October 26, 2000
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A Foolish Read on NT
They told us, Fools!
Rule Maker Report 6/13/00
They did the numbers. I want to thank TMF Grape for his analysis, which I will be commenting on. Nortel hasn't posted their current quarter on the boards yet, so I am going off his numbers from June.
I love Nortel. I own Nortel. I think they have a future. But today's results are a GREAT example of why the numbers don't lie. We can go around with our Multi-Color Optical Glasses all day spouting about the demand for their products, how it is time to buy the bargain rates.
But let's remember that it is still possible to run a good company into the ground (i.e. Sears) and run a good Optical company into the lower mantle (Lucent). I am pointing to Nortel's numbers- not because I believe that they are a lost cause, but because a lot of people seem to be yelling "Buy at Bargain" and, as much as I like Nortel, I would also love to start some discussion about how they can improve the books. I have seen plenty of people yelling "Bargain Bargain", and very few actually questioning WHY this sell off happened.
The sell off occurred because Nortel reported revenues that not only fell short of 5 Analyst's $7.63b estimates, but also fell short of some others' 7.5b estimates. Why did this revenue shortfall occur?
According to Nortel, this occurred because A) Previous buying trends (from which everyone has been extrapolating revenues) have been inflated by customers hoarding their parts b) now that Nortel is meeting demand with decent lead times, the customers are using their own inventories and c) there is a shortage in qualified personnel (both among Nortel, and its customers) that are qualified to install the components.
It all comes down to Nortel's implementation. They are having trouble taking revenues, and using those revenues to implement their business better. In other words, Nortel is having growing pains.
In TMF Grape's article sited above, Nortel's Cash Conversion Cycle is 126 days. In lay man's terms, 1 Dollar made in the company will take 4 months to be turned into profit. The act of using that dollar to buy raw materials, pay laborers to manufacture them, and then sell it, install it and book the revenue takes over 1 whole quarter! For comparison, TMF Grape points out that Cisco's CCC is 57 days.
Why is this important? Well first off, this means that a product that is started manufacturing today will not result in money that can pay for the next component until 4 months from now. That cash is "Tied Up" for 126 days. Looking at the components for the CCC, we realize that it takes 88 days to turn over inventory. When Management complains that they had shortfalls in production, and yet their Inventories sat in the warehouses for 88 Days, that is probably an indicator that money is being devoted to things that aren't selling hot, instead of going towards those things that can't be kept on the shelves.
We also see that Days Sales Outstanding (Length of time to receive their payment) is 100 days. At the same time, Nortel is paying its non-interest bills in 62 days. If it takes you 100 days to collect a dollar owed, but only 62 days to pay debts, then you are not using that cash to your advantage. Imagine if Nortel could put off its bills for 100 days, and get paid its dues in only 62. That would mean that Nortel can sit on that cash it owes for another 38 days- where it can earn interest, or even pay for more R&D!
TMF Grape also notes an erratic Cash King Margin from our friends of the Northlands. Remember that Cash King Margin is basically showing that, of the cash that is flowing through the company in one given period, take out what was spent on capital. This is the Cash that is free to be used by the company during that period. Divide it by sales, and you get the percentage of sales that actually results in the profitable cash that the company can use to pay dividends, reinvest in growth, etc. TMF Grape could not really explain why one quarter the CKM was -113% (in other words more than double the cash was spent on capital than was generated by sales during the three month period) but other quarters made this loss up (to a tune of 8.3% of sales actually resulting in free cash) for a positive result.
I would postulate (probably incorrectly) that, again, this is due to Nortel's failure to manage production correctly. If a dollar invested in the company takes 126 days to turn a profit, that means the cash is gone- unavailable for you to change in a quick changing industry until it emerges again. So if you are Nortel, and you dump money into making product A, then a month later realize that the demand is really for product B, you must wait 126 days for the Product A to be produced, sold and collected on before you can put the proceeds into B. This may explain the negative Cash King for Nortel. They put money into one product, then realize that they need to meet even more demand, so they OVER SPEND to try and meet the new demand.
Now this is a very simplistic, and possibly incorrect explanation of the CKM relating to Nortel. However, it is clear that, regardless of the causes, if Nortel has no free cash compared to sales in a given quarter, then they are not efficiently running the mill. It is also clear that with a CCC of 126 days, Nortel is hamstrung to meet changing demand. Where Cisco can put a dollar into a product, then put that new dollar (and its gains) into another product elsewhere in under two months, it takes Nortel four months to do the same.
Is Nortel Doomed? Nah.
Do they need to do some serious financial housekeeping? As an owner, cheerleader and demanding shareholder, HECK YES!
I don't know if these numbers changed this quarter, but I doubt that they have been reduced to a level that will allow Nortel to meet the market dynamics as efficiently as they should. The lower the CCC, the quicker that money tied up in production can be used in new production for changed demands.
In addition, my understanding of the Labor Shortages are that they are not fixed. Nortel, and its customers, are still attempting to get enough qualified personnel to install equipment. Though they have aggressively hired more workers, they will take time to ramp up, and there will still be empty seats to fill. This is a problem. Again, we can expect that to cause a glut in inventories. The most efficient business produces what is in demand and ships it right out the door. Of course, this perfect world is not attainable, but we need to be dang close. This act of under-producing, then rushing to make up, over-reacting, then having to give better terms to sell over-produced inventory can hurt the bottom line. And this includes installers. Let's assume that they have all of their production under control- to a tune of around 90 days of inventories outstanding. What does that help if Nortel cannot install the parts? They cannot book the revenue if the customer cannot use their product. Even if they can book the revenue for the part(s), until they can install these ones, they will not be buying any more from you- because they still have components in their inventory.
This does not necessarily mean Nortel is doomed- but it does result in more erratic cash flow. Imagine getting your paycheck on an erratic- almost random- basis. How well would you be able to meet your financial responsibilities?
The Good News is, that most of the full-service industry is having these problems. Optical just appears to have some large lead times. Lucent is having trouble producing to demand's needs, and the entire tech sector is feeling the crunch of labor shortages. This will hurt growth.
The real question, then, appears to be, can Nortel be less bad than its competitors? Much of this is dependent on how well they can improve their production and inventory control, in my opinion. How can they do this?
Again, my comments are not to say that Nortel is terrible. They are to point out that, even though the 27% drop in Nortel's price was probably over reacting, you should expect a reaction when the company makes mistakes. Our concern should be to discuss whether or not we believe this to be a short term problem (Which should be ok for those of us going long) or a long term or permanent problem (in which case, in 5-10 years when you try to sell, the problems will still be affecting price).
Let's talk about it- forgetting about share price- and focus on these issues. What should we expect to see if Nortel gets it's growth under control? What will we see if they continue to have problems (and therefore turn into a bad investment)?
Huzaaah! And Fool On!
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