Heading South at Nortel

The already-rough situation at Nortel keeps getting rougher. The list of legal woes for the largest supplier of telecommunications equipment in North America is growing: On May 17, Canada's chief securities regulator announced that Nortel's top execs would be prohibited from trading the company's shares -- effective immediately. On May 14, a U.S. grand jury subpoenaed financial statements and personnel and accounting records dating from 2000 to the present.

The subpoena is part of a criminal investigation by the U.S. Attorney's Office for the Northern District of Texas in Dallas. Nortel is also subject of a Securities & Exchange Commission investigation and an internal inquiry. On Apr. 28 the Canadian company terminated CEO Frank Dunn and other top managers "for cause." Neither he nor Nortel will say what that cause is. And recent regulatory filings reveal that on Mar. 10 Nortel gave some top execs cash bonuses -- instead of the typical stock or stock-option awards -- only weeks before it announced a second delay in restating financial results for 2003.

Compensating executives with cash was certainly not illegal, says Lon Gerber, director of insider research at Thompson Financial. But it's highly unusual. Little wonder investors reacted badly. Nortel's stock, which had lost more than half of its value over the previous three months, dropped an additional 5.3% on May 14, to $3.60. Then, it fell 8.7%, to $3.26, on the May 17 news of the cash executive compensation.

THIN ICE. That's not as bad as its 52-week low of $2.68, which it hit in July of last year, when the entire telecom sector was reeling from fears that customers wouldn't be ordering new equipment anytime soon. But Nortel's shares are certainly flirting with danger. And some signs indicate that Nortel may soon face more problems.

Calculations by Peter Hofstra, senior investment analyst for AIC funds, show that only about 5 cents of the 17 cents in earnings per share that Nortel posted for 2003 came from operations. That would be a highly unusually ratio for a capital-intensive telecom-equipment supplier. Hofstra believes some of the rest of the earnings came from asset sales. But still, he says, that's thin ice to tread on. Nortel itself has acknowledged that when it does finally restate '03 earnings, earnings may be as much as 50% lower than posted.

And as Nortel struggles to deal with its legal issues, customer defections may become a problem, forcing it to turn to more asset sales. If it's already relying on asset sales for the bulk of earnings, its back could be against the wall.

LOWER RATINGS? Also weighing heavily on Nortel are its debt covenants, which stipulate that unless it releases corrected financial statements in a timely fashion, it faces default on $3.7 billion in long-term debt, says Steve Kamman, an analyst with CIBC World Markets. If holders of more than 25% of its debt were to file a notice of noncompliance and if Nortel fails to file its restated financials within 90 days, its creditors could ask it to pay its debt. That would eat up Nortel's $3.7 billion in cash and equivalents on hand.

The likelihood of such a notice being filed is increasing, judging by the falling price of Nortel's debt. For now, the price declines aren't precipitous. The debt is trading at 90 cents on the dollar, analysts say. But assuming at this point the default can be avoided, which most analysts do, new financing will still come at a higher price, says Kamman.

And Nortel's debt payments could increase, since its legal problems could prompt credit-rating agencies to lower the company's ratings further, he says. Moody's Investors Service has already issued a warning that it may downgrade the debt, all of which already carries a junk rating.

POSSIBLE DEFECTIONS. "It's a never-ending drip," says Jeff Kagan, a telecom analyst with his own business in Marietta, Ga. Ed Snyder, an analyst with Charter Equity Research, is concerned that bad news will overshadow any good news for Nortel in the coming months. "The stock isn't going to rebound from this for a while," he says.

Things could get worse on the business side. In the past, investors assumed that service-provider customers, such as Canada's largest telco Bell Canada and America's largest telecom Verizon, wouldn't defect to avoid network disruptions. But such customer loyalty is no longer mandatory. "The market today is much more concentrated," says Ken Leon, an analyst with Standard & Poor's in New York. The latest generation of phone gear is standardized and interoperable, he points out.

Nortel's customers may be considering turning elsewhere to rivals such as Lucent, Nokia, or Cisco. "Service providers look upon suppliers as strategic partners, and they look for stability, integrity, and focus," says Leon. In Nortel's case, those three traits could be wanting in months to come as the company focuses on its demanding legal situation.

"NOT A GOOD SIGN." Still, Nortel sees brighter days ahead. "This company has been through difficult times before, and we have the spirit and the determination to get through it," says a spokesman. Some analysts believe its alleged accounting missteps will be proven to be relatively small and that Nortel can recover. However, it needs to move immediately to regain investor and customer confidence. And Nortel already faces a number of shareholder lawsuits.

All in all, Nortel faces a perilous time. "Investors are betting that it's not a big deal," says Kagan. "But two rounds of Nortel's top execs have left -- not a good sign." Kagan likens what sometimes happens in accounting scandals with the movie Jaws: Just when you think it's safe to step into the water, something bites you again. Investors should beware.

BusinessWeek Online originally published this article on 19 May 2004.