Typical question in my inbox:
"Hi. I own Nortel (NYSE:NT). What do you think of this company?"
How I answer: "The company used the words 'terminated for cause' when they fired the CEO, Frank Dunn, in April. There are many things that need to happen before I'd be willing to even work on a valuation of Nortel."
How I'd prefer to answer:
"Frankly, there aren't enough controlled substances in the world to make me find owning Nortel's stock desirable."
Let's be frank. I adore nasty situations where shareholders abandon a company due to horrible news. This one is beyond the pale, though. A litany of events at Nortel reads like a wayward version of How to Win Friends and Influence People. Let's call it How to Win Friends and Cause Them to Lose Tons of Money.
In May my colleague Ben McClure witheringly noted that investors had best pay attention when a Canadian CEO is terminated, noting that his homeland is a place "where bungling CEOs are normally punished by way of big pay raises." That's pretty good comedy, right there. Even so, people were piling into Nortel based on the presumption that the bad news had punished the price down below where it deserved to be. Ben rightly noted that the bad news was likely nowhere near its end. And while people could get excited about a potential rebound in telecom spending (which is possible), they also need to recognize that this is a company upon which no trustworthy analysis can be made, because trustworthy financial statements for the last three years do not exist.
Here are the greatest hits on what Nortel is facing:
- Nortel is currently working on restatements of its financial statements from 2001 to the present;
- Nortel is under investigation by the Securities and Exchange Commission, the U.S. Justice Department and the Ontario Securities Commission;
- Nortel is facing criminal investigations in Texas, while Canadian authorities consider similar action;
- Its reported earnings from 2003 will be halved after the restatement;
- This is still at its essence a telecommunications equipment company, and telecommunications hasn't turned around;
- Nortel is in technical default with some of its creditors.
There's plenty more. Perhaps most disconcerting is the recent report in the Wall Street Journal that Nortel's board discovered scores of individual transactions that all conspired to make the company suddenly seem profitable in 2003, when in fact it was not. Some of these transactions were of such small amounts that they were almost impossible to detect. That the deception took the perverse form of profitability by a thousand adjustments suggests to me that the problems are quite systemic in nature. Nortel's got some real cleaning up to do. As recently as mid-2000 the public perception of Nortel rivaled that of Cisco (NASDAQ:CSCO). Now it's not even Lucent (NYSE:LU). At least Lucent seems to have cleaned up its mess.
Who stole cookies from the cookie jar?
Nortel's core business sank like a stone following the collapse of the telecommunications buildout bubble. Nortel flew higher than most, sporting a market capitalization well over $200 billion for most of 2000. The company's business had grown threefold in the previous five years, to more than $30 billion in revenues. Nortel spent aggressively to build out its capacity to meet the anticipated ongoing demand, which failed to materialize. A massive $19.2 billion quarterly loss in the second quarter of 2001, exacerbated by massive writedowns of acquisitions, signaled that the good times had come to a crashing halt.
There are two points in a company's life cycle where there seem to be a higher than normal occurrence of financial chicanery: at a point of great financial distress and at a point where a fast grower sees its growth rates first begin to decline. In a matter of three years, Nortel has encountered each of these conditions, and failed both tests.
As Nortel's new CEO Bill Owens noted in an April conference call (accessed courtesy of CCBN), most of the company's focus for its 2003 restatement is on an accounting convention known as accrued liabilities. These are liabilities that a company believes it has generated but has yet to pay. In Nortel's case, the majority of these liabilities were contractual in nature -- they could be warranties, for example, or take-or-pay contracts. Whatever they were, they started happening constantly at Nortel. Even as revenues spiraled in the late 1990s, Nortel kept reporting accounting losses as the company consistently took non-cash charges related to reserves it set up for accrued liabilities. In an environment where pro forma accounting was king, companies could easily wave these charges off as being inconsequential -- green eyeshade stuff that investors should ignore.
As with any company, some of these reserves served a legitimate purpose -- to placehold for money the company expected to have to spend to satisfy an obligation. But Nortel also used these reserves for another purpose -- to be able to bring earnings back from the dead should the company not be able to live up to analyst projections. So Nortel might find itself a penny short of expectations one quarter, but lo, it had a $100 million reserve related to some pervious acquisition. The company simply reversed the reserve and could count those $100 million as profits. Voila! Found the penny!
Funds that were ignored when they were subtracted below the line were plowed into operating results, where they weren't ignored at all. This worked until it didn't -- when the fiber optics market became so putrid that there wasn't any way to dress up the fact that Nortel's business had collapsed. An internal audit in 2002 that was not disclosed to the public found that Nortel had in excess of $300 million in inappropriately booked reserves. These findings were never disclosed to investors, and some executives at the company believe these amounts were simply added to earnings in late 2002.
Mr. Dunn had pledged to drive Nortel back to profitability, and his executive team had substantial financial incentives to succeed. But in 2003, these goals were impeded by the small fact that Nortel's customer base was in horrible financial shape. In early 2003, however, the company stunned investors by reporting a small profit. Two more positive quarterly reports in the year helped drive Nortel's stock from well below a buck to as high as $7.86. In these quarters the company released more than $380 million in reserves, giving its reported results the burst of oxygen required to go from a reported loss to a reported profit. And wouldn't you know it: the board determined that at least $160 million of that was released improperly.
Systemic Audacity
The Wall Street Journal story paints a picture of a Nortel where diddling reserves has been standard operating procedure for years, not only on the corporate level (i.e., what's reported to shareholders), but also on a division level. In April, William Kerr, the company's newly named CFO, noted that all areas of the company's reported performance "could possibly be affected in the restatement, including research & development, gross margins, and general & administrative." They weren't just bleeding reserves into the bottom line -- it was showing up everywhere.
There's something about the timeline I find mindblowing, though. In 2002, investors complained about the company's deferred liability accounts. Nortel did the audits and found $300 million in improperly booked reserves. But this didn't stop the practice, as the company continued monkeying with reserves. Its results in 2003 included another $380 million, enough to push the company's reported numbers into the black, enough to trigger big fat bonuses for management and thousands of employees. What is simply unbelievable about this, though, is that in May of 2003, Nortel's board demanded that company executives clean up its balance sheet and do an audit on years' worth of reserve accounting. So even while the company was auditing itself, it was hitting the reserve sauce at the exact same time. When the board received an external report in April, it immediately moved to fire three top executives, including Frank Dunn.
We can hope this is the end. In the meantime, people investing in Nortel should know they don't have firm numbers upon which to base a valuation of the firm. More to the point, Nortel will have to undergo a complete change of culture before its business-as-usual becomes something that conforms with accounting principles. This was a company that simply debased itself to "make the number." That being the case, there may be more pain to come as the restatement process continues.
Bill Mann owns none of the companies mentioned in this story. Come take a look at the latest income bearing stock idea from Mathew Emmert! Take a free trial subscription to Motley Fool Income Investor today! The Motley Fool has a disclosure policy.
