Strategy

The good, the bad and the ugly: Nortel Networks

Mike Zafirovski's strategy may have been right, but it probably came a few years too late.

Nortel Networks (TSX: NT) Telecommunications equipment manufacturer
Established: 1895 (as Northern Electric and Manufacturing)
Employees: 30,000
Altman’s Z-Score: 1.57
Probability of bailout: low

How did it go bad?

Depending on how far back you look, some blame former CEO John Roth, who overspent on bad acquisitions during the interwoven dot-com and telecom bubbles. Others blame Roth’s successor, Frank Dunn, the former CFO who was at the helm during Nortel’s seismic accounting scandal, leading to financial restatements that have plagued the company for years. And some point to the unsuccessful 19-month tenure of Bill Owens, the heat-of-the-moment replacement for Dunn (who was fired for cause in early 2004 and still faces legal charges, though he denies any wrongdoing).

But to blame his predecessors is to create excuses for current CEO Mike Zafirovski, who was hired in November 2005 at much cost — US$20 million in salary, plus US$40 million to settle a contract dispute with his former employer, Motorola. Zafirovski was confident he could fix Nortel’s mess. He and his hand-picked team of execs crafted a three-to-five-year turnaround plan that involved a new corporate structure, a focus on dramatically improving gross margins and operating expenses, and realigned R&D priorities.

The strategy may have been right, but it probably came a few years too late. Nortel’s competition and customers were already consolidating, and low-cost foreign competitors such as China’s Huawei were coming on strong. Meanwhile, Nortel’s product portfolio was appearing frayed, with too much reliance on older technologies. And that was all before the credit markets froze, the economy tanked and customers deferred capital spending programs. Nortel was quickly unable to finance its heavy debt burden, and hopes to sell its promising Metro Ethernet Networks division went nowhere.

How ugly is it?

On Jan. 14, Nortel filed for bankruptcy protection in Canada, the United States, Israel and the U.K., one day before $107 million in interest payments came due. In December, its debt ratings had already been reduced by Moody’s to Caa-2 (signalling a threatening bankruptcy) and several of Nortel’s suppliers were getting antsy — some had even stopped shipments due to late payments. Without protection, Nortel says it would have stopped operations in Canada as soon as Q2 this year.

Further proof of the company’s dire straits came on March 2, when it released Q4 and fiscal year-end results for the period ending Dec. 31. They were ugly.

• Q4 revenue was down 15% year over year; annual revenues were down 5% to US$10.4 billion.

• It lost US$5.8 billion last year, or US$11.64 a share, including non-cash charges of US$2.2 billion in Q4 to reduce goodwill and deferred tax assets.

• It burned US$1.1 billion in cash, ending the year staring at US$4.5 billion in long-term debt.

Nortel is now creating a restructuring plan it hopes to present to creditors in April, but has already announced 5,000 employees are being laid off. The company has decentralized its operations into three major lines of business — Carrier Networks, Enterprise Solutions and Metro Ethernet Networks — while groups such as marketing, R&D and even the global services division that once spanned the company have been broken up and tucked into the three corporate silos. Why the shuffle? The theory is that it will be easier to sell one or more division outright if they are already separate.

What if?

Nortel hopes to re-emerge as a smaller, more focused entity, but that depends on finding one or more willing buyers — and that’s no sure thing in this economy. What was unthinkable less than a decade ago is now a real possibility: Nortel as a corporate entity could disappear altogether.

It is already greatly diminished, but as of its bankruptcy protection filing, Nortel still employed 5,800 people in Canada, 4,000 of whom work in Ottawa at its Carling facility (taking up only half of the 2.2-million-square-foot campus). There’s also an executive office in Toronto, and three specialty R&D centres in Montreal, Calgary and Belleville, Ont. Those numbers are almost certain to dwindle with the announced layoffs, although the company has not revealed details of where it will cut. (It has 30,000 people worldwide.) At one point in 2000, Nortel was the world’s largest supplier of telecom equipment, earning revenues of US$30 billion and employing 94,500 people worldwide — 25,900 people in Canada, 12,600 of whom were in R&D.

But employee numbers only scratch the surface. Although Nortel’s R&D spending has steadily slipped since it paid out US$4 billion in 2000, the US$1.6-billion it spent last year was likely the largest in corporate Canada (the company doesn’t break out how it spends R&D in different countries, and it does have big research facilities in seven other countries). Even if some of Nortel’s multinational competitors do acquire parts of its business, there is no certainty they will continue investing in high-value R&D activity in this country.

Nortel has traditionally been a headwater of innovation for the Ottawa region: Denzil Doyle, the so-called father of Silicon Valley North, in 2008 mapped out some 450 companies that trace their roots at least indirectly back to Nortel. But, in stark contrast to the first waves of layoffs earlier this decade, sidelined Nortel employees will now receive no severance, and risk capital is scarce in Canada. Some may find relevant work in Ottawa, but many could leave.

Something else is lost without a national flag-bearer like Nortel: access to global markets. Brian Hurley, a 15-year veteran of Nortel and Bell Northern Research who left in 2002 to pursue entrepreneurial ventures, says the Nortel name carried a great reputation. “I could go to any number of companies in the telecom or technology worlds, and just mentioning I was from Nortel would get me in the door to talk to them,” he says. Startups typically struggle to reach decision-makers, but those with personal contacts at Nortel found that path a little easier. “By losing that ability to open doors, we diminish our ability to be competitive,” says Hurley.

Perhaps the companies that pick up Nortel’s pieces will invest in Canada. But a far-flung satellite R&D office does not bode well for employees wanting a deeper knowledge of business issues.

At this stage, the sad fact is that even a best-case scenario means a much smaller Nortel — one with more focus, true, but also far fewer employees and far fewer financial resources to invest in research and development. In other words, the best things Nortel offered Canada are already gone.