Finally, Good News from Nortel

Third-quarter results show a big turnaround. A few more of thoseand perhaps an acquisition or twomight bring the company back into favor

Asked in advance of Nortel Networks' quarterly report how he feels about the company's performance these days, one analyst shoots back: "They stink!"

Who could blame him? For the better part of four years, the telecom-equipment maker has disappointed Wall Street with a steady supply of red ink, accounting fiascos, shareholder lawsuits, regulatory investigations, and multiple firings of top executives.

But perhaps Nortel (NT) is starting to put all that behind it. The embattled company reported on Nov. 6 that it earned $27 million in the third quarter—a turnaround from the $63 million loss suffered over the same three-month period in 2006.

While revenues fell, a closer look also offers encouragement. Third-quarter sales totaled $2.7 billion, falling 7.6% from the year-ago tally of $2.9 billion. But the year-ago numbers include revenue from a cellular business Nortel sold in late 2006. After excluding that unit's sales from the 2006 figures, third-quarter revenue was down just 2% from year-ago levels. And for the first nine months of 2007 revenues are actually 2% higher if the sold division's results are excluded.

Orders Are Up

The best sign of future growth, says CEO Mike Zafirovski, is that orders for Nortel products were up 2% in the third quarter, to $2.3 billion, or 9% above the year-ago level when the wireless unit's orders are excluded. "Orders translate into future revenues," he told BusinessWeek in an interview. "This is a pretty good sign that speaks to the relevance of the top line."

Another good sign: The accounting troubles that have plagued the company for so long finally appear to be under control. Zafirovski has resolved regulatory investigations by federal agencies such as the Securities & Exchange Commission. Nortel's major shareholder lawsuits have been settled, and the accounting deficiencies that have forced the company to restate years of financial reports have been cut from a staggering 12,000 in 2004 to 21 today, Zafirovski says: "Those dark clouds are being blown away by strong winds of positive results."

The biggest positive is the jump in Nortel's margins. Zafirovski, a protégé of legendary General Electric (GE) CEO Jack Welch in the early-to-mid '90s, has long been an effective cost-cutter and unwavering advocate of building profitability. That's what he did as the president of GE Lighting and later as head of Motorola's (MOT) cell-phone business. In his two years as CEO of Nortel, he's been doing it again.

Analysts Want More

Under Zafirovski, Nortel has made a huge improvement in profit margins by shoring up its procurement processes, its supply-chain efficiency, and its spending. In the third quarter, gross margins swelled to 43%, up from 38.4% a year earlier and the highest level in nine quarters. Operating margins are climbing as well, reaching 5% in the third quarter, vs. 2.2% a year ago. Those "bright spots," JPMorgan Chase (JPM) analyst Ehud Gelblum wrote in a report, support "our thesis that Nortel's cost-cutting program is on track."

That doesn't mean skepticism doesn't linger. Gelblum believes that without a transformative acquisition or partnership, Nortel's top-line growth could sputter. Wall Street has been abuzz with speculation the company might buy Tellabs (TLAB), a maker of telecom transport gear based in Naperville, Ill. UBS (UBS) analyst Nikos Theodosopoulos has posited that Nortel may be considering acquisitions aimed at speeding up growth or increasing its scale in areas such as Internet-based telephone and TV technologies.

Analysts have said that a larger company could use Tellabs to increase its own product offerings and secure a greater position with U.S. telephone carriers and other large communication companies.

But in acquiring Tellabs, Nortel could find itself buying new problems. Tellabs has been stumbling through its own spate of subpar quarters of late. Still, Zafirovski needs to add scale since his top rivals are bulking up on mergers and acquisitions, from this year's combination of Alcatel and Lucent (ALU) to a drumbeat of investments by Cisco Systems (CSCO). "The rationale would be: Add another slow growth business and make it a really big business," says Ittai Kidron, an analyst at CIBC World Markets (CM). "That way you can cut more cost."

On the Prowl

Zafirovski wouldn't comment on Tellabs in particular, but he continues to say an acquisition isn't out of the question. "We are looking at things across the board," he told BusinessWeek. "We're always looking at complementary activities to help us bulk up."

If Nortel does make a move, look for Zafirovski to add muscle to its high-growth enterprise business. That unit, which competes with kingpin Cisco in providing office-communications gear to big companies, is a major priority. Nortel is already pumping 80% of its $416 million research and development budget into that product line, as well as emerging businesses such as WiMAX networks and unified communications technologies that meld phone, cellular, e-mail, and other services. That share of R&D spending is way up from 45% a couple of years ago, when far too much money was invested in declining businesses. "The composition of [R&D] spending now is so superior to what we had before," Zafirovski says.

Next quarter and beyond, Nortel's chief suggests, should be just as strong as this one. Momentarily, at least, Wall Street is buying it. Nortel shares surged 18%, to $19.18, after the report, but they still languish 40% below the 52-week high. So you may forgive investors and analysts if they take a wait-and-see approach. "Although I'm willing to give credit for gross-margin progress," says Kidron, "I still don't see growth in the business."

Zafirovski will have to deliver many more strong quarters—and maybe make an acquisition—to blow away the disappointment completely.