Oh, Canada!

By Lawrence Carrel

SmartMoney.com

April 28, 2004

IS ANOTHER ENRON brewing north of the border?

What had been considered a relatively minor bookkeeping problem at Nortel Networks (NT) erupted into a major scandal Wednesday after the maker of telecommunications equipment shocked Wall Street by firing its chief executive, Frank Dunn, along with other top managers. The Canadian company also announced that it needed to restate three years' worth of financial results for the third time in seven months. Shares of Nortel sank 28% to $4.05. With 310 million shares traded, Nortel alone accounted for 17% of the New York Stock Exchange's volume on Wednesday.

"This is a serious issue for the CEO," says Michael Markowski, director of research at StockDiagnostics.com, an independent research house in Sarasota, Fla. "It restated numbers for the fourth quarter of 2002 and the first and second quarters of '03, and now it's saying the CEO, when the company restated, didn't give the real numbers."

William Owens, a Nortel director, was named to replace Dunn, whom the company said was terminated "for cause." Nortel also sacked for cause its top two bean-counters, Chief Financial Officer Douglas Beatty and Controller Michael Gollogly. Both had been on paid leave since March 15. Their interim replacements, William Kerr as CFO and MaryAnne Pahapill as controller, were made permanent. In addition, four senior finance execs were placed on paid leave.

The brouhaha dates back to October 2003, when Nortel said it needed to restate financial results from the beginning of 2000 all the way through the first half of 2003. Many on Wall Street viewed the move as relatively benign. A big part of the scenario revolved around $900 million of liabilities carried on the balance sheet as of June 30, 2003, which needed to be allocated to earlier periods. The restatement actually reversed some losses during earlier periods.

Then last month the company warned that it needed to revise the revised numbers. On top of that, Nortel said the accounting errors would delay the filing of its 2003 annual report with the Securities and Exchange Commission. At the time, it declined to say when the work would be completed.

Matters took a turn for the worse on Wednesday when Nortel's audit committee said the company needs to restate 2001, 2002 and all of 2003. Net earnings for 2003 will be halved, and previously reported profits for the first half of 2003 will become losses. Revenues are expected to be unaltered, though costs could change. On an unaudited basis, Nortel in January reported a 2003 profit of $732 million on sales of $9.81 billion.

Adding to the pain: Because of all the financial irregularities, the company can't report preliminary results for the first quarter of 2004. The numbers were due to come out on Thursday. Nortel did say, however, that on an unaudited basis it had $3.6 billion in cash as of March 31, down from $4.0 billion at the end of December. Nortel added that its independent auditor, Deloitte & Touche, hasn't yet reviewed the restatements for the years under question.

"The two big issues for the company are, can it file the amended 10-K in time, and can it avoid disrupting its operations," says Jim Kelleher, an analyst at New York research house Argus Research. "It already violated the debt covenants, and the risk now is a required prepayment of the debt, which is serious, because it would have to borrow at a poor rate." (Kelleher doesn't own shares of Nortel Networks; Argus Research doesn't do investment banking.)

By delaying the filing of its audited 2003 financial report beyond March 30, Nortel violated the obligations of its public debt, which totals $3.6 billion in notes and convertibles. While the company isn't automatically in default, if it fails to file the 2003 results within 90 days after the debt holders announce the noncompliance, the debt could be called in.

Markowski, of StockDiagnostics.com, which evaluates the operating cash flow of companies vs. their reported earnings, says he raised red flags on Nortel in November. The firm became worried after determining that Nortel was posting negative operating cash flow while reporting positive earnings. Based on negative operating cash flow, Markowski thinks Nortel could show a loss of $40 million for the first six months of 2003.

"We think it's entirely possible that when the smoke clears, this company could have lost $400 million in the third quarter of 2003," says Markowski. "If that's the case, that would wipe out nearly all of its equity. That means it would have nothing on the balance sheet. We think the company has a severe problem, and based on these numbers it could be a potential candidate for bankruptcy protection."

In response to a question from SmartMoney.com about the possibility of bankruptcy, a Nortel official pointed to the company's "strong cash position."

Not everyone on Wall Street has such a dire view of Nortel's prospects; rather, some chalk up the latest fiasco to executive greed rather than business struggles.

"We believe the main issue surrounds management being aggressive on accounting accruals and some minor revenue recognition in order to show profitability and get paid bonuses," wrote Dayle Hogg, an analyst at Toronto brokerage Griffiths McBurney & Partners in a Wednesday note upgrading the stock to Buy from Reduce. "Our thesis has been and remains that Nortel is better positioned in terms of product breadth than most of its competitors and has sufficient cash to meet its obligations. Under a worst-case scenario, where they have to repay $3.6 billion in outstanding debt and convertible, we believe Nortel could raise new debt or equity to replace it." (Hogg doesn't own shares of Nortel Networks; Griffiths McBurney & Partners doesn't have an investment-banking relationship with the company.)

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"I think this is a very similar scenario to Enron," says Markowski of StockDiagnostics.com. "Given that it had between $400 million and $500 million of negative operating cash flow in the second and third quarters of 2003, that could translate into $400 million in unreported losses. Right now, after you subtract $2.2 billion in goodwill, you have a tangible net worth of $1 billion. If it has to restate its third quarter, which has $400 million of negative operating cash flow, plus the fourth quarter of 2003 and the first quarter of 2004, I think it could wipe out all of Nortel's equity. This stock should be trading a lot lower than it is. The company will do all it can to stave off bankruptcy." (Markowski doesn't own shares of Nortel Networks; StockDiagnostics.com doesn't do investment banking.)