Nortel: Nowhere To Go But Up

David M. Ewalt
08.20.04

NEW YORK - It certainly sounds like bad news when a company fires seven executives for financial malfeasance, lays off 3,500 employees and advises investors that it expects sluggish market growth for the year. But for Ontario-based Nortel Networks, it's all evidence that the company is getting itself back on track and working to improve its fortunes.

To be sure, the telecom equipment manufacturer has been having a rough year, suffering through an accounting scandal, as well as civil and criminal investigations by both American and Canadian officials. The company has said it will have to restate several years worth of revenues and delay this year's quarterly earnings reports, all while watching its stock price plummet. Sales are slow, margins are low, and, in April, the company fired CEO Frank Dunn, CFO Douglas Beatty and controller Michael Gollogly.

But like an alcoholic who hits rock-bottom and reaches out for help, the latest news suggests that Nortel (nyse: NT - news - people ) is finally facing up to its problems. The company's fortunes seem bound to improve.

Nortel's financial guidance for the first and second quarters, released Thursday, indicates revenues in line with expectations, comparable to competitors like Lucent (nyse: LU - news - people ). Sales aren't great, but that has more to do with slack IT spending than the quality of Nortel's products, according to analysts.

"They're performing about as well as you can expect them to," says Legg Mason Wood Walker analyst Timm Bechter. "They're right about where I thought they'd be. I do still think they can grow stronger than the rest of the market...They have a very strong product portfolio."

As part of their efforts to emerge from their past, Nortel is continuing to restructure its operations, and Thursday's news that they'd cut 3,500 jobs shows how the company is slimming down and refocusing on its most profitable product lines. The company expects to save approximately $450 million to $500 million annually from the move.

"I think it's necessary," says Scotia Capital analyst Gus Papageorgiou. Nortel's margins are significantly lower than competitors Lucent and Ericsson (nasdaq: ERICY - news - people ), and the company needs to cut costs, he says.

The layoffs--about 10% of the company's workforce--will come mostly from middle management in its North American operations and are a side effect of the company's efforts to move from four operating units to just two, one focusing on major telecom carriers like AT&T (nyse: T - news - people ) and the other on big corporate customers.

"This is a major undertaking," says Bechter. "You have a company that's like four little companies, little fiefdoms, and you're trying to integrate that."

While the mass layoffs may help the company improve profitability and help Nortel better target sales, the company may see even more benefit from the firing of just seven executives. Each of the unidentified individuals had responsibility for financial reporting at the line of business and regional levels, according to the company. By cutting them loose now, Nortel is not only distancing itself from its past, but reducing the chances that any civil or criminal indictments will be directed at the company.

It's a smart move, but it's going to take a while for the shadow of scandal to pass entirely. "Until you're clean, you're still dirty," says Bechter. "Even though they've got new management in there that very clearly has made it a priority to have credibility...until they're done with the restatements, reported all the quarters and put a couple new quarters out there under the new regime, there's going to be this overhang."

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