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Just off Highway 427, in an industrial strip of suburban Toronto, sits the new global headquarters of Nortel Networks Corp. The 160,000-square-foot building is one of a set of triplets whose neighbours are a hulking food warehouse and a miscellany of small businesses. Inside the HQ, the perks consist of wireless access, a small cafeteria and a wellness centre. Long gone are the 2.5 kilometres of walking trails, the basketball court, the Zen garden and the indoor climbing wall—indeed, all the accoutrements of Nortel's former million-square-foot home further west, in Brampton.

Welcome to what its public relations crew calls "the new Nortel"—the one that Mike Zafirovski has been trying to turn around since he took over as CEO in November, 2005. Wearied by a seemingly endless chain of embarrassments at the once-bulletproof company, investors welcomed Zafirovski as a veritable superhero. With a winning record in the U.S. phone industry and even a sort of superhero nickname to boot—Mr. Z—Zafirovski was the guy who would set things right.

The Z team insists they have what it takes to get Nortel off the floor and reclaim its status as a Canadian champion. But more than two years after Zafirovski's arrival, the challenge they face is not so much how to grow but how to keep from shrinking further. While Nortel has struggled with its repair job, the telecom industry has moved on in ways that make the odds of Nortel catching up even more daunting. Perhaps the only route to redemption is combining fortunes with another beleaguered player—like the wireless business of Zafirovski's alma mater, Motorola, as rumours had it in early February.

Nortel's chief strategy officer, George Riedel, for one, isn't ready to make any grandiose commitments. "Is there a chance we're going to be the 100,000-person organization we used to be 10 years ago?" he asks. "Who knows? That's a long, long way."

In 2000, it seemed as if everyone in Canada owned Nortel shares. The stock was on a tear, lifting the manufacturer of telecommunications equipment to the top spot in the country for market capitalization, ahead of even the banks. CEO John Roth was lionized by Time and the business press.

All of this was thanks to a world that had gone mad for Web-surfing and e-mail, making one of Nortel's bread-and-butter products, optical equipment, white hot. Nortel's big boxes move Internet or long-distance phone traffic through networks owned by telecoms. As telecoms around the world scrambled to expand their optical networks and increase their bandwidth, investors couldn't get enough of Internet stocks, including Nortel.

But when the tech bubble burst in 2000, telecoms suddenly recognized they wouldn't need all the bandwidth capacity after all, and abruptly slashed their orders with Nortel and rivals such as Lucent Technologies Inc. The U.S. Securities and Exchange Commission alleges that this is when Nortel's bookkeeping faux pas started—according to the SEC, executives pulled forward revenue to mask the slowdown and meet targets.

By the first quarter of 2001, Nortel's fate had changed dramatically. It was losing money and axing thousands of jobs, like the rest of the telecom-gear gang. By the end of that year, Roth was on his way out, replaced by the company's unflashy chief financial officer, Frank Dunn, a Nortel lifer.

Although customers kept a tight hold on their purse strings, there were promising signs for Nortel in the spring of 2002, when Dunn started talking about leaving the red ink behind. Indeed, Nortel recorded a profit in the first quarter of 2003. But the SEC alleges that Nortel inappropriately used reserves to make the gain.

While its rivals continued on the path to recovery, Nortel's accounting issues mounted and held the company back. Financial restatements for prior years, issued at the end of 2003, went from being viewed as a hiccup related to the restructuring chaos to a full-blown crisis in their own right. The accounting fiasco led to the firing of Dunn, chief financial officer Douglas Beatty and controller Michael Gollogly in April, 2004, and also opened the door to criminal and regulatory probes on both sides of the border, along with shareholder lawsuits. "I'm glad I haven't had to live through some of the things they've had to live through," says Tim Krause, chief marketing officer for North America at Nortel's French-U.S. rival Alcatel-Lucent. Ultimately, Nortel went through four restatements.
Dunn's replacement, board member William Owens, had limited experience in the tech business but boasted an illustrious military CV: He was formerly the second-ranking officer in the U.S. military. The last-minute appointment was meant to soothe worried investors, customers and employees. Owens was a caretaker, not a turnaround specialist.

Nortel fell further behind. Its top-notch research and development organization began to do more "farming" than "hunting," as John Roese, the company's current chief technology officer, likes to put it. Efforts were focused not on future breadwinners but on older products that were big money-makers at the time but were destined to fade.

The lack of innovation led to missed opportunities, including in the enterprise (that is, non-telecom business customers) and wireless markets. Nortel had done very well for itself selling equipment for traditional circuit-switched phone networks.

But it wasn't fast on its feet when a new technology emerged, voice over Internet protocol (VoIP), which lets businesses make calls over the same network that carries their data applications.

Soon, Nortel's rival, Cisco Systems Inc. of San Jose, California, renowned for its strength in data networking, had snagged the top spot for VoIP gear for the enterprise market. The No. 1 position should have been a slam dunk for Nortel.

Another failure: Nortel devoted little of its research budget to an up-and-coming wireless Internet technology, WiMax, which has since become one of the key evolutionary paths beyond today's so-called third-generation (3G) cellphone networks. Again, Nortel is now faced with playing catch-up with larger rivals.

The damage can be summed up in the opinion of one telecom customer. For major upcoming projects, Nortel is less likely to be on his list of supplier candidates than Alcatel-Lucent, Telefon AB LM Ericsson or even a determined young Chinese rival, Huawei. "For future products and what's happening now, Nortel doesn't seem to be there for our company," the client says.

Indeed, it's not the company we used to know. Nortel's revenue shrivelled to $11.4 billion (U.S.) in 2006 from $27.9 billion (U.S.) in 2000. Two-thirds of the work force has disappeared as countless rounds of cuts reduced the head count to 33,000 currently from 94,500 in 2000. And the company's market capitalization has slumped to a dreary $5 billion from a high nearing $250 billion in 2000.

Stakeholders can at least glimpse light at the end of the tunnel on the scandal front. In the past two years, Nortel has settled shareholder lawsuits and regulatory probes related to the accounting mess. In February, 2006, the company reached a $2.5-billion (U.S.) settlement with shareholders. In May of last year, Nortel agreed to pay $1 million in costs as part of a settlement with the Ontario Securities Commission. And in October, 2007, Nortel consented to a $35-million (U.S.) civil penalty in a settlement with the SEC. Probes by the RCMP and the U.S. Attorney for the Northern District of Texas are ongoing.

Having survived the worst of the bookkeeping ordeal, Nortel's board started looking in 2005 for a long-time CEO to replace Owens. It ultimately decided on Zafirovski, U.S. cellphone giant Motorola Inc.'s former chief operating officer. Zafirovski was credited with turning around Motorola's cellphone handset business and was looking for a chance to prove himself after getting passed over for the company's top job. It looked like a perfect fit; investors were as pumped as Zafirovski about his ambitions for the company.

"I'm convinced Nortel will be a big winner again," Zafirovski told reporters at a press conference in Toronto on Oct. 17, 2005. He pledged to dramatically bolster Nortel's profitability and make its R&D machine run better.

What he didn't know on that day was, there were plenty of booby traps waiting for him. Some were hidden inside Nortel; others were waiting outside its doors.

Owens was the first among Nortel's senior ranks to publicly sound the alarm about new Chinese competitors, most notably Huawei. The ground was shifting quickly. How to compete in a world where it costs three times more to keep engineers in Ottawa than it does in China? The new Chinese players passed on these savings to customers—which helped them scoop up yet more contracts and squeezed prices for all suppliers in the industry.

Huawei's numbers tell the story. In 2004, Huawei generated $3.83 billion (U.S.) in revenue. Two years later, the figure had grown to $8.5 billion (U.S.), just $3 billion (U.S.) short of Nortel's results that year. The Chinese upstart is now among the top six equipment sellers worldwide for the two most popular digital cellphone technologies, CDMA (code division multiple access) and GSM (global system for mobile communications), according to U.S. market research firm Dell'Oro Group. Nortel, for now, is still ahead, standing in second place for CDMA, and in fourth spot for GSM. But in the optical transport market, Huawei has surpassed Nortel, Dell'Oro's figures show.

Nortel and its traditional competitors are trying to adjust by elbowing in on Huawei's home advantage. The Canadian company is shifting R&D jobs from more expensive locations such as the U.S., to emerging countries such as China, India and Turkey.

But it's not as if Huawei were the only new competitor in town. Telecom-equipment companies are accustomed to partnering with a couple of 600-pound gorillas—Microsoft and IBM—to expand their suite of products. But now the two are becoming competitors in some areas. New jargon attests to the trend: "co-opetition." "The world is moving to one of co-opetition more and more," says Al Safarikas, a senior marketing official at Cisco. "What is a co-operative, collaborative relationship in one area could be a competitive relationship in a different area."

The biggest shakeup in the industry, though, came not from new entrants but from the marrying mood among the old guard. The matchmaking began in October, 2005, when Swedish wireless wizard Ericsson agreed to buy most of struggling British telecom-equipment maker Marconi Corp. PLC for $2.39 billion. Then, in April, 2006, Alcatel of France merged with its U.S. rival Lucent creating a cross-Atlantic behemoth that boasted $25 billion (U.S.) in revenue the previous year. Later in the year, Nokia Corp. and Siemens AG merged their telecom network businesses, creating yet another monster—this one with $23.34 billion in combined revenue in 2005. Ericsson wasn't done with its shopping spree, however, snapping up U.S. network equipment company Redback Networks Inc. for $1.9 billion (U.S.) in December, 2006. Ericsson posted annual revenue of $27.8 billion for the year.

Nortel was dwarfed and alone, kicked out of the big boys' club. Cisco, which had shown some interest in partnering with Nortel in 2004, never came calling. The chances of Nortel's becoming a top-flight contender again are slim, observers say. "I don't think so," says Dell'Oro analyst Alan Weckel when asked about the prospect. "In terms of how many acquisitions they'd have to make and growth they'd have to do to do that, it would be difficult."

The possibility of a wireless hookup with Motorola notwithstanding, some observers worry about the issue of scale. Although relatively diminutive, Nortel doesn't enjoy the focus of smaller, more specialized companies. It still wants to play in all the big equipment markets—land-line and wireless gear for businesses and phone carriers—but it can't tap the R&D budget that its larger rivals enjoy. Nortel is spreading itself too thin to remain competitive in all those areas, critics warn. "You just moved into a house that's smaller than your old house," says Sanford C. Bernstein analyst Paul Sagawa. "You're going to have to sell some furniture even if you don't like to do it. If you try to put all that furniture in a house that's small, you're just going to suffer for it."

Sagawa is perhaps best known in Canada for his unpopular—but accurate—prediction in September, 2000, that the good times were about to end for Nortel and its rivals. In a January interview (before he changed jobs at Bernstein), he said Nortel should focus on areas where it's strong and can stand up against rivals, such as optical equipment and networks for telecom and cable companies. And that means Nortel should also divest assets, including the enterprise business—which includes phone systems, WiFi and data networking equipment—in which, Sagawa says, Cisco is the leader. So far, Zafirovski has only parted with two businesses where Nortel lacked scale to compete—one in wireless, another in switching.

Other observers believe a mid-sized Nortel actually has an advantage: nimbleness. The married players can reap all kinds of cost savings and deploy a larger R&D budget, but bringing together two very different cultures can be challenging and distracting. "Major mergers of huge entities that are so culturally diverse, such as Alcatel and Lucent, are going to be fraught with problems," University of Ottawa management professor Tyler Chamberlin says. "It's uncertain as to whether that's ever going to work."

Indeed, the newlyweds haven't had an easy time of it. One catalyst for union was the belief that greater scale could help shield them from downward pressure on the price of their products as phone customers themselves merge and demand better rates. Yet, they are still getting squeezed, along with the rest of the industry. "One of the reasons the markets are kind of flat in the 2007 to 2008 time frame is there's a lot of power going to the buyer as opposed to the supplier," says Alcatel-Lucent's Tim Krause. And the economic slowdown in the U.S. could further dent revenue.

Alcatel-Lucent spooked investors last year when it issued three warnings about financial results. In October, it announced plans to chop another 4,000 jobs, on top of 12,500 cuts earlier in the year. Then came its results for the year, including a $3.4-billion (U.S.) writedown stemming from the merger. Also in October, Ericsson issued a warning that third-quarter revenue and operating profit wouldn't meet analysts' expectations.

The stocks of Alcatel-Lucent and Ericsson have each lost more than 50% of their value since July of last year. Of course, Zafirovski doesn't have much to cheer about, either. As of early February, Nortel was trading around $11, not far from its level in the darkest moments of 2002. "I think they're recognizing that the company is in a very, very difficult situation," says Mark Sue, an analyst at RBC Dominion Securities Inc. "As talented as Mike is, he could only do certain things. You have to give a CEO some tools, and Nortel didn't leave him any."

Zafirovski proved his mettle early. At 16, he moved from Macedonia to the U.S. with his family, having only a few words of English at his command. By the time he graduated from high school at 17, he had won a swimming scholarship to Edinboro University of Pennsylvania, where he went on to earn a degree in mathematics.

Then it was on to General Electric Co.'s fabled training grounds, where Zafirovski steadily climbed the ranks for a quarter of a century, internalizing famous GE truths about market share (you should be No. 1 or 2 in a market or get out) and employee training (develop talent through intensive programs).

Zafirovski left GE, where he ultimately was president and CEO of the worldwide lighting business, to take the reins of Motorola's laggard cellphone business in 2000. By the third quarter of 2001, that unit had returned to the black.

Yet the driven Zafirovski, who spends his spare time running marathons, was passed over twice for promotions at Motorola. The second time was in 2003, when Zafirovski, then chief operating officer, lost the CEO post to an outsider, former Sun Microsystems Inc. COO Edward Zander. Zander resigned last November, leaving a stressed company that has failed to find a follow-up to its iconic Razr phone. By this February, Motorola was considering breaking itself up. Hence, perhaps, the talk of a joint venture with Nortel in wireless.

As Nortel CEO, Zafirovski has kept a low public profile since the splash of publicity for his appointment. He rarely gives in-depth interviews to the press. (He recently told The Wall Street Journal that he did a good job on his 2007 resolution to respond quickly to e-mails, but still has work to do on getting meetings started on time.) An aide said Zafirovski's travel-intensive schedule was too packed for him to be interviewed for this story.

RBC's Sue says that's all right: Zafirovski is focusing on the big job ahead rather than drumming up publicity. He says the CEO has been "very responsive" to the financial community. "He recognizes the company still has a lot of work to do, so I think he's rolled up his sleeves and is trying to fix the internal issues," Sue says. "When there are better things to say, I'm sure he will be more vocal."

Although Zafirovski has followed through with the initiatives he outlined the day of his appointment—eliminating the troubles with Nortel's financial reporting, making its R&D organization more effective—an overall turnaround is not evident. When he began, Zafirovski said it would take three to five years. Chief strategy officer Riedel says the latter target is more realistic. "Are we frustrated with the pace of change?" Riedel asks. "Yes we are. Why is that? Because we're all working hard. We all want to see it happen faster."

Zafirovski spent his first year attracting a new management team from top companies such as IBM, GE, Motorola and Juniper Networks. Perforce, Nortel and some members of the old guard parted ways, including Brian McFadden (chief research officer), Sue Spradley (president of global services and operations) and Dion Joannou (president of North American operations). Of the current top 21 executives at Nortel, only nine predate Zafirovski's arrival. Observers had long argued the company needed new blood, and applauded this recruiting drive.
Newcomers to Nortel—and in some cases to Canada—have secured a lot of the key positions in Zafirovski's cabinet. Riedel brings critical experience from his time at smaller rival Juniper, where he was vice-president of strategy and corporate development, and McKinsey & Co., where he co-led its telecom and high-technology practices in North America and Asia. He spends his time in Toronto and on the road.

Chief technology officer John Roese, at 37, is one of the younger faces in the executive suite. The fast-talking executive is the only one of the top 21 to blog (at blogs.nortel.com/ctoblog). He's held jobs at three other tech companies, most recently at Broadcom Corp., and is based at Nortel's R&D head office in Ottawa. The other recent arrivals include chief marketing officer Lauren Flaherty, who had a hand in IBM's makeover in the 1990s. Also from IBM comes German-born Dietmar Wendt, who is Nortel's president of global services. U.K. import Pavi Binning took on the challenging chief financial officer role in November. His recent posts have included CFO at Marconi, where he was part of the team that divested units and cut debt in a bid to stabilize the company before it was sold to Ericsson.

With the new team in place, Zafirovski launched a cost-cutting program that aims to remove $1.5 billion (U.S.) in operating expenses by the end of this year. Part of the savings came from the R&D group, which has a $1.7-billion (U.S.) budget and 12,500 employees—and the focus on "farming" older products that concerns Roese. That category consumes 55% of the pie. Management would rather have the share be 20%, with 60% directed at mature, growth products in categories such as CDMA, and the remaining 20% toward up-and-coming technologies like WiMax. By the end of 2007, Roese reckons he achieved that 20/60/20 ratio and reduced R&D as a percentage of revenue to the targeted 15%, from 17% in 2006. All told, he wants to ensure "we have a nimble, flexible and focused R&D organization that has its budget focused on the future, not on the past."

Not all cost-cutting has been easy. Selling, general and administrative expenses were nearly 23% of revenue in the third quarter, much higher than the 15%-to-17% target. As a result, the company's operating margin was 5% in the period, a far cry from its long-term goal of 13%.
Nortel eked out a profit, albeit a small one, in the third quarter, in part because it sold the wireless business. Now shareholders want to see proof that Nortel can capitalize on the changes to its R&D organization and deliver healthy revenue growth. For 2007, the company forecast revenue would be down slightly, in part because it sold a business. Zafirovski has predicted that there will be "modest growth" in revenue this year.

Some analysts are feeling relatively upbeat about Nortel's outlook. In January, TD Newcrest analyst Chris Umiastowski raised his rating on the company to "Action List Buy" from "Buy," calling it a stock to own in 2008. "We believe the company is showing much improved financial performance and expect the improvement to continue when Nortel announces its Q4 results," Umiastowski wrote in a note to clients.

Where Nortel places its bets now will largely determine its fate. Under Zafirovski and Roese, the company is focusing on a few emerging product areas.

The one most people have heard about is WiMax, which is basically speedy Internet service over wireless technology. Phone carrier Sprint plans to offer WiMax service in the U.S. this year. Nortel and others are betting this technology will take off, as it promises to provide much faster Web access than current cellphone service. But it's such a small market at this point that Dell'Oro doesn't even track market share.

Another so-called fourth generation, or 4G, wireless technology, called LTE (long-term evolution), is further out. Nortel, Alcatel-Lucent and Ericsson all plan to sell equipment in this area. This technology, too, offers rapid Internet service on cellphones. Cellphone carriers around the globe will upgrade to one or the other of the technologies in coming years.

Quicker networks are also a buzzword for land-line infrastructure as consumers spend ever more time on the Internet. Nortel sells optical equipment that can transport Internet traffic at 40 gigabits a second (versus the currently more typical 10 gigabits), offering carriers a chance to upgrade their networks to provide ampler bandwidth.

Another new technology, called PBT (provider backbone transport), lets service providers use Ethernet—typically in place to hook up all the computers in a company—as a network that can carry everything from voice to video to Internet services across a city at fast rates.

Where it not long ago had nothing new to pitch to customers, Nortel now has shiny new products to show. And some clients are buying into the vision, including BT Group PLC for PBT technology, and Verizon's European business for Ethernet gear. If Nortel had asked a big customer like Spain's Telefonica two years ago what it wanted to talk about, "they'd say, 'I don't know,' " according to Riedel. "Today [they say], 'Talk to me about LTE, tell me about this WiMax stuff, tell me about 40 gig on optical, tell me about this PBT stuff you've got.' There's a significantly different type of conversation that's happening today than perhaps two years ago."

It's obviously a change in the right direction. The only problem—and this is the final tectonic change in the industry that Nortel must reckon with—is that services, not hardware, are what's really bringing in the money. For many customers, all the networks and equipment look alike and don't change much with each supplier. So they want to pay the lowest price possible; it's becoming a commoditized business. As Alcatel-Lucent's Krause explains, "When you're supplying a fibre-optic system undersea, that's just a big fat pipe. When you supply platforms and applications that really help the operator differentiate from its competitors, you've moved up the value chain."

Avaya agrees. "If you're a traditional manufacturer of phone equipment, you've been in for a rough ride over the past decade," says Tracy Fleming, Avaya's national IP telephony practice leader. "The ultimate killer app is really customer service."

Nortel didn't have much of a services business when president of global services Dietmar Wendt joined the company in 2006. In a phone interview in January, he outlined the new opportunities, starting with offering products and services that bring voice, e-mail and video together, an effort that was bolstered by a partnership with Microsoft. For example, Nortel and Microsoft together sell software that allows users to make calls from their computers. Nortel also manages different services for customers, including contact centres.

What Nortel isn't doing is accepting responsibility for running a customer's entire network, as Alcatel-Lucent and Ericsson do—because it's not large enough to do so. While Riedel describes these outsourcing contracts as a headache, he acknowledges they are also where the megadeals will be done, rather than in equipment upgrades like in the late 1990s boom. "There won't be $1-billion contracts [for Nortel]," Riedel says. "It won't be, 'We won the pot of gold.' It's not a grand slam. It's doubles and singles."

One way that Nortel could grow more quickly is by going shopping. In the past two years, rumours have linked it to Avaya, Tellabs and 3Com, buys that would have allowed it to boost its product portfolio and cut costs. None has panned out. A wireless union with Motorola, should it happen, is much more ambitious than what Dell'Oro's Weckel has forecast—he believes Nortel could benefit from add-on purchases of $20 million (U.S.) or $30 million (U.S.) to fill in technology gaps in the product portfolio.

Zafirovski has said Nortel is ready to buy, but the only move he has made to date is the 2005 purchase of a California-based data networking company, Tasman Networks Inc., for $99.5 million (U.S.) in cash. (The addition was designed to help Nortel catch up with Cisco.) Nortel doesn't have the balance sheet to do big deals, according to RBC's Sue. The company's cash pile fell to $3.1 billion (U.S.) at the end of September, from $3.5 billion (U.S.) nine months earlier.

And don't look for Nortel itself to get bought out. All the large players are busy integrating the purchases they made in recent years, while private-equity firms are on the sidelines amid the current credit crunch. Cisco wouldn't bite either, Sagawa believes. "Cisco would rather that Nortel just flop around and struggle and that they slowly take away their business," he says.

Nortel's failure to do any bold deals or sell off more assets to date has attracted criticism that Zafirovski doesn't have the strategic mind required to resuscitate Nortel. "My take on Mike Z: He's a much better operator than he is a strategic thinker," Sagawa says. "If you gave him a business that was humming along and asked him to make it better, he's probably your guy. If you take a business that's got serious problems and tell him to figure out what it should be in the future, I think it's a struggle."

Riedel explains why management is not audacious: Caution makes more sense. "I wish it was happening faster," Riedel says. "But I'm not going to be silly and take unreasonable risk to the business and to the reputation of the company as a result of trying to push something before it's really ready to go."

That does sound like a "new Nortel."