A Potentially Rewarding Investment in Nortel, Deeply Troubled, Deeply Undervalued

Nortel yesterday announced a reduced sales forecast as well as the intended sale of a key Metro Ethernet division (a "premium asset"). The market responded by dropping its stock price by more than 50%. The day Nortel chose to make this announcement coincided with a global meltdown (what were they thinking?) certainly helped push the stock off a cliff. The company clearly has its share of troubles.

Notwithstanding these troubles, the company's valuation at the end of the day yesterday was USD$1.3B. With sales of $10B ($8.5B excluding Metro Ethernet), this means the company trades at 12% of annual sales, which is tremendously undervalued compared to its peers. Cisco trades at 3X annual revenues, that is 25X higher than Nortel's ratio. A common, reasonable high-tech company would trade at least at 1X annual sales. The Metro Ethernet division alone, with superb and unique optical products (for example allowing telcos to run 4x or 10x traffic on existing fiber lines) could fetch $500M to $1.5B alone.
Nortel also has a wireless division (particularly for LTE, Long Term Evolution) which is riskier but is worth something as well.

Moreover, the company's cumulative tax losses are roughly $6B. A profitable company which buys Nortel as a whole will inherit these tax losses, which can be worth approximately $1B in cash savings for the acquirer.

The company is selling its premium division because it is in trouble, its financial position is not strong, customers are buying less, competition is tough, and it does not enjoy the economies of scale of other players such as Cisco and Ericsson. However, I believe the company is deeply undervalued at the current prices, at least by a factor of 2 or more.

On the negative side, the company has $3.1B in cash, and $4.5B in debt.

Counting the Metro Ethernet sale as $1B, tax losses at $1B, and not counting any assets, technology, people, the company is worth a solid $0.6B in cash. Adding a paltry 50% annual revenues, the company is worth north of $4.5B, compared with the current market cap of $1.3B.

While you can be rewarded by buying the stock straight, a potentially rewarding strategy is to use leverage and buy the following call options.

September 2.50 traded at 0.30.
October 2.50 traded at $0.60
October 5.00 traded at $0.05
December 2.50 traded at $0.70
December 5.00 traded at $0.15

The September and October 2.50s and the December 5s can be extremely rewarding. Keep in mind that the current stock market steep decline is not over yet. Please do your own diligence.