Trouble on the Line for Nortel?

Chief Exec Mike Zafirovski says the maker of telecom equipment is bouncing back, but not fast enough for many analysts

Investors had high hopes for Mike Zafirovski when he took over as chief executive of Nortel, the troubled Canadian telecom-equipment maker. After all, he was already legendary for turning around Motorola's (MOT) cell-phone business, so some shareholders reckoned he would make quick work of Nortel's (NT) woes. And to hear Zafirovski tell it, that's just what's happening. On May 16, the executive said he has accomplished much to get Nortel, long plagued by losses and bad accounting, back on track.

Having met with hundreds of customers since taking the helm, Zafirovski expects Nortel to show sales growth in the high single-digits through yearend. He's slashing six product lines, refocusing on promising new businesses like ethernet broadband equipment, and cutting millions of dollars in costs. About 90% of his new executive team is in place, though Nortel is still looking for a chief technology officer and someone to run its Asian operations. "We are very excited as to where we are," Zafirovski said during a conference call with the media. "We have a stabilizing foundation and optimism for the future."

He reiterated this optimism during a separate call with investors: "We are confident we will -- and can -- create a great company," he said. But some weren't buying it. The company's stock fell 4.3%, to $2.47, the day Zafirovski issued the update. Mark Sue, an analyst with RBC Capital Markets, cut his 2006 and 2007 earnings estimates and price target.


  Analysts say the company isn't improving profit margins at a fast enough clip, and that it gave too little information on when it expects to recognize revenue from certain contracts. "You have Mike Zafirovski talk about how pleased they are with the progress, but the numbers don't match with the story," says Albert Lin, an analyst with American Technology Research.

Nortel's forecasts for first-quarter sales and this year's operating margins sent a signal it may take management longer to right the ship than previously expected. First-quarter sales will be flat to down slightly from a year earlier, when revenue was $2.54 billion. Nortel also said the loss for the first three months of the year widened from last year's $49 million.

The company, now in the midst of restating financials, is expected to release results by the week of June 5 (see BW Online 3/13/05, "No Accounting for Nortel's Woes"). But analysts surveyed by Thomson Financial were expecting a profit of $95 million on $2.7 billion in sales. "Obviously, things aren't turning around as quickly as we hoped," says Richard Windsor, an analyst with Nomura.


  Another disappointment: Nortel's projected operating margins. Zafirovski expects the margins, currently hovering near zero, to improve by 300 to 500 basis points a year in the next three years, as he cuts some $1.5 billion in costs by eliminating layers of management, among other efforts. Some analysts expected a steeper improvement, given the low starting base.

Nortel also gave too little information on when it plans to include deferred revenue whose recognition has been deferred until the underlying contracts are fulfilled, analysts say. The company's deferred-revenue account has ballooned to $3.5 billion amid restatements and changes in the company's accounting. That balance will decline in coming years, Nortel said, but it didn't specify by how much or how fast.

Investors had hoped that about $2 billion of that deferred revenue would be recognized this year, pushing Nortel, which only booked $10.5 billion in sales in 2005, ahead of rivals like Lucent (LU) in performance, says Lin. "This was an opportunity for Nortel to look good," he adds. "This is why a lot of people own the stock. But after today, [the timing of this revenue recognition] seems very nebulous."


  To add to the company's laundry list of ongoing woes, it's facing tougher competition in its key markets. In China, Nortel faces fierce price pressure from gearmakers Huawei and ZTE. In the U.S., it's bound to continue butting heads with Lucent, an even stronger competitor now that it's merging with European giant Alcatel (ALA) (see BW Online, 4/05/06, "The Alcatel Effect").

Making matters more challenging, telecommunications providers are consolidating and growth in wireless spending is slowing, which means Nortel is fighting bigger rivals for fewer carrier dollars. And Nortel's accounting restatements and executive changes of the past few years haven't done it any favors either. "Customers have been nervous about Nortel's viability," says Nomura's Windsor. During the media call, Zafirovski did indicate that customers have been receptive during his slew of recent visits.

Investors and analysts are skittish about calling this the low point for a company that has disappointed in the past. But there's greater consensus on another point. "The road to recovery is going to be a long one," says Peter Hofstra, senior analyst with AIC funds.