Q&A with Nortel's Mike Zafirovski

The Nortel CEO owns up to disappointment with margins and explains why the telecom equipment maker is stepping up investment in WiMAX technology

It's a long way from full recovery, but finally Nortel Networks (NT) is showing signs of life. The Toronto-based telecom equipment maker said on Nov. 7 that it posted a narrower third-quarter loss as robust demand for next-generation wireless gear and equipment for enterprise networks fueled a 17% surge in revenue, to $2.96 billion.

Despite the progress, Wall Street wasn't completely impressed. Nortel shares fell 24 cents, or 10%, to $2.15, mainly because investors were troubled by its lackluster profitability. Nortel lost $99 million, or 2 cents a share, in the three months ended Sept. 30 compared with a loss of $136 million, or 3 cents a share, a year earlier.

It was margin performance in particular that disappointed investors. Nortel's gross margin—the percentage of profit after the cost of making it—came in at 38%, while Wall Street was expecting 40%.

Trouble at the Margins

From the day he took the helm, Nortel CEO Mike Zafirovski has emphasized the importance of improving profit margins. Carriers and corporations are buying more next-generation equipment, but that gear has lower profit margins than older products as fierce competition puts pressure on prices. Adding to the problem, Nortel acknowledged that it encountered higher expenses as it attempts to upgrade product development.

Zafirovski admitted in a conference call with analysts that unless Nortel boosts gross margin above 40%, it won't be able to achieve its longer-term goal of raising operating margins from single-digit percentages to the midteens. Zafirovski addressed that challenge, explained how he's trying to improve product quality through a program called "lean Six Sigma," and discussed progress in Nortel's turnaround effort with BusinessWeek telecom writer and Chicago Deputy Bureau Chief Roger O. Crockett. Edited excerpts of their conversation follow.

What are the strongest indicators that you are making progress in the turnaround of Nortel?

Two indicators are customer and employee satisfaction. Both are up dramatically in the second half of the year vs. the first half. The surveys we do indicate satisfaction was 20% higher in October than in April. So customers are getting much more satisfaction from Nortel products and service.

You have a so-called "business transformation" model to drive savings. How is that progressing?

We are starting the business transformation with a target of $1.5 billion in operating margin expansion. I am confident we will be able to achieve that. One method of reaching our goal is through our lean Six Sigma initiative. It's a program to attain high quality of performance in our products, to drive perfection in our processes. And the lean part is an effort to get there faster and have simpler processes.

Profit margins have always been an important metric for you to meet, yet margins were below expectations this quarter. What happened?

The level of profitability improvement is not where I'd like to see it. I am measuring profitability by operating margin. Although quarter-over-quarter our operating margin improved (to 1.4%) we should be further ahead. That's why I want to accelerate our lean Six Sigma program. We need to bring in expected results faster. Our target now is to reach margin goals by the middle of 2007 rather than late 2007. We are about 500 basis points deficient vs. our benchmarks. So we want to show meaningful improvement by the middle of 2007, and the balance of improvement in relation to our benchmarks by 2008. Similarly, our R&D has been in the range of 18% of revenues. So, rather than improve to 15% by 2008, we plan to get there by the middle of 2007.

You have not met expectations in terms of gross margin as well, right?

Our gross margin has been between 38% and 39% for several quarters. That is the good news. What I am unhappy about is I have not been able to move them up above 40%.

Elements affecting gross margin are: 1) Faster acceptance of new-generation technology. Every time you have a new technology (from PBX voice servers to VoIP equipment), the gross margin is lower in the beginning. 2) Pricing pressure, particularly in Europe and the developing markets. You have a significant number of competitors on the carrier side in those markets.

What progress are you making in remaking the company to address new business opportunities such as WiMAX?

First, I want to be clear that we are not betting the farm on WiMAX. But having said that, the second-half investment we are making in WiMAX is five times the original budget for the second half of this year. So we are really increasing our spending. We want to make sure we have a market advantage. So we are careful to make sure we are picking the right WiMAX trials (such as Sprint Nextel's (S)) to be a part of.

Are you aiming to be the leader in WiMAX and when do you expect to reach your target?

This is not a 2006 game, but we're making the investments. This is one of the examples of focusing on businesses where we can achieve at least a 20% share. We are leaving the UMTS (a technology that provides high-speed wireless Internet access) market where we do not believe we have a chance to be successful. But in next-generation mobile (WiMAX), we can be highly successful. We're in a position to be one of the top players. Right up front.

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