Nortel1
Introduction
This case investigates several aspects of selling a voice/data switch by Nortel (previously
Northern Telecom) to current major industrial customers. The first part of the case will examine
the sale itself and its projected profit consequences. Later on in the case, Nortel invades a new
market and needs to consider the response of a major competitor to this invasion.
There are three modes of communications technology: low-speed voice, high-speed data, and
high-speed video. Historically, telephone communications has concerned itself with voice
communications. Traditional switch vendors, such as AT&T, Nortel, Ericsson, and Siemens
Stromberg Carlson, have sold narrow bandwidth switches capable of handling voice
transmissions to local exchange carriers, that is, local phone company central offices. The
emergence of high-speed data communications and videoconferencing requires widebands and
broadbands. The challenge for the future is whether data transmission will exist side by side
with voice transmission or whether new technology will integrate both modes. The traditional
switch vendors, such as Nortel and AT&T, are betting that new products can be developed, that
will overlay data transmission on existing voice networks. These new capabilities would build
on existing voice switch platforms by offering switched digital services and additional services
such as frame relay or switched multimegabit data service (SMDS). New competitors, such as
Fujitsu and Alcatel, believe that new technologies will be developed to integrate both modes.
The new mode they are betting on is called asynchronous transfer mode (ATM).
The Switching Market and Nortel
The switching market in general is flat. In the United States in 1993, the local switching market
was valued at $1.3 billion and is projected to drop to $1.1 billion in 1998. In 1992, the number
of switches sold, both new and replacement, was 941. In 1993, the total number of switches was
635 and it is projected to be 358 for 1998.
Nortel, based in Canada, is one of the major suppliers of switches in Canada and the United
States. BCE Inc., a Canadian property, owns a majority share in Nortel as well as Bell Canada.
Nortel has had a strong presence in the U.S. market since 1984. With the breakup of AT&T,
Nortel was able to make advances into the U.S. market that had previously been very difficult to
break into. In fact, Nortel is very close to AT&T in sales revenues of office phone systems to
businesses in the United States, and it narrowing AT&T’s lead in digital central-office switches in
the U.S. Nortel also has a recently established joint venture with Motorola to produce cellular
equipment. If successful, this venture should place both firms in very advantageous positions in
1 This case was called Northern Telecom in previous editions, and is based in part on the following articles: William
C. Symonds, “High-Tech Star: Northern Telecom is Challenging Even AT&T,” Business Week, July 22, 1992, pp.
54-58; Larry Luxner, “Mexico Reaches for New Telcom Heights,” Telephony, February 3, 1992, pp. 22-28;
Anonymous, “Called Together,” The Economist, October 19, 1991, p. 90; Bob Vinton and Steven Titch, “Ericsson
Nets Big SW Bell Order,” Telephony, February 18, 1991, pp. 9-10; John Williamson, “Smart Networks Equal Big
Bucks,” Telephony, March 2, 1992, pp. 19-21; Michael Warr, “Modularity Is the Name of the CO Switching Game,”
Telephony, April 8, 1991, pp. 34-42; Gary M. Miglio, “Avoiding the Telco Marketing Gridlock,” Telephony,
November 11, 1991, pp. 21-26.
this emerging industry. Another recent joint venture is with Matra of France for the production
of digital mobile phone equipment. Nortel also has joint ventures with firms in Poland and Spain
and does business in many other countries. Much of Nortel’s growth and vision can be attributed
to its chairman and CEO, Paul G. Stern, who was named to the position in 1989 and has a
reputation for demanding excellence from all his employees. Under the leadership of Stern,
Nortel has rapidly grown to $8.2 billion in 1994 revenues in the United States – this accounted
for 50% of worldwide Nortel sales.
Technology
Nortel is involved in many aspects of the telecommunications industry, including the
manufacture and sale of central office switches. In the past, this industry has been centered
around the installation of voice networks. Two areas of technology that are assuming increasing
importance for the industry are high-speed data communications and wireless cellular
communications. Data and image communications involve a fundamentally different type of
switching that requires a greater bandwidth. All of the switch vendors agree that standard voice
communications are not the growth market of the future. Two divergent approaches to meet this
challenge are being used by competitors in this industry. Traditional switch vendors, such as
Nortel, expect that new asynchronous mode (ATM) technologies, such as frame relay or
switched multimegabit data service (SMDS), will be overlaid onto the existing network in the
future.
Another dimension of communications technology that is receiving increasing emphasis due to
the rapid emergence of data transmission is the establishment of standards. Traditional switch
vendors are developing software to make their switches compatible with national ISDN
standards.
The Product and Competition
Nortel is one of the major suppliers of central office (CO) switches. The other major competitors
are AT&T, Ericsson, and Siemens Stromberg Carlson. These three competitors dominate the
traditional voice switch industry. Nortel and AT&T are running neck and neck, each with about
45% of the switch market. For every line that Siemens shipped in 1990, for example, Nortel and
AT&T shipped eight between them. The potential shift to new ATM technologies offers hope to
new competitors, such as Fujitsu and Alcatel, to break the stranglehold held by traditional switch
suppliers.
The workhorses of the Nortel central office switch line are the DMS 10 and DMS 100 switches.
A survey of telephone companies reported that the local exchange carriers perceive Nortel’s
central office switches to be more flexible than AT&T’s. Nortel was chosen five-to-one over
AT&T on how easy it is to enhance a product by adding new features. They were rated equal on
how easy it is to enhance a switch for busy-hour call capacity.
Sale of the New Product
Local exchange carriers (LECs) constitute one of Nortel’s major customer bases. The LECs sell
services such as Centrex to business customers. The ability to offer Centrex depends on the type
of switch equipment the LECs possess, and the marketing of services like Centrex is often done
in conjunction with switch vendors such as Nortel.
The traditional switch vendors are convinced that the key feature to upgrading new technologies
into switch networks is modularity. This allows the LECs and their vendors to protect the
embedded switches while providing entry into new arenas. This trend began with Nortel’s
“Evergreen” approach to switching and has been followed by AT&T with “Service 2000” and
Siemens Stromberg Carlson’s “Vision O-N-E.” These companies feel that the new generation
switch is far in the future and are trying to protect their installed equipment base with modularity.
We will explore Nortel’s efforts to sell switches to local exchange carriers in the United States.
One strategy is to cooperate with LECs in the marketing of Centrex lines compatible with
Nortel’s DMS line of central office switches. This part comprises several steps: forecasting
sales, projecting diffusion rates, competitive positioning, advertising budgeting, and profit
analysis.
Market Diffusion
Although demand for switches is currently flat and not expected to improve greatly over the next
few years by many industry analysts, some revival in sales is likely to occur as technology
improves and switching equipment becomes more flexible and amenable to new applications
(see Competitive Positioning section for discussion of flexibility in application). Current total
market demand in the United States for central office switches equivalent to Nortel’s DMS line is
placed at about 2,000. Based on discussions with industry experts, “innovator” and “early
adopter” customers make up a tiny fraction of high potential customers, but are likely to be very
quick to commit to the new technology. This is good for Nortel and its competitors, as these
customers are very likely to influence the purchase patterns of other potential customers in much
the same way as “opinion leaders” influence the adoption of consumer nondurable goods among
their circle of influence. Due to the relatively flat market conditions currently prevailing,
however, it is unlikely that diffusion will be rapid through the later adopters. These experts on
the telecommunications industry were asked to provide estimates of the innovation and imitation
rates for use in a BASS diffusion model, based on preliminary adoption patterns and general
understanding of the market. They selected an innovation rate of 0.08 and an imitation rate of
0.2. These figures capture the essence of diffusion in this market: rapid adoption by imitators,
but relatively slow diffusion into other segments of the market.
Competitive Positioning
A small-scale survey of purchasing managers in the switching equipment industry was
undertaken to determine the most salient product attributes. The main concerns of most
switching equipment purchasers are price, speed of transmission, and system flexibility. All
main competitors (AT&T, Nortel, Ericsson, and Siemens) were rated on both attributes by each
purchasing manager on a scale of 0 to 5. Each of the manufacturers was perceived to be
technologically advanced and to offer high-speed transmission switches; however, potential
customers do see differences among the competitors in terms of transmission speed offered.
Some customers (referred to as Segment 1 below) are willing to pay a premium for speed; others
(Segment 2) do not require “speed at all costs” but will trade off transmission speed for
flexibility of application. The two segments are of approximately equal size.
It is known that some manufacturers offer higher speed, while others offer higher flexibility. For
example, there is a strong perception that Nortel’s switches are much more flexible than those of
AT&T in the sense that it is easy to add new features to the switch at a later date. On certain
flexibility issues (such as the ability to expand call capacity during peak periods), all
manufacturers were rated equally; but overall Nortel was seen as offering a few special features
and capabilities that boosted its flexibility over what is offered by competitors.
Based on the survey results, a positioning map for Nortel and its competitors can be constructed.
These data can be used as input to the PERCEPTOR model, which then can forecast long-run
market shares for Nortel and its main competitors.
Attribute 1
(Speed)
Attribute 2
(Flexibility)
Segment Ideals For: Segment 1 3.25 2.25
Segment 2 2.00 4.00
Brand Positions AT&T 3.75 2.75
Nortel 3.00 4.00
Ericsson 4.25 1.90
Siemens 2.25 3.20
Profit Analysis
Several versions of voice/data switches are available to customers according to their particular
needs and specifications. On average, the purchase price is $600,000 (including service costs to
the customer), with variable costs averaging about half of this.
By examining internal financial records, Nortel was able to develop the following financial
estimates that can be used as inputs to the CASHFLOW model.
Fixed (indirect) production costs = $10,000,000 yearly.
Fixed advertising (marketing) expenses = $1,000,000 yearly.
Corporate overheads (exclusive of R&D) charged to the new product = $10,000,000 yearly.
R&D to be charged to the new product: 5% of dollar sales, beginning in Year 1.
Cannibalization: negligible.
Project abandonment: negligible.
Tax rate: 34%, with no applicable tax credits.
Cost of capital: 15%.
Working capital:
Cash as percent of sales: 10%.
Inventory as percent of sales: 10%.
Accounts Receivable as percent of sales: 15%.
Working capital recovery in Year 5:
Percent of cash: 100%.
Percent of inventory: 80%.
Percent of accounts receivable: 100%.
New investment in production facilities: $1,000,000 in Year 0 (1994), $100,000 in Year 1 (1995),
both depreciated over five years using straight-line method.
Entry Into the Mexican Market2
With the North American Free Trade Agreement, Nortel sees an opportunity in Mexico. The
Mexican phone company, Telmex, that had previously been operated as a state agency, was
privatized in 1990. A consortium composed of Southwestern Bell, France Telecom and Grupo
Carso paid $1.76 billion for a 20.4% controlling interest in the company and the remainder of the
stock was sold to the general public.
With the privatization of Telmex and the Free Trade Agreement with the United States and
Canada, Mexican officials are hoping to improve phone service substantially in the near future.
Carlos Kauachi, executive vice president of Telmex, was quoted as saying that Telmex hopes to
comply with phone service requests in about half the time that is required now. Telmex’s
objectives apparently are great improvements in phone service to the average Mexican (in a
2 This section of the case is not based on historical fact but is meant to illustrate the concept of competitive attack an
defensive maneuvering via the DEFENDER model.
country of over 90 million people), via pro-business market strategies and capitalizing on free
trade.
Ericsson is a strong competitor to Nortel, with superior knowledge of the southern and
southwestern U.S. market. Ericsson has a solid track record with Southwestern Bell, and in fact
in 1989 the two companies signed a long-term contract worth millions of dollars in sales. As
recently as 1991, Ericsson supplied over three dozen digital processors to that company. This is
only the most recent of several contracts with Southwestern aimed at upgrading service in Texas.
Ericsson has also been successful as a supplier of telephone service equipment in Mexico, and
needs to defend its turf against Nortel and Motorola, which is also poised to attack.
Prior to privatization, Ericsson was a joint operator of Telmex, along with a state agency.
Ericsson operates a factory outside Mexico City that produces switches for public and private
networks. The company enjoyed sales of $500 million in 1991, making it the 24th largest
industrial concern in Mexico. Approximately 70% of Ericsson’s annual production in Mexico
goes to Telmex. In contrast, Nortel de Mexico had annual revenues in 1991 of approximately
$80 million. This part of the case looks at Ericsson’s strategic response to the potential invasion
by Nortel in the Mexican switch market. Total size of the Mexican market is expected to be 800
units next year.
After a few months passed, it was clear that Siemens was not going to challenge seriously in the
market. The result was a triopoly, with AT&T and Ericsson holding the majority of market share
between them and Nortel the only feared competitor. Ericsson was concerned that Nortel might
be making serious inroads into its market with the development of this new central office switch.
Fortunately, Ericsson had committed some time ago to improving flexibility (its weakest
attribute) and, if pressed, could rush a new, highly flexible product out to the marketplace in
short order. Industry experts would rate the new Ericsson product’s flexibility at roughly 2.30 on
a scale of 1 to 5. The new positions would thus look as follows:
Attribute 1
(Speed)
Attribute 2
(Flexibility)
Brand Positions Ericsson 4.25 2.30
AT&T 3.75 2.75
Nortel 3.00 4.00
Ericsson’s switch is priced at $550,000 and AT&T’s at $540,000. Nortel is expecting to price its
product at $600,000.
Ericsson’s defensive maneuvering would be, of course, a potentially severe threat to the success
of Nortel in this market, and company executives are wondering whether they should make any
changes to their product’s current position in anticipation of such a defensive strategy. (Assume
that the other competitors incur roughly the same level of fixed and variable costs as does
Nortel.)