A new start for Marconi 11

Marconi's annus horribilis ends on a bright note
Monday 31 Dec 2001
The shares have bounced back in recent days, but they're pricing in a lot and David Stevenson thinks investors might be better of exiting now


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There is some good news at Marconi. There’s the BT’s e-payphones deal and the five year $80 million Grande Comm deal to supply deep fibre to Texan customers. A series of minor sales along with property disposals have raised another £100m to add to the £765m raised by the sale of Marconi Medical sold to Philips. Just last week, the company sold its domestic appliances unit. Marconi has said it will meet its target debt range of £2.7-3.2 bn.

And then there’s the recent interim results, which showed that despite heavy losses, the group was cash positive in September, and that second quarter operating profits, were around £5m. Add in a series of clearly stated targets to reduce operating costs in the core telecoms business from £1.4bn per annum to £1bn – they’ve already taken out £244m – and plans to get gross profit margins up to 35 per cent, with net margins at 10 per cent, and it's clear the tide has turned.

Yes, but...

...we need to take a much closer look at the hard cash figures behind these results.

Foremost, debt still needs to come down, likely via the sale of more Marconi Capital businesses. Aside from the domestic appliances unit, these include the Gilbarco petrol pumps division, followed by the retail automation division and the digital imaging systems division. The combined price is likely to be around £750m, so knock that off the £3.5bn and further assume that the group can run the remaining divisions at cash neutral, and you have a net debt position of about £2.75bn. As well as cutting debt, Marconi needs to run its business much more efficiently for cash, pushing down working capital and increasing cashflow. But Dresdner Kleinwort Wasserstein analyst Per Lindberg, one of Marconi's biggest bears, points to a rather disconcerting projection in the report to analysts following the interim results. For Marconi to not increase its debt position from operating activities, it will have to turn 15 per cent of its turnover straight into cashflow, a figure that only the likes of Cisco could ever hope to achieve. In fact, Lindberg is clearly sceptical about the whole debt position, as he thinks the directors are clearly under-estimating the decline in the core business and the consequent worsening of the cash flow position. He reckons that net debt will probably be around £3.24bn by March next year, just above the target set by the management.

Wildly overpriced or a bargain?

Still, let's give Marconi the benefit of the doubt and accept that it’ll hit £2.75bn, add in the £1.3bn existing market capitalisation, and we have a business with an enterprise value (equity plus debt) of about £4bn based on March 2002 debt projections.

Is that a figure that makes the shares worth a look? The answer very much depends on how the core business is run in the next year or so. I suspect that we have to almost write off the financial year ending in March 2002, and focus instead on the March 2003 fiscal year. Assuming all the non-core stuff is sold for £750m, the 'Marconi Core' telecoms business should be turning over between £600 and £900 million per quarter. So assume Marconi Core makes £3bn in annual sales, hits its self imposed gross profit target of 35 per cent and generates about £1bn before group operating costs. Knock off the £1bn in further operating costs, and it just about breaks even.

But if Marconi Core can generate £3.5bn in revenue instead of £3bn, then it could produce operating profits of about £200m before exceptionals. The equivalent for £4bn in sales in 2003 equates to an even more generous operating profit of £400m.

So it's highly geared to improving sales. But even at the mildly bullish £3.5bn sales target, Marconi would be trading at 20 times profits - pretty steep for a company that's still got it all to do. In reality, most analysts reckon that Marconi will be lucky to hit a net operating margin of 6 to 7 per cent.

The break-up option

There is one alternative way of measuring Marconi’s true value – its value to other companies wanting to buy it. The real jewel in the crown is the optical networking business specialising in SDH gear for telecoms companies, especially in Europe. The other jewel in the crown is the deep fibre operation at Reltec.

According to Lindberg, these two key divisions probably account for about £800m of the £3 to £3.5bn core telecoms business turnover. If these divisions were floated off they’d probably command at least 2.5 times sales, similar to US competitor Tellabs. But a competitor looking to fill in a gap in their product portfolio might be prepared to pay three times sales, equating to about £2.5bn.

The remaining divisions would be lucky to command one times sales. Let's be charitable and assume they do, giving a value of about £2-2.5 bn for the non-sexy bits. Add it all up (£4 to £4.5bn), deduct the debt of around £2.75bn, and we have equity worth between £1.25bn and £1.75bn, which equates to between 45p and 65p. And remember that this is the most optimistic scenario.

So no matter how you cut it, Marconi really is not worth more than 65p, and probably not much more than 45p in reality. Speculation may push it up to the late 60’s, but I suspect that a fair fundamental value is between 25 and 45p a share. Take your profits while you can !