A Closer Look at Nortel

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Onto tonight's report.... Last week, I wrote an optical networking industry overview and discussed some of the leading optical equipment makers. Jeff Ferry, Director of Strategic Media Relations for Nortel Networks (NYSE: NT), contacted me after reading that column, and the two of us met for lunch on Tuesday. Our meeting gave me an opportunity to learn more about Nortel, which is one of the most significant competitors of Cisco Systems (Nasdaq: CSCO), a company that I also cover for Fool Research.

One thing that's always important for shareholders to do is keep an eye on the competitors of the companies they own. This is one of the key reasons behind the Monopoly Status comparisons in the Rule Maker Ranker spreadsheet. In tonight's report I'll take a first look at Nortel with a focus on its business. Next week, I'll run it through the Rule Maker paces and see how it stacks up from a numbers perspective.

Nortel's home is north of the border in Canada, but a closer look at the distribution of its sales make it apparent how important the U.S. is to Nortel's success. More than half (56%) of its sales are to the U.S. market while only 8% are to the Canadian market. The company's "Come Together" commercials are a part of its efforts to become more a part of the vernacular of U.S. investors. The company's 1998 acquisition of Bay Networks for $6.9 billion has also enabled it to take on more of a Silicon Valley-type culture.

Like Cisco, Nortel is active on the acquisition front. Acquisitions are a very important part of Nortel's business strategy, as the company realizes that someone else may do a better job of developing a product than it does. Nortel views bringing a product to market and, even more importantly, being the first one to bring it to market as a key ingredient to success in its industry.

Nortel's total revenues in 1999 were $22.2 billion. The company expects that its topline will grow by 30-35% in 2000, which would mean total projected revenues of $28 billion to $30 billion in 2000. On a product-line basis, Nortel's business can be broken down into five segments: optical, high-speed access, wireless, e-business, and telephony. Let's look at each.

Optical

Optical represents the biggest and fastest-growing portion of Nortel's business. The company expects that optical sales in 2000 will be $10 billion, which represents sequential sales growth in the 20-25% range. In the first quarter, sales of optical products grew by an astounding 150% over the prior year. As is common in the optical products industry, the primary issue holding back Nortel's growth is capacity constraints.

Nortel's optical business is keyed by its 10-gigabit source laser technology. Ten-gigabit systems are large, long-haul systems. These systems actually were a key to Nortel's ability to catapult over Lucent Technologies (NYSE: LU) into the leadership position in the optical space. The reason for this is that just a few years ago, Nortel's competitors did not foresee the need for such high-capacity systems and believed that 2.5-gigabit systems would be sufficient. However, in 1996 data surpassed voice as the most frequently transmitted medium over networks. The increasing rate at which data is passing over networks has only enhanced the need for larger and larger capacity systems. As a matter of fact, just this week Qwest Communications (NYSE: Q) announced results of some pilot tests of Nortel's 40-gigabit systems.

One other important advantage that Nortel has over its competitors is its ability to offer an end-to-end line of optical products. This is something that has provided Cisco many competitive advantages over the years in the sale of its own traditional networking solutions. However, Cisco's optical product line is not as extensive as Nortel's. As a matter of fact, Nortel does not view Cisco as one of its significant competitors in the optical space. Jeff Ferry mentioned that Lucent, CIENA Corporation (Nasdaq: CIEN), Sycamore Networks (Nasdaq: SCMR), and start-ups were currently its biggest competitors in optical equipment.

Nortel also has an optical components business that's similar in size to that of Rule Maker Portfolio holding JDS Uniphase (Nasdaq: JDSU). Although Nortel has started to outsource more of its manufacturing activities recently (it has sold a number of its manufacturing facilities), it still manufactures some of its own products. Outsourcing has a few advantages in terms of a company's financial statements. It allows the company to have lower levels of fixed assets and inventory on its books, which can lead to improvement in some of its turnover ratios as well as a better return on invested capital. During our meeting, Solectron (NYSE: SLR) was mentioned as one of the primary firms to which Nortel has outsourced manufacturing activity.

High-Speed Access

This product segment provides Internet access via both digital subscriber line (DSL) and cable. It was interesting for me to learn that Nortel is looking to provide voice-over-cable solutions. In other words, you could have one pipe into your home that is used to transmit voice, data, and even your favorite TV shows. The first-quarter acquisition of Promatory will help Nortel strengthen its position in the broadband dial access market. The company develops next-generation DSL platforms for high-speed Internet access.

Wireless

Nortel is making a concerted effort to be an important participant in the transition of wireless from voice-only to a range of voice and data services over the next few years. It recently won an important contract from British Telecom (NYSE: BTY) and also is a supplier for AT&T Wireless (NYSE: AWE). Nortel told me that Ericsson (Nasdaq: ERICY) is the leader in wireless and that it is vying with Motorola (NYSE: MOT) and our own Rule Maker Nokia (NYSE: NOK) for the number two spot in that industry. Nortel's first-quarter wireless revenues grew by more than 45% year-over-year.

E-business

E-business is one way in which I was told that Nortel looks to distinguish itself from its competitors in the networking infrastructure space. Although the majority of information that is transported over networks is in the form of data, only voice transmission is currently profitable. Nortel aims to make data transmission profitable for its customers as well. This was one of the reasons behind the company's recent acquisition of Clarify. Nortel's Clarify eBusiness Applications unit will provide enterprises (large customers) and service providers with business-to-business (B2B) applications and services that can be utilized to manage customer relationships and build virtual Internet marketplaces. As a matter of fact, earlier this week Nortel was part of a group of eight companies that launched an Internet-based trading exchange.

Telephony

Nortel is the number two supplier of telecom equipment (Lucent is number one). This huge but slow-growing market represents the traditional part of Nortel's business. At present, sales of these products are growing at less than 10% annually. These products are for both enterprise and carrier-based networks. Nortel aims to make networks that have at least "five nine" reliability (i.e., 99.999% reliable).

Summary

So, the question to ask is whether Nortel is a Rule Maker. Based upon the business and where Nortel stands competitively, I'd say that it could be. It's certainly the leader in terms of offering optical solutions for the Internet. It has a strong position in wireless and high-speed access as well. It's certainly possible that there could be more than one Rule Maker in the networking infrastructure industry. In order to determine if Nortel is such a company, we need to run the numbers and see how it fares. We'll review the numbers in my report next Tuesday.

If you wish to discuss this report further, please feel free to ask your questions on any of the discussion boards linked below.

Have a Foolish weekend.

Phil Weiss (TMFGrape on the boards)

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