Nortel's Long, Hard Slog

Things are better than a year ago, but that's not saying much. CEO Mike Zafirovski knows he must invest, cut jobs, and maybe sell some businesses

Investors are eager for clues to the direction Nortel will take under newly appointed Chief Executive Mike Zafirovski. And they picked up plenty on Feb. 23, when Zafirovski began taking the wraps off his turnaround plan for the troubled telephone-gear maker. His assessment after four months on the job: "We are probably [at] ground zero." And: "We have a very tall mountain to climb."

But before the ascent begins, Nortel has trimming to do, Zafirovski hinted at an RBC Capital Markets conference. That means Nortel, which has already cut more than 60% of its workforce in recent years, is likely to eliminate more jobs and units that aren't up to snuff, according to Stanford Bernstein analyst Paul Sagawa.


  Zafirovski plans to concentrate on markets where Nortel can outstrip rivals. "We tried to be everything to everybody," Zafirovski explained. "Now, we need to focus." Specifically, the new executive team will target areas where Nortel can achieve 20% or greater market share, he said.

Nortel has attained that goal in only 5 of the more than 20 markets it serves, Zafirovski said. Areas of future investment will include Internet Protocol TV, a technology that sends video over broadband lines, and WiMAX, which enables high-speed wireless access over large areas, Zafirovski said.


  But fast-growing markets like IPTV are crawling with rivals, and to stay ahead of the curve, Nortel may have to make near-term investments that push back profitability when it achieves profitability, says Sagawa. "The choices that Mike Z. has are tough medicine."

Still, Zafirovski says the company will spend about $1.9 billion on research and development this year. That's in keeping with spending in recent years. Zafirovski has set an ambitious target of reaching 15% operating margins in as little as three years. That key yardstick of profitability fell into negative territory in the first nine months of 2005. Analysts expect Nortel to reach annual profitability in 2006.

The company has yet to delve into specifics of the strategy, but it's clear that IP-related gear will be paramount. Last quarter, Nortel was the leader in soft switches and media gateways that make IP networks tick, with 26% share, according to telecom consultancy Dell'Oro Group.


 In IP PBXs -- boxes that enable companies to make calls via the IP network -- Nortel is neck-and-neck with Cisco (CSCO). "Nortel is so much further ahead than other vendors," says Tam Dell'Oro, founder of networking- and telecommunications-industry market researcher Dell'Oro Group. "I don't think people realize that."

Even so, Nortel's position is under siege by rivals Lucent (LU), Alcatel (ALA), Cisco, and others that are jumping headlong into this fast-growing market. Today, Lucent has more than 77 IP-related trials, and Nokia (NOK) and Ericsson (ERICY) have each announced more than 50 trials, estimates Standard & Poor's analyst Ken Leon. "Nortel is well below that," he says. And rivals including Lucent have been announcing large contracts in North America recently.

To compete, Nortel needs to ramp up its IP-related investments by cutting the resources it devotes to less promising product lines -- perhaps by passing such marginally successful businesses to joint ventures. One possibility: Nortel could partner with Siemens or Huawei, with which it already has a joint venture, on types of wireless infrastructure gear where Nortel has less than 10% market share, says Sagawa. "It's better to own half of [a joint venture] that's competitive," he says (see BW Online, 2/02/06, "Nortel and Huawei's Broadband Pact").


  Nortel might want to exit its optical transport business, which used to drive the company's revenues in the 1990s, says Dell'Oro. While growing and profitable, the business seems to take the company away from its focus of delivering intricate equipment that helps provide consumers with music, video, and phone calls over the Internet, she says.

Other possible cuts: Nortel makes telephones for IP and legacy networks, and those phones are quickly turning into a very price-competitive market, says Dell'Oro. Sony (SNE), Panasonic and Samsung are all expected to turn up the heat in this category and send margins downward. Another possibility: enterprise Ethernet equipment, which enable applications like e-mail, Dell'Oro says. Today, Nortel owns less than 5% of this market.

Exiting some businesses isn't easy, as customers sometimes purchase products in tandem. If Nortel cuts the Ethernet business, "that will have a negative impact on its PBX business," says Dell'Oro. About five years ago, when 3Com (COMS) cut its high-end Ethernet gear (where it had only a tiny share) to focus on higher-volume low-end equipment, its overall Ethernet gear-market share plummeted from around 20% to less than 10%, says Dell'Oro. "Different products are interrelated," she says.


  Indeed, whatever cuts Zafirovski has to make, one thing is certain: They will be painful. But then, Zafirovski has faced challenges before, when he turned around the ailing handset division at Motorola (MOT) (see BW, 10/31/05, "Handyman's Special"). "This is not an overnight [success] story," Zafirovski said.

Indeed, at the conference, RBC analyst Mark Sue asked Zafirovski if he should upgrade Nortel's stock. "I think it's delinquent of you, to be honest," Zafirovski said. But while Nortel is in a better place than it was a year or two ago, as Zafirovski himself concedes, it's got a long climb ahead.

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