How Nortel Stole Optical A few years ago no one thought this sleepy Canadian telecom equipment maker would go anywhere. Now look who's laughing.
By Christine Y. Chen Reporter Associate Ahmad Diba

(FORTUNE Magazine) – Brampton, Ont., is the last place on earth you'd expect to find a jewel of the new economy. Dixie Road, a long industrial stretch about 45 minutes northwest of Toronto, is dotted with large, faceless warehouses, the occasional fast food joint, and lots of half-empty parking lots. Silicon Valley this ain't. My cabbie takes us past a dilapidated building bearing the sign BRAMPTON POULTRY PRIDE, then breezes past a large Ford manufacturing plant. When I tell him we should be reaching the headquarters of Nortel Networks any minute now, he shrugs and says, "Hmmph. Never heard of 'em."

That's not exactly the response you'd expect to the name of the world's 16th most highly valued company. Long regarded as a quiet Canadian cousin to the telecom equipment makers of the U.S., Nortel never attracted the gaudy headlines of its more glamorous competitors to the south. Most people thought of Lucent and Cisco as the main contestants in the battle to wire the world for the broadband era.

That all began to change a couple of years ago, when Nortel awoke from its hibernation and started acting hungry. For a 105-year-old company that used to count fire alarms and ladders among its products, Nortel's resurgence has been stunning in its swiftness. In the past four quarters revenues grew by 37%, to $26 billion. And though its stock has slid 18% in the past few weeks along with that of other telecom equipment makers, Nortel's share price has more than tripled in the past year, to $68, giving the company a market cap of $203 billion--still less than half the size of Cisco's but 60% greater than Lucent's.

How did Nortel get to be so hot? As networking equipment companies scrambled to help telcos build new data networks, CEO John Roth placed a savvy bet that optical networking technology would hold the key to the future. Fiber-optic networks transmit signals as pulses of light along thin glass strands rather than as electrons in slow, unwieldy, and costly copper networks. Nortel gambled on a new way to let its fiber-optic gear carry far more traffic than anyone else's. The stakes in the contest are huge. RHK, a telecom research firm in South San Francisco, estimates that the world market for optical equipment will nearly triple, from $31 billion in 1999 to $90 billion by 2003.

While Nortel was pushing out the technological horizon in optical networking, its competitors were busy looking elsewhere. Lucent, spun out of AT&T in 1996, was bogged down by obligations to keep older networks running for its big telco customers. And Cisco is an arriviste in the telecom business, having built its business on routing and corporate data networks. So Nortel managed to steal a key market from its rivals. According to Dell'Oro, a Portola Valley, Calif., research firm, Nortel controls 43% of the global market for optical equipment, trouncing its nearest competitor, Lucent, which has a 15% share. Even better, it has virtually no competition in the market for gear with the highest carrying capacity. As a result, Nortel's optical revenues are expected to surge this year by 100%, to $10 billion.

You might think that such drastic growth in a behemoth like Nortel could have been instigated only by some Young Turk imported from the outside world. Yet CEO John Roth is a company lifer, and at first blush the lanky 57-year-old doesn't seem the type who could jolt a sleeping company awake. Clad in a dark, nondescript suit and tie, the 6-foot, 2-inch Calgary native has a sober, stately demeanor. Even when he gets excited, like when he talks about taking one of his six high-performance cars for a spin on the track, his voice is low, steady, and deep, reminiscent of actor Jerry Orbach's. From appearances alone, Roth could be the poster boy for the old economy.

But beneath the assured and matter-of-fact exterior beats the heart of a fast-talking Silicon Valley entrepreneur. "John is actually a very dynamic guy," says Don Smith, president of Nortel's optical Internet unit. "He's very aggressive. People underestimate him." Roth joined Nortel in 1969 as a design engineer. He rose through the ranks to become Nortel's first president of wireless networking in 1993, establishing Nortel in the cellular business during the crucial switch from analog to digital technology. Named COO in 1995, he took over the top job in October 1997, when CEO Jean Monty left to become the chief executive at BCE, Canada's leading telecom company.

Roth came in determined to make a splash. In December 1997 he wrote a letter to all Nortel employees, calling for a "right-angle turn" that would make the company a key player in the digital era--the leader in, and perhaps the creator of, Webtone networks. He wrote: "I want Nortel to [make] the Internet as easy to access as the voice network, and as fast, as reliable, as secure, and as much a part of our everyday lives as dial tone is today." Nortel employees think of the letter as magic words that forced everyone to stop thinking about old-fashioned telephones and start thinking about the Internet.

In the next three years Roth made sweeping changes throughout the company. He moved headquarters from Toronto to a new million-square-foot building in Brampton, a quirky symbol of Nortel's past and future. Parts of the building have the staid, oak-paneled look of an old-economy company, yet it is dotted with the Foosball tables and rock-climbing walls of an Internet startup. Roth changed the company name to Nortel Networks, believing that the old name, Northern Telecom, wasn't new-economy enough.

While a new name is cosmetic, Roth also proved himself willing to take radical and painful measures. Believing that Nortel's future lay in its ability to adopt new technologies swiftly, he shifted the focus from internal development to acquisition from outside. So he slashed manufacturing, selling 19 of Nortel's 26 plants, most of which made products he thought would soon be old hat.

Then Roth set off on a major-league buying spree to prepare for the future. He started with a thud. In 1998 he paid $9.1 billion to buy upstart Bay Networks. The deal was supposed to help the company take on Cisco in data networking and give Nortel street cred as a cutting-edge player. But investors, believing that Roth had overpaid and would have a hard time ingesting Bay, punished Nortel's stock, which tumbled 56% in four months.

Roth pressed on and kept making deals--15 more of them, for $21 billion--slowly infusing Nortel with startup know-how. As Yankee Group analyst Sanjay Mewada says, Nortel learned the values of an entrepreneurial culture and speedy product development. But the key to Nortel's spectacular success was the bet that Roth had placed on optical networking even before he became CEO.

Fiber-optic networks per se are nothing new. Major phone companies like AT&T, WorldCom, and Sprint have been installing fiber for years, mostly across long distances--spanning continents and crossing the ocean floors. Much of it lay dark--a reserve for the future. But in the past few years the rise of the Internet has created an explosion in data traffic and hence in the demand for bandwidth, or carrying capacity, by the world's telecom companies. Instead of just transporting phone conversations from Tupelo to Topeka, telecom networks are also being used to transmit e-mail, Web pages, and video to multiple locations all over the world. This vast quantity of information eats up enormous amounts of network capacity. So telcos need to start lighting up all their fiber to handle the burgeoning load.

Although no one in the mid-1990s could have known how fast the Internet would grow, Roth understood that the demand for bandwidth would be massive--or as Credit Suisse First Boston analyst James Parmelee puts it, "a discontinuity to be exploited." Still wearing his engineering hat in 1994, Roth sat down and drew a little chart. "With voice traffic growing steadily at about 3% a year and data traffic growing at about 30% a year, it took no genius to see that 1996 would be a crossover year, where total data traffic would surpass voice," he explains. "We'd been chugging along. But 1996 was coming soon. So I said, 'Come on, guys. Let's get with it.'"

Roth had faith that he could corner the market if he moved quickly enough. Most telecom carriers in the mid-1990s were asking fiber-optic suppliers for equipment that could carry 2.5 billion bits of data per second on a single strand of fiber, which they felt would give them plenty of muscle to handle all the traffic flowing over their networks. Nortel's rivals, like Lucent, thought such speeds reached the limits of fiber-optic technology; at faster rates the lasers that transmitted the signal would melt the glass.

Roth accepted neither assumption. He was convinced that the demand for bandwidth would be higher than his customers predicted and that his engineers could push the technology further. He ordered his team to start developing a system called the OC192, which, at ten billion bits (or gigabits) per second, would be four times faster than Lucent's. An OC192 system would have so much carrying power that if everyone in the U.S. made a phone call at the same time, all the signals could travel over a single strand of fiber.

It was a gutsy play. Optical networks President Greg Mumford says, "There was a risk that our equipment would get too hot with lasers flashing ten billion times per second, or that the fiber in the ground wouldn't operate at ten gigs, or that the customers wouldn't want the capacity, or that the bandwidth demand wouldn't be as high as we thought." But Nortel figured out how certain frequencies of light could work in a supercharged system without breaking down the glass. Nortel also discovered how, using beams of light of slightly different colors, it could send 32 separate beams along a strand of fiber at once while the rest of the industry was stuck at eight. Combined with the fourfold increase in laser speed, Nortel upped network capacity 16 times in one stroke.

Nortel still had to convince customers that they needed such firepower. Over the next couple of years telcos like MCI tested the OC192, but no one bought it. Roth needed a breakthrough. So on a Sunday in spring 1997 he flew to Denver to talk with Joe Nacchio, the newly named CEO of upstart long-distance carrier Qwest. "Joe said to me, 'I have all this fiber and I need to light it up, so give me 2.5 gigabits a second,' " Roth recalls. "I said, 'That's not enough. You need ten.' " Nacchio replied that Roth might be right, but he could only afford the cheaper system. So Roth made a bargain. He promised to install the ten-gigabit system but would charge Qwest only for the smaller one. Nortel would collect more only if Qwest used additional 2.5-gigabit increments. Nacchio said yes. Within months Qwest used up all the spare capacity on its new system.

For Nortel the deal was a landmark. COO Clarence Chandran, widely viewed as Roth's heir apparent, says, "From there on out it just fell like Niagara." With demand for bandwidth exploding, Nortel found more and more customers for its OC192 system. By fall 1999, customers were asking for fully loaded ten-gigabit systems, and Nortel was the only company that made them. Archrival Lucent introduced a competing system only in February 2000. Lehman Brothers analyst Tim Luke estimates that Nortel's share of this most lucrative end of the market is more than 90%. Already Nortel is working on 40- and 80-gigabit systems.

Even now that Nortel has grabbed the optical networking crown, Roth has not stopped tinkering. Perhaps the biggest riddle he has yet to solve is what to do with his optical components business, which manufactures lasers, filters, and other nuts and bolts that companies like Nortel and Lucent use in building fiber-optic networks. That business is white-hot. In early summer, for instance, component maker JDS Uniphase paid $41 billion for a not very famous rival, SDL. It's a perfect time for Nortel to cash in and raise funds for future purchases. In July, Roth came close to selling the component business to Corning for $100 billion, but the deal fell apart because Corning would have had to cede control of the company to Nortel. He hints that the business is still for sale, but in the meantime he continues to pump it up so that it holds its value, opening a new components lab outside Ottawa and announcing a $1.9 billion investment to double manufacturing capacity, mostly for optical components.

But that business is just a distraction. Having banked on optical networking once, Nortel will bet on it again. Roth firmly believes that the entire telecom network, which still uses electronic transmission for local traffic, will eventually be completely photonic. That means glass fibers won't stretch merely between cities and into big office buildings but also into homes and small businesses too.

Nortel was able to blind-side its rivals in the first round of the optical networking game. This time everyone's watching. In local markets the company will face stiff competition from upstarts like Sycamore and Ciena. In wireless Nortel is tackling global giants like Nokia and Ericsson. And Nortel must contend with its traditional competitors. Although Lucent has been troubled, it's far from dead; it is revamping its management, and Wall Street still sees the company as a good long-term investment. And if any company knows how to move quickly, it is Cisco, which recently made a flurry of acquisitions to get into the optical contest. With competition coming from so many sides, Roth laughs at the suggestion that Nortel is no longer an underdog. "We'll never picture ourselves as a Goliath," he says. But he is happy to think of Nortel as a very muscular David, and one with laser vision at that.

REPORTER ASSOCIATE Ahmad Diba

FEEDBACK: cchen@fortunemail.com