Nortel's New CEO Has His Work Cut Out

As CFO Frank Dunn replaces John Roth, he has at least one thing to celebrate: It can't get much worse for the maker of telecom gear

On Oct. 2, telecom giant Nortel Networks announced it had ended a long-running search for a new CEO to replace the outgoing John Roth. The newly anointed Frank Dunn will become president and CEO of the struggling optical- and wireless-equipment maker on Nov. 1, a move culminating a 25-year stint with Nortel, where he was previously chief financial officer. During the past five years, Dunn witnessed Nortel's transformation into a behemoth serving nearly half of the world's market for optical-transmission and switching gear that enables voice calls and Internet traffic.

As CEO, Dunn inherits an ailing former heavyweight with considerably less market share than earlier in the company's history. Between the last quarter of 2000 and the second quarter of this year, Nortel's (NT ) market share dropped from 47% to 17% of the optical-gear market, according to telecom consultancy Dell'Oro Group. Phone- and data-carrier spending on new gear may have declined further after the Sept. 11 terrorist attacks. That means the company's optical-equipment sales might continue their free fall through 2002, say analysts. Even areas where strong demand had been forecast for 2001 -- such as for wireless infrastructure and optical networks used in metro areas -- no longer appear as robust.

That's bad news for Nortel. On Oct. 2, the company announced it would further reduce its workforce to 45,000 employees, down from 94,500 at the beginning of the year. This means the company plans to shed an additional 20,000 employees over past job reductions, although half of the latest round will likely leave as the company sells off less profitable units. The company will also write off $750 million in inventory, and $750 million in trade receivables and customer financing in the third quarter of 2001. Nortel will announce its quarterly results on Oct. 18.


  The magnitude of the job cuts and write-offs came as an unpleasant surprise to most analysts, who now believe the downturn in the telecom equipment sector is proving even more severe than previously thought. They worry that Nortel might slash its research-and-development spending, which added up to nearly $900 million in its first quarter, says Martin Pyykkonen, analyst with investment bank C.E. Unterberg, Towbin. That could mean fewer "hot" products down the road -- and less revenues, says Mark Lucey of TD Securities.

The Oct. 2 announcements came on the heels of September, 2001, downgrades from Lehman Bros. and TD Securities. The latest announcement, though, caused TD Securities' Lucey to lower his target price for the stock from $6 to $5.50. And Pyykkonen downgraded the shares from "buy" to "neutral" after reassessing Nortel's forward prospects. Investors mirrored these moves: Nortel's already depressed shares dropped 4% in early trading on Oct. 3. The stock is trading near $5, down 93% from its 52-week high of $70. In the second quarter of 2001, Nortel reported a whopping $19.4 billion net loss due to massive write-downs of goodwill accrued from its 1999 and 2000 acquisition spree.

The latest woes come amid a continuing stream of bad news for telecoms. Competitors Lucent Technologies, Cisco Systems, and Alcatel have all cut thousands of jobs and announced significantly diminished prospects. That belies the root cause of Nortel's poor outlook, a protracted dip in the telecommunications-equipment sector. Total infrastructure spending by telecommunications companies will slide 23% this year and another 27% in 2002, according to Ken Leon, analyst with investment bank ABN AMRO. In the North American market, where Nortel got 53% of its second-quarter revenues, the decline in revenues could prove particularly severe as cash-strapped carriers continue to hang onto their purse strings. All told, Nortel's total sales could fall by more than 14% in 2002, according to Paul Sagawa, analyst with investment house Sanford Bernstein.


  The decrease should play out in all of the various market segments. Nortel's sales of equipment used to speed voice and data traffic in metro areas will drop nearly 30% next year, according to Bernstein. Sales of long-haul optical equipment used to stream voice and data communications over greater distances should not bounce back until late in 2002, says Brian Van Steen of telecom consultancy RHK. Meanwhile, Nortel's wireless infrastructure sales, growing at 20% before the tragedy, might enjoy only a 2% to 3% growth thereafter, estimates Leon. Wireless equipment accounted for about 20% of Nortel's revenues in the past quarter.

In particular, a slowdown in sales of one product could hurt Nortel disproportionately. Nearly 40% of Nortel's revenues depend on its integrated optical product OPTera Connect, a system that allows carriers to quickly set up services and increase the capacity of their backbone networks at a lower cost than previous generations of switching gear. These so-called "intelligent networking" systems sounded great before the telecom bubble burst. Now carriers have grown suspicious of trying out new technologies and might not buy as many of these integrated optical systems as hoped, says Pyykkonen.

For Nortel to blame everything on the sector woes might not be entirely accurate. Rival Lucent Technologies (LU ) is overhauling its business and also suffers from slower sales. Yet Lucent managed to overtake Nortel in market share this year, going from 9% share of the global market in the fourth quarter of 2000 to 21% share in the second quarter of 2001, according to Dell'Oro. Lucent's secret? The company restructured its business faster, says ABN AMRO's Leon. Although prices in telecom gear often remain well-kept secrets, Lucent might have undercut Nortel and grabbed sales, speculates Ted Moreau, analyst with investment bank Robert W. Baird & Co.


  Nortel also needs to get rid of the slow-growing enterprise part of its business, which accounts for about 15% of the company's revenues and serves large companies instead of carriers, says Leon. Already, on Oct. 2, Nortel announced it had sold most of its customer relationship management software assets to Amdocts Ltd. (DOX ) for $200 million in cash. More product lines might be eliminated soon. The directory and security service software, remnants of the June, 1998, Bay Networks acquisition, is likely up for sale, says Lucey.

The rapid slide at the Canadian company has ended former CEO John Roth's aspirations to solidify a position as the dominant telecom-gear maker. "There's no vendor today that has an advantage in technology," says Shin Umeda, principal analyst with Dell'Oro.


  To be sure, no one expects Nortel to disappear. The company should remain at about 15% to 25% market share and grow revenues in the future. At the same time, contracts still come Nortel's way. The company got a $300 million, three-year contract for network upgrades at Voice Stream Wireless on Sept. 26. And on Oct. 3, Nortel announced that client SBC Communications will also buy its metro optical products. Furthermore, no one thinks it could get any worse. "The bad news about Nortel is very, very well known," says Sagawa, who recently upgraded the stock.

That may be, but Nortel shocked investors and analysts with its most recent announcement. And weak financial results won't let up anytime soon. In the third fiscal quarter, Nortel expects revenues of $3.5 billion and a net loss of $3.6 billion after tax. That's far worse than the $700 million loss on $4 billion revenues expected by 33 analysts polled by FirstCall before the Oct. 2 announcement. Now, most industry number crunchers figure the company will turn back into the black in 2003, later than previously expected. Clearly Frank Dunn has his work cut out for him in reviving the fortunes of the company that John Roth built for a different time and reality.

By Olga Kharif in New York

Edited by Alex Salkever