Nortel and the Unintended Consequences of Sarbanes-Oxley

We hope that we are not being too entirely naïve when we observe that something smells in this latest episode in the ongoing Nortel saga, and in our humble opinion, it is unlikely to be Frank Dunn, the recently deposed CEO of the company, despite the fact that he was fired “for cause”. Indeed, the mere thought that someone who had invested 3 years of blood, sweat and tears into the restructuring of this massive company into a lean, mean profit-generating machine – which included the firing of some 65,000 people – would then turn around and fudge the books in order to gain a little early traction in the bonus department simply does not make sense. Of course, the fact that ‘Red’ Wilson and John Cleghorn, two men of unquestionable integrity in the Canadian business community, were the ones doing the firing lends credibility to the fact that “something” happened, but the question is what, and more profoundly, why. Thus far, without the actual numbers in front of us, and a deeper understanding of their implications, we can all only speculate on what did go wrong, but we do not suspect that it is as serious as it is made out to be. In other words, despite the attempt of the Globe and Mail to make this into a genuine made-in-Canada scandal on a par with WorldCom and Enron is more an attempt by the Globe to sell newspapers than convey a semblance of reality.

What we do know is that during the period of massive restructuring and associated write-offs it transpired that more was [probably] written down than needed to be. The years 2001 and 2002 were therefore perhaps a bit ‘less worse’ than was shown to be at the time. In correcting these ‘errors’ in 2003, it is entirely possible that 2003 thereby appeared to be a little better than it actually was. Regardless, what we do know that what emerged was still nothing to write home about, although it was an improvement over 2001 and ’02. By the time the 4th quarter results were released, that blockbuster quarter confirmed that a powerful turnaround had transpired. A bare three months later, it now appears as if the results for 2003 were only half as good as it seemed, the top brass had received huge bonuses for unfinished business, and scandal was rocking one of the pillars of our business community.

What utter rot. In fact, there are two stories at play here, one that occurred at Nortel, and another that occurred in the stock market. That one has impinged on the other, causing havoc in the markets and raising alarms everywhere (including in those law offices dedicated to chasing ambulances and suing any company whose stock price declines in value for any reason whatsoever). The SEC has gallumped in, the OSC is not far behind, and even the RCMP (having maced people in BC to bad press not so long ago) is trying to work up an Elliot Spitzer-like image.

There is (and was) a turn at Nortel, but the turn is of the slow and steady kind, not a new prelude to a rocket into nano-space. Yet that is the way the stock market perceived it and for this, it has again paid dearly – although not perhaps, as much as Frank Dunn. From the stock market lows of $0.68, there should have been a price recovery: that low price was ridiculous and was spawned by the completely erroneous fear that the company was “going under”. It wasn’t, but it made for good press and better worrying. The kind of earnings levels which the company seems to be capable of generating on an ongoing basis are not nearly as robust as the market wished to embrace. We listened in of that fateful conference call and what we did not hear from management was the kind of hip-hooray, rally-round-the-flag-boys stuff that John Roth liked to generate when he was CEO in the great glory year that led to the $125 price peak. What we did hear, however, was a strong sense of palpable excitement from the analysts in attendance (by phone or whatever), a sense that the good times were back and that the promise of high tech was only temporarily derailed, not permanently shunted to the slow track. Frank Dunn tried his best to be modest in the face of it, although (we admit) it was also clear that he was proud of his accomplishments, as he should have been. It is also difficult to be totally modest when the mob is screaming for a new star and wants it to be you.

So, the market for Nortel took off into hyperspace, rising to almost C$12, despite the reality that under the best of assumptions, the stock was only worth about C$5 at maximum. Perhaps with an ambitious $0.30 earnings forecast that the more hopeful of analysts rolled out for 2005, one could offer up perhaps C$8, but those 4th quarter numbers were, as we said at the time, loaded with extra stuff and were totally untaxed. Plaudits, but not fireworks were called for. It was absolutely inevitable that there would be a ‘morning after the night before’ and that the nitwits would be burnt again, as they deserved to be. It was a matter of “how”, not “if”. The “how” came as it became apparent that the numbers were indeed pedestrian with the added sense of injustice that they were not only pedestrian, but were a little overstated.

So 2003 earnings were cut in half. Half of not much is still not much. After 3 years of all that effort, which has paid off, did the bonus paid to Mr Dunn seem egregious when we pay Carlos Delgado of the Toronto Blue Jays a multiple of that to have fun every day? We think not. No disrespect to Carlos – please don’t trade him, Ted Rogers – but Mr Dunn hit some homeruns as well. But it does all come down to perception, and these days, with corporate governance issues being driven by the Sarbanes-Oxley Act down in the US, perception is everything. No one can forgive the meltdown following the greatest surge of greed in the entire history of mankind, and there has to be guilty persons to burn at the stake. Few can actually examine their own motives and part in that brief and glorious paean to Mammon: it is just too painful.

The US is famous for over-reacting to everything that comes their way that isn’t to their liking. They don’t like world trade conditions? Bring in Smoot-Hawley. Commies got you worried? Bring on Joseph McCarthy. Messrs Ebbers and Skilling pull fast ones? Let’s do the impossible under Sarbanes-Oxley and get all CEOs to guarantee their financial statements, regardless of the fact that we have managed to create some 130 or so different accounting conventions under which no two accountants can possibly arrive at the same final numbers without severe collusion. Then, when any given CEO has done so, prove that he is a liar by bringing in a third accountant.

Was there fraud involved at Nortel in those 2003 numbers? No. What would possibly be the motive for it? Why would anyone devote 3 years of such effort and then throw it away for a couple of quick bucks, even if that “2” has six zeros behind it? It makes zero sense given the payoff coming in the years ahead. But did the Board of Directors of Nortel have any option except to throw Dunn to the wolves? Under Sarbanes-Oxley, probably not. The mob wanted blood, and it has got it. As Gustav Le Bon remarked over 200 years ago, “the mob yields to instincts which had they been alone would have been kept under restraint – the sentiment of responsibility which always controls individuals disappears entirely”, adding elsewhere that “it is necessary to arrive at a solution of the problems offered by the crowd psychology or resign ourselves to be devoured by them”. Welcome Sarbanes-Oxley.

Will anything useful come out of all of this? For one thing, companies will be much less likely to offer analysts any earnings guidance which may be a mixed blessing. Perhaps analysts can go back to being analysts and not toadies for their corporate finance departments. Perhaps we will see more ‘sell’ recommendations (but don’t count on it). Hopefully, there will be less “creative accounting” as well. Do not expect a line up of people looking to become corporate directors or members of independent audit committees, although come to think of it, this does open up an entirely new profession for the unemployed and broke who have nothing to lose anyway.

The bottom line is that we firmly suspect that when the “new” numbers are released and fully parsed, they will not show that very much really occurred. A little tweaking here and there and it will be found to be much ado about nothing. What really happened is that the mob got excited all over again, and is resentful that they were wrong again. It has to be someone’s fault. The Americans with their holier-than-thou mentality which erupts from time to time in well-meaning but ill-conceived legislation have spawned a monster and there are more victims to be rendered from limb to limb before this Joe McCarthy-like bill gets placed in the trash heap of poor ideas where it belongs.

If, as Ottawa has stated, the matter were simply a case of losing $1 billion or so in tax revenues, it would hardly matter provided that the tradeoff for the tax losses was one of faster capital formation and job creation in the future. But this is the exact opposite of what will happen. The resultant capital destruction will certainly lead to a loss of current taxes, but also it will result in a decline in entrepreneurial activity and future growth opportunities. On this basis alone, Ottawa should kill income trusts now. While there may still be some places where income trusts are appropriate, such as royalty trusts, the onus of proof as to their future economic efficacy should shift to the sponsors and underwriters, and the standards of proof should be very high indeed.

The “Oil Story” Gains Traction

Both Marc Faber and Don Coxe have recently reiterated the positive story for oil and gas and herein, we note a few features of their argument.

• Oil consumption in Asia, with its population of 3.6 billion people, is about 20 million barrels per day. In comparison, oil demand in the U.S., with a population of 285 million, is 22 million barrels per day. Based on demand trends in the last ten years, Asia's demand for oil is likely to double within the next six to 12 years. This Asian rise in demand, which compares to a total current global oil supply of 78 million barrels, will inevitably mean higher energy prices.
   
• Matthew Simmons of Simmons & Company published a study on Saudi Arabian oil reserves. While he did not forecast a decline in Saudi oil production, he questioned the assumption that Saudi Arabia is in a position to meaningfully increase its production of crude oil. Simmons raised the possibility that Ghawar, Saudi Arabia's largest field, with a daily production of five million barrels, the largest in the world, could be past its best years. Moreover, based on the experience of declining production at other large oilfields in the world, Simmons' report suggests that Saudi Arabia's five super-giant oilfields will at some point (maybe sooner rather than later) also experience declining production.
   
• Most notably, in 1956, Mr. King Hubbert predicted that U.S. oil production would peak out in the early 1970s. Hubbert was then widely criticized by some oil experts and economists, but in 1971 Hubbert's prediction came true, and US oil production has fallen close to 60%. Hubbert's methods of oil reserve analysis now predict that a peak in world oil production will occur sometime between 2004 and 2008.

While we are always keenly aware that there can be shorter term volatility in commodity prices including energy, the fundamentals are appealing and the standard valuations of most oil and gas stocks in P.E. terms are still very attractive relative to the indices, their upside potential in SAC terms remains substantial, and an over-weighted position in portfolios should continue to pay off both relatively and absolutely in the months (and quite possibly years) to come.