UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549
FORM 10-Q
OR
For the Transition Period From _____________________ to _____________________
Commission file number 001-07260
Nortel Networks Corporation(Exact name of registrant as specified in its charter)
Registrant’s telephone number including area code (905) 863-0000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to filing requirements for the past 90 days.
Yes ü No
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes ü No
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as at April 30, 2003
3,852,615,643 without nominal or par value
TABLE OF CONTENTS
PART IFINANCIAL INFORMATION
PART IIOTHER INFORMATION
All dollar amounts in this document are in United States dollars unless otherwise stated.
NORTEL NETWORKS, NORTEL NETWORKS LOGO, NT and the GLOBEMARK are trademarks of Nortel Networks.MOODY’S is a trademark of Moody’s Investor Services, Inc.S&P 100, S&P 500 and STANDARD & POOR’S are trademarks of The McGraw-Hill Companies, Inc.
2
3
NORTEL NETWORKS CORPORATIONConsolidated Statements of Operations (unaudited) for the three months ended
The accompanying notes are an integral part of these consolidated financial statements
4
NORTEL NETWORKS CORPORATIONConsolidated Balance Sheets (unaudited) as at
5
NORTEL NETWORKS CORPORATIONConsolidated Statements of Cash Flows (unaudited) for the three months ended
6
NORTEL NETWORKS CORPORATIONNotes to Consolidated Financial Statements (unaudited)(millions of U.S. dollars, except per share amounts, unless otherwise stated)
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
Supplemental Consolidating Statements of Operations for the three months ended March 31, 2003:
22
Supplemental Consolidating Statements of Operations for the three months ended March 31, 2002:
23
Supplemental Consolidating Balance Sheets as at March 31, 2003:
24
Supplemental Consolidating Balance Sheets as at December 31, 2002:
25
Supplemental Consolidating Statements of Cash Flows for the three months ended March 31, 2003:
26
Supplemental Consolidating Statements of Cash Flows for the three months ended March 31, 2002:
27
You should read this section in combination with the accompanying unaudited consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States. This section contains forward looking statements and should be read in conjunction with the factors described below under “Forward looking statements”. All dollar amounts in this Management’s Discussion and Analysis of Financial Condition and Results of Operations are in millions of United States dollars unless otherwise stated.
Where we say “we,” “us,” “our,” or “Nortel Networks,” we mean Nortel Networks Corporation or Nortel Networks Corporation and its subsidiaries, as applicable. Where we refer to the “industry”, we mean the telecommunications industry.
Business overview
Nortel Networks is an industry leader and innovator focused on transforming how the world communicates and exchanges information. We supply products and services that support the Internet and other public and private data, voice and multimedia communications networks using wireline and wireless technologies, which we refer to as “networking solutions”. A substantial portion of our company has a technology focus and is dedicated to research and development. This focus forms a core strength and a factor differentiating us from many of our competitors. We envision an information society where people will be able to connect and interact with information and with each other instantly, simply and reliably, seamlessly accessing data, voice and multimedia communications services and sharing experiences anywhere, anytime.
Our operations are organized in four reportable segments: Wireless Networks; Enterprise Networks; Wireline Networks; and Optical Networks.
Nortel Networks Corporation’s common shares are publicly traded on the New York and Toronto stock exchanges under the symbol “NT”. Nortel Networks Limited is our principal direct operating subsidiary. Nortel Networks Corporation holds all of Nortel Networks Limited’s outstanding common shares but none of its outstanding preferred shares.
Recent developments
Common shares
At our annual and special shareholders’ meeting on April 24, 2003, our shareholders gave authority to our Board of Directors to implement a consolidation of our outstanding common shares, also known as a reverse stock split. As a result, our Board of Directors has the authority at its sole discretion to implement a consolidation of our common shares at any time, if at all, prior to April 15, 2004. If a share consolidation is determined to be in the best interests of Nortel Networks and its shareholders, our Board of Directors will select a consolidation ratio within the range of one post-consolidation common share for every five pre-consolidation common shares to one post-consolidation common share for every ten pre-consolidation common shares.
Shareholder rights plan
At our annual and special shareholders’ meeting on April 24, 2003, our shareholders approved the reconfirmation and amendment of our shareholder rights plan which, will expire at the annual meeting of shareholders to be held in 2006 unless it is reconfirmed at that time. Under the rights plan, we issue one right for each common share outstanding. These rights become exercisable upon the occurrence of certain events associated with an unsolicited takeover bid. For additional information, you should refer to “Shareholders rights plan” in note 14 of our financial statements in our Annual Report on Form 10-K for the year ended December 31, 2002 filed with the Securities and Exchange Commission on March 10, 2003 and to the Registration Statement on Form 8-A/A filed by Nortel Networks with the Securities and Exchange Commission on April 25, 2003.
Discontinued operations
During the first quarter of 2003, we substantially completed the wind down of our access solutions operations. We closed a number of transactions in the first quarter of 2003, including:
28
EDC support facility
On February 14, 2003, we announced that Nortel Networks Limited had entered into an agreement with Export Development Canada, or EDC, regarding arrangements to provide for support, on a secured basis, of certain of our performance related obligations arising out of normal course business activities. This facility provides for up to $750 in performance related support for our operations and is expected to facilitate improved liquidity. Currently, $300 is committed support for performance bonds. See “Available credit and support facilities” for additional information.
Stock options
We adopted fair value accounting for new grants or modifications of stock options beginning January 1, 2003. As a result, all stock option grants or modifications in 2003 and beyond will be expensed over the stock option vesting period based on their fair value at the date the options are granted or modified. The effect of the adoption of Statement of Financial Accounting Standards No. 148, or SFAS 148, was a stock option expense of $5 in the first quarter of 2003. If we continue to grant options in 2003 at a similar level to 2002, the expected impact on net earnings (loss) per share will be approximately ($0.01) per common share for 2003. For additional information, you should refer to “Significant accounting policies” in note 2(t) of our financial statements in our Annual Report on Form 10-K for the year ended December 31, 2002 filed with the Securities and Exchange Commission on March 10, 2003.
Results of operations — continuing operations
Segment revenues
Geographic revenues
29
Consolidated revenues
Our consolidated revenues declined 18% in the first quarter of 2003 compared to the first quarter of 2002. The decline was primarily due to the continuing industry adjustment and capital spending constraints experienced by our service provider and enterprise customers. Many of our customers continued to realign capital spending with their current levels of revenue and profits in order to maximize their return on invested capital. Also, excess network capacity continued to exist in the industry which has led to continued pricing pressures on the sale of certain of our products. As a result, our customers continued to change their focus from building new networks to conserving capital, decreasing their debt levels, reducing costs and/or increasing the capacity utilization rates and efficiency of existing networks.
From a geographic perspective, the 18% decline in revenues was primarily due to a:
Our consolidated revenue declined $121 from $2,520 in the fourth quarter of 2002 to $2,399 in the first quarter of 2003. The decline was primarily due to the seasonality more traditionally associated with the first quarter of our fiscal year as well as a result of the continued capital spending constraints experienced by our customers.
Geographic revenues for the first quarter of 2003 compared to fourth quarter of 2002:
We expect overall spending in the telecommunications equipment market to be down modestly in fiscal 2003 compared to fiscal 2002. We also expect that capital spending levels in the second quarter will be similar to the first quarter of 2003. Given the ongoing economic and geopolitical uncertainty, customers continue to spend cautiously. We cannot predict the economic impact of acts of war or terrorism on the global market or the transmission of contagious diseases such as Severe Acute Respiratory Syndrome, or SARS, in the Asia Pacific region. We expect to see continued constraints on capital spending by customers due to:
30
Also, we expect that we will continue to experience pricing pressures on sales of our products as a result of increased competition. It is difficult to predict the duration of the current industry adjustment, as growth in industry spending is not expected to occur until global geopolitical uncertainty and economic and financial concerns have subsided. Market visibility remains limited and we do not expect that our results of operations for any quarter will necessarily be consistent with our historical quarterly profile or indicative of our expected results in future quarters. See “Forward looking statements” for factors that may affect our revenues.
Wireless Networks revenues
The following chart summarizes recent quarterly revenues for Wireless Networks:
The 16% decline in Wireless Networks revenues in the first quarter of 2003 compared to the first quarter of 2002 was primarily due to an ongoing focus by wireless service providers on capital and cash flow management, reflecting slower subscriber growth and increased competition for customers by wireless service providers. As a result of this focus, many customers continued to delay capital expenditures.
Code Division Multiple Access, or CDMA, revenues declined significantly in the first quarter of 2003 compared to the first quarter of 2002, primarily due to customers, particularly in the United States, continuing to experience capital spending constraints driven by their continued focus on capital and cash flow management. Time Division Multiple Access, or TDMA, revenues declined substantially in the first quarter of 2003 compared to the first quarter of 2002 primarily due to the continued transition to newer wireless technologies. The substantial decline was primarily due to United States customers continuing to migrate from the mature TDMA technology to CDMA and Global System for Mobile communications, or GSM, technologies. However, TDMA revenues continued to be a smaller portion of Wireless Networks revenues in the first quarter of 2003 compared to the first quarter of 2002.
Overall GSM revenues, which includes General Packet Radio Standard, or GPRS, and Enhanced Data Rates for Global Evolution, or EDGE, declined significantly in the first quarter of 2003 compared to the first quarter of 2002 due to a substantial decline in the Asia Pacific region and a significant decline in the United States. The substantial decline in the Asia Pacific region was primarily due to a decline in the overall growth rate of GSM technology deployments by wireless service providers in the second half of 2002 and the first quarter of 2003. As of the first quarter of 2003, many of our GSM customers in the Asia Pacific region have completed their network deployments, and as a result, have sufficient capacity to currently meet additional subscriber demands. In the United States, the significant decline was primarily due to continued slow subscriber growth and completion of some networks by certain service providers. In EMEA and CALA, GSM revenues increased substantially in the first quarter of 2003 primarily due to new contracts won with certain service providers in the second half of 2002.
Universal Mobile Telecommunications Systems, or UMTS, revenues increased significantly in the first quarter of 2003 compared to 2002. The significant increase was primarily due to the resolution of contractual issues, including collectibility, with a certain customer experienced in the second half of 2002. However, larger network deployment delays continued in the
31
first quarter of 2003 primarily due to the technology issues associated with third generation, or 3G, handsets and network performance by certain vendors. In the first quarter of 2003, UMTS revenues continued to be a small but growing portion of our Wireless Networks revenues.
From a geographic perspective, the 16% decrease in Wireless Networks revenues in the first quarter of 2003 compared to the same period in 2002 was primarily due to a:
Compared to the fourth quarter of 2002, Wireless Networks revenues decreased 6%, primarily due to:
From a geographic perspective, Wireless Networks revenues decreased 6% in the first quarter of 2003 compared to the fourth quarter of 2002 as a result of considerable declines in the Asia Pacific region and a decline in the United States, which were partially offset by a significant increase in EMEA and considerable increases in CALA and Canada.
In the first quarter of 2003, Wireless Networks revenues continued to be primarily generated by sales of CDMA and GSM technologies. We continue to expect that revenues associated with our TDMA technologies will decline in 2003. Overall GSM sales are also expected to decline as networks are built out and subscriber growth slows. In 2003, our CDMA 3G and UMTS technology sales are expected to grow, compared to 2002, and represent a larger proportion of Wireless Networks revenues as 3G technologies are expected to gain a greater foothold in the market due to increased wireless data traffic and requirements for greater wireless spectrum efficiency. Also, we expect to experience increased pricing pressures on sales of certain of our Wireless Networks products as a result of increased competition.
As with the rest of the industry, our wireless customers are experiencing significant pressure and are adapting to a new, more stringent spending environment due to the lack of available financing and a slower subscriber growth in the overall wireless market. We anticipate a reduction in global capital expenditures for wireless operators in 2003 and 2004, compared to 2002, but cannot predict the complete impact. We also expect some consolidation in this marketplace, including a reduction in the number of service providers in certain regions due to competition and/or adjustments in deployment plans and schedules. In addition, the timing of the anticipated change in revenue mix from the different wireless technologies has become increasingly difficult to predict as a result of the complexities and potential for delays in the implementation of UMTS network deployments. All of these factors could adversely affect our Wireless Networks revenues in the future.
32
Enterprise Networks revenues
The following chart summarizes recent quarterly revenues for Enterprise Networks:
The 9% reduction in Enterprise Networks revenues in the first quarter of 2003 compared to the first quarter of 2002 was primarily a result of our enterprise customers continuing to delay their purchase decisions on certain products due to the economic uncertainty in the industry.
Revenues from the circuit and packet voice portion of this segment were essentially flat in the first quarter of 2003 compared to the first quarter of 2002. We experienced a reduction in revenue associated with our integrated voice recognition products due to enterprises employing more stringent capital spending approval processes resulting in purchase decision delays. This decrease was partially offset by an increase in revenues associated with our internet protocol, or IP, telephony solutions as customers continued to migrate towards packet voice solutions.
The data networking and security portion of this segment experienced significant declines in the first quarter of 2003 compared to the first quarter of 2002. The significant decrease in revenues was primarily due to continued customer spending constraints and delayed purchasing decisions by customers. Also, we experienced a reduction in the number of service contract renewals associated with our legacy routing portfolio in the first quarter of 2003 compared to the first quarter of 2002.
From a geographic perspective, the 9% decline in Enterprise Networks revenues in the first quarter of 2003 compared to the first quarter of 2002 was primarily due to a:
Enterprise Networks revenues decreased 6% in the first quarter of 2003 compared to the fourth quarter of 2002. The decline was primarily due to:
From a geographic perspective, the 6% decline in the first quarter of 2003 compared to the fourth quarter of 2002 was due to a decline across all regions except the Asia Pacific region, which increased.
33
We anticipate that communications networks will continue to increase the use of voice over packet technologies. We expect that data, voice and multimedia communications technologies will continue to converge, and enterprises will look for ways to maximize the effectiveness of their existing networks while reducing ongoing capital expenditures and operating costs. However, the timing of this progression is unclear. We also anticipate that demand will continue for our traditional circuit switching products. Overall, we expect that the continuing industry adjustment will have a negative impact on the level of spending by our enterprise customers.
Wireline Networks revenues
The following chart summarizes recent quarterly revenues for Wireline Networks:
The 18% decline in Wireline Networks revenues in the first quarter of 2003 compared to the first quarter of 2002 was primarily due to a substantial reduction in capital spending by our service provider customers as a result of the continuing industry adjustment.
Compared to the first quarter of 2002, revenues decreased in the circuit and packet voice portion of this segment due to a substantial decrease in revenue associated with our traditional circuit switching products. The substantial decline in our traditional switching products was primarily due to the tightened capital markets and continued capital spending constraints experienced by our service provider customers. This substantial decline was partially offset by a substantial increase in revenues in our packet based technologies due to certain new service provider contracts awarded in the second half of 2002 and the first quarter of 2003.
The significant decline in revenues in the data networking and security portion of this segment was primarily due to a decline in demand for mature products, compounded by the ongoing industry adjustment as our service provider customers, in all regions, continued to reduce their capital expenditures.
From a geographic perspective, the 18% decline in Wireline Networks revenues in the first quarter of 2003 compared to the first quarter of 2002 was primarily due to a:
34
Our Wireline Networks revenues increased 11% in the first quarter of 2003 compared to the fourth quarter of 2002, primarily due to:
From a geographic perspective, Wireline Networks revenues increased 11% in the first quarter of 2003 compared to the fourth quarter of 2002 primarily as a result of considerable increases in the United States and Canada, which were partially offset by a substantial decrease in the Asia Pacific region.
In the future, we anticipate that service providers will continue to increase the use of packet-based technologies in their communications networks as they look for ways to optimize their existing networks and offer new revenue generating services while controlling capital expenditures and operating costs. Although we experienced an increase in revenues in our packet-based technologies in the first quarter of 2003 compared to the same period in 2002, the timing of when there will be continued and sustainable demand is unclear. We expect that the continuing industry adjustment and reduction in capital spending by our customers will have a negative impact on the level of spending by our service provider customers and could adversely affect Wireline Networks revenues in the future.
Optical Networks revenues
The following chart summarizes recent quarterly revenues for Optical Networks:
The 33% decline in Optical Networks revenues in the first quarter of 2003 compared to the first quarter of 2002 was primarily the result of the continuing industry adjustment and substantial reductions in capital spending by our United States and EMEA customers in the long-haul portion of this segment.
Revenue in the long-haul portion of this segment declined substantially in the first quarter of 2003 compared to the first quarter of 2002. The substantial decline was primarily due to the continuing industry adjustment and continued capital spending constraints in the United States and EMEA as customers continued to focus on maximizing return on invested capital by increasing the capacity utilization rates and efficiency of existing networks. In addition, significant excess inventories continued to exist in this portion of the segment which resulted in ongoing pricing pressures.
Also, in the fourth quarter of 2002, we sold certain optical components assets to Bookham Technology plc, or Bookham. As a result, our first quarter results in 2003 in the long-haul portion of this segment do not reflect revenues generated from these assets. In the first quarter of 2002, revenues generated from the optical components assets sold to Bookham were less than 5% of the total revenue of $406. For additional information relating to the sale of these assets to Bookham, you should refer to information contained in our Annual Report on Form 10-K for the year ended December 31, 2002 filed with the Securities and Exchange Commission.
35
Revenue in the metro optical portion of this segment increased significantly in the first quarter of 2003 compared to the same period in 2002. The significant increase was primarily due to a substantial increase in the Asia Pacific region due to new customer contracts in 2003 compared to the insignificant revenues in the first quarter of 2002. The substantial increase in the Asia Pacific region was partially offset by a substantial decline in EMEA primarily due to EMEA customers continuing to focus on maximizing return on invested capital by increasing the capacity utilization rates and efficiency of existing networks.
From a geographic perspective, the 33% decline in Optical Networks revenues in the first quarter of 2003 compared to the first quarter of 2002 was primarily due to a:
Optical Networks revenues decreased 22% in the first quarter of 2003 compared to the fourth quarter of 2002 primarily due to substantial declines in both the optical long-haul and metro optical portions of this segment. The substantial declines were primarily due to the more traditional seasonality associated with the first quarter of our fiscal year and the continued capital spending constraints in the United States and EMEA.
From a geographic perspective, Optical Networks revenues decreased 22% in the first quarter of 2003 compared to the fourth quarter of 2002 primarily as a result of considerable declines in the United States and Canada, and a decrease in EMEA.
Our major customers in the optical long-haul portion of this segment remain focused on maximizing return on their invested capital by increasing the capacity utilization rates and efficiency of existing networks. We expect that any additional capital spending by those customers will be increasingly directed to opportunities that enhance customer performance, revenue generation and cost reduction in the near term. We expect that customers in this portion of the segment will continue to focus on route by route activities, adding channels to existing networks, and interconnectivity and bandwidth as it is required in the short term. Further, we believe that building out networks for increased bandwidth will remain longer term projects. Revenues in the optical long-haul portion of the segment are primarily based on network build-outs and, consequently, generally include a number of long-haul products packaged together in an end-to-end solution. As a result, almost all products within this portion of the segment are generally affected in the same manner as fluctuations in the needs of our customers typically result in corresponding increases or decreases in overall optical long-haul revenue.
In the metro optical portion of this segment, we expect to see an increase in demand for metro Dense Wavelength Division Multiplexing, or metro DWDM, as our customers begin to deploy inter-office fiber infrastructure. As a result, we expect that the metro optical portion of this segment will continue to become a larger percentage of the overall Optical Networks revenues.
Due to the severe reduction, in number and size, of new optical long-haul network build-outs and due to the nature of the relationship between the products within the optical long-haul portion of this segment, we do not expect a meaningful recovery in the optical long-haul market before early 2004. Also, we anticipate that pricing pressures on optical system vendors will continue due to intense competition, large inventories and a diminished market. As a result, we expect that our Optical Networks revenues will decline in 2003 compared to 2002 and will be one of our last segments to recover from the significant industry adjustment.
36
Gross profit and gross margin
Gross margin improved 16.9 percentage points in the first quarter of 2003 compared to the first quarter of 2002 primarily due to:
While we cannot predict the extent to which changes in product mix and pricing pressures will impact our gross margin, we continue to see the effects of our restructuring work plan which we began implementing in 2001 to create a cost structure that is more reflective of the current industry and economic environment. As a result, we expect that gross margin will continue to trend in the low 40% range for the remainder of 2003. See “Forward looking statements” for factors that may affect our gross margins.
Wireless Networks gross margin improved by approximately 11 percentage points in the first quarter of 2003 compared to the same period in 2002. The improvement was primarily due to changes in our customer and product mix and ongoing product cost improvements.
Enterprise Networks gross margin improved by approximately 9 percentage points in the first quarter of 2003 compared to the same period in 2002. The improvement in gross margin was primarily due to:
Wireline Networks gross margin decreased by approximately 8 percentage points in the first quarter of 2003 compared to the same period in 2002. The decline in gross margin was primarily due to:
37
Optical Networks gross margin improved by approximately 55 percentage points in the first quarter of 2003 compared to the same period in 2002. The improvement in gross margin was primarily due to:
Operating expenses
Selling, general and administrative, or SG&A, expense declined $257 in the first quarter of 2003 compared to the same period in 2002. The substantial decline in the first quarter of 2003 compared to the first quarter of 2002. The decrease was primarily due to:
We will continue to manage SG&A expense according to the requirements of our business, allocating resources and investment where customer demand dictates, and reducing resources and investment where opportunities for improved efficiencies present themselves. We expect that SG&A expense will continue to trend lower in the second quarter of 2003 compared to the first quarter of 2003.
Wireless Networks SG&A expense decreased significantly in the first quarter of 2003 compared to the first quarter of 2002. The decrease was primarily due to the continued impact of our workforce reductions across all regions and associated reductions in other related costs such as information services and real estate.
Enterprise Networks SG&A expense decreased significantly in the first quarter of 2003 compared to the first quarter of 2002. The decrease was primarily due to the continued impact of our workforce reductions, primarily in the United States and Canada, and associated reductions in other related costs such as information services and real estate.
Wireline Networks SG&A expense decreased substantially in the first quarter of 2003 compared to the first quarter of 2002. The decrease was primarily due to:
38
Optical Networks SG&A expense decreased substantially in the first quarter of 2003 compared to the first quarter of 2002. The decrease in SG&A expense was primarily due to:
As a result of the gross margin and SG&A expense improvements mentioned above, our consolidated contribution margin improved by $528 in the first quarter of 2003 compared to the same period in 2002. All of our four reportable segments contributed positive contribution margin in the first quarter of 2003.
Research and development, or R&D, expense represents our planned investment in our next generation core products across all businesses. R&D expense decreased $106 in the first quarter of 2003 compared to the first quarter of 2002, reflecting workforce reductions and focused investments to drive market leadership across our product portfolios. Included in R&D expense in the first quarter of 2003 was an accrual for the employee return to profitability bonus plan.
Our continuing strategic investments in R&D are aligned with technology leadership in anticipated growth areas, while targeting a level of R&D expense that is more representative of our overall cost structure. We will continue to manage R&D expense according to the requirements of our business, allocating resources and investment where customer demand dictates, and reducing resources and investment where opportunities for improved efficiencies present themselves. Our research and development efforts are currently focused on key next generation networking solutions including wireless data, wireless LAN (local area networks), packet voice solutions, broadband connectivity, internet protocol, or IP, multimedia services and security. We expect that R&D expense in the second quarter of 2003 will trend lower from the first quarter of 2003.
The amortization of acquired technology in the first quarter of 2003 and 2002 primarily reflected the charge related to the acquisition of Alteon WebSystems, Inc. The remaining net carrying value of acquired technology will be fully amortized in 2003 and was $65 on March 31, 2003 and $98 on December 31, 2002.
39
For acquisitions completed subsequent to July 1, 2000, we are required to allocate a portion of the purchase price to deferred compensation related to unvested options held by employees of the companies acquired. This deferred compensation is amortized to net income/loss based on the graded vesting schedule of the option awards. Deferred stock option compensation was $15 in the first quarter of 2003 compared to $25 in the first quarter of 2002. The decrease of $10 was primarily due to the cancellation of unvested stock options that were held by employees whose employment was terminated in 2002. Currently, we expect that the amount of deferred stock option compensation for the next two quarters will remain at a similar amount to the first quarter of 2003.
In the first quarter of 2003, we recorded special charges of $134 related to our continued restructuring work plan to streamline operations and activities around core markets and leadership strategies. Net workforce reduction charges of $61 related to the cost of severance and benefits associated with approximately 800 employees notified of termination during the first quarter of 2003. Net contract settlement and lease costs of $78 related to the cancellation of existing contracts across all segments. Also, we recorded a net increase in the carrying value of plant and equipment of $5 for valuation increases related to special charges recorded in previous periods.
In the first quarter of 2002, we recorded special charges of $487 related to our restructuring work plan. Workforce reduction charges of $327 were related to the cost of severance and benefits associated with the approximately 4,400 employees notified of termination. Contract settlement and lease costs included negotiated settlements of approximately $63 to either cancel contracts or renegotiate existing contracts across all of our segments. Also, we recorded $85 in plant and equipment write downs within global operations, a function that supports all of our segments, and within our Optical Networks reporting segment. In the first quarter of 2002, we also concluded that the Xros, Inc. X-1000 IPR&D project did not meet short-term market requirements. In connection with that decision, we recorded a $12 write down of acquired technology associated with this project.
Currently, we expect that approximately $20 to $30 of special charges related to our restructuring work plan will be incurred in the second quarter of 2003.
For additional information related to our restructuring activities, see “Special charges” in note 5 of the accompanying unaudited consolidated financial statements.
Other income (expense) — net
In the first quarter of 2003, other income — net was $50, which primarily included a payment received from a settlement related to intellectual property use and reductions in accruals principally related to: the wind-down of integration activities of previously acquired companies, operations originally structured as joint ventures, and miscellaneous tax matters; which were partially offset by foreign exchange and investment losses.
Interest expense
The decrease in interest expense of $18 in the first quarter of 2003 compared to the same period in 2002 was primarily related to the reduction in the outstanding balances of our notes payable and long-term debt.
Income tax benefit (provision)
In the first quarter of 2003, we recorded a full valuation allowance on the tax benefit of the pre-tax loss from continuing operations of $131. The valuation allowance was recorded in accordance with Statement of Financial Accounting Standards, or SFAS, No. 109, “Accounting for Income taxes”, which requires that tax valuation allowances be established when it is more likely than not that some portion or all of a company’s deferred tax assets will not be realized. The valuation allowances can be primarily attributed to continued uncertainty in the industry. If market conditions improve and future results of operations exceed our current expectations, our existing tax valuation allowances may be adjusted, resulting in recognition of additional future tax benefits. Alternatively, if market conditions deteriorate further or future results of operations are less than expected, additional tax valuation allowances may be required for all or a portion of our deferred tax assets.
40
Approved tax legislation in the first quarter of 2002 in the United States extended the net operating loss carryback period from two years to five years. As a result, we were able to carryback available United States losses from 2001 and utilize approximately $700 of deferred income tax assets previously recognized, generating additional cash recoveries of approximately $700 in the first quarter of 2002.
Other
In the first quarter of 2003, our SG&A, R&D and Other income — net included approximately $80 of favorable impacts associated with reductions in accruals which principally related to the accumulation of charges associated with the integration activities of previously acquired companies and operations originally structured as joint ventures as well as miscellaneous tax matters. During the three months ended March 31, 2003, we reviewed the matters related to the wind-down and settlement of balances associated with the integration activities of previously acquired companies and operations originally structured as joint ventures and determined that based on decreases in transactional activity and magnitude of their net position that it was appropriate to reduce certain accruals. Such amounts and matters included foreign exchange, transfer pricing and other statutory assessments, charges in transit and acquisition and divestiture and disposal activities. These balances were considered to be in dispute, erroneous and/or for amounts which could not be resolved. These items were more than offset by costs related to the return to profitability employee bonus plan and stock-based compensation expense.
Net loss from continuing operations
As a result of the items discussed under our results of operations, our reported net loss from continuing operations improved by $705 in the first quarter of 2003 compared to the first quarter of 2002.
Results of operations — discontinued operations
During the first quarter of 2003, we substantially completed the wind-down of our access solutions operations and recorded net earnings of $190 (net of tax) related to the sale of certain components of this business. The $190 in net earnings was primarily related to a $101 gain from the disposition of certain shares and a membership interest in certain Arris Group Inc. companies and a gain of $95 from the settlement of certain trade and customer financing receivables. Our intent to exit this business was originally approved by our Board of Directors on June 14, 2001. The continued deterioration in industry and market conditions delayed certain disposal activities beyond the original planned timeframe of one year. In particular, actions involving negotiations with customers, who have also been affected by industry conditions, took longer than expected. Although disposal activities continued beyond the one-year period, we have continued to present the access solutions operations as discontinued operations in the accompanying unaudited consolidated financial statements.
For additional information, see “Discontinued operations” in note 14 of the accompanying unaudited consolidated financial statements.
Application of critical accounting policies
There have been no changes to our critical accounting policies since December 31, 2002. For a description of our critical accounting policies, see our Annual Report on Form 10-K for the year ended December 31, 2002 filed with the Securities and Exchange Commission.
Liquidity and capital resources
Cash flows
The following table summarizes our cash flows by activity and cash on hand:
As of March 31, 2003, our primary source of liquidity was our current cash and cash equivalents, or cash. At March 31, 2003, we had cash of $3,999, excluding $227 of restricted cash and cash equivalents. We believe this cash will be sufficient to fund our current business model, manage our investments and meet our customer commitments for at least the next 12 months. However, if capital spending by service providers and other customers declines more significantly than we currently
41
expect, we may be required to adjust our current business model. As a result, our revenues and cash flows may be materially lower than we expect and we may be required to further reduce our investments or take other measures in order to meet our cash requirements. We may seek additional funds from liquidity generating transactions and other conventional sources of external financing. We cannot provide any assurance that our net cash requirements will be as we currently expect, that we will continue to have access to our credit facilities when and as needed, or that liquidity generating transactions or financings will be available to us on acceptable terms or at all.
Cash flows used in operating activities were $81 due to a net loss from continuing operations of $136, less an adjustment of $240 for non-cash related items, plus a net cash outflow of $185 from operating assets and liabilities. Cash inflows of $47 from accounts receivable were primarily due to increased cash collections during the first quarter of 2003. Cash inflows of $111 from inventories were primarily due to product shipments exceeding additions to inventories in the first quarter 2003. The net cash outflows of $343 from the remaining operating assets and liabilities were primarily due to:
Cash flows from investing activities were $9 and were primarily due to: a decrease of $20 in restricted cash and cash equivalents held as cash collateral for certain bid, performance related and other bonds; proceeds of $7 from the sale of certain investments and businesses; and proceeds of $6 from the sale of plant and equipment. These amounts were partially offset by $18 in plant and equipment expenditures and a net increase in long-term receivables of $4.
Cash flows used in financing activities were $61 and were primarily due to $43 used to reduce our long-term debt and a net reduction of $17 of notes payable.
Uses of liquidity
Our cash requirements for the next 12 months are primarily to fund:
Also, from time to time, we may purchase our outstanding debt securities and/or convertible notes in privately negotiated or open market transactions, by tender offer or otherwise, in compliance with applicable laws.
The remaining cash payments of $364 relating to workforce reduction initiatives are expected to be substantially completed by mid 2004. The remaining cash payments of $696 related to contract settlement and lease costs are expected to be substantially completed by the end of 2010. We expect to incur approximately $600 to $700 in restructuring work plan related cash outflows during the remainder of 2003.
Our contractual cash obligations for long-term debt, outsourcing contracts, operating leases and unconditional purchase obligations remained substantially unchanged from the amounts disclosed as at December 31, 2002 in our Annual Report on Form 10-K filed with the Securities and Exchange Commission.
In the first quarter 2003, we purchased $39 of our 6.125% Notes due February 15, 2006. Also in 2003, we plan to repay the remaining $164 of our 6.00% Notes due September 1, 2003.
42
We enter into bid, performance related and other bonds in connection with various contracts. Bid bonds generally have a term less than twelve months, depending on the length of the bid period for the applicable contract. Performance related bonds generally have a term of twelve months and are typically renewed, as required, over the term of the applicable contract. Other bonds generally have a term of twenty-four months. The various contracts to which these bonds apply generally have terms ranging from two to five years. Any potential payments that we would be required to make are related to our performance under the applicable contract.
The following table provides information related to these types of bonds, as at:
Historically, we have not had to make material payments and we do not anticipate that we will be required to make material payments under these types of bonds.
The criteria under which bid, performance related and other bonds can be obtained have changed due to declines in the economic and industry environment and our current credit condition. In addition to the payment of fees, we have experienced cash collateral requirements in connection with obtaining new bid, performance related and other bonds. However, we do not expect that the requirements and/or fees to obtain bid, performance related and other bonds will have a material adverse effect on our ability to win contracts from potential customers.
Our support facility with EDC provides support for certain of our obligations under bid and performance related bonds and may reduce the requirement for us to provide cash collateral to support these obligations. Although this facility provides for up to $750 in support, only $300 is committed support for these bonds. In addition, any bid or performance related bonds with terms that extend beyond June 30, 2004, which is the expiry date of this facility, are currently not eligible for the support provided by this facility. Unless EDC agrees to an extension of the facility or agrees to provide support in respect of any such bid or performance related bonds on a case-by-case basis outside the scope of the facility, we may be required to provide cash collateral to support these obligations. In addition to the support facility with EDC, our existing security agreements permit us to secure additional obligations under bid and performance related bonds with the assets pledged under the security agreements and to provide cash collateral as security for these types of bonds. See “Available credit and support facilities” for additional information on this support facility and the security agreements.
In the normal course of business, we have guaranteed the debt of certain customers. These third party debt agreements require us to make debt payments throughout the term of the related debt instrument if the customer fails to make a scheduled payment. Historically, we have not had to make material payments and currently we do not anticipate that we will be required to make material payments under these debt instruments. Our third party debt agreements remain substantially unchanged from the amounts disclosed as at December 31, 2002 in our Annual Report on Form 10-K filed with the Securities and Exchange Commission.
43
We enter into supply contracts with customers for products and services, which in some cases involve new, undeveloped technologies or requirements for us to build and operate networks. We also enter into network outsourcing contracts with customers to operate their networks. Some of these supply and network outsourcing contracts contain delivery and installation timetables, performance criteria and other contractual obligations. If we do not meet these requirements, it could result in:
As is common in our industry, our supply and network outsourcing contracts are highly customized to address each customer’s particular needs and concerns. The nature of the triggering events and the amounts and timing of the penalties associated with these contracts can vary significantly due to a variety of complex, interrelated factors. We have not experienced material penalty payments on our supply and network outsourcing contracts in any recent reporting period.
Certain of our key supply arrangements were negotiated prior to the current industry and economic downturn. As a result of the extent and duration of this downturn, in respect of one of these arrangements, based on our current revenue levels, we will not meet the minimum volume levels contained in the contract. As a result, we may be obligated to compensate the supplier for certain direct costs. The amount of such direct costs cannot be reasonably estimated at this time. The amount of any such compensation would be based on a variety of complex, interrelated factors (including applicable factors that could mitigate such direct costs). An obligation to pay such compensation could have a material adverse effect on our business, results of operations, financial condition and/or supply relationships.
Generally, customer financing arrangements may include financing in connection with the sale of our products and services, as well as funding for non-product costs associated with network installation and integration of our products and services. We may also provide funding for working capital purposes and equity financing.
The following table provides information related to our customer financing commitments, excluding our discontinued operations, as at:
In the first quarter of 2003, our gross customer financing commitments and related provisions each decreased by approximately $100 as a result of the securitization of outstanding balances associated with two of our customers and the write down of a third customer balance as a result of the customer’s bankruptcy restructuring.
We currently have customer financing commitments and/or balances outstanding in connection with the construction of new networks, including 3G wireless networks. Although we may commit to provide customer financing to customers in areas that are strategic to our core businesses, we remain focused on reducing our overall customer financing exposures in accordance with any obligations under our financing agreements. During the first quarter of 2003, we reduced undrawn commitments by $152 reflecting commitment expiration, cancellations and changing customer business plans. As of March 31, 2003, approximately $500 of the $649 in undrawn commitments was not available for funding under the terms of our financing agreements. In addition to being highly selective in providing customer financing, we have programs in place to monitor and mitigate customer credit risk, including performance milestones and other conditions of funding. Management
44
is focused on the strategic use of our customer financing capacity and on reducing the amount of our existing and future customer financing exposure.
We continue to regularly assess the levels of our customer financing provisions based on a loan-by-loan review to evaluate whether they reflect current market conditions. We review the ability of our customers to meet their repayment obligations and determine our provisions accordingly. Any misinterpretation or misunderstanding of these factors by us may result in losses in excess of our provisions. These losses could have a material adverse effect on our business, results of operations, financial condition and customer relationships.
Our ability to place customer financing with third party lenders has been significantly reduced primarily due to:
As a result, we are currently directly supporting most commitments and outstanding balances and expect this to continue in the future as well. While we will continue to seek to arrange for third party lenders to assume our customer financing obligations, we expect to fund most customer financings in the normal course of our business from working capital and conventional sources of external financing. Commitments to extend future financing generally have conditions for funding, fixed expiration or termination dates and specific interest rates and purposes. Based on the terms of the existing agreements, we expect that a substantial amount of these undrawn commitments will not be funded in 2003. However, we cannot predict with certainty the extent to which our customers will satisfy the applicable conditions for funding, and subsequently request funding, prior to the termination date of the commitments.
On October 19, 2002, we entered into a number of put option and call option agreements as well as a share exchange agreement with our partner in three European joint ventures. If the options and share exchange are exercised, we would be required to deliver to our joint venture partner net consideration of approximately $114, consisting of approximately $42 in cash, and an in-kind component of approximately $72, representing the return of a loan note currently owed to us by an affiliate of our joint venture partner. The option agreements and the share exchange agreement can be exercised between July 1, 2003 and December 31, 2003 subject to certain terms and conditions. If the transactions are completed, we will acquire the minority interests in two of these joint ventures and dispose of our minority interest in the third joint venture.
As of March 31, 2003, the remaining accruals of the discontinued access solutions operations totaled $66 and were related to future contractual obligations and estimated liabilities during the planned period of disposition. The remaining accruals are expected to be substantially drawn down by cash payments over the period of disposition. During the first quarter of 2003, we generated cash of approximately $253 on the disposition of various assets from the access solutions operations.
For additional information related to our discontinued operations, see “Discontinued operations” in note 14 of the accompanying unaudited consolidated financial statements.
Sources of liquidity
We currently have $750 in available and undrawn credit facilities which expire in April 2005. These credit facilities were entered into on April 12, 2000 by Nortel Networks Limited and Nortel Networks Inc. and permit borrowings for general corporate purposes. As of March 31, 2003, there were no balances drawn under our available credit facilities.
The $750 April 2000 five year credit facilities contain a financial covenant requiring that Nortel Networks Limited’s consolidated tangible net worth at any time be not less than $1,888. As of March 31, 2003, we were in compliance with this covenant. We continue to monitor the financial position of Nortel Networks Limited in light of this covenant and if we incur
45
net losses or record additional charges relating to our restructuring work plan, the accounting of our registered pension plans, the valuation of deferred income tax assets or for other events, Nortel Networks Limited’s consolidated tangible net worth may be reduced below the $1,888 threshold. If Nortel Networks Limited is unable to comply with the consolidated tangible net worth covenant, we will be unable to access the $750 April 2000 five year credit facilities.
On February 14, 2003, Nortel Networks Limited entered into an agreement with EDC regarding arrangements to provide support, on a secured basis, of certain of its performance related obligations arising out of normal course business activities. This facility, which expires on June 30, 2004, provides for up to $750 in support including $300 of committed revolving support for performance bonds or similar instruments of which $95 was utilized as at March 31, 2003. The remainder is uncommitted support for performance bonds, receivables sales and/or securitizations of which $65 was utilized as at March 31, 2003.
The support facility with EDC does not materially restrict Nortel Networks Limited’s ability to sell any of its assets (subject to certain maximum amounts) or to purchase or pre-pay any of its currently outstanding debt. EDC is not obligated to make any support available unless certain customary conditions are satisfied and Nortel Networks Limited’s senior long-term debt rating by Moody’s has not been downgraded to less than B3 and that its debt rating by Standard & Poor’s has not been downgraded to less than B–. If Nortel Networks Limited defaults on its obligations under the support facility with EDC and EDC calls upon the security provided under the security agreements in an amount exceeding $100, Nortel Networks Limited and Nortel Networks Inc. would also, as a result, be in default under their $750 April 2000 five year credit facilities and, we and Nortel Networks Limited would be in default under our outstanding public debt.
Nortel Networks Limited’s obligations under the support facility with EDC are secured on an equal and ratable basis under the existing security agreements entered into by Nortel Networks Limited and various of our subsidiaries that pledge substantially all of Nortel Networks Limited and its subsidiaries assets in favor of certain banks, including the banks under the $750 April 2000 five year credit facilities, the holders of Nortel Networks Limited’s public debt securities and the holders of our 4.25% convertible senior notes. The security provided under the security agreements is comprised of:
If Nortel Networks Limited’s senior long-term debt rating by Moody’s returns to Baa2 (with a stable outlook) and our rating by Standard & Poor’s returns to BBB (with a stable outlook), the security will be released in full. If both the $750 April 2000 five year credit facilities and the support facility with EDC are terminated, or expire, the security will also be released in full. Nortel Networks Limited may provide EDC with cash collateral (or any other alternative collateral acceptable to EDC), in an amount equal to the total amount of its outstanding obligations and undrawn commitments and expenses under this facility, in lieu of the security provided under the security agreements.
For additional information relating to our outstanding public debt, the $750 April 2000 five year credit facilities and the support facility with EDC, see “Long-term debt, credit and support facilities” in note 7 of the accompanying unaudited consolidated financial statements. For additional financial information related to those subsidiaries providing guarantees, see “Supplemental consolidating financial information” in note 17 of the accompanying unaudited consolidated financial statements. For information relating to our debt ratings, see “Credit ratings” below. See “Forward looking statements” for factors that may affect our ability to comply with covenants and conditions in our credit and support facilities in the future.
In the second quarter of 2002, we filed a shelf registration statement with the United States Securities and Exchange Commission and a base shelf prospectus with the applicable securities regulatory authorities in Canada, to qualify for the potential sale of up to $2,500 of various types of securities in the United States and/or Canada. The qualifying securities
46
include common shares, preferred shares, debt securities, warrants to purchase equity or debt securities, share purchase contracts and share purchase or equity units (subject to certain approvals). As of March 31, 2003, approximately $1,700 of the $2,500 available under the shelf registration statement and base shelf prospectus has been utilized. Approximately $800 remains available for use.
Credit ratings
The ratings remain on negative outlook by Moody’s and Standard & Poor’s. There can be no assurance that our credit ratings will not be lowered further or that such ratings agencies will not issue adverse commentaries, potentially resulting in higher financing costs and further reduced access to capital markets or alternative financing arrangements. Our credit ratings may also affect our ability, and the cost, to securitize receivables, obtain bid, performance related and other bonds, access the support facility with EDC and/or enter into normal course derivative or hedging transactions.
Off-balance sheet arrangements, contractual obligations and contingent liabilities and commitments
Off-balance sheet arrangements
We currently conduct certain receivable sales and lease financing transactions through special purpose entities and are in the process of assessing the structure of these transactions against the criteria set out in the Financial Accounting Standards Board Interpretation No. 46 — “Consolidation of Variable Interest Entities”, or FIN 46.
Our receivable sales transactions are generally conducted either directly with financial institutions or with multi-seller conduits. We do not expect that we will be required to consolidate any of these entities or provide any of the additional disclosures set out in FIN 46.
Certain lease financing transactions are structured through single transaction special purpose entities that currently do not have sufficient equity at risk as defined in FIN 46. In addition, we retain certain risks associated with guaranteeing recovery of the unamortized principal balance of debt which is expected to represent the majority of the risks associated with the special purpose entities’ activities. The amount of the guarantee will be adjusted over time as the underlying debt matures. Therefore, we expect that unless the existing arrangements are modified prior to July 1, 2003, we will be required to consolidate the assets, liabilities and any non-controlling interests of these special purpose entities effective July 1, 2003. The total assets and total liabilities held by these entities at March 31, 2003 were each approximately $176 and these amounts represent the collateral and maximum exposure to loss, respectively, as a result of our involvement with these entities.
Contractual obligations
Our contractual cash obligations for long-term debt, outsourcing contracts, operating leases and unconditional purchase obligations remain substantially unchanged from the amounts disclosed as at December 31, 2002 in our Annual Report on Form 10-K filed with the Securities and Exchange Commission.
In the first quarter of 2003, we purchased $39 of our 6.125% Notes due February 15, 2006. Also in 2003, we plan to repay the remaining $164 of our 6.00% Notes due September 1, 2003. In the first quarter of 2003, we also reduced our unconditional purchase obligations by $24 through normal business related activity.
47
Contingent liabilities and commitments
In certain instances, we are committed to provide future financing to certain customers in connection with their purchases of our products and services. The undrawn commitments were $649 at March 31, 2003 and $801 at December 31, 2002. Commitments to extend future financing generally have conditions for funding, fixed expiration or termination dates and specific interest rates and purposes. Based on the terms of the existing agreements, we expect that a substantial amount of these undrawn commitments will not be funded in 2003. However, we cannot predict with certainty the extent to which our customers will satisfy the applicable conditions for funding, and subsequently request funding, prior to the termination date of the commitments.
Our purchase commitments remain substantially unchanged from the amounts disclosed as at December 31, 2002 in our Annual Report on Form 10-K filed with the Securities and Exchange Commission.
On October 19, 2002, we entered into a number of put option and call option agreements as well as a share exchange agreement with our partner in three European joint ventures. If the options and share exchange are exercised, we would be required to deliver to our joint venture partner net consideration of approximately $114, consisting of approximately $42 in cash, and an in-kind component of approximately $72, representing the return of a loan note currently owed to us by an affiliate of our joint venture partner. The option agreements and the share exchange agreement can be exercised between July 1, 2003 and December 31, 2003, subject to certain terms and conditions. If the transactions are completed, we will acquire the minority interests in two of these joint ventures and dispose of our minority interest in the third joint venture.
Through our normal course of business, we have also entered into other indemnifications or guarantees that arise in various types of arrangements including:
Historically, we have not made any significant payments under any of these indemnifications or guarantees. In certain cases, due to the nature of the agreement, we have not been able to estimate our maximum potential loss or the maximum potential loss has not been specified. However, for those agreements where we have been able to make an estimate, the maximum amount that we would be obliged to pay remains substantially unchanged from the amounts disclosed in our Annual Report on Form 10-K for the year ended December 31, 2002 filed with the Securities and Exchange Commission.
Legal proceedings
Nortel Networks and/or certain of our directors and officers have been named as defendants in various class action lawsuits. We are unable to determine the ultimate aggregate amount of monetary liability or financial impact to us in these legal matters, which unless otherwise specified, seek damages from the defendants of material or indeterminate amounts. We are also a defendant in various other suits, claims, proceedings and investigations which are in the normal course of business. We cannot determine whether these matters will, individually or collectively, have a material adverse effect on our business, results of operations and financial condition. We, and any of our named directors or officers, intend to vigorously defend these actions, suits, claims, proceedings and investigations.
48
For additional information related our legal proceedings, see “Contingencies” in note 15 of the accompanying unaudited consolidated financial statements.
Forward looking statements
Certain statements in this Quarterly Report, contain words such as “could,” “expects,” “may,” “anticipates,” “believes,” “intends,” “estimates,” “plans,” “envisions,” and other similar language and are considered forward looking statements. These statements are based on our current expectations, estimates, forecasts and projections about the operating environment, economies and markets in which we operate. In addition, other written or oral statements which are considered forward looking may be made by us or others on our behalf. These statements are subject to important risks, uncertainties and assumptions, which are difficult to predict and the actual outcome may be materially different. Some of the factors which could cause results or events to differ from current expectations include, but are not limited to, the factors described below. Unless required by applicable securities laws, we do not have any intention or obligation to publicly update or revise any forward looking statements, whether as a result of new information, future events or otherwise.
We have restructured our business to respond to industry and market conditions. The assumptions underlying our restructuring efforts may prove to be inaccurate and we may have to restructure our business again in the future.
We have substantially completed our efforts to restructure our business to realign resources and achieve desired cost savings. We have based our restructuring efforts on certain assumptions regarding the cost structure of our business and the nature, severity and duration of the industry downturn. These assumptions may or may not be correct and as a result, we may determine that further restructuring in the future will be needed. Our restructuring efforts may not be sufficient for us to achieve ongoing profitability and meet the changes in industry and market conditions. We must manage the potentially higher growth areas of our business, as well as the non-core areas, in order for us to achieve ongoing profitability.
While restructuring, we have made, and will continue to make, judgments as to whether we should further reduce our workforce or exit, or dispose of, certain businesses. These workforce reductions may impair our ability to achieve our current or future business objectives. Costs incurred in connection with restructuring efforts may be higher than estimated. Any decision by management to further limit investment or exit, or dispose of, businesses may result in the recording of additional charges. As a result, the costs actually incurred in connection with the restructuring efforts may be higher than originally planned and may not lead to the anticipated cost savings and a return to ongoing profitability.
As part of our review of restructured businesses, we also look at the recoverability of their tangible and intangible assets. Future market conditions may trigger further write downs of these assets due to uncertainties in:
We will continue to review our restructuring work plan based on our ongoing assessment of the industry adjustment and the business environment.
We may be materially and adversely affected by continued reductions in spending by our customers.
A continued slowdown in capital spending by service providers and other customers may affect our revenues more than we currently expect. Moreover, the significant slowdown in capital spending by our customers, coupled with existing economic and geopolitical uncertainties and the potential impact on customer demand, has created uncertainty as to market demand. As a result, revenues and operating results for a particular period can be difficult to predict. In addition, there can be no certainty as to the severity or duration of the current industry adjustment. Our revenues and operating results have been and may continue to be materially and adversely affected by the continued reductions in capital spending by our customers. If the reduction of capital spending continues longer than we expect and we incur net losses as a result or if we are required to record additional charges relating to our restructuring work plan, the valuation of deferred income tax assets or for other events, we may be unable to comply with the financial covenant under our current credit facilities. As well, we have focused on the larger customers in certain markets, which provide a substantial portion of our revenues. A reduction or delay in business from one or more of these customers, or a failure to achieve a significant market share with these customers, could have a material adverse effect on our business, results of operations and financial condition.
49
Our operating results have historically been subject to yearly and quarterly fluctuations and are expected to continue to fluctuate.
Our operating results have historically been and are expected to continue to be subject to quarterly and yearly fluctuations as a result of a number of factors. These factors include:
Our decision to adopt fair value accounting for employee stock options on a prospective basis commencing January 1, 2003 will cause us to record an expense over the stock option vesting period, based on the fair value at the date the options are granted, and could have a significant negative effect on our reported results.
Additionally, we are required to perform goodwill impairment tests on an annual basis and between annual tests in certain circumstances, to value our deferred tax assets and to accrue unfunded pension liabilities, each of which may result in a negative effect on our reported results.
We enter into agreements that may require us to make certain indemnification payments to third parties in the event of certain changes in an underlying economic characteristic related to assets, liabilities or equity securities of such third parties. We have historically not made any significant indemnification payments under such agreements. The occurrence of events that may cause us to become liable to make an indemnification payment is not within our control and an obligation to make a significant indemnification payment under such agreements could have a significant negative effect on our reported results.
Significant fluctuations in our operating results could contribute to volatility in the market price of our common shares.
Global economic conditions affecting the industry, as well other trends and factors affecting the industry, are beyond our control and may result in reduced demand and pricing pressure on our products.
There are trends and factors affecting the industry that are beyond our control and may affect our operations. Such trends and factors include:
50
Economic conditions affecting the industry, which affect market conditions in the telecommunications and networking industry, in the United States, EMEA, Canada and globally, affect our business. Reduced capital spending and/or negative economic conditions in these and/or other areas of the world have resulted in, and could continue to result in, reduced demand for or increased pricing pressures on our products.
Our gross margins may be negatively affected, which in turn would negatively affect our operating results and could contribute to volatility in the market price of our common shares.
Our gross margins may be negatively affected as a result of a number of factors, including:
Lower than expected gross margins would negatively affect our operating results and could contribute to volatility in the market price of our common shares.
We may not be able to attract or retain the specialized technical and managerial personnel necessary to achieve our business objectives.
Competition for certain key positions and specialized technical personnel in the high-technology industry remains strong, despite current economic conditions. We believe that our future success depends in part on our continued ability to hire, assimilate in a timely manner, and retain qualified personnel, particularly in key senior management positions and in our key areas of potential growth. An important factor in attracting and retaining qualified employees is our ability to provide employees with the opportunity to participate in the potential growth of our business through programs such as stock option
51
plans and employee investment plans. The scope of these programs for employees and the value of these opportunities have been adversely affected by the volatility or negative performance of the market price for our common shares (including the possible consolidation of our common shares). We may also find it more difficult to attract or retain qualified employees because of our recent significant workforce reductions and business performance which has negatively impacted our level of incentive programs and incentive compensation plans. In addition, if we have not properly sized our workforce and retained those employees with the appropriate skills, our ability to compete effectively may be adversely affected. We are also more dependent on those employees we have retained, as many have taken on increased responsibilities due to the workforce reductions. If we are not successful in attracting, recruiting or retaining qualified employees, including members of senior management, we may not have the necessary personnel to effectively compete in the highly dynamic, specialized and volatile industry in which we operate or to achieve our business objectives.
Future cash flow fluctuations may affect our ability to fund our working capital requirements or achieve our business objectives in a timely manner.
Our working capital requirements and cash flows historically have been, and are expected to continue to be, subject to quarterly and yearly fluctuations, depending on such factors as timing and size of capital expenditures, levels of sales, timing of deliveries and collection of receivables, inventory levels, customer payment terms, customer financing obligations and supplier terms and conditions. In addition, due to the current general economic and industry environment, and our current credit condition, an increased portion of our cash and cash equivalents may be restricted as cash collateral for customer performance bonds and contracts, notwithstanding the support facility with EDC. The $750 April 2000 five year credit facilities are our only remaining credit facilities. We continue to have ongoing discussions with our banks and other financial institutions to explore additional financing opportunities and credit and support arrangements. As we continue to assess our overall liquidity and business needs as well as our expected financial performance, we may elect or it may be necessary to reduce or terminate the $750 April 2000 five year credit facilities prior to their expiries. We believe our cash on hand will be sufficient to fund our current business model, manage our investments and meet our customer commitments for at least the next 12 months. However, a greater than expected slow down in capital spending by service providers and other customers may require us to adjust our current business model. As a result, our revenues and cash flows may be materially lower than we expect and we may be required to further reduce our capital expenditures and investments or take other measures in order to meet our cash requirements. We may seek additional funds from liquidity-generating transactions and other conventional sources of external financing (which may include a variety of debt, convertible debt and/or equity financings). We cannot provide any assurance that our net cash requirements will be as we currently expect, that we will continue to have access to the $750 April 2000 five year credit facilities or the support facility with EDC when and as needed, or that liquidity- generating transactions or financings will be available to us on acceptable terms or at all. Our inability to manage cash flow fluctuations resulting from the above factors and the potential reduction or termination of the $750 April 2000 five year credit facilities or the support facility with EDC could have a material adverse effect on our ability to fund our working capital requirements from operating cash flows and other sources of liquidity or to achieve our business objectives in a timely manner.
Our business may be materially and adversely affected by our high level of debt.
In order to finance our business we have incurred, and have credit facilities allowing for drawdowns of, and have a shelf registration statement and a base shelf prospectus for potential offerings of, significant levels of debt compared to historical levels, and we may need to secure additional sources of funding, which may include debt or convertible debt financing, in the future. A high level of debt, arduous or restrictive terms and conditions relating to accessing certain sources of funding, failure to meet the financial and/or other covenants in our credit and/or support facilities and any significant reduction in, or access to, such facilities, poor business performance or lower than expected cash inflows could have adverse consequences on our ability to fund the operation of our business.
Other effects of a high level of debt include the following:
52
The Nortel Networks Limited $750 April 2000 five year credit facilities contain a financial covenant. If we are unable to comply with this covenant, it will adversely affect our ability to access these credit facilities.
The $750 April 2000 five year credit facilities include a financial covenant which requires that Nortel Networks Limited’s consolidated tangible net worth at any time be not less than $1,888. We continue to monitor the financial position of Nortel Networks Limited in light of this covenant and we expect that if we incur net losses or record additional charges relating to our restructuring work plan, the accounting of our registered pension plans, the valuation of deferred income tax assets or for other events, Nortel Networks Limited’s consolidated tangible net worth may be reduced below the $1,888 threshold. If Nortel Networks Limited is unable to comply with this covenant, we will be unable to access these credit facilities.
An increased portion of our cash and cash equivalents may be restricted as cash collateral if we are unable to conclude satisfactory arrangements for alternative support for certain obligations arising out of our normal course business activities.
The support facility with EDC may not provide all the support we require in respect of certain of our obligations arising out of our normal course of business activities. In particular, although this facility provides for up to $750 in support, only $300 is committed support for performance bonds. In addition, bid and performance related bonds with terms that extend beyond June 30, 2004, which is the expiry date of this facility, are currently not eligible for the support provided by this facility. Unless EDC agrees to an extension of the facility or agrees to provide support outside the scope of the facility, we may be required to provide cash collateral to support these obligations. We cannot provide any assurance that we will reach an agreement with EDC on these matters. We are also in discussions with banks and financial institutions regarding arrangements, in addition to the support facility with EDC, that would provide for additional support, possibly on a secured basis, of these obligations, which include letters of credit, letters of guarantee, indemnity arrangements, performance bonds, surety bonds, receivables purchases, securitizations and similar instruments and arrangements. We cannot provide any assurance that such discussions will result in satisfactory arrangements. If we are unable to successfully conclude these arrangements and do not have access to sufficient support for such obligations under the support facility with EDC, an increased portion of our cash and cash equivalents may be restricted as cash collateral provided as security for these obligations, which could adversely affect our ability to support some of our normal course business activities and our ability to borrow in the future.
Changes in respect of our public debt ratings or current credit condition may materially and adversely affect the availability, the cost and the terms and conditions of our debt and alternative financing arrangements.
Certain of our outstanding debt instruments are publicly rated by independent rating agencies, which ratings are below investment grade. These public debt ratings and our current credit condition affect our ability to raise debt, our access to the commercial paper market (which is currently closed to us), our ability to engage in alternative financing arrangements, our ability to engage in normal course derivative or hedging transactions and our ability to obtain customer performance bonds and contracts. These public debt ratings have also caused the security that we granted to certain banks and holders of our outstanding public debt under our existing security agreements to become effective. This security, which consists of pledges of substantially all of the assets of Nortel Networks Limited, will continue to apply to Nortel Networks Limited’s obligations under the $750 April 2000 five year credit facilities, the support facility with EDC and our outstanding public debt, unless such credit facilities are terminated or expire, and such support facility expires or alternative collateral is provided, or such public debt ratings return to investment grade (as specified in the credit facilities) or higher. The continued existence of such security arrangements may adversely affect our ability to incur additional debt or secure alternative financing arrangements. In addition, EDC is not obligated to make any support available unless certain customary conditions are satisfied, and Nortel Networks Limited’s senior long-term debt rating by Moody’s has not been downgraded to less than B3 and that its debt rating by S&P has not been downgraded to less than B—.
Our current credit condition requires us, in addition to the payment of fees, to also post cash collateral to secure certain bid, performance related and other bonds and may also negatively affect the cost to us and terms and conditions of debt and alternative financing arrangements. Additionally, any negative developments regarding our cash flow, public debt ratings, current credit condition and/or our incurring significant levels of debt, or our failure to meet certain covenants under our credit and/or support facilities, could cause us to lose access to and/or cause a default under such facilities and/or adversely affect further the cost and terms and conditions of our debt and alternative financing arrangements.
53
An inability of our subsidiaries to provide us with funding in sufficient amounts could adversely affect our ability to meet our obligations.
We may at times depend primarily on loans, dividends or other forms of financing from our subsidiaries to meet our obligations for payment of interest and principal on outstanding public debt and corporate expenses. An inability of our subsidiaries to pay dividends or provide loans or other forms of financing in sufficient amounts could adversely affect our ability to meet these obligations.
We have risks related to our defined benefit plans.
We currently maintain various defined benefit plans in North America and the United Kingdom which cover various categories of employees and retirees. Our obligations to make contributions to fund benefit obligations under these plans are based on actuarial valuations, which themselves are based on certain assumptions about the long-term operation of the plans, including employee turnover and retirement rates, the performance of the financial markets and interest rates. If the actual operation of the plans differs from the assumptions, additional contributions by us may be required. The equity markets can be, and recently have been, very volatile, and therefore our estimate of future contribution requirements can change significantly in a short period of time. Similarly, changes in interest rates can impact our contribution requirements. In a low interest rate environment, the likelihood of required contributions in the future increases. If we are required to make significant contributions to fund the defined benefit plans, our reported results could be materially and adversely affected and our cash flow available for other uses may be significantly reduced.
If market conditions deteriorate further or future results of operations are less than expected, additional valuation allowances may be required for all or a portion of our deferred tax assets.
We currently have deferred tax assets, which may be used to reduce taxable income in the future. We assess the realization of these deferred tax assets quarterly, and if we determine that it is more likely than not that some portion of these assets will not be realized, an income tax valuation allowance is recorded. If market conditions deteriorate further or future results of operations are less than expected, future assessments may result in a determination that it is more likely than not that some or all of the net deferred tax assets are not realizable. As a result, we may need to establish additional tax valuation allowances for all or a portion of the net deferred tax assets, which may have a material adverse effect on our business, results of operations and financial condition.
Our performance may be materially and adversely affected if our expectations regarding market demand for particular products prove to be wrong.
We expect that data communications traffic will grow at a faster rate than the growth expected for voice traffic and that the use of the Internet will continue to increase. We expect the growth of data traffic and the use of the Internet will significantly impact traditional voice networks, both wireline and wireless. We believe that this will create market discontinuities. By market discontinuities, we mean opportunities for new technologies, applications, products and services that enable the secure, rapid and efficient transport of large volumes of information over networks and allow service providers and carriers to increase revenues and improve operating results. Market discontinuities will also make traditional voice network products and services less effective as they were not designed for data traffic. We believe that these market discontinuities in turn will lead to the convergence of data and voice through upgrades of traditional voice networks to transport large volumes of data traffic or through the construction of new networks designed to transport both voice and data traffic. Either approach would require significant capital expenditures by service providers. We also believe that such developments will give rise to the demand for Internet Protocol , or IP, optimized networking solutions, and third generation, or 3G, wireless networks. IP is the predominant method by which data is sent from one computer to another on the Internet — a data message is divided into smaller packets which contain both the sender’s unique IP address and the receiver’s unique IP address, and each packet is sent, potentially by different routes and as independent units, across the Internet. There is no continuing connection between the end points which are communicating versus traditional telephone communications which involve establishing a fixed circuit that is maintained for the duration of the voice or data communications call. 3G wireless networks are an evolution of communications networks from second generation wireless networks for voice and low speed data communications that are based on circuit switching — when a call is dialed, a circuit is established between the mobile handset and the third party, and the connection lasts for the duration of the call. By comparison, 3G networks allow devices to be “always on” because the networks are packet-based. We expect 3G wireless networks to include such features as voice, high speed data communications and high bandwidth multimedia capabilities, and usability on a variety of different communications devices, such as cellular telephones and pagers, with the user having accessibility anywhere and at any time to these features.
54
We cannot be sure what the rate of such convergence of voice and data networks will be, due to the dynamic and rapidly evolving nature of the communications business, the technology involved and the availability of capital. Consequently, market discontinuities and the resulting demand for IP-optimized networking solutions or 3G wireless networks may not materialize. Alternatively, the pace of that development may be slower than currently anticipated. It may also be the case that the market may develop in an unforeseen direction. Certain events, including the commercial availability and actual implementation of new technologies, including 3G networks, or the evolution of other technologies, may occur which would affect the extent or timing of anticipated market demand, or increase demand for products based on other technologies, or reduce the demand for IP-optimized networking solutions or 3G wireless networks, which in turn may reduce purchases of our networking solutions by our customers, require increased expenditures to develop and market different technologies, or provide market opportunities for our competitors. Our performance may also be materially and adversely affected by a lack of growth in the rate of data traffic, a reduction in the use of the Internet or a reduction in the demand for IP-optimized networking solutions or 3G wireless networks in the future.
We have made, and may continue to make, strategic acquisitions in order to enhance our business. If we are not successful in operating or integrating these acquisitions, our business, results of operations and financial condition may be materially and adversely affected.
In the past, we acquired companies to enhance the expansion of our business and products. We may consider selective opportunistic acquisitions of companies or businesses with resources and product or service offerings capable of providing us with additional product and/or market strengths to help fulfill our vision of transforming how the world communicates and exchanges information. Acquisitions involve significant risks and uncertainties. These risks and uncertainties include:
Our inability to successfully operate and integrate newly acquired businesses appropriately, effectively and in a timely manner could have a material adverse effect on our ability to take advantage of further growth in demand for IP-optimized network solutions and other advances in technology, as well as on our revenues, gross margins and expenses.
We operate in highly dynamic and volatile industries characterized by rapidly changing technologies, evolving industry standards, frequent new product introductions and short product life cycles.
The markets for our products are characterized by rapidly changing technologies, evolving industry standards, frequent new product introductions and short product life cycles. We expect our success to depend, in substantial part, on the timely and successful introduction of high quality, new products and upgrades, as well as cost reductions on current products to address the operational speed, bandwidth, efficiency and cost requirements of our customers. Our success will also depend on our ability to comply with emerging industry standards, to operate with products of other suppliers, to address emerging market trends, to provide our customers with new revenue-generating opportunities and to compete with technological and product developments carried out by others. The development of new, technologically advanced products, including IP-optimized networking solutions and 3G wireless networks, is a complex and uncertain process requiring high levels of innovation, as well as the accurate anticipation of technological and market trends. Investments in such development may result in
55
expenses growing at a faster rate than revenues, particularly since the initial investment to bring a product to market may be high. We may not be successful in targeting new market opportunities, in developing and commercializing new products in a timely manner or in achieving market acceptance for our new products.
The success of new or enhanced products, including IP-optimized networking solutions and 3G wireless networks, depends on a number of other factors, including the timely introduction of such products, market acceptance of new technologies and industry standards, the quality and robustness of new or enhanced products, competing product offerings, the pricing and marketing of such products and the availability of funding for such networks. Products and technologies developed by our competitors may render our products obsolete. Hackers may attempt to disrupt or exploit our customers’ use of our technologies. If we fail to respond in a timely and effective manner to unanticipated changes in one or more of the technologies affecting telecommunications and data networking or our new products or product enhancements fail to achieve market acceptance, our ability to compete effectively in our industry, and our sales, market share and customer relationships could be materially and adversely affected.
In addition, unanticipated changes in market demand for products based on a specific technology, particularly lower than anticipated, or delays in, demand for IP-optimized networking solutions, particularly long-haul and metro optical networking solutions, or 3G wireless networks, could have a material adverse effect on our business, results of operations and financial condition if we fail to respond to such changes in a timely and effective manner.
We face significant competition and may not be able to maintain our market share and may suffer from competitive pricing practices.
We operate in a highly volatile industry that is characterized by industry rationalization and consolidation, vigorous competition for market share and rapid technological development. Competition is heightened in periods of slow overall market growth. These factors could result in aggressive pricing practices and growing competition from smaller niche companies, established competitors, as well as well-capitalized computer systems and communications companies, which, in turn, could have a material adverse effect on our gross margins.
Our major competitors in Wireless Networks have traditionally included Telefonaktiebolagat LM Ericsson, Lucent Technologies Inc., Motorola, Inc., Siemens Aktiengesellschaft and Nokia Corporation. More recently, Samsung Electronics Co., Ltd. and Huawei Technologies Co., Ltd. have emerged as competitors. Our principal competitors in the sale of our Enterprise Networks solutions to enterprises are Cisco Systems, Inc., Avaya Inc., Alcatel S.A., and Siemens. We also compete with smaller companies that address specific niches, such as Foundry Networks, Inc., Extreme Networks, Inc., Enteresys Networks, Inc., 3Com Corporation and Genesys Telecommunications Laboratories, Inc. Our principal competitors in the sale of our Wireline Networks products to service providers are large communications companies such as Cisco, Lucent, Alcatel and Siemens. In addition, we compete with smaller companies that address specific niches within this market, such as Sonus Systems Limited, BroadSoft, Inc., Taqua Inc., Redback Networks Inc., Equipe Communications Corporation, Laurel Networks, Inc. and WaveSmith Networks, Inc. Certain competitors are also strong on a regional basis, such as ZTE Corporation and Huawei. Our major competitors in Optical Networks include Alcatel, Lucent, Siemens, Fujitsu Limited, Marconi plc, Cisco, Huawei, NEC Corporation, Ciena Corporation and ADVA International Inc. Since some of the markets in which we compete are characterized by the potential for rapid growth and, in certain cases, low barriers to entry and rapid technological changes, smaller, specialized companies and start-up ventures are now or may become principal competitors in the future. We may also face competition from the resale of used telecommunications equipment, including our own on occasion, by failed, downsized or consolidated high technology enterprises and telecommunications service providers. In addition, one way to maximize market growth, enhance existing products and introduce new products is through acquisitions of companies, where advisable. Certain of our competitors may enter into additional business combinations, to accelerate product development, or to engage in aggressive price reductions or other competitive practices, creating even more powerful or aggressive competitors.
We expect that we will face additional competition from existing competitors and from a number of companies that have entered or may enter our existing and future markets. Some of our current and potential competitors have greater marketing, technical and financial resources, including access to capital markets and/or the ability to provide customer financing in connection with the sale of products. Many of our current and potential competitors have also established, or may in the future establish, relationships with our current and potential customers. Other competitive factors include the ability to provide new technologies and products, end-to-end networking solutions, and new product features, such as security, as well as conformance to industry standards. Increased competition could result in price reductions, negatively affecting our operating results, reducing profit margins and potentially leading to a loss of market share.
56
We face certain barriers in our efforts to expand internationally.
We intend to continue to pursue international and emerging market growth opportunities. In many international markets, long-standing relationships between potential customers and their local suppliers and protective regulations, including local content requirements and type approvals, create barriers to entry. In addition, pursuing international opportunities may require significant investments for an extended period before we realize returns on such investments, if any, and such investments may result in expenses growing at a faster rate than revenues. Furthermore, such projects and investments could be adversely affected by:
Difficulties in foreign financial markets and economies and of foreign financial institutions, particularly in emerging markets, could adversely affect demand from customers in the affected countries. An inability to maintain or expand our business in international and emerging markets could have a material adverse effect on our business, results of operations and financial condition.
Fluctuating foreign currencies may negatively impact our business, results of operations and financial condition.
As an increasing proportion of our business may be denominated in currencies other than United States dollars, fluctuations in foreign currencies may have an impact on our business, results of operations, and financial condition. Our primary currency exposures are to Canadian dollars, United Kingdom pounds and the Euro. These exposures may change over time as we change the geographic mix of our global business and as our business practices evolve. For instance, if we increase our presence in emerging markets, we may see an increase in our exposure to such emerging market currencies, such as, for example, the Chinese Renminbi. These currencies may be affected by internal factors, and external developments in other countries, all of which can have an adverse impact on a country’s currency. Also, availability to enter into normal course derivative or hedging transactions in the future may be impacted by our current credit condition. We cannot predict whether foreign exchange losses will be incurred in the future, and significant foreign exchange fluctuations may have a material adverse effect on our results of operations.
We may become involved in disputes regarding intellectual property rights that could materially and adversely affect our business if we do not prevail.
Our industry is subject to uncertainty over adoption of industry standards and protection of intellectual property rights. Our success is dependent on our proprietary technology, which we rely on patent, copyright, trademark and trade secret laws to protect. While our business is global in nature, the level of protection of our proprietary technology provided by such laws varies by country. Our issued patents may be challenged, invalidated or circumvented, and our rights under issued patents may not provide us with competitive advantages. Patents may not be issued from pending applications, and claims in patents issued in the future may not be sufficiently broad to protect our proprietary technology. In addition, claims of intellectual property infringement or trade secret misappropriation may be asserted against us or our customers in connection with their use of our products and the outcome of any such claims are uncertain. A failure by us to react to changing industry standards, the lack of broadly-accepted industry standards, successful claims of intellectual property infringement or other intellectual property claims against us or our customers, or a failure by us to protect our proprietary technology, could have a material adverse effect on our business, results of operations and financial condition. In addition, if others infringe on our intellectual property rights, we may not be able to successfully contest such challenges.
57
Rationalization and consolidation in the industry may cause us to experience a loss of customers and increased competition.
The industry has experienced the consolidation and rationalization of industry participants and this trend may continue. There have been adverse changes in the public and private equity and debt markets for industry participants which have affected their ability to obtain financing or to fund capital expenditures. Some operators have experienced financial difficulty and have, or may, file for bankruptcy protection or be acquired by other operators. Other operators may merge and we and one or more of our competitors may each supply products to the companies that have merged or will merge. This rationalization and/or consolidation could result in our dependence on a smaller number of customers, purchasing decision delays by the merged companies and/or our playing a lesser role, or no longer playing a role, in the supply of communications products to the merged companies. This rationalization and/or consolidation could also cause increased competition among our customers and pressure on the pricing of their products and services, which could cause further financial difficulties for our customers. A rationalization of industry participants could also increase the supply of used communications products for resale by affected industry participants, resulting in increased competition and pressure on the pricing for our new products. In addition, telecommunications equipment suppliers may enter into business combinations, or may be acquired by or sell a substantial portion of their assets to other competitors, resulting in accelerated product development, increased financial strength, or a broader base of customers, creating even more powerful or aggressive competitors. We may also see rationalization among equipment/component suppliers. The business failures of operators, competitors or suppliers may cause uncertainty among investors and in the industry generally.
Changes in regulation of the Internet and/or other aspects of the industry may affect the manner in which we conduct our business and may materially and adversely affect our business, results of operations and financial condition.
There are currently few domestic or international laws or regulations that apply directly to access to or commerce on the Internet. We could be materially and adversely affected by regulation of the Internet in any country where we operate in respect of such technologies as voice over the Internet, encryption technology and access charges for Internet service providers. We could also be materially and adversely affected by increased competition, or by reduced capital spending by our customers, as a result of the change in the regulation of the industry. In particular, on February 20, 2003, the United States Federal Communications Commission, or the FCC, announced a decision in its trienniel review proceeding of the rules regarding unbundled network elements, or UNEs. The text of the FCC’s order and reasons for the decision has not yet been released. Although the decision may impact the business decisions of our United States based service provider customers, the extent of that impact has not been determined. If a jurisdiction in which we operate adopts measures which affect the regulation of the Internet and/or other aspects of the industry, we could experience both decreased demand for our products and increased costs of selling such products. Changes in laws or regulations governing the Internet, Internet commerce and/or other aspects of the industry could have a material adverse effect on our business, results of operations and financial condition.
Our stock price has historically been volatile and further declines in the market price of our common shares or our other securities may negatively impact our ability to make future strategic acquisitions, raise capital, issue debt or retain employees.
Our common shares have experienced, and may continue to experience, substantial price volatility, including considerable decreases, particularly as a result of variations between our actual or anticipated financial results and the published expectations of analysts and as a result of announcements by our competitors and us. Also, we are no longer listed on the S&P 500 or S&P 100 indices which may also affect the price volatility of our common shares. Our credit quality, any equity or equity related offerings, operating results and prospects, among other factors, including any exclusion of our common shares from any other widely followed stock market indices, will also affect the market price of our common shares.
The stock markets have experienced extreme price fluctuations that have affected the market price and trading volumes of many technology and telecommunications companies in particular, with potential consequential negative effects on the trading of securities of such companies. A major decline in the capital markets generally, or an adjustment in the market price or trading volumes of our common shares or our other securities, may negatively impact our ability to raise capital, issue debt, secure customer business, retain employees or make future strategic acquisitions. These factors, as well as general economic and geopolitical conditions, and continued negative events within the technology sector, may in turn have a material adverse effect on the market price of our common shares.
Substantial price volatility may result in Nortel Networks failure to meet the minimum listing requirements of the New York Stock Exchange which includes a minimum share price condition.
58
There are risks associated with a share consolidation.
By special resolution approved by our shareholders at the annual and special meeting of shareholders held on April 24, 2003, the board of directors has the authority, in its sole discretion, to consolidate our issued and outstanding common shares (also known as a reverse stock split) at any time prior to April 15, 2004 at a consolidation ratio selected by the board of directors, provided that (i) the ratio may be no smaller than one post-consolidation common share for every five pre-consolidation common shares, and no larger than one post-consolidation common share for every ten pre-consolidation common shares, and (ii) the number of pre-consolidation shares in the ratio must be a whole number of common shares (that is, either five, six, seven, eight, nine or ten). In addition, notwithstanding approval of the proposed consolidation by the shareholders, the board of directors, in its sole discretion, may revoke the special resolution, and abandon the consolidation without further approval or action by or prior notice to the shareholders.
There can be no assurance that our board of directors will implement the proposed share consolidation. Failure to implement the proposed share consolidation may increase the probability that our common shares would be delisted from the New York Stock Exchange in the future due to failure to satisfy the minimum share price listing condition. In addition, in the event that the trading price or trading volume of our common shares on the New York Stock Exchange were to fall to an abnormally low level, the New York Stock Exchange would have discretionary authority to begin delisting proceedings prior to any action by our board of directors to implement the proposal.
There can be no assurance that any increase in the market price for each of our common shares resulting from a share consolidation will be sustainable or that it will equal or exceed the direct arithmetical result of the consolidation (that is, from five to ten times the pre-consolidation price, depending on the ratio selected by our board of directors) since there are numerous factors and contingencies that would effect such price, including the status of the market for the common shares at the time, our reported results of operations in future periods and general economic, geopolitical, stock market and industry conditions. Accordingly, the total market capitalization of our common shares after a possible share consolidation may be lower than the total market capitalization before such consolidation and, in the future, the market price of the common shares may not exceed or remain higher than the market price prior to such consolidation. Further, there can be no assurance that post consolidation, Nortel Networks continues to meet the minimum listing requirements of the New York Stock Exchange. If such minimum listing requirements are not met, the New York Stock Exchange would have discretionary authority to begin delisting proceedings. The delisting of Nortel Networks common shares from the New York Stock Exchange could have a material adverse effect on the market price and liquidity of the common shares.
While a higher share price may help generate investor interest in our common shares, there can be no assurance that a share consolidation will result in a per share market price that will attract institutional investors or investment funds or that such price will satisfy the investing guidelines of institutional investors or investment funds. As a result, the trading liquidity of the common shares may not necessarily improve as a result of a share consolidation.
If the share consolidation is implemented and the market price of our common shares declines, the percentage decline may be greater than would occur in the absence of the share consolidation. The market price of the common shares will, however, also be based on our performance and other factors, which are unrelated to the number of common shares outstanding. Furthermore, the liquidity of our common shares could be adversely affected by the reduced number of common shares that would be outstanding after the share consolidation.
Acceleration of the settlement date on early settlement of our purchase contracts could contribute to volatility in the market price of our common shares.
On June 12, 2002, concurrent with the offering of our common shares, 28,750 equity units were offered, each initially evidencing ownership of a prepaid forward purchase contract, or purchase contract, entitling the holder to receive our common shares, and specified zero-coupon U.S. treasury strips. The aggregate number of our common shares issuable on the settlement date of the purchase contracts will be between approximately 473 million and 567 million shares, subject to some anti-dilution adjustments (which include adjustments for a possible consolidation of our common shares), depending on the applicable market value of Nortel Networks common shares. As at April 30, 2003, 28,002 purchase contracts were outstanding. The settlement date for each purchase contract is August 15, 2005, subject to acceleration or early settlement in certain cases. If we are involved in a merger, amalgamation, arrangement, consolidation or other reorganization event (other than with or into Nortel Networks Limited or certain other subsidiaries) in which all of our common shares are exchanged for consideration of at least 30 percent of the value of which consists of cash or cash equivalents, then a holder of purchase contracts may elect to accelerate and settle some or all of its purchase contracts, for our common shares. The settlement date under each purchase contract will automatically accelerate upon the occurrence of specified events of bankruptcy, insolvency or reorganization with respect to us. Upon acceleration of the settlement date, holders will be entitled to receive 20,263.12
59
common shares per purchase contract (regardless of the market price of our common shares at that time), subject to some anti-dilution adjustments. A holder of purchase contracts may also elect to accelerate the settlement date in respect of some or all of its purchase contracts. Upon an early settlement on or after February 15, 2003, the holder will receive 16,885.93 common shares per purchase contract (regardless of the market price of Nortel Networks common shares at that time), subject to some anti-dilution adjustments. An acceleration of the settlement date or early settlement of our purchase contracts could contribute to volatility in the market price of our common shares.
The current downturn in the economy has increased, and could continue to increase, our exposure to our customers’ credit risk and the risk that our customers will not be able to fulfill their payment obligations to us under customer financing arrangements.
The competitive environment in which we operate has required us in the past to provide significant amounts of medium-term and long-term customer financing. Customer financing arrangements may include financing in connection with the sale of our products and services, funding for certain non-product and service costs associated with network installation and integration of our products and services, financing for working capital and equity financing. While we are seeking to reduce our customer financing exposure, we expect we may continue in the future to provide customer financing to customers in areas that are strategic to our core business activity. If we do, we may be required to directly hold a significantly greater amount of such financings than in the past, when we were able to place a large amount of our customer financing obligations with third party lenders.
We expect to continue to hold most current and future customer financing obligations for longer periods prior to any possible placement with third-party lenders, due to, among other factors, recent economic uncertainty in various countries, adverse capital market conditions, our current credit condition, adverse changes in the credit quality of our customers and reduced demand for telecommunications financing in capital and bank markets. In addition, risks generally associated with customer financing, including the risks associated with new technologies, new network construction, market demand and competition, customer business plan viability and funding risks, may require us to hold certain customer financing obligations over a longer term. We may not be able to place any of our current or future customer financing obligations with third-party lenders on acceptable terms.
Certain customers have been experiencing financial difficulties and have failed to meet their financial obligations. As a result, we have incurred charges for increased provision related to certain trade and customer financing receivables. If there are further increases in the failure of our customers to meet their customer financing and receivables obligations to us or if the assumptions underlying the amount of provisions we have taken with respect to customer financing and receivables obligations do not reflect actual future financial conditions and customer payment levels, we could incur losses in excess of our provisions, which could have a material adverse effect on our cash flow and operating results.
Negative developments associated with our supply and network outsourcing contracts and contract manufacturing agreements may materially and adversely affect our business, results of operations, financial condition and supply relationships.
We have entered into supply contracts with customers to provide products and services, which in some cases involve new technologies currently being developed, or which we have not yet commercially deployed, or which require us to build and operate networks. We have also entered into network outsourcing contracts with customers to operate their networks. Some of these supply and network outsourcing contracts contain delivery and installation timetables, performance criteria and other contractual obligations which, if not met, could result in our having to pay substantial penalties or liquidated damages, the termination of the related supply or network outsourcing contract, and/or the reduction of shared revenues, in certain circumstances. Unexpected developments in these supply and outsourcing contracts could have a material adverse effect on our revenues, cash flows and relationships with our customers.
Our ability to meet customer demand is, in part, dependent on us obtaining timely and adequate component parts and products from suppliers, contract manufacturers, and internal manufacturing capacity. As part of the transformation of our supply chain from a vertically integrated manufacturing model to a virtually integrated model, we have outsourced a substantial portion of our manufacturing capacity to contract manufacturers. We work closely with our suppliers and contract manufacturers to address quality issues and to meet increases in customer demand, when needed, and we also manage our internal manufacturing capacity, quality, and inventory levels as required. However, we may encounter shortages of quality components and/or products in the future. In addition, our component suppliers and contract manufacturers have experienced, and may continue to experience, a consolidation in the industry and financial difficulties, both of which may result in fewer sources of components or products and greater exposure to the financial stability of our suppliers. A reduction or interruption in component supply or external manufacturing capacity, a significant increase in the price of one or more
60
components, or excessive inventory levels could materially and negatively affect our gross margins and our operating results and could materially damage customer relationships.
Further, certain of our key supply arrangements were negotiated prior to the current industry and economic downturn. As a result of the extent and duration of this downturn, in respect of one of these arrangements based on our current revenue levels, we will not meet the minimum volume level contained in the contract. As a result, we may be obligated to compensate the supplier for certain direct costs. The amount of such compensation would be based on a variety of complex, interrelated factors (including applicable factors that could mitigate such direct costs). An obligation to pay such compensation could have a material adverse effect on our business, results of operations, financial condition, and/or supply relationships.
Our business may suffer if strategic alliances which we have entered into are not successful.
We have entered into a number of strategic alliances with suppliers, developers and members in our industry to facilitate product compatibility, encourage adoption of industry standards or to offer complementary product or service offerings to meet customer needs. In some cases, the companies with which we have strategic alliances also compete against us in some of our business areas. If a member of a strategic alliance fails to perform its obligations, if the relationship fails to develop as expected or if the relationship is terminated, we could experience delays in product availability or impairment of our relationships with our customers.
The adverse resolution of litigation against us could negatively impact our business.
We are currently a defendant in numerous class actions and other lawsuits, including lawsuits initiated on behalf of holders of our common shares, which seek damages of material and indeterminate amounts, as well as lawsuits in the normal course of business. We are and may in the future be subject to other litigation arising in the normal course of our business. Litigation may be time consuming, expensive and distracting from the conduct of our business and the outcome of litigation is difficult to predict. The adverse resolution of any specific lawsuit could have a material adverse effect on our business, results of operations and financial condition.
Recent accounting pronouncements
For a discussion of recent pronouncements, see “Significant accounting policies” in note 1 of the accompanying unaudited consolidated financial statements.
61
Market risk represents the risk of loss that may impact the consolidated financial statements of Nortel Networks due to adverse changes in financial market prices and rates. Nortel Networks market risk exposure is primarily a result of fluctuations in interest rates and foreign exchange rates. Disclosure of market risk is contained in our Annual Report on Form 10-K for the year ended December 31, 2002 filed with the Securities and Exchange Commission on March 10, 2003.
Evaluation of Disclosure Controls and Procedures
Within the 90-day period prior to the filing of this report, an evaluation was carried out under the supervision and with the participation of Nortel Networks management, including our President and Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-14(c) under the Securities Exchange Act of 1934). Based upon that evaluation, the President and Chief Executive Officer and Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures were effective.
Changes in Internal Control
There were no significant changes in our internal controls or in other factors that could significantly affect these internal controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
62
For a discussion of our material legal proceedings, see “Legal proceedings” in Management’s Discussion and Analysis of Financial Condition and Results of Operations.
During the first quarter of 2003, Nortel Networks Corporation issued an aggregate of 235,499 shares upon the exercise of options granted under the Nortel Networks/BCE 1985 Stock Option Plan and the Nortel Networks/BCE 1999 Stock Option Plan. The common shares issued on the exercise of these options were issued outside of the United States to BCE Inc. employees who were not United States persons at the time of option exercise, or to BCE in connection with options that expired unexercised or were forfeited. The common shares issued are deemed to be exempt from registration pursuant to Regulation S under the United States Securities Act of 1933 (the “Securities Act”), as amended. All funds received by Nortel Networks Corporation in connection with the exercise of stock options granted under the two Nortel Networks/BCE stock option plans are transferred in full to BCE pursuant to the terms of the May 1, 2000 plan of arrangement, except for nominal amounts paid to Nortel Networks Corporation to round up fractional entitlements into whole shares. Nortel Networks Corporation keeps these nominal amounts and uses them for general corporate purposes.
63
64
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: May 9, 2003
65
CERTIFICATION
I, FRANK A. DUNN, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Nortel Networks Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
6. The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
66
I, DOUGLAS C. BEATTY, certify that:
67