Nortel's new game plan: Canada telecom

Financial restatements aside, it's going to be a long, busy year for Nortel Networks.

Mike Zafirovski had likely hoped that his first conference call as president and CEO of Nortel Networks Corp. would go better. After all, it was his first chance to publicly lay out his plan for the troubled telecom equipment maker. Instead, on the morning of March 10, Zafirovski and executive vice- president and chief financial officer Peter Currie had to once again discuss how Nortel was unable to get its accounting straight: for the third time in three years, it would need to issue a sweeping restatement of its financial results. Top-line revenue figures for 2003, 2004 and the first nine months of 2005 were under revision, they said, and the Brampton, Ont., company's 2005 year-end results would have to wait until the finance team completed the restatement process, sometime in April.

For Zafirovski, who joined the company on Nov. 15 and had spent much of the following 116 days assessing its operations and setting in motion a massive re-evaluation of the entire business, Nortel's now-infamous history of bad bookkeeping sabotaged his opportunity to talk about the future. “The restatement is disappointing to many, I'm sure,” he told analysts, but also argued that it was “the right thing to do” and expressed confidence in his finance team. “We will not allow this to become an impediment or an excuse in our plans to remake Nortel into a great company.”

But the restatement had, in fact, already thrown a wrench into his plans. Zafirovski was expected to have revealed Nortel's new research-and-development spending plans the week of Feb. 27. Instead, the company remained silent until the March 10 conference call, which itself was hastily announced the prior evening (but remained vague about R&D plans). In the call, Zafirovski acknowledged how the number fumble weighed on him and his team. “We'd been debating whether we should be discussing our long-term objectives when it became evident that we'd have to be discussing the restatements,” he said. “But I thought this was a perfect time for our investors, our customers, to have a good appreciation of our commitment to address all sorts of issues.” One of which might have been the price of Nortel's stock (TSX: NT) which closed on March 9 at $3.61, well off its 52-week high of $4.22.

Indeed, Zafirovski spent 10 minutes of the 70-minute call first going over what he saw as Nortel's strengths, but also how the company intended to fix its many weaknesses–and those go far beyond accounting problems. In doing so, he painted a picture of a company even more deeply troubled than many may have realized.

Of course, Nortel's profound inability to report financial results accurately has made it difficult to really know much about the company. But Zafirovski made it clear that whatever the actual numbers, things have not been going well. “I would argue our last strong overall financial performance was in 1998,” he said. “It's been a very inconsistent performance in the last five years.”

And he went on, describing Nortel as being still too complex, despite the efforts his predecessor, Bill Owens, made in restructuring the organization. Zafirovski also noted that the company's products were of only “average” quality, and that while Nortel has some processes in place to ensure that, for example, products get to market swiftly, those processes are “not followed as rigorously as we will.” Finally, he said, “We have tried to be too many things to too many people.”

Only now is the scale and depth of the transformation that's necessary at Nortel emerging. In December, a small battalion of 80 “top-performing” employees began working full-time alongside 12 consultants from McKinsey & Co., with another 40 colleagues helping part-time. Grouped into six teams, each led by the most senior members of Zafirovski's management team, they are tasked with finding ways to simplify how Nortel functions, generate new revenues and expand its operating margins by US$1.5 billion by 2008. Costs must be reduced. Quality and processes must be improved. Teams must collaborate more.

Some of the improvements are expected to come through introducing the Six Sigma program, a culture-changing exercise that statistically measures performance and questions a company's established ways of doing things. Zafirovski spent the first 25 years of his career at General Electric, which is famous for its use of Six Sigma. He quickly hired four former GE executives, including Joseph Flanagan, who joined Nortel as its new VP of order management on Feb. 27 and is considered an expert in the program.

But that is just the beginning. As part of his presentation, Zafirovski also laid out an all-encompassing six-point plan to turn Nortel around within three to five years. It is an aggressive agenda, even for a guy who earned the moniker Mr. Fix-It for overhauling troubled communications-equipment maker Motorola during his five-year tenure there. In addition to his plans to restructure internal operations, and ongoing efforts to improve Nortel's financial controls and corporate governance, Zafirovski has set a goal of being ranked as one of the top 25 companies globally for its practices. Nortel must also address its product portfolio, and the focus of the R&D efforts that support it.

Zafirovski has already made one key move: in January, Nortel pulled the plug on its much-anticipated MPE 9500 edge-router, code-named Neptune, that was intended for telecom carriers looking to handle increasing loads of Internet traffic, but had languished in development for years while competitors like Cisco Systems, Alcatel and Juniper Networks beat it to the marketplace. Now, the technology will be used in wireless and voice-networks equipment–and Nortel bows out of the carrier edge-router market altogether. It will likely not be the last time the company abandons a product segment, either. Analysts cite its flagging GSM wireless business, for instance. Zafirovski has committed to attaining at least 20% market share in a business segment, or getting out.

Nortel's R&D strategy will reflect that approach. “We are not nearly as efficient spending that US$1.8 [billion] to US$1.9 billion today as we should be,” Zafirovski said during the conference call. “Also, we're not spending enough of that money on longer-term opportunities.” But while the money needs to be reallocated into areas that will result in significant revenue growth–the CEO identified IP-based multimedia, IP-TV and wireless broadband technologies as three areas of focus–he added, “we will not be cutting back R&D.”

Analysts, who were preoccupied with digesting the significance of yet another financial restatement, remained, at best, cautiously optimistic about the direction Zafirovski is taking Nortel. Ehud A. Gelblum, a New York-based analyst with J. P. Morgan Securities, wrote in a report that the target of improving operating margins by US$1.5 billion by 2008 is “a good goal, though ambitious.” He added that while it would bring the firm closer to its industry peers' gross margins, “it could be challenging for Nortel to achieve this goal.”

What limited financial guidance Zafirovski and Currie could offer in light of the restatements was not heart-stopping. While they predicted operating expenditures to stay flat, revenue will grow only 5% to 9% over fiscal 2005. Analysts say that will mostly come from a joint venture with LG Electronics in South Korea, and Nortel's new Government Solutions division, the result of the 2005 purchase of PEC Solutions based in Fairfax, Va.

Multiple financial statement revisions aside, 2006 is shaping up to be a long, busy year for Nortel.