December 23, 2004

Nortel's Post-Accounting Challenges

"D-Day" for Nortel Networks Corp. is Jan. 10 -- the day the company is expected to start filing its much-anticipated restated financial results for 2003 and the first two quarters of 2004.

Nortel hopes this process will finally provide closure on an embarrassing accounting scandal that has seen 10 senior financial executives fired, including chief executive Frank Dunn and chief financial officer Doug Beatty.

But what happens after its audited results have been disclosed and dissected?

Rather than marking the end of Nortel's challenges, its financial results are just one hurdle -- albeit a major one -- the telecom equipment maker has to overcome to regain its credibility and momentum in a sector expected, at best, to see modest growth over the next two years.

Investors, meanwhile, are taking a wait-and-see approach. The stock has been hovering around $4 for the past month, after touching a 52-week low of $3.49 in mid-November. Among analysts, 19 rate Nortel as a "hold," three have it as a "sell" and three call it a "buy."

Here are some of the challenges facing the company:

THE TELECOM MARKET

After a period of implosion from 2001 to 2003, the telecom equipment market is starting to stage a slow recovery as carriers, cable companies and businesses make strategic investments in areas such as Internet telephony and wireless networks. As a result, telecom equipment sales are expected to grow 5% in 2005 and 5% in 2006.

Nortel is well-positioned in Internet telephony with products that allow carriers to migrate their networks from older, circuit-switch systems to Internet-based technology. The company is also one of the leading suppliers of wireless equipment, buoyed by strong demand in Europe and Asia as carriers there look to increase the speed of their networks.

Duncan Stewart, a partner with Tera Capital, said Nortel needs to come up with new and interesting technology through internal research and development, or an acquisition. "Three years from now, it would be 10% of their business, or a $1-billion business," he said. "This would mean an acquisition of $500-million to $1-billion."

The counter-argument to Mr. Stewart's suggestion is that Nortel's recent track record in making acquisitions is terrible: it spent billions of dollars during the telecom boom to buy companies with little or no revenue.

"Acquisitions are for companies that know what they are doing; Nortel needs need to fix their own house," said one analyst.

Nortel may decide to strike joint ventures to move into new areas. A good example is a deal with Symantec Corp. to develop new products and technologies to battle network threats.

Another issue is whether Nortel's financial troubles are having an impact on customers. In a recent research note, BMO Nesbitt Burns analysts Paras Bhargava said Nortel's recent guidance of a year-over-year decline in 2004 sales compared with earlier guidance of a single-digit year-over-year increase suggests the accounting woes are causing Nortel to lose market share.

"Management distraction due to the prolonged restatements is perhaps a reason for the decline in revenues," he wrote. "Nortel's peers are showing revenue growth in 2004, and NT's new guidance implies share loss, particularly in the important wireless arena."

A NEW CEO

There is already speculation Nortel is conducting a search to replace William Owens, who replaced Frank Dunn as CEO in April. The idea is that Mr. Owens, a former admiral in the U.S. Navy with little telecom experience, will gracefully step aside after Nortel begins to show signs of stabilizing early next year.

Some analysts say the company needs a CEO who knows the telecom industry and global carriers, while others suggest Nortel should go with an executive from outside the industry, much as Ericsson Telephone Co. hired Carl-Henric Svanberg as its CEO last year. He had been CEO of Assa Abloy, the world's leading lock maker.

"If you are going to change CEOs, you need to do what Ericsson did -- bring a turnaround executive -- someone from a cyclical industry," said Steve Levy, an analyst with Lehman Brothers. "The only thing we have been able to judge [Mr. Owens] on is his ability to set a deadline and not make it."

BOARD OVERHAUL

Nortel's board has been assailed for being asleep at the switch and approving lucrative compensation packages that go back to ex-CEO John Roth. The most vulnerable directors include chairman Red Wilson; Robert Ingram, vice-chairman of GlaxoSmith PLC, who stepped down from the Molson board in July; Sherwood Smith, a former executive with a electrical utility in North Carolina; former Michigan governor James Blanchard; and lawyer Louis-Yves Fortier.

"This is one of the top 10 cases of corporate board negligence in Canadian history," Mr. Stewart said. "These guys are poster boys for how not to do it. As a shareholder, I wish the board would change."

Since the accounting scandal began to surface in late-2003, there have been no resignations or departures from Nortel's board. The only additions have been John Manley, the former federal finance minister, and Manfred Bischoff, a former executive with DaimlerChrysler AG.

In contrast, Lucent Technologies Inc., which has gone through its own accounting and financial troubles, has appointed six new directors to its 11-person board since 2002.

CLASS-ACTION LAWSUITS

Nortel has been hit with a flurry of class-action lawsuits, and the situation may become even more litigious after Nortel finally discloses its restated financial statements. It is estimated Nortel could pay US$500-million to US$1-billion in cash and/or stock to settle many of these suits. If some of the lawsuits are not settled, trials could start early next year.

Then, there are investigations being done by the U.S. Securities and Exchange Commission and the Ontario Securities Commission.

In 2003, the SEC fined WorldCom Inc. US$750-million for accounting irregularities, while JPMorgan Chase was fined US$135-million to settle charges it played a role in helping Enron Corp.'s accounting fraud. Earlier this year, the SEC fined Lucent for securities fraud and violation of the reporting, books and records and internal control provision of the federal securities.

COMPLETION OF RESTRUCTURING

Nortel is in the midst of eliminating 3,250 employees -- a move that will shrink its workforce to about 32,000 and generate annual savings of US$500-million. The cuts are part of Nortel's efforts to reduce its operating expenses to at least 35% of revenue in 2005. The big issue is how much of what Nortel is shedding is fat and how much is bone. In August, during a conference call when the restructuring was unveiled, Mr. Owens said, "We are not restructuring ourselves out of business."

© National Post 2004

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