Nortel collapse

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The Rise and fall of a giant … or how to destroy 400 Billion Dollars in 9 Years…

The GEMBA 2009 Project

Morten Gavlen Javier Gonzalez

..................................................................................................................... Frederik Nilner

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1. EXECUTIVE SUMMARY ........................................................................................................ 4 2. INTRODUCTION ................................................................................................................... 5 3. NORTEL – General Recent History ....................................................................................... 6 Internet Bubble ...................................................................................................................... 6 Accounting Troubles ............................................................................................................... 6 Structure ................................................................................................................................. 7 The last few Years before the filing ........................................................................................ 7

4. Bankruptcy Filing ................................................................................................................. 8 Chapter 11, a description ....................................................................................................... 8 Chapter 7 – Liquidation ................................................................................................. 8 Chapter 11 – Business reorganization .......................................................................... 8 Chapter 13 – Individual reorganization ........................................................................ 9

After the filing ........................................................................................................................ 9 Management .......................................................................................................................... 9

5. Background on Nortel competition ................................................................................... 11 Ciena ..................................................................................................................................... 11 Cisco Systems ....................................................................................................................... 11 Ericsson ................................................................................................................................. 11 Alcatel Lucent ....................................................................................................................... 12 Nokia Siemens Networks ..................................................................................................... 12 Huawei .................................................................................................................................. 12

6. Analyzing Financial Data .................................................................................................... 13 Method ................................................................................................................................. 13 ROIC ...................................................................................................................................... 13 Return on sales ..................................................................................................................... 13 Cost of goods sold ................................................................................................................ 13 Selling, General and Administrative Expenses ..................................................................... 14 Capital Turnover ................................................................................................................... 14 Fixed Assets .......................................................................................................................... 14 Intangible Assets .................................................................................................................. 14 Cash position ........................................................................................................................ 15 Working Capital .................................................................................................................... 15

7. Analyzing Management at Nortel ..................................................................................... 16 Unclear strategy + failed execution = Bad Management ..................................................... 16

8. Nortel Bankruptcy – Possible future developments ......................................................... 19 Breaking up the family jewels into Business Units ............................................................... 19

9. What’s left of Nortel – what might happen? .................................................................... 20 Enterprise Solutions .................................................................................................... 20 Carrier Networks ......................................................................................................... 20 Metropolitan Ethernet Networks (MEN) .................................................................... 20

10. Which companies will be interested in Nortel’s MEN ? Why ? ...................................... 23 CISCO .................................................................................................................................... 23 ALCATEL LUCENT .................................................................................................................. 23 ERICSSON .............................................................................................................................. 23 HUAWEI ................................................................................................................................ 23 TELLABS ................................................................................................................................ 24 INFINERA .............................................................................................................................. 24

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NSN ....................................................................................................................................... 24 CIENA .................................................................................................................................... 24

11. Conclusions ...................................................................................................................... 27 12. Appendices ...................................................................................................................... 28 Absolute Company Assets over Time (Million Dollars) ........................................................ 34 Absolute Turnover over Time (Million Dollars) .................................................................... 34

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1. EXECUTIVE SUMMARY

The telecom industry has experienced a series of technological and market specific changes over the last decades. Inventions like internet, GSM, UMTS, 3G and soon to come 4G are all pushing the industry sector towards new and unproven ground where the only certainty is that the demand will be there. The market itself developed on other levels as well, deregulation of the telecom market, and the opening up of the monopolistically driven telephone networks have allowed new actors onto the scenes that in the midst of the 20th century were considered as closed.

Nortel, once one of the giants, at the turn of the century retained 30% of the Toronto’s stock market value, only to find itself today, 9 years later, in Chapter 11 with the intention to sell of all assets to the highest bidder. Having seen this 100 plus years old company survive through several different phases of technology and market, this paper aims to look behind the scenes to find out how it was possible for such a major actor to suddenly go belly up.

Financial studies shows a company striving to cut costs as of 2000, but unable to recover lost turnover. The introduction of the next generation mobile communication technology 4G also did not come early enough, preventing necessary turnover compensation. Early dismembering of the lucrative UMTS business to Alcatel Lucent also removed the bread and butter basis for a stable switch over into new technologies.

Managerial aspects to the fall of the Canadian giant seem to have been many. Over belief in key performance indicators and incentive programs not assuring long time growth forced Nortel into situations counter productive to the necessary stable growth and technology adaptation. The mere fact that 4 CEOs had a go at the first 8 years of the 21st century does indicate the instability at hand. Several corruption and accounting scandals rattled Nortel as well at the break of the new century, and the markets never regained belief in management.

Historically, Nortel was a hard core technology production company, over time moving towards a high tech internet service provider entity with mind breaking developments in several areas. This evolution was not mirrored in the culture of the company, where engineering skills and values remained in power in spite of the evolution of the company towards service. At the end, Ericsson, Avaya, Alcatel Lucent and recently Ciena divided the company between them, and the rests of Nortel are more present in libraries than on any market. This paper will give you insights and show you the details behind the drastic demise of one of Canada’s and the worlds most impressive value destructive adventures.

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2. INTRODUCTION It is a part of evolution, companies come and companies go. Through thoroughly complicated mechanisms, mergers, joint ventures, acquisitions and semi Darwinist behaviors, new and temporarily stronger units are created, only to face the same processes over and over again. Looking back over the last hundred years or so, a non negligible number of great companies have seen this happen to them, and the world keeps turning after their disappearance as it did before. Actually, the relative number of companies that survive the 100 year mark with the same basic legal structure is very low, and if we look at companies once publicly listed, the number drops even further. The owner structures, hierarchies and investments are directed and named differently in the legal framework that our current society is governed by, all as a part of the eternal battle for market, supplier or customer power, followed by a not always logical mixture of individual demand for glory and fame. What if we look at one of the companies going through a very strong change, maybe even risking its mere existence? What has been going on in the company over the last years (maybe evidence is hidden even further back, but we shall limit ourselves to the last few decades)? By doing this, possibly we can gain financial and managerial insights to be used in future situations where the right managerial call has to be made. The Canadian telecommunications company Nortel, or more specifically Nortel Networks Cooperation, is an example we have chosen to follow through the hardship of the end other the 20th and the beginning of the 21st century, to the finally end up in Chapter 11 and under Canadian Creditors protection act. What actually went on financially? Where there managerial issues? Was technology itself a factor? Or, what about the markets, how did they behave in this time period? All of these questions may not be answered; some may lead us to insights. Only by diving deep into the remains to be found in literature, across internet and economic journals can we get in under the surface and try to express what actually went on. Let the journey begin… Society and telecommunication The Telecommunication Industry and all activities associated with it has taken an important position in the word economy. In 2006 the official estimates claim 3% of the gross world product (GDP), or somewhere around USD 1.2 Trillion where allocated to this industry.1 Macro economically speaking, a link between the development of the telecom sector in a country and its economic growth is generally considered as valid. Socially the behavioral patterns of the new generations are strongly influenced by the new information era, with SMS and social networking sites as two examples of second degree implications of the telecom development. New legislative organs and debates on international levels have been born alongside the technological evolution and of course the military impacts are evident.

1 « Telecom Industry to reach 1.2 Trillion in 2006 », VoIP Magazine, 2005

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3. NORTEL – General Recent History

Nortel, the name stemming from the early Northern Electric and Manufacturing Company Limited founded in 1895 as the American telecom pioneer BELL decided to created a stand alone entity for production aimed for the Canadian market, is since 1999 officially Nortel Networks Cooperation.

In many ways this Toronto based technology enterprise represents for years the Canadian capacity to outperform the US neighbors. During certain phases of its last 10 years of existence, Nortel was the absolute dominant as an employer and as actor on the local Canadian stock market. In many ways the local social and political interests are intertwined with the development of the company, and now at the verge of its breakdown, protectionist behaviors surface in order to desperately protect what is left, often without any substance behind. The Canadian quasi giant, standing semi strong with still 30 000 employees and an $11 Billion turnover in 2007 is, or was, one of the major actors on the world telecom markets. The main competitors, across business units are well known actors such as Cisco Systems, Ericsson, Alcatel Lucent, Nokia Siemens Networks, Motorola, Huawei and NEC.

Internet Bubble When Nortel market capitalization was at its top, it represented more than a third of the Toronto Stock Exchange value. As the bubble of the internet era burst, Nortel stock price fell from C$124 to C$0.47, reducing the market capitalization value from C$398 Billion in September 2000 to less than C$5 Billion in August 2002. It was much debated at the time that the CEO John Roth had sold stock options just before the fall in 2000 for over C$135 Million alone.

Accounting Troubles In the early 21st century, Nortel was the scene for an accounting scandal that would leave traces for years to come.2 The Internet Bubble had left the company bleeding, and a new top management was appointed with CFO Frank Dunn taking over as CEO after John Roth who retired under controversy. Frank Dunn then managed a major restructuring project reducing the workforce by two thirds (eliminating some 60 000 jobs) and then finally reaching positive results in the beginning of 2003. Apparently these numbers were based on some very creative bookkeeping by Dunn, his CFO Beatty and a controller by the name of Gollogly. The audit that followed reworked the balance sheets for 2001, 2002 and 2003 repositioning some $900 Million of liabilities, and large amounts of revenues being incorrectly booked in the late 20th century. The results of this mismanagement were many, bonuses were repaid by managers, Dunn, Beatty and Gollogly were fired and the brand Nortel was heavily damaged through the association with corruption and an accounting scandal.

2 « Nortel », en.wikipedia.org/wiki/Nortel, 17.11.2009

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Structure Around 2007, the company presented itself with 4 major business units

• Enterprise solutions, 2007: $2620 Million turnover, 23.9% of total.

Enterprise networking solutions for internet, VoIP, security, multimedia messaging, call centers and several integrated software applications on the workstations of the enterprise clients. These clients range from small companies to large multinationals. The business segment was still enjoying strong growth at the end of 2007. Collaboration with Microsoft and IBM open up for further business development.

• Carrier Networks, 2007: $4493 Million turnover, 41% of total.

Mobility Network Solutions, Carrier Networking solutions and specifically solutions for mobile applications. Complete systems for GSM, GPRS and EDGE for customers like France Telecom and T-‐Mobile in the US.

• Metropolitan Ethernet Networks, MEN, 2007: $1525 Million turnover, 13.9% of total

A combined IP networks & optical technology for carrier and enterprise solutions.

• Global Services 2007: $2087 Million turnover, 19% of total.

The separate service unit proposing service in four main areas: Network support, network management, network implementation and network applications.

• Nortel Government Solutions

This entity is a separate company, and manages contracts and contacts with public institutions in the US and around the world.

The last few Years before the filing In no way did the following managements rest prudent over the time to follow. The last years leading up to January 14th 2009 were filled with active managerial decisions like3

• April 2005, PEC Acquired, an IT service company with 1700 employees. • December 2005, acquisition of Taman Networks to gain insights and market knowledge on

high performance WAN IP. • December 2006, divestiture of the radio based UMTS activity; all assets sold to Alcatel-‐

Lucent.

3 « Nortel », fr.wikipedia.org/wiki/Nortel, 24.09.2009

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4. Bankruptcy Filing

On January 14th 2009 Nortel Network Inc and 14 of its subsidiaries filed petitions for bankruptcy in the United States Bankruptcy Court for the District of Delaware seeking relief under chapter 11 of the US Bankruptcy Code. At the same time, similar filings were made in Canada, Israel and the UK. Already in December 2008 Moody’s rating had gone down to Caa-‐2 signaling a risk for bankruptcy.

Chapter 11, a description In order to understand what happened to Nortel on the 14 of January, A brief description of the Chapter 11 proceedings and regulations.4

In general the American Chapter 11 is considered very lenient on management, often seen as guilty in creating the situation forcing the company to call for support . The European counterparts are much stricter to the post bankruptcy management. There are 3 main chapters in the United States Bankruptcy Code, regularizing bankruptcy cases.

This picture describes the complexity schematically.5

Chapter 7 – Liquidation Deals with the liquidation of a bankruptcy, i.e. companies in very large debt situations can immediately be liquidated and the assets sold to reimburse the creditors in order of priority. Also individuals can be concerned by this.

Chapter 11 – Business reorganization If a business is unable to pay its creditors, they or the business can seek protection under Chapter 11. This normally implies that the business continues under the control of the debtor, but that it is subject to oversight and jurisdiction of the court. The Chapter 11 allows the debtor in possession several means to restructure the business. A debtor can organize new loans under favourable terms, with the new creditors being prioritized on repayments. Contracts can be cancelled and or rejected, litigation is not possible due to a state of “Automatic Stay” where any litigation initiatives are held until liquidation or the company emerges from Chapter 11.

4 « Chapter 11 », en.wikipedia.org/wiki/Chapter_11 5 www.bancruptyvisulas.com, 18.11.2009

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Any Chapter 11 filing will be follow by a bankruptcy plan. This plan is proposed by any party interested in the case, and agreed upon with all the creditors. If no agreement can be found, either the company passes to Chapter 7 – Liquidation or the activity returns to a status quo before the filing allowing for individual direct “classical” legal measures to be taken. A Chapter 11 subject can pass to Chapter 7 – Liquidation if this is in the interest of all creditors, or the company in question can be liquidated under Chapter 11 with the current management if this is deemed the best solution. During the reorganization, the creditors are reimbursed according to a priority list defined by law. Secured debts (with i.e. collateral or security interest) will be paid first, and the employees and suppliers before any unsecured credits are addressed. The prior level of priority must be completely cleared before proceeding to the next one.

Chapter 13 – Individual reorganization As chapter 11, chapter 13 defines a plan for the concerned party (an individual) to refinance its debt over time. This is in contrast to Chapter 7 that offers immediate relief.

After the filing

Although the initial intention of Nortel CEO M Zafirovski seems to have been to re-‐stabilize the company and renegotiate the debt through a Chapter 11 procedure, the final effects of the crises were stronger then what he had expected. Thus, the events that followed show the new chosen direction, to move towards a refinancing by auctioning away the divisions one by one. On the 25 of February 2009, Nortel announced the disengagement of 3200

persons, or approximately 10% of the remaining workforce. In July 2009 Nortel sells its Enterprise Solutions business to Avaya for $475 Million. Also in July, Ericsson acquires the Carrier Networks division from Nortel for an estimated USD

$1,130 Million. This in spite of some heavy political movements against a sell of an industry of this size to a foreign entity.

Management President and CEO Mike Zafirovski, earlier at GE and Motorola, member of the board at Motorola and Boeing6, joined the company in 2005, well aware of the company’s actual situation. As a practicing Ironman triathlete he was used to long and hard challenges, possibly this one was the first one he failed.7 After four years of active restructuring and planning for the future in the aftermath of the internet bubble that plunged Nortel from $30 to $11 Billion turnover in only a few years, the crisis in 2008 might simply have been too much for the Canadian telecom operator.

6 « Nortel Networks Group », BusinessWeek, , 17.11.09 7 « Nortel’s Road to Bankruptcy », BusinessWeek, 15.01.09

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At his side, Mr. Zafirovski had amongst others 8

John Roese, CTO, 2 years and seven months at Nortel, history of several different CTO positions Richard Lowe, President Carrier Networks, history of 29 years at Nortel Joel Hackney, President Enterprise Solutions, Nortel from 2005 – history at GE as GM for GE

Industrial Philippe Morin, President of Metro Ethernet Networks, history of 19 years at Nortel Dietmar Wendt, President Global Services, history at IBM Chuck Saffell Jr, CEO Nortel Government Solutions, career history in governmental organizations M. Zafirovski eventually resigned on August 10, 2009 on his own initiative. That he is now filing claims for a retroactive severance package (USD 12 Million) has set off major reactions within the Nortel and ex Nortel employee community. Other top executives received major retention packages after the filing of January 14th as the hope was initially to re-‐emerge after the filing, even though any severance pays to employees after that date had been frozen, as compensations funds are considered general assets of the company and subject to claim for all creditors.

8 « Nortel Networks Group », BusinessWeek, , 17.11.09

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5. Background on Nortel competition The number of actors on the telecom market is hard to define. Below is a brief description of a couple of the competitor that Nortel faces in the optical switching and optical transport segments.

Ciena 2008: 2203 Employees, USD Revenue 0.9 Billion. Despite its relative small size compared to the other actors listed here, Ciena has a leadership position in the optical transport and switching

market Ciena’s bid for the MEN business as a stalking horse9, [a term describing the first bidder and the special terms that follow from negotiation on that specific role] gives them a favorable position to move forwards into the bidding phase.

Cisco Systems

2008: > 65 000 Employees, USD Revenue 36.1 Billion. Cisco Systems is a California based telecom company, founded in 1984 by a married couple studying at Stanford University10. In the internet boom of

1999 the company was the single most valued company in the World with a market capitalization value above USD 500 Million. Still in June 2009, the company has a market capitalization value of above USD 100 Billion, allowing for a position in the DOW Jones index as General Motors was delisted from the index as it applied for protection under Chapter 11.

Ericsson

2008: 78 740 Employees, SEK Revenue 208 Billion. [USD 29 Billion] Ericsson, or Telefonaktiebolaget L. M. Ericsson, is a Swedish company based in Kista outside Stockholm founded in 1876 by Lars Magnus Ericsson. Ericsson has

in the 21st century been focusing further and further on back end technology solutions to support internet and communications. The creation of Sony-‐Ericsson in 2001 emphasized this strategic move away from B2C industry. The business unit Carrier Networks was acquired from Nortel after the bankruptcy.

9 « The Stalking Horse », www.jonesday.com 10 « Cisco Systems », en.wikipedia.org/wiki/Cisco_Systems

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Alcatel Lucent 2008: 77 717 Employees, EUR Revenue 16,9 Billion. [USD 25.4 Billion] Alcatel Lucent is a France Telecom Company based in Paris, France. Late 2006 the UMTS Business of Nortel was acquired by Alcatel Lucent. The Ex CEO of Alcatel Lucent, Mrs. Patricia Russo, is a non executive member of the board at Avaya Inc, the company who later bought the Nortel Business Unit Enterprise Solutions.

Nokia Siemens Networks

2008: 60 000 Employees, EUR revenue 15,3 Billion [USD 22.7 Billion] Created in 2006, the Siemens AG COM Business Unit (with certain exceptions) and the Nokia Network Business Group merged into a new company on June 19, 2006. Headquartered in Espoo, Finland.

Huawei

2008: 87 502 Employees, USD Revenue 23.3 Billion Huawei is the main Chinese actor on the global telecom market. Based in Shenzhen in the Guangdong, it was established in 1988 and is still today privately held. In December 2008, BusinessWeek magazine puts Huawei in third position after Google and Apple as the world’s most Influential companies.

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6. Analyzing Financial Data

Method The DuPont Analysis simply breaks down the results (Return on Invested Capital) of a company into subparts that allow for intra industry comparisons. The model is not applicable in all company comparisons, but for classical structures with production, sales and product development, the tool provides insights otherwise difficult to realize. All analysis for the results below can be found in graphical form at the end of this paper.

ROIC The ROIC gives us a measure for how efficiently a company is allocating its capital. It is usually expressed as a ration between NOPAT (Net operating profit after tax) / Total capital invested. For a company to allocate its capital efficiently ROIC needs to be higher than the company’s WACC. As we can see from the bar charts showing ROIC there is only two out of five companies that even manage to have a positive ROIC over the last four years. Even without information on the companies’ WACC, we can clearly state that the three companies with a negative ROIC are destroying value. With so many of the major players in the industry destroying value, it could be a sign that there is overcapacity in the industry and that some of the players need to exit. From the ROIC figures of the last four years Nortel we can see that Nortel is the weakest of the major players. Adding the knowledge of accounting scandals earlier in the decade, it is surprising that Nortel has been able to continue for as long as it has as an independent actor. Economic profit as measured by Invested Capital (ROIC – WACC) gives us an indicator of how much value is actually being destroyed by these companies.

Return on sales Return on sales is considered as the operational profit margin. It measures a company’s operational efficiency, and is expressed as a ratio between EBIT/Revenue. Once again we see that there are two companies, Ericsson and Cisco, that stick out and are the only ones delivering healthy margins. The ratio charts also show a clear trend towards increased pressures on margins through the years 2005 to 2008. Interestingly enough Nortel shows an opposite trend until disaster hits in 2008. This might have been interpreted as a turnaround operation but is more likely to have been more accounting magic and an effort to meet margin targets at all costs. Incidentally, some of the same behavior is observed in Ciena’s figures which might be a bad sign for the future.

Cost of goods sold The ratio of turnover to Cost of goods sold (COGS) tells us how effective a company is at producing its good and getting an adequate price in the market. Comparing all the companies we see that with the exception of NSN, which probably have some post-‐merger operational problems, Nortel has a consistently higher COGS/Revenue ratio than the others. This can possibly be attributed to aggressive pricing but is most likely a result of an over-‐engineered product portfolio. Nortel has

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always been a company that focused on being a technology leader and this has most probably been to the detriment of production costs. There is a marked trend across all companies that the ration of COGS to the turnover is increasing over the period studied. This is evidence of an increasingly tougher market place and the companies are cutting prices in order to retain volumes.

Selling, General and Administrative Expenses The SG&A ratio tells us how much of the company’s revenues are spent on activities that can be directly linked to products. A large part of these costs are quite “sticky” as it takes time to downsize warehouse capacity or to lay-‐off people if the downturn is considered to be long-‐term. As such, it is normal that we will see certain increase in this ratio as growth slows, but there is something out of the ordinary going on in Nortel that has an increase of over 20% in its SG&A. We can attribute this event to the fact that while Nortel sold the UMTS business unit and started to shed off the rest of the company units (starting with the Alteon unit), it still maintained an unhealthy level of unnecessary support functions that weighed down on its SG&A. In addition, the order of the day during the analyzed period of time was to bring in orders and all abuses of SG&A to that end were practically excused.

Capital Turnover The capital turnover tells us how effectively invested capital is used to generate revenues and is expressed by the ration Revenues/Invested Capital. The telecom equipment industry is a capital intensive industry as exhibited by all companies showing a Capital Turnover of less than 1. The big exception here is Ericsson which is managing their balance sheet far more efficiently than its competitors with a capital turnover of nearly 2. The data still shows quite a bit of variation between the companies but Nortel seems to be in line with what should be expected in this industry.

Fixed Assets When analyzing the fixed assets we want to see how efficiently the company uses its fixed assets to generate revenue. In this analysis the fixed asset category is broken down into two categories. Property, Plant and Equipment (PPE) and Long Term Investments (LTI). First looking at PPE we see that Nortel has the least efficient use of fixed assets, and Ericsson has by far the most efficient. Again we will argue the point that Nortel’s wish to always be in the forefront of technology development makes their factories more expensive not only to run but also to build. The more dramatic development is shown in the evolution of LTI. Here we see that Nortel almost stops its long term investments from 2006 an onwards. This is a clear sign that the company is having serious trouble. However, this sharp decline in investments is managing to keep the total Capital Turnover looking quite healthy for 2007.

Intangible Assets Intangible assets are defined as non-‐monetary assets that are not physical in nature. They can be divided into two primary sub-‐categories – legal intangibles (that can be owned) and competitive intangibles (not owned but embedded in the organization). The two most important sources of

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intangible assets in the telecom equipment industry are patents and goodwill that stems from acquisitions where a premium over book value has been paid for the acquired company. Earlier in the decade Nortel had to massively write down its goodwill after it was discovered that it had overpaid some of its acquisition. As we can see from the charts the ratio of intangible assets/expense ratio varies hugely between the companies and Nortel does not seem to have inflated this asset class, still they take a huge write-‐down in 2008. The value that is left for intangible assets are mostly patents and will probably be a significant part of the value for acquirers. Whether or not all patents will be sold as parts of the divisions will be an interesting story to follow.

Cash position The cash position is a signal of financial strength and liquidity. A strong cash position means that the company has enough cash to fund operations and sustain market downturns. However, a cash position that is too strong can be signaling a lack of new development within the company. Two of the companies in this study seem to fall into that category. Both Cisco and Ciena hold so much cash that investors should ask themselves if it is not better to put the money in the bank rather than invest in companies that do not put their money to work. Nortel’s cash position seems reasonable in this industry.

Working Capital Working Capital is an indicator of a company’s short term financial health. Does its current assets support its current liabilities? We see that both Nortel and Alcatel has negative working capital whereas the other companies operate in a range between 0 and 15% of revenue. The negative working capital of Nortel is probably a sign that current liabilities are used to fund the operating cycle while maintaining its cash position.

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7. Analyzing Management at Nortel

Unclear strategy + failed execution = Bad Management

In spite of all the court hearings, restructuring negotiations and massive layoffs, Nortel Networks still had to file for bankruptcy at the beginning of 2009. Along the way, it dragged the millions of shareholders that held a dash of hope for survival. Was this really a surprise to the market? In our view, the signs were there; in big bold red above and below the line. Nortel had been in a state of coma for most of the past five years and any mention of Nortel in the news was actually NOT good news. Nortel has been an active participant of one of the worst management mayhems of the telecommunications industry in recent history. Four (4) CEOs in eight (8) years, a series of massive layoffs totaling 65,000 jobs cut since 2001 and several accounting scandals later, what’s left of Nortel? It is a fact that assets are being passed on to the highest bidder. For the thousands of employees who have already lost their jobs, the many more who certainly will and the shareholders whose funds have disappeared into thin air, Nortel’s bankruptcy filing is of no comfort.

For most Canadians, Nortel was more than a Canadian company and never just a mere investment stock. Nortel stood for international Canadian success and was a symbol of its modern telecommunication industry. To put it in perspective, the US has Cisco, Finland has Nokia and Sweden has Ericsson. Today, Nortel is simply a symbol of unjustified investments, an example of a financial roller coaster and the evidence of value destruction in a company where its management was entirely responsible of its demise. We want to discuss here the culprit of this mess as well as the mistakes made. Naturally, the simplistic manner to approach this will be to blame it on the overall industry consolidation and the fact that a bubble is in burst mode in the telecommunications industry since 2001. However, we look for the brains of the operation and more specifically for the people responsible.

Nortel’s downfall can be easily digested by merely looking at the portrayal of its four CEOs since 2000. Although Nortel’s problem may have arguably commenced several years back, let’s start with John Roth, who was named Canada’s CEO of the Year by a Bay Street panel in the fall of 2000 right after Nortel’s stock hit its peak of $124 a share. Of course, one week after receiving the award, Roth delivered the first of a series of disappointments during his term: quarterly earnings fell short of analysts’ expectations and the stock sunk 25% in a single day. As the great communicator, Roth quickly assured the public that Nortel’s growth will still hold and that he was forecasting a 30% rise in sales. The joy did not last long since only sixty days after that, Roth cut that forecast in half and announced a layoff to 10,000 people. The signs were there; it looked like the beginning of the end. Further signs? Well, Roth will retire by the end of 2001 and will walk away with approximately $139 million in compensation and stock options. By today’s standards, an outrageous amount of money for a failed company; in yesteryear, a newsworthy front page article representing success. After Roth, Nortel decided that it was time to put the house in order and wanted show the street as well as its shareholders that they could restore confidence and had the intention to remain in a particular business segment only if they could be either #1 or #2. To do that, Nortel quickly named Frank Dunn. Let’s clarify that Dunn was Roth’s CFO and was portrayed as the man who will bring financial restraint to a company that had grown unwieldy. Dunn led the company for 2½ years and the stock fell by half during his watch. Dunn was fired for cause in April 2004 after surmounting allegations that he had helped orchestrate a massive accounting fraud aimed at inflating profits. Dunn is currently still prosecuted in Canada and the US and denies any wrongdoing. Nortel management lived, fed off and was compensated on performance indicators. The company was strictly operated

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by indicators without regard for the overall value created or destroyed. In this case, we know they were value destroying indicators because they concentrated in the everyday operations rather than on the life of the company.

By the time the company was turned to Mr. Owen in 2004, Nortel’s mishaps had exploded into full-‐blown scandals. The ex-‐Navy admiral and former vice-‐chairman of the U.S. Joint Chiefs of Staff was brought in to re-‐establish trust and credibility. Unfortunately for employees, shareholders and the future of Nortel, the appointment achieved neither. Owens’ integrity was not in question; however, his ability at running navy ships and its personnel was not necessarily a leverage point to operate a company of the size and complexity of Nortel. A direct result of this was the defection of top executives and a 30% decline in the stock price within a short period of 18 months. By this time, any outside observer could have concluded that incompetence was the real problem at Nortel and Owens could do nothing to change that perception. If incompetence was the problem, why not then find a top executive with a proven record of delivering performance and strict management. Enter Mr. Mike Zafirovski.

Mike Zafirovski was a rising star at Motorola and was hired at a great expense. Mike’s arrival to Nortel was announced with bells and whistles. After all, Mike had a track record at Motorola and had worked with the best Six Sigma practices at GE. Mike certainly knew how to turnaround a company and was considered to have great industry knowledge. During his tenure, Nortel did become leaner but not meaner; Nortel did try to considerably lower its costs, we can see this from our analysis. In fact, we can consider that Nortel was an athlete preparing for a marathon by first loosing weight to go faster, but eventually not concentrating in the essential muscles nor working on its resistance or breathing techniques.

After Nortel completed a reverse 10-‐for-‐1 stock split in 2006, it announced the sale of its UMTS division to Alcatel-‐Lucent for USD $320 million. Nortel sold off this unit on a straight cash agreement; 1,700 Nortel employees transferred to Alcatel, mostly engineers based in France, Canada and China. Nortel's reverse stock split reduced the number of shares from more than 4 billion and drove the share price up to $21.15 at the close of trading. Since Mike joined Nortel in 2005, he implemented strict cost-‐savings measures, hired a solid management team and tightened the firm's product focus calling with a cost-‐savings target of USD $1.5 billion per year by 2008. Zafirovski’s goal was to reduce Nortel's involvement in product areas and focus on markets where its strategy could achieve a dominant position. The areas of focus gravitated along the lines of WiMax (wireless broadband delivery) and emerging 4G wireless networks. Nortel strived to increase resources dedicated to strategic business, but the sale of the UMTS unit was perceived as a mistake and a strategic blunder. The reason is that in Nortel’s intent to emphasis 4G development to deliver high-‐speed broadband services to mobile users and its focus on the underpinning elements of mobile video and multimedia revolution in mobile operators, it had to still continue to deliver superior value to GSM, CDMA and UMTS customers because these customers will be the basis for their intended growth in 4G networks.

It appears that the costs actually shifted from further workforce reductions onto future development projects that never did actually see the light of day. One such project would have positioned Nortel in the subscriber broadband management arena where, at the time, Redback held a dominant position, but where Nortel was developing a highly competitive product. The product never saw the light of day and Redback was eventually acquired in 2007 for 1.9Billion USD in cash by Ericsson. Nortel is unable to cope with existing contracts, continue to be the technology innovator it once was and has destroyed any of its remaining value.

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We could of course not blame it all on Mike, or can we? It’s clear that for the past five (5) years the telecommunications market has changed at a high pace. Nortel never did recover from the mistrust created after the accounting scandals and its debt necklace became heavier year after year. It could have been a tad unrealistic for the market to expect Mike, the triathlon participant, to run in ski boots and a wetsuit while carrying a bike over his shoulders and being chased by a mob. Granted it was an impossible task, but while we know that Nortel’s CEO was still using a private jet just six (6) days after Nortel filed for bankruptcy protection and as the company announced non-‐compensated dismissals for thousands of workers, refused salary increases, instituted further cost-‐cutting measures and confirmed that previously dismissed Nortel employees will not be receiving severance payment because of the bankruptcy filing, one can wonder.

Greed, check; deceit, check; incompetence, check; plain bad judgment based on desperation and on managing by indicators rather than value creation, check. All of Nortel’s mishaps fall in one of the previous categories. As such, we must not forget the role that investment companies and advisors also had in this. AT Nortel’s peak, fund managers rushed to comply with investors’ wishes to invest in Nortel stock. As a company, Nortel did a great job of over-‐valuating the impact of their innovations while selling themselves as the only company that could be a major force for operators, enterprises and end consumers. Well, Nortel did not achieve that, but Cisco certainly did. Of course, at the time, nobody even thought of a company like Nortel going bankrupt and any fund manager that avoided the stock based on strict fundamentals was deemed as incompetent, lost their customers and some even their jobs. On the descent, as Nortel was killing the company, shredding workers, selling and shutting down units, continuing to miss revenue and profit targets, people would still ask “so when is it going to recover “. We know the answer now and we should have seen it then; recovery was never to be.

Upon his departure, Zafirovski says that Nortel will live on in one form or another. It will certainly live in the memories of many. The Nortel we loved as employees, as shareholders and as admirers of technological innovation, that Nortel is long gone. Nortel has indeed left the building; in fact it has left the whole industry and has taken all of its value.

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8. Nortel Bankruptcy – Possible future developments

Breaking up the family jewels into Business Units Right after Nortel, Canada’s 100-‐year old communications company, went into Chapter 11 bankruptcy protection in January of 2009, it immediately started the split process. The basis of this process was to divide Nortel into several self-‐supporting business units which could be sold off separately. Nortel split its business into four divisions: Carrier Networks, Metro Ethernet Networks, Enterprise Solutions and the LG-‐Nortel joint-‐venture. The breaking-‐up clearly affected Nortel’s first quarter revenues falling by 37% to $1.73bn and the company made a loss of USD $244M in the first three months of 2009. First quarter results showed a decline in revenue and margins as expected due to the severe economic downturn as well as Nortel’s creditor protection filings. Despite the declines, revenue had actually stabilized and cash balance was stable as of year-‐end 2008. Nortel’s purpose in breaking up the company into divisions was to concentrate its businesses and get the most value for shareholders and creditors. These were key considerations in the decision-‐making process as they continued to evaluate the ultimate path forward for the businesses. It appears that at the time, there were discussions being held with external parties in order to evaluate all restructuring alternatives. The move to stand-‐alone units provided Nortel with maximum flexibility and it even expanded its shared services organization in order to improve support for its standalone business units. However, the split will not bring immediate relief to the failed company. Nortel employees across the regions were taking legal actions to prevent further illegal redundancies. For example, a portion of Nortel staff laid off in the UK, did not receive any redundancy pay or proper notice period. Nortel’s ecosystem – partners, suppliers, customers – suffered. There were other employee protests before the UK Parliament and demonstrations outside Ernst & Young's offices in London. E&Y are Nortel's administrators and employees protested that Ernst and Young allowed $23m in bonus payments to senior Nortel execs while approving redundancies.

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9. What’s left of Nortel – what might happen? Below is a brief overview of the main Nortel divisions still standing at the beginning of 2009 and what has transpired up to the time in which we concluded our project.

Enterprise Solutions

Enterprise solutions for internet, VoIP, security, multimedia messaging, call centers and integrated software applications for small companies & large multinationals. Nortel’s enterprise division holds a strategic alliance with Microsoft since 2006. Further, this division signed a channel distribution agreement with Dell and in turn Dell provides professional services to the combined Nortel enterprise & Dell solutions. Nortel’s Enterprise Networks was eventually sold to AVAYA in September of 2009 for USD $950M. Other potential suitors were Siemens alongside the private equity firm Gores Group.

Carrier Networks

Nortel’s Carrier Networks division provides Mobility and Carrier Networking Solutions specifically designed for mobile operators. The business includes GSM, GPRS and EDGE systems for major operators around the world. A significant portion of Nortel’s Carrier Networks division (not including GSM/GSM-‐R) was sold to Ericsson for USD $1.13Billion in July 2009. Other potential suitors for this particular business included NSN alongside the private equity firm Mattlin Patterson. The remaining GSM/GSM-‐R business was also purchased by Ericsson & Kapsch in October of 2009 for USD $103M.

Metropolitan Ethernet Networks (MEN)

Nortel’s MEN is the coveted asset of the family. Nortel’s MEN provides operator solutions for the unprecedented internet traffic growth and the implementation of IP networks combined with optical technologies. Nortel’s MEN applies to both major carriers and enterprises and is a preferred partner for major international and pan-‐European networks. For the purposes of our project, we have concentrated our analysis in Nortel’s MEN division since this is actually the first division that was considered for sale and the one which has incited the highest amount of interested parties while only representing 14% of the overall Nortel businesses. It seems that all significant players, whether small, medium-‐sized, or mammoths, in the telecom world are in one way or another interested in Nortel’s MEN. We will describe and elaborate the reasons why we believe there is in fact an interest and then we will enumerate the considerations as to which companies will want to buy these bankrupt assets. We have launched ourselves into the ring and picked one of the top contenders and will endeavor to analyze the detailed reasons and fundamental facts that we believe justify a purchase by this top contender. However, we do want to point out that no matter which of these companies eventually ends up with the assets, they will all have a common issue: incomplete information. The suitor which proves to have stamina, higher commitment and goes above and beyond during the due diligence process, will stand out from the

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pack and prevail. Further, that same commitment will be essential to actually complete any integration into an existing company structure as well as in adapting the company to a joint culture.

Why would anyone want these assets? Nortel's products are indeed top class, they have built a strong customer base over the years and for small to mid-‐size suitors it could be an instantaneous manner to roughly double revenues. The concerns here should focus around the fact that: MEN business has not recently generated a significant amount of cash from operations, the ethernet market segment is highly price sensitive and revenue outlook for 2010 may prove lower (less than USD $ 1Billion) due to any integration uncertainties. In addition, the suitor has to have a plan to deal with Nortel’s inability to maintain an acceptable degree of customer satisfaction in their major high-‐margin customers during the past few years. Nortel's Metro Ethernet Networks includes the following products

• long-‐haul transport

• metro optical ethernet switching

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• ethernet switching, transport and aggregation

• associated management systems

Nortel’s MEN division currently has an annual revenue run rate of roughly $1.2B and, surprisingly, it is a break-‐even unit.

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10. Which companies will be interested in Nortel’s MEN ? Why ?

We believe that the companies that can have an interest in Nortel’s MEN assets are: Cisco, Alcatel Lucent, Ericsson, Huawei, Tellabs, Infinera, Nokia Siemens and Ciena. For the purpose of the project, we will discuss here only the ones we consider the most relevant. It is a possibility that all of them will be certainly snuffling around these assets to gain competitive information, regardless of whether or not they actually have an intention of acquiring or bidding for the assets. In our view, only a few of them have a true interest in the acquisition; the key vendors that may fully grasp the true value proposed by these assets and that have the appropriate willingness to pay may be Nokia Siemens and Ciena. As such, these two companies are discussed last in this section.

CISCO Cisco would love to get their hands on Nortel’s Optical Assets. Cisco has the highest amount of cash available of any telecom player today (USD $35B) and the highest rate of success in the acquisition arena (more than 150 since 1993). However, integration of a business unit that also requires a degree of turn-‐around activities is not Cisco’s strength. Given the information we’ve analyzed, we can see that Nortel MEN’s division will require a turn-‐around specialist in order to provide true return for all possible buyers.

ALCATEL LUCENT

Based on our analysis, we do not necessarily believe that Nortel MEN’s portfolio will fit well into the existing Alcatel-‐Lucent product line. Alcatel-‐Lucent already enjoys leadership in three (3) of the four (4) market segments covered by MEN and the gap between their number one position will not be easily challenged by any company that is placed either 3rd or 4th. Alcatel-‐Lucent’s leadership is currently focused on their strategic initiative rather than on restructuring and integrating. Further, the previous integration of Nortel’s 3G UMTS division into Alcatel-‐Lucent was not a complete success.

ERICSSON

Ericsson is quite busy digesting their latest acquisition: Nortel’s Carrier Networks division for USD $1.13B. Ericsson has a 40G solution and firm plans and trials for their 100G products. However, acquisition of Nortel’s MEN will allow them to speed up their entrance into the 100G market.

HUAWEI

Acquisition by Huawei makes a lot of sense. Not only will Huawei, will gain entry into the long-‐coveted US market, but it will also complement its own optical portfolio. The issue is that Huawei will still be considered a foreign entity and does not offer any evident guarantees to Nortel’s existing US government contracts. The idea of transporting “government sensitive” traffic is not a pill easily swallowed and will be tough to get approval.

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TELLABS

While Tellabs can profit from MEN’s assets in the optical market, it is not an optical specialist in the same realm as NSN or Ciena. Further, Tellabs has recently invested USD $200M to repurchase its stock and so their bank account may not be ready for further disbursement.

INFINERA

Infinera is also one of the leaders in the digital optical network market and should be a major contender for Nortel MEN’s assets. We believe that Infinera needs to first assess if acquiring technology that they are already develop makes sense for the. Additionally, Infinera will need to associate itself with an entity that will sponsor the acquisition. For example, a private equity firm will need to be assured by Infinera’s management that they can provide strategic direction to their business given the expected lower growth in the optical market and margin pressure over time. An interesting fact about Infinera is that about 70% of top management came from Ciena and its acquisition of Lightera. Ciena is discussed further in the document.

NSN

Based on our analysis, Nokia Siemens is certainly motivated to go after Nortel MEN’s division. NSN has approximately USD $1.2Billion in cash and could still be aching from losing the wireless bid to Ericsson. Nokia Siemens Networks has recently announced it was seeking out acquisitions that will enhance the scale of existing product and service business lines and deepen relationships with key customers; all of this while still announcing a major corporate restructuring and plans to lay off up to 6,000 employees.

After unsuccessfully bidding for Nortel's wireless business, we know Nokia Siemens does have the capacity to place a competitive proposal and could be faced with Ciena in the run for Nortel’s MEN. Nokia Siemens was the stalking horse bidder for Nortel's CDMA business and LTE assets but was quickly bumped off-‐course by Ericsson AB in the auction.

Looking at their product portfolio, it will make sense for Nokia Siemens to get a slice of Nortel's optical and metro Ethernet business. NSN is a true contender and we believe that they will be eager to acquire the Canadian vendor's MEN assets as it will significantly boost its presence in North America. NSN has the motivation to establish presence through the MEN business and Nortel's customer base and does not want to be content with simply observing mobile vendor rival Ericsson bulk up in that particular region and also step into their core wireless business.

CIENA

As we noted before, Ciena is in a comfortable cash position with USD $1.2B in cash reserves; this is though coupled with USD $800M in debt. We have estimated Nortel MEN’s value to around USD $580M and Ciena will need even more cash than that to acquire Nortel’s MEN. We do believe that Ciena is actually in a good position without any acquisition and avoiding any integration challenges. However, there are indeed benefits to the deal and there are associated costs. Ciena can immediately double its sales and major customers, such as Verizon, AT&T, Qwest, and Sprint, have expressed approval to such an acquisition. Ciena needs to do the analysis for themselves but more importantly for the other side and their competitors as well. Ciena can capitalize on Nortel’s Sonet/SDH customer’s needs to upgrade their networks to WDM gear. Ownership of MEN wouldn't

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guarantee Ciena those upgrades, but Ciena will be better placed to make the upgrades as an incumbent and not as another player.

Ciena will also be able to accelerate its 40-‐Gbit/s and 100-‐Gbit/s developments. Even though Ciena has already made a mark in 100 Gbit/s, Nortel’s technology in this area is more advanced than Ciena’s. Ciena would own Nortel’s 40-‐Gbit/s technology rather than continue to source it from Opnext Inc.

Ciena will need to perform a thorough due diligence on Nortel’s MEN assets as it needs to have a strategy for its 40G market incursion. Some of Nortel’s talent has already left and there is no true and clear indication of the value remaining. MEN is indeed damaged, but it’s recoverable. Ciena needs to value the benefits and costs of both the acquisition for MEN as well as their contingency plan. Ciena top management and portfolio directors need to know how Fujitsu and NSN will respond to the bid. Ciena must be committed to the transaction but not at the cost of purely maintaining a course of action based on the decision to bid, but on the firm target of creating value for the company. What Nortel debtors are currently looking for is certainly a high price for MEN. However, it is also clear that these debtors will not simply want the company bought at a high price and without a majority of cash consideration. On that note, the debtor’s interest is for the company to be prolonged and in turn for the recovery of the debts incurred. Ciena needs to show that commitment by re-‐assuring the debtors on their leadership in the optical switching market segment and their firm intentions to attain a place amongst the top three (3) optical vendors. With this in mind, the debtors and remaining MEN employees will be motivated to stay and be part of the new reformed structure. If Ciena is clear and fair regarding the value to be placed on Nortel MEN’s assets, it will not cave in into a bidding war and will show that it values MEN as much as MEN employees. This signal will be key for the costly integration and for avoiding and reducing unnecessary costs. As the stalking-‐horse bidder, CIENA is currently offering 769 Million (530 in cash and 239 in convertible bonds) as compared to NSN + OneEquity Partners’ all cash offer of USD 810M

An important point for the eventual acquirer will be their integration experience. Ciena has a mixed track record with acquired companies (Lightera, Omnia, Cyras, ONI Systems, Wavesmith, Catena, World Wide Packets). All companies have eventually been integrated into Ciena’s solutions, but have incurred a relative cost. Financially, Ciena’s stock still has potential gains since it has actually sold for much higher multiples (net cash sales) relative to current levels. The optical market is full of competitors and Ciena is one of the clear leaders (if not the premier company) in their space. Ciena has a fairly stable management team and has endured the rough pre, during and post bubble times and came out of it stronger and leaner. Ciena will benefit from the acquisition because it will beat NSN to the punch by gaining advanced 40-‐ and 100-‐Gbit/s technology, will gain US customers and a MEN business with revenues around USD $1B billion. Ciena will add operational scale and weight to its “mid-‐size vendor” tag and provide competitive guns against ALU and Huawei. In terms of the acquisition, Ciena needs to concentrate on the integration risks, the product overlap, headcount and cultural aspects while still managing the operational and value creation aspects of the acquisition. Another important aspect is Ciena’s shareholders. The amount of cash being put in the table leaves Ciena’s wallet much lighter and will certainly have a negative effect on its share price. Once again, this should not deter Ciena management from continuing on their path to achieve value

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Ciena will have to integrate a part of MEN’s unit that is traditionally a low growth and low margin business and will weaken its balance sheet while still allowing it to gain market share and potentially become the third largest optical vendor. The integration will benefit about 80% of MEN’s employees since they will be extended a contract in a more solid company.

Certainly, ALU and NSN will try to capitalize on the uncertainty surrounding Ciena’s capacity to integrate Nortel’s MEN. Ciena needs to take that opportunity to become stronger and a tougher rival.

To defend its turf, Ciena faced a difficult decision to either gain scale or defend its smaller niche business from increasingly larger foes. In effect, Ciena was forced to buy the Nortel businesses, if for no other reason than to keep it out of the hands of Ericsson, which is becoming a dominant force in telecom equipment supplies. Ciena says it has been considering the move for a year.

When Nortel put its various businesses up for sale last year as it prepared for bankruptcy, the early bids for the Ethernet business were reported to be about $1 billion. Ciena has been evaluating the purchase for a year, and given the price of the deal, clearly benefited by the passage of time and the lack of enthusiastic interest from other potential acquirers.

Looking at individual products, there's a lot of difference between Ciena and Nortel. Ciena's Core Director doesn't have an analogue inside Nortel, and Nortel has a multiservice Sonet /SDH business that Ciena lack. But the companies share an interest in WDM transport. In 2008, those products represented 53 percent of Ciena's revenues and 55 percent of Nortel's optical revenues.

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11. Conclusions It was a powerful era. Nortel, the landmark reference for telecom in Canada, once an international structure at times standing 90 000 person strong with a turnover above 30 Billion Dollar and once a market value of 400 Billion remained for year a reference in the global industry. Then reality caught up. Years and even decades of mismanagement accompanied by bad strategic decisions took the company down death row. Only through last minute sell offs could values around 4 Billion Euros be saved and eventually distributed to creditors. The era ends.

Now, the question remains, what can be learnt from the Nortel saga? Are there important specific events and strategic actions that actual lead to the demise? Well yes, there were some. The company stemmed from a very old engineering culture; it is believed that the very strong and rapid market movements were better caught by competitors structured around light and structure with less inertia. The managerial environment has also often come up as one of the reasons for the decay. By, possibly unconsciously, disconnecting the key performance indicators at local level with the better interests of the company as a whole, multiple examples of sub optimized and even counterproductive measures can be recognized.

The crowning of the downfall was probably initiated in the late 2000 when the accounting and corruption scandals around Roth and his team members were brought to daylight. Ever since, the company struggled with falling stock prices, and lack of confidence in the market. The then following CEOs did not have what it would take to turn such a giant around. Dunn was the ex CFO, already tainted by the scandals and incapable of reinstating confidence. He was in his turn followed by an Admiral, a man of the military stem, certainly apt to lead, but sadly unapt to manage a multinational enterprise.

The relatively early decision to sell off the UMTS business seems in retrospective to have been a critical misjudgment, but Zafirovski still to this day claims that the business area was not strong enough to gain the strategic market leader position. Was that a good decision based on factual consequences, or a power-‐man’s decision not to continue a cash producing part of the destabilized company?

Financial analysis shows a lack of volume and reserve. The last years of its existence, the company managed to restructure some important cost issues, but the so necessary new product spectrum was due far too late in the future.

We believe it is fair to say, that the Nortel structures were no longer adapted to a very volatile market and the managements assigned to restructure far too financial. Only a deep core boring would have revealed the innermost difficulties of the company, and possibly allowed for corrective action. Is this possible with high level star managers? Or is it necessary to let new blood in that addresses these situations even more in vivo? Many questions remain unanswered in this story, but one thing is evident. The Nortel name is sadly no longer the symbol of fortune but utter demise.

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12. Appendices

Nortel collapse

Documents

Transcript of Nortel collapse