Nortel investors pay the price


Electoral Member
Jun 6, 2002
Nortel investors pay the price
From Saturday's Globe and Mail


If there was ever any doubt, it should be laid to rest now: Nortel's shareholders are the sacrificial lambs in the company's struggle for redemption.

The company that issued hundreds of millions of shares during its frenetic acquisition binge when its stock changed hands at stratospheric multiples is now compelled to issue another billion, with the stock at 13-year lows, just to stay alive.

Under the circumstances, existing shareholders can't grumble too much even as a crushing tidal wave of dilution breaks over them. Getting soaked beats being wiped out, which is the alternative. Despite a flush bank account, Nortel's costs are so misaligned with market conditions that it is burning through far more cash than it takes in. Outside financing is crucial, and raising debt is not much of an option. Before this latest issue, a little more than half the company's capital was debt, a ratio five times higher than the industry average.

The company, furthermore, runs a very high risk of breaching covenants on undrawn bank lines of credit. One of these, which matures in December, demands that the company lose no more than $350-million (U.S.) on an EBITDA basis this year. (EBITDA represents earnings before interest, taxes, depreciation and amortization.) Given the first-quarter results, the company can only lose about another $100-million for the rest of the year, which is asking a lot. When such a liquidity crisis threatens, lenders call the shots and equity owners pay.

"You have to think about the negative cash flow and how to cure it," says Dominion Bond Rating Service Ltd. analyst Paul Holman. "That's the essence."

So have they paid enough? That depends on how optimistic one is about Nortel's guidance. Nortel's finances are a fast-moving target, and analysts are far from unanimous in their outlooks. Mr. Holman figures Nortel's cash burn is currently between $1.5-million and $2-billion a year, excluding vendor financing requirements and unusual expenses such as restructuring (which have been less than unusual lately). By the end of next year, the company will need as much as $3.5-billion more in cash than it produces internally.

Nortel started the year with $3.5-billion in cash. Meeting its obligations, including debt repayments, and adding this latest financing will bring cash down to about $2.5-billion or less by the end of the year, assuming the company's guidance is on track. That may be a big assumption, given its relentless inability to meet its own forecasts. The fact that it continues to slash expenses and eye asset sales isn't inspiring in that regard.

Looking ahead, the diversion of opinion widens, depending on revenue and gross margin assumptions. If Nortel's revenue is $13-billion next year and gross margins are as per the first quarter of this year, it doesn't seem likely to be breaking even on a net basis. Factoring in its cash needs, it will face another huge cash-flow deficit, even if Mr. Holman's projections are aggressive (other analysts' forecasts are less severe.)

A high cash burn rate doesn't look devastating, considering Nortel's cash and available credit which, by the end of the year, will be as high as $6-billion. But that assumes that Nortel's credit lines will be intact, which isn't a given. Knocking off, say, $1.5-billion, leaves $4.5-billion. Even factoring in added charges and vendor financing needs, the cash situation seems stable -- again, only depending on the assumptions.

But that's just the short term. The longer term holds perils of its own. When the market does pick up, Nortel may be hard pressed to keep its market share up. Competitors with better balance sheets could make life miserable for Nortel by making vendor financing a bigger part of the equation.

"If this becomes a war of the cheque books," Mr. Holman says, "the company with the liquidity wins."

Equity holders appear to have little to look forward to even in a promising scenario. In two or three years, barring failure or a takeover, Nortel's finances may have returned to normal and its revenue may start to grow again. The growth, we can be fairly sure, will not be robust. If the company's revenue is $14-billion and growing at 10 per cent a year, shareholders won't be spoiled.

At 4-per-cent net margins, the earnings per share will amount to about 13 cents a share. Pick a P/E — 12, 15, 20 — and the potential appreciation on the stock, especially given the risks, hardly substantiates a strong buy.