Negative Equity

The latest news out of Nortel is not good, even if not too surprising. A structured bankruptcy filing was certainly a possibility before this, though it perhaps wasn't expected to be telegraphed to the market so soon. Nortel has learned its lesson and now knows to give the market ample notice of potential adverse events. That is, since it is a non-negligible possibility they need to let the market know now so they don't, again, get hit with shareholder lawsuits if this dire outcome occurs.

But why bankruptcy? Nortel's assets and liabilities are finely balanced so that even on commonly-mentioned valuations shareholders are left with approximately zero equity. On that basis the common shares are worth nothing. Yes, that would be $0.00, and not the currently quoted $0.50 price. Anyone buying shares at this price is betting on a turnaround of some sort.

The corporate debt is not now in default and isn't due for some time. Unfortunately their market capitalization is so low (~US$200M US) in comparison to that debt (well over US$1B) that Nortel cannot issue shares to extinguish even a small part of this debt. If they tried, the share dilution would be so severe it would only accelerate the share price drop toward zero. Then there's the pension shortfall, equally large, that is largely a result of the low market cap. For this reason the pension shortfall can only be made worse with a new equity issue.

On the asset side the picture is equally gloomy. The one business unit that does have some good value is MEN, yet there are clearly no buyers coming forward, or just not at the valuation Nortel would like. This impairs the market's view of their business assets. Add to this the slashed capital budgets of their customers and Nortel's enterprise value, and prospects for future cash flow, basically suck. The market is coming to terms with a situation where Nortel will be in a negative equity position, where their liabilities exceed their assets and enterprise value on the basis of the expectation of any realized market price for each.

Nortel isn't alone in this predicament. This also underlies how sub-prime mortgages played a large role in the current economic crisis. As housing prices declined and debt costs rose, so-called home owners were in a negative equity position. This meant they were better off walking away from the house and letting the banks foreclose. This now unwanted asset undermined the banks since the value of the houses is less than value of the asset they replaced (mortgages).

If Nortel does file for bankruptcy protection, the debt-holders will likewise end up owning the company. Shareholders end up with nothing. The debt-holders also lose big time since not only does the debt exceed the assets, they get saddled with a poorly-priced company that is difficult to sell. This is very much like all those foreclosed houses in the US right now.

While I earlier considered that Nortel might be worth buying at some point, I no longer feel it's worth considering. Miracles can happen, but don't bet a lot on it. It's increasingly likely that Nortel's shares go to zero.