Nortel's Road to Bankruptcy

As a long-distance runner, Mike Zafirovski is used to daunting challenges. An Ironman triathlete unafraid of long, hard slogs, the CEO of Nortel Networks (NT) knew when he took the job back in 2005 that turning around the struggling Canadian telecommunications equipment maker would be no easy task. But you can bet Zafirovski never expected the road, however bumpy, would lead to bankruptcy.

Yet that's exactly where Mike Z., as he's known, has found himself. Nortel, the largest North American maker of telecom gear, said on Jan. 14 it had filed for bankruptcy protection in Canada, the U.S., and Europe.

The Toronto-based company said it still has enough cash to continue operating while the bankruptcy plays out. However, diminishing demand for phone equipment and stiff competition battered Nortel, while the global financial crisis that accelerated in the fourth quarter made it harder for companies like Nortel to restructure loans. "The world changed dramatically in September," Zafirovski says in an interview with BusinessWeek. "So we needed to preserve the balance sheet…and to ensure that we were on sound financial footing for the long term."

Zafirovski spent the day holding meetings and conference calls with staffers and customers trying to explain the decision and salvage some hope for the future. With the cash on hand, Zafirovski expects Nortel to continue meeting demand, supplying equipment for orders and making further sales. Behind the scenes, he's working to hash out a plan that would have the company emerge from bankruptcy operating smoothly. "We're not making any announcements now about our strategy, but we are providing confirmation to our customers," he says.

Burning Through Cash

Whatever its condition upon emergence from bankruptcy, Nortel is in rough shape going in. Once the darling of Canadian business, with $30 billion in revenue, Nortel had recently become a $10 billion shell of its former self. The company is saddled with mounting debt and dwindling cash flow. The company would have hit a cash crunch by the end of 2010, said UBS (UBS) analyst Nikos Theodosopoulos. Nortel had $2.6 billion in cash at the end of the third quarter, and by some analyst estimates has been burning through about $300 million to $400 million in cash a quarter. "It was better to file [for bankruptcy] now with cash on hand than wait until they were under more pressure," Theodosopoulos says.

Zafirovski was hired because he was perceived to be the sort of change agent needed to return Nortel to its former glory. An alum of General Electric (GE) and one of the few executives credited with wringing profits out of Motorola's (MOT) ill-performing phone unit in recent years, Zafirovski was thought at least to have the skills for turning around a company that had long suffered from declining sales and managerial upheaval.

Not only had the tech bubble burst, but Nortel was coming out of an accounting scandal that required a great deal of attention from Zafirovski and his team for much of his first year. He was battling to regain shareholders' confidence. "The stock became almost tainted merchandise," says Michael R. Sprung, president of Sprung & Co. Investment Counsel. "The investment community certainly had doubts about his ability and the board's to turn the company around."

True to form, Zafirovski didn't waste time setting new goals. At the heart of his plan was dramatic improvement in Nortel's operating margins, a yardstick of profitability. Nortel's margins were wallowing around 6% at the time, and Zafirovski pledged to boost them as high as 19% before long.

Did Nortel Exit the Wrong Business?

Zafirovski now says revenue growth and cash flow filled out a three-pronged approach to improvement. The plan was to redirect the company toward the future. When he took over, some 55% of spending was devoted to "legacy products," such as conventional phone gear that was being systematically replaced with new Internet-based equipment. "So we looked at how do we redirect R&D spending," he says. In hockey terms, he "wanted to go to where the puck [was being hit] rather than where the person is."

Makes sense, but the big question is whether Zafirovski should have pushed Nortel to exit certain businesses sooner and been more aggressive in seeking mergers or joint-venture partnerships that would have given Nortel much needed scale. Nortel has long had its hands in several businesses—from optical networks to wireless infrastructure to government and enterprise systems. But in recent years it has not dominated in any of its markets; Nortel was not No. 1 or No. 2 in its four major businesses. Just as bad, analysts say, it had one of the weakest balance sheets among the telecom equipment companies. "Nortel tried to hold on to all of its pieces," says Ronald Gruia, a telecom analyst for consulting firm Frost & Sullivan. Zafirovski should have focused on one or two and jettisoned the others. "If you do a good job of managing, maintaining all those pieces, you have a very diversified portfolio," Gruia says. But if you fail, "When it comes the time to make cuts, you have to start starving these individual businesses."

When Nortel did decide to exit a business, it chose the wrong one, Gruia says. Nortel opted to jettison one of the dominant next-generation technologies, a 3G technology called UMTS. Yet, some of the world's largest wireless service providers have decided to hitch their fortunes to this technology, rather than those Nortel kept in its quiver. "Getting out of UMTS was a mistake," Gruia says.

Zafirovski vehemently disagrees, noting that Nortel only had a 5% to 6% share in the UMTS business but a 22% stake in the next-generation technology used by Verizon Wireless that it chose to keep. "The move out of UMTS where we were not making money was the best move at the time," he says.

Ironically, bankruptcy might prove to be the best decision Zafirovski has made during his tenure. If it allows Nortel to restructure its debt adequately—Theodosopoulos says it could potentially renegotiate its $4.5 billion in debt to as low as $900 million—there's a chance for a decent second life. Zafirovski will have to either sell or shut down several Nortel businesses as part of the bankruptcy restructuring, enabling the company to "come out a strong and focused technology player." If not, as Sprung says, it will be "a sad end to what was a great Canadian success story."

Before it's here, it's on the Bloomberg Terminal.