Nortel Networks: Cleaning House

During the heady days of the technology boom, shares of Nortel Networks, North America's largest maker of telecommunications equipment, sold for $86. They closed Monday at $2.31, down 97% from their all-time high set in 2000. The price included a gain Monday of 7 cents, or 3.1%, after analyst George Notter of Jefferies & Co. upgraded the stock (symbol NT) from hold to buy.

But if you've been sitting on the stock waiting for it to regain its former glory, your hopes are misplaced. In setting his buy recommendation, Notter said he thought the stock was worth -- get this -- $3. That's 30% above Monday's closing price but a long, long way from $86.

Last week was a busy one for Nortel, which is based in Ontario, Canada. It announced the layoffs of 1,100 employees, froze its pension plan and borrowed $1.3 billion. "We like the changes that new CEO Mike Zafirovski has made in his first eight months," Notter told clients. "Employee morale is improving, underperforming executives are leaving and talented managers are coming in."

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Nortel has been plagued by accounting problems and lawsuits. It restated earnings three times in the past three years. On June 21, the company agreed to settle a $1.9 billion lawsuit with shareholders over accounting fraud. With Nortel's accounting and legal problems behind it, Notter says the company can boost gross profit margins (sales minus cost of sales, divided by sales) by 2.5 percentage points, to 42.5%, in 2008.

Even without accounting and legal woes, Nortel faces fierce competition from rivals. The company is a generalist that has lost market share to specialized competitors, such as Cisco and Ericsson. Sales of wireless data network equipment fell 4% in the first quarter ended March 31. Sales at its cellular equipment business plunged 11%. These businesses account for nearly half of Nortel's total revenue.

Bright spots for the Nortel have been equipment sold to businesses that allows them to provide phone service over the Internet. Sales increased 10% in the first quarter, but more competitors are entering those lucrative businesses. Notter expects Nortel to shut down product lines that generate losses and invest in businesses with higher profit margins.

The telecommunications equipment industry is consolidating, and Nortel may be left without a partner. Alcatel plans to buy Lucent Technologies. Nokia and Siemens want to merge their network equipment businesses. Ericsson acquired Marconi's telecom business. Cisco bought Scientific Atlanta. The idea behind the mergers is that larger equipment makers will be better able to win business from the smaller number of phone companies, which have gone through their own bout of mergers. Consolidation could help boost the profitability of all equipment makers, Notter says. But Zafirovski has said he's not interested in a merger until Nortel improves its financial performance.

Nortel has put shareholders through the ringer. The stock traded for as little as 43 cents in 2002 when many investors thought the company was headed for bankruptcy. Its 52-week high is $3.57, and it traded for about $8.50 in 2004. At its current price, the stock trades for 17 times the 14 cents a share that analysts expect Nortel to earn in 2007, according to Thomson First Call.