free cash flow in the first quarter, a result that follows its typically strong fourth quarter. During 1999, Nortel posted a CKM of 8.3% for the year. This performance was achieved even though its free cash flow for each of the first three quarters of the year was negative. I have to admit that I don't know the reason for this uneven business performance. It's clearly much different than that of Cisco.
If one is looking for a true Rule Making networking infrastructure company, then Cisco is the way to go. Alternatively, if you're looking for a second large player in this industry, Nortel appears to be a much stronger performer from a Rule Maker perspective than Lucent (NYSE: LU). That said, Nortel still falls short of Rule Maker status in four of our six financial criteria. This conclusion also happens to be in-line with your 71% majority decision to choose Cisco as the networking industry representative up for investment consideration in our upcoming Rule Maker Seminar.
If you wish to discuss this report further, please feel free to ask your questions on any of the discussion boards linked below.
Phil Weiss (TMFGrape on the boards)