Raytheon Vs. Nortel Essay, Research Paper

Nortel vs. Raytheon

Two companies taking similar actions that are obtaining very different results

What is happening to the debt position?

Nortel Networks engaged in several acquisitions in 1998. The effect on their income statement was staggering. Despite $17.575 billion in revenues (a $213 million increase from 1997), Nortel?s net income before taxes was negative $537 million. ROE was negative 4.64% compared to the industry average of 13.8%.

Acquisitions, mergers, and partnerships have become a major strategy of many companies in the telecommunications industry. Nortel frequently participates in acquiring other companies in order to expand their business units, products, and lines. In 1998, Nortel?s largest acquisition occurred when they acquired Bay Networks for an estimated US$9.1 billion.

In looking at the 1998 financials (I mention these because of the large dollar amount spent on acquisitions that year), Nortel’s Debt/Equity ratio was interesting. Looking at the balance sheet, total liabilities increased by $1.1 billion (15%). The Statement of Cash Flows shows that Nortel repurchased approximately $1 billion of outstanding stock. Looking at these two numbers, one would expect the debt/equity ratio to increase but it actually decreased by 58%. And from 1997 to 1999, it has decreased from .41 to .16. The 1998 Income Statement also showed a large increase (144000) in the number of outstanding shares. The large increase was due to the conversion of outstanding Bay Networks shares and to exercise stock options by Bay Networks executives.

The operating earnings number on Nortel?s 1999 annual report shows two figures on page 1, GAAP earnings ($-0.15/share) and operating earnings ($1.28/share). What’s behind the difference? The cost of all the Nortel acquisitions: purchased IPRD (intellectual property research & development) for $722MM, acquired technology $686MM and ?goodwill? worth $639MM. That’s about $2 billion in acquisition costs zapped right out of operating earnings. The difference between Nortel?s operating earnings and standard earnings for 1999 was almost entirely attributable to Nortel?s acquisitions of Bay Networks, Shasta, Cambrian, Periphonics, et al.

Raytheon also has been heavily involved in acquisitions. The biggest acquisition occurred in 1997 with the purchase of Hughes Electronics. It?s interesting to note that this purchase was the defense arm of Hughes Electronics. GM kept the Satellite branch of Hughes and although the company has not been profitable the stock has done very well since the sale to Raytheon. The company has done well based on impressive subscription growth for Hughes? satellite system -Direct TV.

Like other defense companies (Lockheed Martin), Raytheon has been buying other

businesses amid an industry wide consolidation. And like others, such as

Lockheed Martin, it has had trouble integrating those new units. This trouble shows in the growth of their debt position and the performance in their net income and cash flow. Since 1997, Raytheon?s total debt ratio has increased from .91 to 1.04. This ratio compares the company’s debt to its assets minus its liabilities to reveal how much debt is cutting into the bottom line. Raytheon is only slightly higher then the industry average of .91. However, the higher the debt, the more important it is to have positive earnings and steady cash flow. In other words they need to be able to pay off the debt, or interest payments will cut into the company?s finances. As we look at stock value we?ll dig in deeper to the cash flow and earning picture.

What is happening to the stock value?

This chart tells the story regarding stock value.

You?ll notice a lot of the stock price change has taken place in the last year. Let?s look at the chart for just the past year.

Nortel Networks stock value has been quite impressive over the past three years. While the book value of these two companies is fairly similar, the same cannot be said of their market cap value. Nortel?s book value is about $12.5 billion and its market cap is approximately $139 billion dollars. Raytheon?s book value is $11 billion, and its market cap doesn?t even match it ? coming in at around $9 billion dollars.

I think there are three primary factors for the difference for the difference in stock value. First of all, investors are currently favoring high growth potential stocks vs. value stocks. While Nortel has offered investors stock price growth, Raytheon has been a low growth stock that has traditionally offered attractive dividends. However, because of the troubles they?ve had in the past year the dividend payout has been reduced from

Secondly, Nortel has had much more favorable trends in regards to sales growth, cash flow and net income. This is especially true during the past year when we have seen the difference in market cap grow between the two companies.

Growth Rates for Nortel and Raytheon 1 Year

Company Industry

Raytheon Revenue -10.36% -2.19%

Nortel Revenue 30.5% 15.4%

Raytheon Net Income -100.0% -4.65%

Nortel Net Income — -44.37%

Raytheon Cash Flow -50.98% -0.48%

Nortel Cash Flow 4.84% -2.64%

The following charts tell the stories regarding sales growth, net income and cash flow for the two companies.

Raytheon?s past year revenue growth is 373.06% lower than the industry average. A large chunk of this poor revenue performance was due to write offs associated with the mergers they?d performed in the past. Nortel’s past year revenue growth is 98.05% higher than the industry average. This revenue increase is due in large part to their growth in the optic networking arena that was primarily achieved via the mergers they performed in the past couple of years.

Raytheon also shows flat sales from 1998 to 1999 and a decrease in sales revenue during the first two quarters. Nortel on the other hand has huge sales increase on a quarter over quarter basis as well as a year over year basis (nearly 50% in some instances).

Quarterly Earnings History Data as of 08/21/2000 Investment research provided by Zacks.com

Raytheon 06/1999 09/1999 12/1999 03/2000 06/2000

Estimate EPS $0.86 $0.57 $0.24 $0.26 $0.29

Actual EPS $0.86 $0.59 $0.21 $0.24 $0.28

Difference $0.00 $0.02 -$0.03 -$0.02 -$0.01

% Surprise 0.0% 3.5% -12.5% -7.7% -3.5%

Nortel 06/1999 09/1999 12/1999 03/2000 06/2000

Estimate EPS $0.13 $0.13 $0.22 $0.09 $0.14

Actual EPS $0.14 $0.14 $0.28 $0.12 $0.18

Difference $0.01 $0.01 $0.06 $0.02 $0.04

% Surprise 5.8% 7.7% 25.0% 27.8% 28.6%

The third reason I think the two stocks have taken different paths deals with the earnings the companies were forecasting and where they actually. The market likes those companies exceed expectations, especially when they can do it on a consistent basis. The opposite is true of those who don?t meet expectations. Let?s look at the look at the results for the past five quarters.

Nortel has 5 positive surprises. Especially the last three quarters. Raytheon on the other hand — 3 quarters in a row of bad surprises.

Is the business riskier?

Although Nortel has a higher beta rating then Raytheon, I think it is very debatable as to which of the two companies carries more risk. Depending on exactly what source you read beta for Nortel runs about 1.5 while Raytheon runs about .5 to .65. As someone who invests in the long term I would put my money on Nortel simply because of the trends that I mentioned above. It appears to me that they have positioned themselves via mergers to be properly positioned to take advantage of the growing sales trend in optical networking. In fact, Lucent, a major competitor of Nortel?s in the optic networking space, has experienced tough going this year. In an earnings release earlier this year Lucent sited as one of the problems their decline in networking sales because they didn?t properly forecast the demand for optic networking. Something Nortel did with flying colors.

An additional comment on beta. I think beta and risk sometimes are tied to closely together. The term I like to use when discussing beta is volatility. Nortel has increased 300% over the past year, but hindsight tells us that it was a much less risky stock then Raytheon, which is now trading at about one-third of the price it did a year ago.

What is the relevant history?

I think the mergers and acquisitions the two companies have done that I discussed earlier are the most relevant pieces of history. For Nortel this has basically been going on during the last three years since they changed their overall strategy (and their name from Northern Telecom).

Raytheon has been more heavily involved in mergers since the mid 90s. I think the industry they are in forced their hand in this matter. I think its also important to note how the party in charge of the White House can have an affect on a company that is as heavily dependant on government spending as Raytheon. Potential investors in Raytheon have to ask themselves ?what kind of future does a company that?s very dependant on government defense have?? It?s a very real possibility that Raytheon is a cash cow that has matured and runs the danger of going further south.

How can we all learn from your analysis?

I think there are four primary lessons in this case.

1. A company?s future prospective earnings can be (and in this case study, are) much more important then current profitability. Hence, book value and market cap value can easily be two different numbers that are not even in the same ballpark.

2. Wall Street and investors do not like bad surprises.

3. Mergers and acquisitions aren?t always a good thing. Especially when the acquiring company increases their debt in the transaction.

4. It?s imperative for a company to maintain and/or increase revenues to cover debt assumed in an acquisition.