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Nortel: Beyond Closing the Books

By Roger O.Crockett It took more than 14 months, but on Jan. 11 Nortel Networks (NT) finally completed its long-awaited restatement of three years of reports. That's after the board of directors first called for an independent accounting review in October, 2003, later let go former CEO Frank Dunn in April, 2004, and then struggled to submit its annual filings to the Securities & Exchange Commission last summer. So it was that CEO Bill Owens declared the delivery of Nortel's restated financials for 2001, 2002, and 2003 "a milestone."

In 2003, the Brampton (Ont.) telecom equipment maker earned $434 million on sales of $10.1 billion. That compares with a restated 2002 net loss of $3 billion on $11 billion in revenue. The restated numbers held little surprise because Nortel had revealed unaudited estimates late last year. But after Owens had missed three self-imposed deadlines to submit the final numbers last summer, Wall Street cheered the fact that Nortel didn't fumble once again. Shares ended the day up 4%, to $3.48.

"Good heavens. It has taken long enough to get there," says Gavin Graham director of investments at Guardian Group of Funds in Toronto. "But when they finally arrived, the numbers are not as bad as we believed."

"A NEW TONE." The best news is that Nortel didn't stop with the release of numbers. It also announced that five directors, including Chairman Lynton R. "Red" Wilson, will step down to allow for "board renewal." It hired a chief ethics officer, Susan Shepard. And it will institute a series of checks and balances to improve how it accounts for earnings.

Shareholders have placed much of the blame for Nortel's protracted accounting scandal at the feet of its board, but none of the outgoing directors has been accused of wrongdoing by the company. "All of these steps are a reflection of a new tone at the top at Nortel," Owens says.

The new Nortel is designed to be a far cry from what appears to be a manipulative one in the past. The independent review, conducted by the law firm Wilmer Cutler Pickering Hale & Dorr, found that loose internal controls and inappropriate behavior by former CEO Dunn led to misstated financial results over the past few years. The report says Dunn advised executives to calculate reserves -- money set aside to cover possible losses from such items as bad contracts -- so that the company could meet internal profit or loss targets.

GIVE IT BACK. As a result, Nortel posted a loss instead of an actual profit in the fourth quarter of 2002, but profits instead of losses in the first and second quarters of 2003. Those profits triggered about $50 million in bonus payments.

Nortel is taking the admirable step of recouping the bonus money. It announced that 12 senior executives will give back $8.6 million in bonuses given under the controversial 2002 plan that rewarded employees for returning the company to profitability. Nortel also says it has asked 10 former employees, including Dunn, to return their 2003 bonuses. "Once the board receives responses to this demand, it should determine the appropriate course of action to pursue with each of these 10 employees," a Nortel statement said.

The internal review found that Dunn "drove senior management" to meet targets for earnings before taxes, especially after a bonus plan was put in place in mid-2002. In the first quarter of 2003 at Dunn's direction, Nortel staff set out "road maps" to achieve profitability for the quarter by using reversals of previously booked provisions even though there was no "accounting trigger" or justification for the reversals, the report says. In the first quarter of 2003, Nortel released a total of $361 million of provisions, allowing it to show a pro forma profit, and Nortel has since determined many of the reversed provisions didn't follow accounting rules, the report says.

"THEY'RE GONE." Nortel terminated Dunn and two other top finance execs in late April, 2004, "for cause" after discovering a pattern of questionable accounting practices. Now shareholders applaud the fact that board members who oversaw Nortel during Dunn's tenure aren't seeking reappointment. "The people who they said did it are the ones [the report shows] did it," says Duncan Stewart, a partner at Nortel shareholder Tera Capital. "This happened on the board of directors' watch. They needed to go, and they're gone. That's another good thing." Dunn couldn't be reached for comment for this story

While Nortel may have put the bulk of its accounting troubles behind it, the future doesn't look all that promising. Owens says it will file unaudited financial statements for the first and second quarters of 2004 before the end of January and follow "soon thereafter" with the filing of unaudited financial statements for the third quarter of 2004. But regarding full-year 2004 financials, Owens says: "I cannot commit to a specific date for the 2004 10-K." Sound familiar?

Looking forward, Owens forecasts higher 2005 sales. But few analysts expect him to lead Nortel to significant growth. Paul Sagawa of Sanford C. Bernstein says every one of its major competitors increased revenues in 2004, while Nortel's appears to have shrunk. Analysts say rival Avaya (AV) has been taking market share at Nortel's expense in the enterprise market. Lucent (LU) and Ericsson (ERICY) have been grabbing share in the wireless arena.

"HERCULEAN TASK." Worse, says Sagawa, Nortel isn't well-positioned in growth products. Owens continues to emphasize that he won't sacrifice research and development and will push into new high-demand areas such as security and government business. But Sagawa warns that a big chunk of Nortel's finance team is being distracted from supporting the business by undergoing continued restatement tasks and new ethics training. To increase market share in that environment "is an altogether Herculean task," Sagawa says.

Owens, known for his indefatigable optimism, didn't surprise anyone by suggesting success is ahead. It's just that few see Nortel as still having the muscle to reclaim its former glory. Crockett is BusinessWeek's Chicago bureau deputy manager

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