Always Follow the Money

After three years of investigation, former Nortel executives may finally be put in the hot seat. This includes Nortel’s former CEO, Frank Dunn, who is credited with conceiving the “brilliant” accounting shenanigans that sent the already beleaguered Nortel stock spiraling toward a disastrous end. The story is an old one, which I’m sure Canadians are bored with, but for the purpose of this article, please bear with me.

Along with Frank Dunn, three more people are facing fraud charges on both sides of the border: former CFO Douglas Beatty, former controller Michael Gollogly, and former assistant controller Mary Anne Pahapill. It all started when the tech bubble burst in 2000. To alleviate the ripple effect that slaughtered the tech sector, Nortel’s executives allegedly manipulated the company’s financial statements and artificially boosted earnings.

Now, there are four basic types of financial statements that public companies are required to file with the securities regulators. These include: 1) a balance sheet, 2) an income statement, 3) a statement of cash flows, and 4) a statement of changes in shareholders’ equity. A company’s management can manipulate two out of four of these statements: the balance sheet and the income statement. The other two are beyond manipulation, simply because they state what happened with either the company’s cash or its total equity during any given reporting period.

Let’s disregard the statement of changes in shareholders’ equity for the time being and instead focus on the statement of cash flows. You see, the Street can be a very unforgiving place. Everything is fine, as long as the Street sees the earnings coming in. However, the moment earnings fall below the Street’s expectations, it’s over for a stock. The company gets hit with downgrades, while the financial press flushes the market with bad news and, even worse, speculation — all of which usually results in weak market performance.

Advertisement

Of course, not all events that adversely impact earnings are the company’s fault — at least not entirely. This is why some leeway is allowed when preparing both a balance sheet and an income statement, so as to allow for unusual and extraordinary charges that appear “below the line.” When decreases in net earnings are recorded in that way, analysts can conclude that although earnings may have fallen below the Street’s expectations, it could be due to unusual and infrequent economic events — not the company’s fundamental weaknesses.

Plus, then you get a company such as Nortel that allegedly abused this loophole to the point of crossing the line by pumping up the earnings and allowing executives to collect outrageous bonuses, based on years of potentially bogus performances.

Of course, there is a simple way to figure this out long before the regulators come after a company’s management. All it takes is a good look at the statement of cash flows. If less money came in and much more went out, then it’s a good indicator that something is amiss.

There are several things to consider when it comes to the statement of cash flows. First, you should look at something called the “cash cycle.” It will tell you how many days a company needs in order to sell its products or services. It will also tell you how long it takes to collect the money owed to it, as well as how long the company takes to pay its own bills.

If that cycle is long, then something negative is definitely occurring — probably starting with the company’s inability to generate revenues from its sales. Since these things tend to produce a snowball effect, you should also look at the company’s inventories to see if they are overstocked. This will tell you volumes about your chances to turn a profit with the stock.

This is precisely what has happened to Nortel — and why the company was so easily swept out to sea when the tech bubble burst. Its inventories were full with no buyers in sight. However, at the time when Nortel was at its peak, I remember I was in a peculiar situation. Let me elaborate.

I was working as a broker when Bell Canada spun off Nortel and awarded its shareholders with free Nortel shares. I think I was the only person in our office advising clients to sell their Nortel shares and buy more Bell shares. Everybody thought I was crazy, but at those prices, and after scrutinizing Nortel’s statement of cash flows, I had good reason to think that the only direction the stock could possibly go was down.

Some clients listened; some didn’t. What happened next is history. I’ll always remember the words of my mentor, who introduced me to the business: “Whatever you do, just make sure you follow the money!”