Nortel Sees the Light

How to manage a $21 billion company growing by 40 percent a year.
A CFO InterviewDecember 1, 2000

When Frank Dunn joined Nortel Networks Corp. as a management trainee out of college in 1976, the company was still known as Northern Electric. It had revenues of $1.1 billion and sold most of the circuit switches, transmission gear, and phones it manufactured to parent Bell Canada Enterprises (BCE), the Ma Bell of the north.

How things change. Dunn, after working in virtually every division of the company over the past 25 years, was appointed CFO at the beginning of last year. And Northern Electric became Northern Telecom became Nortel Networks–now an independent company and one of the premier suppliers of telecom equipment to the voice and data networks of the world.

The road to independence started when Bell Canada realized its equipment manufacturing arm could win much more business as a stand-alone company–much as did AT&T with Lucent Technologies Inc. In 1973, BCE sold 9.9 percent of Nortel to the public. It sold off its remaining 38 percent stake this past May.

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In the past five years, Nortel has been on a tear. Revenues have increased from $9.8 billion to $21.3 billion last year, and its customer base has expanded from the regional phone companies and long-distance competitors to include competitive local exchange carriers, wireless networks, and Internet and application service providers. The Brampton, Ontario-based company has been outgunning chief competitor Lucent in the job of overhauling telecom networks intent on delivering ever-more information to consumers and businesses.

Nortel has not only avoided the organizational upheaval that Lucent is now experiencing, but is also growing nearly as fast as Cisco Systems Inc. In fact, many believe Cisco, king of the enterprise networking market, is now the only competitor that can stop Nortel from grabbing the bulk of the expected boom in future capital spending by telecommunications carriers. With an early and lengthening lead in optical networking products–the hottest tech sector going–Nortel has a good shot at doubling its revenues to $40 billion by 2001.

No surprise that Nortel, whose shares rose from under $10 in late 1998 to a peak of $86 last May, has also become a bellwether stock for the technology market. The company recently sparked a nearly 200-point slide in Nasdaq when optical sales growth was slower than expected in the third quarter. Add to that the recent financial hardships in the telecom service market, and Nortel’s shares have dropped by almost 50 percent in the past five months.

Dunn, however, doesn’t worry much about short-term reactions in the market. “The valuations will come if we keep doing the right things,” says the 46-year-old CFO. Dunn recently spoke with senior editor Andrew Osterland about what the right things are and about the challenges of managing a $21 billion company growing at 40 percent per year.

Wall Street was obviously disappointed with Nortel’s third-quarter results. How would you characterize the quarter?

At the end of Q2, we gave guidance on growth of the low 40 percent range for revenues, and high 30 percent for earnings. When we delivered 42 percent on the top line and 64 percent on the bottom, we thought it was a solid quarter. The Street obviously thought we’d blow through those numbers. But nothing has changed in our outlook for the business.

How has Nortel itself changed from the Northern Electric you joined in 1976?

Nortel’s strength is that we see where we want to go and we value our conviction. We really believe the valuations will come if we keep doing the right things. We’re generally first off the mark on where the market is going, and I think that’s put the company where it is today, growing at 40 percent-plus per year.

For example, we were the first to come up with a digital switch. We decided that was where the window [of opportunity] was, that digital was better than analog or electronic switching. And we invested very heavily back in the late 1960s and early 1970s to come up with a product that would give us a leadership edge.

The next major breakthrough was to invest very heavily in the high-speed optical backbone network. When everybody else decided that 2.5 gigabits was more than enough speed for telecom networks, we decided that we wanted a 10-gigabit system. We came out with our OC-192 product back in late 1996, when a lot of our major competitors were still struggling to get it out the door. It’s on its third hardware platform and seventh software release. Now we’re bringing out a 40- and 80-gigabit network. Obviously, it was Lucent that failed to meet that challenge; they stuck with their 2.5.

At the same time, we get out of things we don’t believe can differentiate us in the future. We used to make a lot of the power equipment that goes around a lot of the various outside plant capability. We used to be in the fiber-optics manufacturing business. We used to have Nortel-branded phones. We don’t do any of those things anymore. Our mindset is, if somebody else can do it just as well as we can, let them do it. We have to do things that no one else can do.

How did the Bay Networks acquisition fit into your first-mover philosophy?

Back in 1998, we saw that the world was changing to a packet environment, away from a circuit-switched environment. You can’t transmit data cost-effectively and in huge volumes over a circuit-switched network; you’ve got to go to an Internet protocol (IP) core. So we decided we needed IP and routing capability to complement our strengths. And we decided that the company that had the technical capability was Bay Networks.

The acquisition also told us, and the people watching us, that we had to change and go in a new direction. When you hear about the third-generation wireless networks, those backbones are going to be packet-based. When 90 percent of your traffic will be data and only 10 percent voice, you’ve got to move to a packet-ready network. That’s where we’re going.

Along the way, how has your customer base changed?

In 1995, 70 percent of our product offerings were circuit-switched products, and 70 percent of them were sold to the regional Bell operating companies. Today, less than 25 percent of our products are circuit-switched products, and my RBOC customer base is less than 20 percent of the total. In five years, the company has been reengineered to where the growth segments are, and we’ve moved away from where we were. We have 20 percent [of our business] with wireless customers. We have 18 percent with the enterprise customers. And we have 40 percent with the new carriers–the MCI WorldComs, Sprints, and Qwests of the world.

Will the financial problems many telecom service providers are experiencing affect their demand for your products?

No. I’ve been doing financial planning for the last five years, and every year at this time, there’s concern that there’s going to be reduced capital spending. When you’re a service provider, the worst thing you can tell the capital markets is that you’re going to spend a lot more capital. [Wall Street] is always worried about cash flow, capital expenditures, the whole bit. So when providers are out there talking to analysts, they never say, “I’m going to spend a lot more than you guys ever thought.” But if you go back and plot what they’ve said they’d spend versus what they really do spend, it’s always higher.

Are you sure the pattern will repeat?

Our job is to make our customers the most competitive in the landscape they deal with. And when they win in the marketplace, they’re going to come back to the company that helped them win. It’s a very competitive landscape, and people who can make money by having more innovation put into their networks to differentiate themselves and give themselves a cost advantage are going to continue to make the investments. If [Nortel can] cut your network costs by 50 percent, can you afford not to spend the capital?

Nortel has a goal of doubling capacity every nine months and cutting costs by 50 percent. What role does finance play in meeting that objective?

When you look at the traditional mindset of finance, it may play a cop role. We’re unbelievably far away from that paradigm. Traditionally, we do a lot of reporting, internal controls, and so on. But those are taken for granted. Now when I look at a month in a quarter, the only thing I ask is, “What have you learned this month with the financial information you have?” We spend a lot of time saying, “What happens if we move away from this capability and our business is focused here and this happens? It’s much more scenario based.”

We’re also much more focused on the customer. When you look at what drives this business today, it’s all about supplying the total solution. It’s not the lowest price, it’s not the most innovation, it’s not the best commercial terms. It’s all of the above, and it’s a solution. Every customer has a different need. Our finance team has gone from the core of looking at how we develop products to the edges where our customers are. We spend more time understanding what the best solution set is because these customers want a total proposition that will make them competitive. Innovative pricing is a big business for us.

What is innovative pricing?

Here’s an example. A customer says, “I talked to a competitor and they say 2.5 gigs is more than enough for me. I don’t think I need 10 gigabits.” So we say, “We think you do need it, but what we’ll do is deploy a 10-gigabit system in your network, and you pay us for only 2.5. When you want the next 2.5, pay us for that. We’ll sell you only what you think you need, but we know better. And by the way, if you want to turn on more capacity sooner, you get a better deal. And if you don’t ever want to turn it on, that’s OK because we’re not going to make you do that.” We created what we call PAYGO–Pay As You Go.

How do you account for it?

By writing the whole thing off against the pricing for 2.5 gigs. So people say Nortel’s margins don’t look as good, because we wrote off a lot of equipment and costs that were basically unused. Then, customers start turning it on and they say, “Wow! Look at the demand!” When you lead in capability, generally not all of your customers fully appreciate that value. So, how do you incent them to do the things that don’t seem right?

In the current telecom environment, will your financing activity and financial risk increase?

My customer finance activity went from $0.6 billion in 1998 to about $1.3 billion at the end of the second quarter, even though my business has grown by almost 50 percent. My job at Nortel is to be an arranger, not a banker. I try to show customers how they can structure a business plan and a finance equation that’s going to be positive in the markets to attract capital.

What if capital markets aren’t buying it?

People in the capital markets didn’t fully understand how personal communication services [PCS] would be able to compete against cellular. The capital markets needed some experience, so we offered $1.3 billion of financing to Sprint PCS. Then, we worked the capital markets to move that paper.

Another example is Qwest, which came up with a wholesale optical backbone. Traditionally, all the carriers had an optical backbone, but no one would be a wholesaler. So, we offered financing to Qwest. Soon after, people saw the business opportunity in firms like Qwest and Metranet [bought by AT&T], so we sold the debt to someone else. Now we’re financing application service providers (ASPs).

How big will the ASP market be for you?

There’s going to be an evolution to ASPs. We believe the intelligence will sit on the network and basically be put on your device when you need it. ASPs will become the central office switches for network operating centers. The biggest issue right now is that the Web is not a reliable place, so people just dabble in it. That’s going to change dramatically, and very, very soon. If I’m an enterprise and I have a big facility business, I’m going to bring an optical connection into the major downtown buildings. But what happens if I have a small office in Winnipeg? I’m not going to put up my own big infrastructure to manage it, but I want the touch and feel that I have in this office today. I think with the intelligence sitting on the network, more of the devices will become just access tools versus computer-processing tools.

Nortel has acquired 18 companies worth more than $30 billion in the past three years. What are your key elements of due diligence?

We think of it as part of the business of making decisions. We look at where we have to go, and then see what skills we have in-house and where we are short. Then our strategy is to get that outside.

When we acquire companies, we also give them the resources to finish the project. Then we start a team to decide what the next generation of that product is. For example, we acquired a high-speed access vehicle, CVX1800. The second generation of that product is already in the marketplace. Once we give you the resources to finish the project, we start the next generation, which is more reliable, more scalable, because that’s what we’re really good at. We may not come up with every great idea, but we can make the next one better.

Has the rise in your stock price affected your pricing of acquisitions?

If you want to buy a crummy network for a crummy price, you still won’t compete in the marketplace. You’ve got to buy a world-class product. It’s the same thing with acquisitions. No matter what price you pay for something, if it’s crummy, or doesn’t have the right people with the right skills and mindset, you overpaid for it.

How much of your manufacturing is outsourced?

Back in the beginning of 1999, we were looking to outsource about 50 percent of our manufacturing capability. It’s turned out to be about 30 percent, because our optical business, which is still mainly in-house, grew dramatically. When we started hitting our volume in the back end of 1999 and into 2000, we would have needed more than double our capacity [to meet the demand], and we couldn’t have scaled that fast. Having partners out there helped us quickly scale and gave us the flexibility to meet customer demand. If we had to bring up manufacturing online, we would have been dealing with six months, a year, two years, instead of two or three months. That’s why we outsourced.

What are the core activities you keep in-house?

High-end manufacturing, more complicated leading-edge capability, and systems integration. We used to have 27 manufacturing facilities; now we’re down to 7 system houses. It’s all about how to become faster.

The idea of doing the manufacturing only where you add value seems to be the model Cisco has pursued. True?

We believe our leadership is in our systems-integration ability. Cisco really outsources that function. From a pure systems-integration point of view, they don’t do anywhere near what we do. We also believe there is value to high-end manufacturing, so I think we’re different from Cisco there, too. On our component strategy, for example, we focus on the leading edge. We let other people make the components that are generally available in the marketplace. We work with JDS Uniphase, Corning, SDL, and the Japanese manufacturers to get those components. But the components that give us leadership at the systems network level, we make.

Cisco is making a big effort in your traditional telecom service market. How will Nortel improve its performance in the enterprise market?

We really believe there is tremendous synergy between enterprise and the carrier. Why? Because when you hear the phrase “carrier-managed services,” it means carriers are going to provide enterprises with their solution sets. The big driving force of bandwidth demand will be E-business. We talk of data growing 30 percent a year for the past 30 years. What’s going to spike that up is mobility, bringing the Internet to your pocket, driving data across the mobility. That’s a big event. We want to have an E-business or Web capability for our businesses. We now have global reach, global marketing, sales, and distribution capabilities. We believe it’s imperative to offer that to the enterprise as well as the carrier. Does that mean that every element of an enterprise is critical to Nortel? No, but E-business and E-business solutions are critical.

What are the biggest risks to your continued success?

It’s not whether we keep coming up with innovations or keep leading in optical networking. The bigger issue is to create a culture in which the best people come to–and stay at–Nortel. They must be leaders, risk-takers, and continuous learners. Of course, we all want the same people. The challenge is to attract and maintain the best people who can live in this environment.