Whither Nortel?

As a former employee of Nortel back in the '90s I am saddened by their present dilemma. Saddened, yes, but not surprised. This slide in Nortel's fortunes reflects what, in my view, is a long-standing and never corrected problem in the fundamentals of their business. They still don't seem to know what they want to be when they grow up. That is, just what business are they in?

Let me give an abbreviated review of Nortel's history to put this in some context. At each major phase, as I will define it, I will try to summarize their business focus, with the understanding that I have to simplify, though hopefully not over-simplify.

1. Pre-1996: Engineering-driven, hardware-based product business, selling primarily to telephone companies and secondarily to enterprises. The only significant service business was post-sales product support; telcos had their own large internal organizations to develop systems and processes to use the products. Major competitors in the carrier space were AT&T (now Lucent), Siemens, GTE, Ericsson, Alcatel, and some 2nd-tier vendors like Tekelec. It was difficult for smaller vendors to sell into the carriers.
   
   
2. 1996 to 2001: There are two new strategies that overlap, but with different start times. With the opening of the telecom market in the US in 1996, and elsewhere shortly thereafter, there were a large number of start-ups in the carrier space. These included the large optical players like Qwest and Level 3, hundreds of CLECs, a smaller number of wireless players (by means of the then novel spectrum auctions), and cable companies (MSOs) that turned their attention to telephony. Nortel approached these companies the same way as before - sell them products to build telephone networks. Since many of these companies were neophytes, or at least new to the segments they were entering, Nortel and other vendors needed to offer more. Apart from the disastrous vendor financing, Nortel developed a services organization to help these companies build their business plans and network plans, and even to help operate their networks. Apart from network operations, the planning work was given away; these services became part of the cost of sales.
   
   The second strategy that began in 1998 was to begin its transformation into an IP company (Roth's "right angle turn"), since they correctly ascertained that IP was the future of networks, and Cisco was increasingly a competitor. Not having time to transform the company's products overnight, Nortel began its strategy of acquiring IP companies, starting with Bay Networks. The bidding war among Nortel and the other major vendors was intense and the number of companies bought was enormous. They could afford this with their 'dot com' inflated stock valuation.
   
   By 2001 when their stock tanked (along with everyone else's) Nortel had failed on both strategies. The first being to build a services business as a complement to their products business, and the second to become a leader in the IP products business, including telephony, IP infrastructure and applications. The reasons they failed are many, but are not the subject of this article. Suffice to say that 2001 was the start of a very difficult time at Nortel. Most of the services business was dismantled and purchased product companies were shuttered. The remaining product lines saw their revenues plunge as many of their customers disappeared, along with the money Nortel lent them to finance their purchases, and their former large customers merged and cut capital expenditures. Not only that, without a sustainable IP presence, Cisco and many newer companies were making large inroads into Nortel's traditional customer base and were setting the technology agenda for network evolution. And so the cutbacks began, as did Nortel's gradual slide into irrelevance.
   
   
3. 2002 to 2008: As the company contracted they were able to bring costs more in line with revenues (even with the accounting scandals of this period), and so were able to keep the lights on. After all, Nortel still had top-notch products and engineering even if it all looked more and more like a patchwork quilt in comparison to what their customers were looking for. Revenue was also impacted by the transformation from a hardware-based business to one that was increasingly software-based. There is a comparison that can be made to the IBM PC business in the early days where they persisted with a hardware-based business model, with the software being thrown in for pretty much nothing. We know what that led to: Microsoft's growth into a giant while IBM lost the PC business entirely. Unlike IBM, however, Nortel has not succeeded in turning services into a significant business. Their business is still product based. Even with some excellent success with IP telephony this is primarily a software business with its lower revenues in comparison to hardware.

So there we are as 2008 comes to a close. There is no clear foundation in their business - it remains a patchwork. Their attempt to refine the product portfolio by selling or killing products and business units only answers short-term financial metrics and further confuses their customers. Just what kind of company is Nortel? At the moment no one really knows, and possibly not even within the company, though we can hope. Consider this quote from a recent Globe and Mail article:

Among investors, there was increased frustration that Nortel lacks the scale and the financial flexibility to become a top player again. “They're worth more dead than alive,” said a portfolio manager of one large equity stakeholder who asked not to be named.

Nortel is playing defense, not offense. That is not a business strategy; it is one that smacks of desperation, which is the view of many analysts watching the company. The stock price cannot recover until they define themselves clearly and at least put in place a credible plan to execute. Investors have to see the potential for growth to bid up the stock. As was noted in this article in the Ottawa Citizen, technology companies are often priced on growth, and so it is common to see the market cap of high-growth companies at many times annual sales. Nortel as of Friday was trading with a P/S of about 0.13!

So what are Nortel's options? I see three main strategies they could follow, or some sensible combination of them:

• Continue as a product-based business. Unfortunately they will never regain their past dominance. They don't have the talent (or the ability to attract the best talent), the R&D budget, the speed, and investors will not give them the time needed. They can keep the products and technology that is most profitable or promising and get rid of the rest. Management is doing that now. MEN is a puzzle since it is profitable and no one in the company knows or will say why it's being sold, so it may indeed be an indication how big Nortel's problems are; many suspect they are doing this because they need the money now to shore up the company. If they continue with a incomplete mix of products they cannot be a prime vendor to the major carriers. Instead they may be relegated to supporting the bids of larger vendors with the few pieces they can supply.
  
  
• Become a network integrator. If you don't have all the products in-house and want to bid on the largest network projects you must bring in other vendors to supply the missing pieces. These outside products may indeed form the lion's share of the bids. Nortel can rebuild its credibility with the carriers by becoming effective at doing this. I know they have tried (including from personal experience), though perhaps not as successfully as others. It requires building an 'ecosystem' of products that they can guarantee will inter-operate and that also use a common management framework. They must also demonstrate the expertise to support these products. They have made some missteps in the past though if they begin to take it seriously, rather than treating outside vendors as a threat, they could excel at this strategy.
  
  
• Service business, both consulting and operations. I have my doubts that they could regain credibility in this space, especially since much of that expertise is long gone and they may not have the luxury of time to build the business. Further, the competition is much stronger now than it was a decade ago.

This article is going to end with a whimper, not a bang. I have no magical solutions to offer. At worst Nortel could be dismantled, with its valuable products and people sold piecemeal to other companies. The company is now so sick that may be all their investors will have the patience for. It will be a loss to Ottawa (and perhaps even Canada) even should those pieces survive since there will no longer be a dominant, or any, Canadian branding on those businesses.

The company has repeatedly failed in the past to reform itself into a major player with the strengths to compete in the new telecom environment. Why would this time be different? In conclusion, I am not hopeful that Nortel can survive the decade.