UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549
FORM 10-Q
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 July 31, 2003
3,952,885,068 without nominal or par value
TABLE OF CONTENTS
PART IFINANCIAL 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.
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NORTEL NETWORKS CORPORATIONConsolidated Statements of Operations (unaudited)
The accompanying notes are an integral part of these unaudited consolidated financial statements.
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NORTEL NETWORKS CORPORATIONConsolidated Balance Sheets (unaudited)
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NORTEL NETWORKS CORPORATIONConsolidated Statements of Cash Flows (unaudited)
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NORTEL NETWORKS CORPORATIONNotes to Consolidated Financial Statements (unaudited)(millions of U.S. dollars, except per share amounts, unless otherwise stated)
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Supplemental Consolidating Statements of Operations for the three months ended June 30, 2003:
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Supplemental Consolidating Statements of Operations for the three months ended June 30, 2002:
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Supplemental Consolidating Statements of Operations for the six months ended June 30, 2003:
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Supplemental Consolidating Statements of Operations for the six months ended June 30, 2002:
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Supplemental Consolidating Balance Sheets as at June 30, 2003:
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Supplemental Consolidating Balance Sheets as at December 31, 2002:
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Supplemental Consolidating Statements of Cash Flows for the six months ended June 30, 2003:
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Supplemental Consolidating Statements of Cash Flows for the six months ended June 30, 2002:
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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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 into 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
Asset and liability review and analysis
In light of a period of unprecedented industry adjustment and subsequent restructuring actions, including workforce reductions and asset write-downs, in the second quarter of 2003 we initiated a comprehensive review and analysis of identifiable categories of our assets and liabilities, or the comprehensive review. The amounts under review were recorded when our balance sheet and income statement were much larger. Specifically, what would have been relatively minor amounts in prior periods may be considered to be material to current periods. The comprehensive review is in addition to reviews normally performed by us in connection with the recording of our current period financial results.The outcome of the comprehensive review may result in the elimination of certain assets and liabilities (including accruals and provisions). As part of the comprehensive review, we are currently assessing the support for certain of our liabilities which were initially recorded, along with corresponding charges to income, in prior periods. These liabilities represented less than 2% of our total liabilities as at June 30, 2003. The outcome of the comprehensive review is currently not expected to have a negative impact on our net assets. Reported results in one or more prior periods may be affected, potentially resulting in the non-material reduction of prior period losses. No amounts relating to the elimination of any such assets and liabilities have been included in our results for the second quarter of 2003. The comprehensive review is ongoing, and we expect to substantially conclude it in the third quarter of 2003.
Customer financing commitments
During the first half of 2003, we reduced undrawn customer financing commitments by $134 reflecting commitment expirations, cancellations and changing customer business plans. As of June 30, 2003, approximately $100 of the $667 in undrawn commitments was not available for funding under the terms of our financing agreements. Subsequent to June 30, 2003, we renegotiated an agreement with a certain customer and reduced our undrawn commitments by approximately $509, leaving approximately $158 in aggregate undrawn commitments.
Ownership adjustment in our French and German operations
On July 18, 2003, we announced that we will realign our business activities in France and Germany. As a result, we will increase our ownership in our core businesses in these countries, consistent with our overall global business strategy. Subject to final regulatory approval, we will acquire the 42% ownership interest in Nortel Networks Germany GmbH & Co. KG and the 45% ownership interest in Nortel Networks France S.A.S., currently held by European Aeronautic Defence and Space Company EADS N.V., or EADS, our partner in three European joint ventures. When completed, these transactions will bring our ownership in each company to 100%. These companies are responsible for the sales and marketing of our products in France and Germany. At the same time, EADS will increase its ownership in EADS Telecom S.A.S. (formerly EADS Defence and Security Networks S.A.S.) from 59% to 100% as a result of acquiring our equity ownership in that company.
For additional information, see “Joint ventures/minority interests”.
EDC support facility
On February 14, 2003, Nortel Networks Limited 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
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of normal course business activities. This facility provides for up to $750 in performance related support for our operations and has reduced our need to utilize restricted cash as collateral for our performance related obligations. Currently, $300 is committed support for performance bonds. On July 10, 2003, we announced an amendment to the EDC support facility which extended the termination date to December 31, 2005 from June 30, 2004. See “Available support facility” for additional information.
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 in 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 Nortel Networks 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 “Shareholder 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, or SEC, on March 10, 2003 and to our Registration Statement on Form 8-A/A filed with the SEC 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:
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, or SFAS, No. 148 was a stock option expense of $7 in the second quarter of 2003 and $12 in the first half 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 SEC.
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Results of operations — continuing operations
Segment revenues
Geographic revenues
The following table summarizes our geographic revenues based on the location of the customer:
Consolidated revenues
Our consolidated revenues declined 16% in the second quarter of 2003 compared to the second quarter of 2002 and declined 17% in the first half of 2003 compared to the first half of 2002. These declines were across all segments and were primarily due to the continuing industry adjustment, tightened capital markets and/or capital spending restrictions experienced by our service provider and enterprise customers. Customer spending remained cautious, with many of our customers realigning capital spending with their current levels of revenues 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 focus on 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 16% decline in revenues in the second quarter of 2003 compared to the same period in 2002 was primarily due to a:
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From a geographic perspective, the 17% decline in revenues in the first half of 2003 compared to the same period in 2002 was primarily due to a:
Our consolidated revenues declined $73 from $2,399 in the first quarter of 2003 to $2,326 in the second quarter of 2003. The decline was primarily due to continuing capital spending restrictions experienced by our service provider and enterprise customers. Also contributing to the decline in revenues were some incremental one time shipments on new contracts in the first quarter of 2003 in the United States that were not repeated in the second quarter of 2003.
Geographic revenues for the second quarter of 2003 compared to the first quarter of 2003 decreased 5% in the United States, decreased 9% in EMEA, decreased 23% in CALA, increased 27% in Asia Pacific and increased 6% in Canada.
Given the ongoing economic and geopolitical uncertainty, customers continue to spend cautiously. We expect to see continued restrictions on capital spending by customers due to:
Also, we expect that we will continue to experience pricing pressures on sales of certain of our products as a result of increased competition. Further, customer spending is expected to remain cautious while customers assess the impact of the recent Federal Communications Commission, or FCC, decision regarding unbundled network elements, or UNEs. It is difficult to predict the duration of the current industry adjustment, as growth in industry spending is not expected to occur until the economic and financial concerns and the geopolitical uncertainty 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.
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Wireless Networks revenues
The following chart summarizes recent quarterly revenues for Wireless Networks:
Wireless Networks revenues declined 12% in the second quarter of 2003 compared to the second quarter of 2002 primarily due to an ongoing focus by wireless service providers on capital and cash flow management and increased competition for customers by wireless service providers. Many customers continued to heavily scrutinize capital expenditure requirements and postponed or reduced their capital spending.
Code Division Multiple Access, or CDMA, revenues declined in the second quarter of 2003 compared to the second quarter of 2002 primarily due to customers, particularly in the United States, continuing to implement capital spending restrictions driven by their continued focus on capital and cash flow management. CDMA revenues also declined substantially in CALA primarily due to many of our customers completing their initial network deployments in 2002 and, as a result, having sufficient capacity to currently meet additional subscriber demand. CDMA revenues in Asia Pacific increased substantially in the second quarter of 2003 compared to the second quarter of 2002 and partially offset the declines in the United States and CALA. This substantial increase was primarily due to new contracts with certain service providers and other customers expanding their existing networks to meet increased subscriber demand.
Time Division Multiple Access, or TDMA, revenues declined substantially in the second quarter of 2003 compared to the second 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 GSM and CDMA technologies. TDMA revenues continued to be a smaller portion of Wireless Networks revenues in the second quarter of 2003 compared to the second quarter of 2002.
Overall GSM revenues, which includes General Packet Radio Standard, or GPRS, and Enhanced Data Rates for Global Evolution, or EDGE, declined slightly in the second quarter of 2003 compared to the second quarter of 2002 due to a significant decline in the United States and a substantial decline in Asia Pacific. The significant decrease in revenues in the United States was primarily due to a continued decline in the overall growth rate of GSM technology deployments by wireless service providers as a result of sufficient network capacity. In Asia Pacific, the substantial decline in GSM revenues was primarily due to the completion of network deployments by many of our customers as of the beginning of the first quarter of 2003 and as a result, they have sufficient capacity to currently meet additional subscriber demand. GSM revenues increased substantially in EMEA and CALA in the second quarter of 2003 compared to the same period in 2002 and partially offset the declines in the United States and Asia Pacific. The substantial increases were primarily due to new contracts with certain service providers.
Universal Mobile Telecommunications Systems, or UMTS, revenues decreased substantially in the second quarter of 2003 compared to the same period in 2002 as operators continued to scrutinize and delay deployment plans. However, in both the second quarter of 2003 and the second quarter of 2002, UMTS revenues accounted for an insignificant amount of total Wireless Networks revenues.
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From a geographic perspective, the 12% decrease in Wireless Networks revenues in the second quarter of 2003 compared to the same period in 2002 was primarily due to a:
In the first half of 2003, Wireless Networks revenues declined 14% compared to the same period in 2002 primarily due to the ongoing focus by wireless service providers on capital and cash flow management, and increased competition for customers by wireless service providers. As a result, many of our customers continued to heavily scrutinize their capital expenditure requirements and postponed or reduced their capital spending.
CDMA revenues decreased in the first half of 2003 compared to the first half of 2002 primarily due to a substantial decline in the United States and Canada as customers continued to experience capital spending restrictions driven by their continued focus on capital and cash flow management. In Asia Pacific, CDMA revenues increased substantially in the first half of 2003 compared to the same period in 2002 primarily due to new contracts with certain service provider customers and other customers expanding their existing networks to meet increased subscriber demand.
TDMA revenues declined substantially in the first half of 2003 compared to the first half of 2002 primarily due to the continued transition to newer wireless technologies. The substantial decline was primarily due to United States and Canada customers continuing to migrate from the mature TDMA technology to GSM and CDMA technologies. In the first half of 2003, TDMA revenues accounted for less than 10% of total Wireless Networks revenues.
GSM revenues decreased in the first half of 2003 compared to the first half of 2002 due to a substantial decline in Asia Pacific and a significant decline in the United States. The substantial decline in Asia Pacific 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 half of 2003. As of the beginning of the first quarter of 2003, many of our GSM customers in Asia Pacific have completed their current network deployments, and as a result, they have sufficient capacity to currently meet additional subscriber demand. In the United States, the significant decline was primarily due to the completion of some network deployments by certain service providers. In EMEA and CALA, GSM revenues increased substantially in the first half of 2003 primarily due to new contracts with certain service providers.
UMTS revenues were essentially flat in the first half of 2003 compared to the first half of 2002. In the first half of 2003, operators continued to scrutinize and delay deployment plans.
From a geographic perspective, the 14% decrease in Wireless Networks revenues in the first half of 2003 compared to the first half of 2002 was primarily due to a:
Compared to the first quarter of 2003, Wireless Networks revenues increased 4% in the second quarter of 2003, primarily due to a:
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From a geographic perspective, Wireless Networks revenues increased 4% in the second quarter of 2003 compared to the first quarter of 2003 as a result of an 87% increase in revenues in Asia Pacific and a 51% increase in revenues in Canada. These increases were partially offset by a 28% decline in revenues in CALA and an 11% decline in revenues in EMEA. United States revenues were essentially flat in the second quarter of 2003 compared to the first quarter of 2003.
In the first half 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 compared to 2002. In 2003, our 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.
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 overall slower economic conditions. We anticipate a reduction in global capital expenditures for wireless operators in 2003 compared to 2002. 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.
Enterprise Networks revenues
The following chart summarizes recent quarterly revenues for Enterprise Networks:
Enterprise Networks revenues declined 14% in the second quarter of 2003 compared to the second quarter of 2002 and was primarily a result of:
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Revenues from the circuit and packet voice portion of this segment decreased in the second quarter of 2003 compared to the second quarter of 2002 primarily due to a decrease in the United States and a significant decline in EMEA. The decline in the United States was primarily due to a decrease in demand for our traditional circuit switching products as our enterprise customers’ networks had sufficient capacity to meet demand. In EMEA, the significant decline was primarily due to the transition of certain service contracts to our channel partners during the first half of 2003. These declines were partially offset by a substantial increase in revenues associated with our packet voice solutions in the second quarter of 2003 compared to the same period in 2002 as a result of the continuing evolution of traditional circuit switching technology towards converged internet protocol, or IP, telephony solutions.
Revenues in the data networking and security portion of this segment declined substantially in the second quarter of 2003 compared to the second quarter of 2002. This substantial decline was primarily due to a reduction in the number of service contract renewals associated with our legacy routing portfolio, primarily in the United States. Further, revenues associated with certain of our Layer 2 products declined as a result of pricing pressures driven by increased competition for enterprise customers. In Asia Pacific, revenues decreased substantially primarily due to one time incremental shipments of certain products in the second quarter of 2002 which were not repeated in the second quarter of 2003.
From a geographic perspective, the 14% decline in Enterprise Networks revenues in the second quarter of 2003 compared to the second quarter of 2002 was primarily due to a:
Enterprise Networks revenues declined 12% in the first half of 2003 compared to the first half of 2002 and was primarily due to:
Revenues from the circuit and packet voice portion of this segment decreased in the first half of 2003 compared to the first half of 2002. We experienced a substantial reduction in revenues associated with our traditional circuit switching and interactive voice response products primarily due to continuing capital spending restrictions as a result of the economic uncertainty in the industry. These declines were partially offset by a substantial increase in revenues associated with our IP telephony solutions as customers continued to migrate towards converged packet voice solutions.
Revenues associated with the data networking and security portion of this segment decreased significantly in the first half of 2003 compared to the first half of 2002. The significant decrease in revenues was primarily due to a decline in revenues associated with our legacy routing portfolio and a reduction in the number of service contract renewals associated with these products. Also, we experienced a decline in revenue in certain of our other data networking and security products primarily due to pricing pressures driven by increased competition.
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From a geographic perspective, the 12% decline in Enterprise Networks revenues in the first half of 2003 compared to the first half of 2002 was primarily due to a:
Enterprise Networks revenues decreased 11% in the second quarter of 2003 compared to the first quarter of 2003 primarily due to:
From a geographic perspective, the 11% decline in the second quarter of 2003 compared to the first quarter of 2003 was primarily due to a 14% decline in revenues in EMEA, an 8% decline in revenues in the United States, a 21% decline in revenues in Canada and a 32% decline in CALA.
We anticipate that enterprise customers will continue to increase the use of voice over packet technologies in their communications networks. 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. Although we anticipate that demand will continue for our traditional circuit switching products, it is difficult to determine the extent to which the decline in these revenues will continue as a result of the migration to voice over packet technologies. We are also working to complete the realignment of our channel strategy to address the demand of the small and medium sized enterprise customers. Overall, we expect that the continuing industry adjustment will have a negative impact on the level of spending by our enterprise customers.
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Wireline Networks revenues
The following chart summarizes recent quarterly revenues for Wireline Networks:
Wireline Networks revenues declined 16% in the second quarter of 2003 compared to the second quarter of 2002 primarily due to a substantial reduction in capital spending by our service provider customers as a result of the continuing industry adjustment and continued cautious customer spending.
Revenues from the circuit and packet voice portion of this segment decreased significantly in the second quarter of 2003 compared to the second quarter of 2002 primarily due to a substantial decrease in our traditional circuit switching product revenues in the United States and also uncertainty regarding the recent FCC decision regarding UNEs. The decline in our circuit switching product revenues was primarily due to the continuing impact of tightened capital markets and capital spending restrictions experienced by our service provider customers. Revenues from our packet voice solutions increased substantially in the United States and Canada in the second quarter of 2003 compared to the second quarter of 2002 and continued to represent a small, but growing, portion of overall Wireline Networks revenues. The increase was primarily due to new service provider contracts.
Revenues from the data networking and security portion of this segment decreased in the second quarter of 2003 compared to the second quarter of 2002 and was primarily due to substantial declines in Asia Pacific and CALA. In these regions, we experienced a decline in demand for our mature products compounded by the ongoing industry adjustment as service providers continued to reduce their capital expenditures.
From a geographic perspective, the 16% decline in Wireline Networks revenues in the second quarter of 2003 compared to the second quarter of 2002 was primarily due to a:
Wireline Networks revenues declined 17% in the first half of 2003 compared to the first half of 2002. These declines were primarily due to a substantial reduction in capital spending by our service provider customers as a result of the continuing industry adjustment.
Revenues from the circuit and packet voice portion of this segment decreased significantly in the first half of 2003 compared to the first half of 2002 primarily due to a substantial decrease in our traditional circuit switching product revenues and also uncertainty regarding the recent FCC decision with respect to UNEs. The decline in our circuit switching revenues was primarily due to the
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continuing impact of tightened capital markets and, capital spending restrictions experienced by our service provider customers. Revenues from our packet voice solutions increased substantially in the United States and Canada in the first half of 2003 compared to the first half of 2002 primarily due to some incremental one time shipments in the first quarter of 2003 relating to new contracts awarded in the second half of 2002 and the first quarter of 2003.
Revenues from the data networking and security portion of this segment decreased significantly in the first half of 2003 compared to the first half of 2002 primarily due to substantial declines in Asia Pacific and CALA regions and a significant decline in the United States. In these regions, we experienced a decline in demand for our mature products primarily due to the ongoing industry adjustment as service providers continued to reduce their capital expenditures.
From a geographic perspective, the 17% decline in Wireline Networks revenues in the first half of 2003 compared to the first half of 2002 was primarily due to a:
Our Wireline Networks revenues decreased 12% in the second quarter of 2003 compared to the first quarter of 2003 primarily due to:
From a geographic perspective, Wireline Networks revenues decreased 12% in the second quarter of 2003 compared to the first quarter of 2003 primarily as a result of a 26% decrease in the United States partially offset by a 10% increase in EMEA. The remaining geographic regions were essentially flat compared to the first quarter of 2003.
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 half of 2003 compared to the same period in 2002, the timing of when service providers will deploy packet-based technologies on a wider scale is unclear. Further, it is difficult to determine the effect the recent FCC ruling regarding UNEs will have on our business as our customers assess its impact. 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.
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Optical Networks revenues
The following chart summarizes recent quarterly revenues for Optical Networks:
Optical Networks revenues declined 27% in the second quarter of 2003 compared to the second quarter of 2002. This decline was primarily due to the continuing industry adjustment, tightened capital markets and substantial reductions in capital spending by our United States, Canada and EMEA customers in both the long-haul and metro optical portions of this segment. These declines were partially offset by a substantial increase in Asia Pacific due to new contracts with customers in the second quarter of 2003.
Revenues in the long-haul portion of this segment decreased substantially in the second quarter of 2003 compared to the second quarter of 2002. The substantial decline was primarily due to the continuing industry adjustment, tightened capital markets and continued capital spending restrictions in the United States, Canada and EMEA as our service provider customers continued to focus on maximizing return on invested capital by increasing the capacity utilization rates and efficiency of existing networks. Also contributing to the decline in the United States were revenues associated with a one time shipment to a certain enterprise customer in the second quarter of 2002 which was not repeated in the second quarter of 2003. In addition, significant excess inventories continued to exist in this portion of the segment which resulted in ongoing pricing pressures.
In the fourth quarter of 2002, we sold certain optical components assets to Bookham Technology plc, or Bookham. As a result, our second quarter results in 2003 in the long-haul portion of this segment do not reflect revenues generated from these assets. In the second quarter of 2002, revenues generated from the optical components assets sold to Bookham were approximately 5% of the total revenues 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 SEC.
Revenues in the metro optical portion of this segment decreased significantly in the second quarter of 2003 compared to the second quarter of 2002. The significant decrease was primarily due to a substantial decrease in EMEA as a result of the continuing industry adjustment, tightened capital markets and capital spending restrictions by customers.
From a geographic perspective, the 27% decline in Optical Networks revenues in the second quarter of 2003 compared to the second quarter of 2002 was primarily due to a:
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Optical Networks revenues declined 30% in the first half of 2003 compared to the first half of 2002. These declines were primarily the result of the continuing industry adjustment, tightened capital markets and substantial reductions in capital spending by our United States, Canada and EMEA customers in the long-haul portion of this segment.
Revenues in the long-haul portion of this segment declined substantially in the first half of 2003 compared to the first half of 2002. The substantial decline was primarily due to the continuing industry adjustment, tightened capital markets and continued capital spending restrictions in the United States, Canada 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.
As mentioned above, our long-haul revenues in the first half of 2003 do not reflect revenues generated from the optical component assets sold to Bookham. In the first half of 2002, revenues associated with these assets were approximately 5% of the total Optical Networks revenues of $812.
Revenues in the metro optical portion of this segment decreased significantly in the first half of 2003 compared to the first half of 2002. The significant decrease was primarily due to a substantial decrease in revenues in EMEA and the United States and was partially offset by a substantial increase in revenues in Asia Pacific. The declines in EMEA and the United States were primarily the result of the continuing industry adjustment, tightened capital markets and customer spending restrictions. The substantial increase in revenues in Asia Pacific was primarily due to new customer contracts in 2003 for expansions of existing networks to meet increased customer demand.
From a geographic perspective, the 30% decline in Optical Networks revenues in the first half of 2003 compared to the first half of 2002 was primarily due to a:
Optical Networks revenues increased 10% in the second quarter of 2003 compared to the first quarter of 2003 primarily due to increased customer spending in the United States on both our long-haul and metro optical products. The increased spending in the United States was mainly due to customers expanding existing networks and the resolution of contractual issues with certain customers in the first quarter of 2003. The substantial increase in revenues in the United States was partially offset by a substantial decline in revenues in EMEA which was mainly due to some incremental one time shipments of products in the first quarter of 2003 which were not repeated in the second quarter of 2003.
From a geographic perspective, Optical Networks revenues increased 10% in the second quarter of 2003 compared to the first quarter of 2003 primarily as a result of a 77% increase in revenues in the United States partially offset by a 26% decrease in revenues in EMEA. The remaining geographic regions were essentially flat.
On August 10, 2003, we essentially finalized the realignment of Optical Networks with the sale of certain assets of our high speed module business. We do not expect that the sale of this business will have a material impact on our business, results of operations and financial condition. Going forward, our efforts will focus on providing next generation optical networking systems, including the evolution of next generation SONET/SDH systems, metro Dense Wavelength Division Multiplexing, or
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metro DWDM, systems and optical long-haul line and terminal solutions. Also, we will continue to invest in core technologies, such as efficient service adaptation, aggregation, switching and management that will enable our customers to deploy optical networking services which we believe will lead the networking transformation towards packet-based networks.
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, revenues 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, interconnectivity and bandwidth as it is required in the short term. Further, we believe that building out networks for increased bandwidth will remain long term projects.
In the metro optical portion of this segment, we expect to see an increase in demand for 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, it is difficult to predict when a meaningful recovery in the optical long-haul market will occur. 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.
Gross profit and gross margin
Gross margin improved 9.2 percentage points in the second quarter of 2003 compared to the second quarter of 2002 primarily due to:
Gross margin also improved 13.1 percentage points in the first half of 2003 compared to the first half of 2002 primarily due to:
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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 8 percentage points in the second quarter of 2003 compared to the second quarter of 2002. The improvement was primarily due to changes in product mix and ongoing product cost improvements.
Wireless Networks gross margin improved by approximately 9 percentage points in the first half of 2003 compared to the first half of 2002. The improvement was primarily due to changes in product mix and ongoing product cost improvements.
Enterprise Networks gross margin improved by approximately 3 percentage points in the second quarter of 2003 compared to the second quarter of 2002. The improvement in gross margin was primarily due to:
Enterprise Networks gross margin improved by approximately 6 percentage points in the first half of 2003 compared to the same period in 2002. The improvement in gross margin was primarily due to:
Wireline Networks gross margin increased by approximately 8 percentage points in the second quarter of 2003 compared to the second quarter of 2002. The increase in gross margin was primarily due to:
Wireline Networks gross margin increased by approximately 8 percentage points in the first half of 2003 compared to the same period in 2002. The increase in gross margin was primarily due to:
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Optical Networks gross margin improved by approximately 31 percentage points in the second quarter of 2003 compared to the second quarter of 2002. The improvement in gross margin was primarily due to:
Optical Networks gross margin improved by approximately 43 percentage points in the first half 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 $351 in the second quarter of 2003 compared to the second quarter of 2002 primarily due to:
In the first half of 2003, SG&A expense declined $608 compared to the first half of 2002. These declines were primarily due to:
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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. For the year 2003, we expect that our annual SG&A expense will continue to decline compared to 2002 although not to the same extent as was experienced in 2002 compared to 2001.
Wireless Networks SG&A expense decreased substantially in both the second quarter of 2003 compared to the second quarter of 2002 and the first half of 2003 compared to the first half of 2002. These declines were primarily due to:
Enterprise Networks SG&A expense decreased significantly in both the second quarter of 2003 compared to the second quarter of 2002 and the first half of 2003 compared to the same period in 2002. These decreases were primarily due to:
Wireline Networks SG&A expense decreased substantially in both the second quarter of 2003 compared to the second quarter of 2002 and the first half of 2003 compared to the same period in 2002. These decreases were primarily due to:
Optical Networks SG&A expense decreased substantially in both the second quarter of 2003 compared to the second quarter of 2002 and the first half of 2003 compared to the same period in 2002. These reductions were primarily due to:
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As a result of the gross margin and SG&A expense changes discussed above, our consolidated contribution margin improved by $409 in the second quarter of 2003 compared to the second quarter of 2002 and by $937 in the first half of 2003 compared to the first half of 2002. All of our four reportable segments contributed positive contribution margin in the second quarter and first half of 2003.
Research and development, or R&D, expense represents our planned investment in our next generation core products across all segments. R&D expense decreased $100 in the second quarter of 2003 compared to the second quarter of 2002. The decline was primarily due to workforce reductions and focused investment decisions to drive market leadership across our product portfolios.
R&D expense also decreased $206 in the first half of 2003 compared to the first half of 2002 primarily due to our workforce reductions and focused investments to drive market leadership across our product portfolios. The decline was partially offset by an accrual in the first quarter of 2003 for the employee return to profitability bonus plan for which no similar accrual was made in the first half of 2002.
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:
For the year 2003, we expect that our annual R&D expense will continue to decline compared to 2002 although not to the same extent as was experienced in 2002 compared to 2001.
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The amortization of acquired technology in the first half of 2003 and the same period in 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 the third quarter of 2003 and was $33 on June 30, 2003 and $98 on December 31, 2002.
For acquisitions completed subsequent to July 1, 2000, we were required to allocate a portion of the purchase price to deferred compensation related to unvested stock 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 stock option awards. Deferred stock option compensation was $17 in the second quarter of 2003 compared to $21 in the second quarter of 2002 and was primarily due to the completion of the deferred compensation amortization associated with certain employees’ vesting periods. Deferred stock option compensation was $32 in the first half of 2003 compared to $46 in the first half of 2002. This decline was primarily due to the completion of the deferred compensation amortization associated with certain employees’ vesting periods and 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 decline slightly compared to the expense recorded in the second quarter of 2003.
In the second quarter of 2003, we recorded special charges of $5 related to our continued restructuring work plan. Included in this charge was a reduction of $33 related to revisions to prior accruals. Workforce reduction charges of $21 related to the cost of severance and benefits across all segments associated with approximately 300 employees notified of termination during the second quarter of 2003. Net revisions of $12 to reduce prior accruals primarily related to termination benefits where actual costs were lower than our original estimates across all segments. Contract settlement and lease costs were $14 and related to leased facilities and furniture that were no longer being used across all segments. Net revisions of $3 increased prior accruals and related to changes in estimates associated with the cost of vacating previously identified properties and changes in sublease revenue assumptions which extended across all segments. Also, we recorded a charge of $3 related to current period write downs for various leasehold improvements and excess equipment. Net revisions of $24 to reduce prior accruals related to adjustments in our original plans or estimates for the closure of certain facilities.
In the first half of 2003, we recorded special charges of $139 related to our continued restructuring work plan. Included in this charge was a reduction of $14 related to revisions to prior accruals. Workforce reduction charges of $92 related to the cost of severance and benefits associated with approximately 1,100 employees notified of termination during the first half of 2003 which extended across all segments. Net revisions of $22 to reduce prior accruals primarily related to termination benefits where actual costs were lower than our original estimates across all segments. Contract settlement and lease costs were $37 and related to newly identified leased facilities and furniture that we determined were no longer being used across all segments. Net revisions of $58 increased prior accruals and related to changes in estimates associated with the cost of vacating previously identified properties and changes in sublease revenues which extended across all segments. Also, we recorded charges of $24 related to current period write downs for various leasehold improvements and excess Optical Networks equipment. Net revisions of $50 to reduce prior accruals related to adjustments in our original plans or estimates for the closure of certain facilities.
In the second quarter of 2002, we recorded special charges of $403 related to our restructuring work plan. Workforce reduction charges of $117 related to the cost of severance and benefits associated with approximately 1,900 employees notified of termination which extended across all segments. Contract settlement and lease costs included negotiated settlements of approximately $1 to either cancel contracts or renegotiate existing contracts across all of our segments. We recorded approximately $270 in plant and equipment write downs within Optical Networks. Also in the second quarter of 2002, we recorded $15 related to the write down of certain acquired technology in Optical Networks due to our reassessment of market conditions.
In the first half of 2002, we recorded special charges of $890 related to our restructuring work plan. Workforce reduction charges of $444 were related to the cost of severance and benefits associated with the approximately 6,300 employees notified of termination which extended across all segments. Contract settlement and lease costs included negotiated settlements of approximately $64 to either cancel contracts or renegotiate existing contracts across all of our segments. Also, we recorded approximately $355 in plant and equipment write downs within global operations, a function that supports all of our segments, and within Optical Networks. Also in the first half of 2002, we recorded $27 related to the write downs of acquired technology in Optical Networks due to our reassessment of market conditions.
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Currently, we expect that approximately $30 to $40 of special charges related to our restructuring work plan will be incurred in the second half 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 half of 2003, other income — net was $54, which primarily included:
Interest expense
Interest expense decreased $18 in the second quarter of 2003 compared to the second quarter of 2002 and declined $36 in the first half of 2003 compared to the first half of 2002. These declines were primarily due to a reduction in the outstanding balances of our notes payable and long-term debt.
In the third quarter of 2003, we expect that our quarterly interest expense will remain at a level similar to that of the second quarter of 2003.
Income tax benefit
In the first half of 2003, we recorded a tax benefit on the pre-tax loss of $107 from continuing operations before minority interests and equity earnings in net loss of associated companies. This tax benefit resulted from the tax expense on income generated from discontinued operations and a tax refund for a previously unrecognized loss carryback. This tax benefit was partially offset by various non-income related taxes.
We will continue to record a full valuation allowance on the tax benefit of losses generated from continuing operations to the extent that such benefits exceed the tax effect of income generated from similar transactions discussed above. These valuation allowances are in accordance with 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. Our valuation allowances are primarily attributed to continued uncertainty in the industry. 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. For additional information, see “Tax asset valuation”.
Other
In the first quarter of 2003, our SG&A, R&D and Other income — net included approximately $80 of favorable impacts ($50 in other income (expense) — net, $25 in SG&A expense and $5 in R&D expense) associated with 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. During the first quarter of 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, 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.
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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 $683 and $1,388 in the second quarter and first half of 2003, respectively, compared to the same periods in 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 originally 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 15 of the accompanying unaudited consolidated financial statements.
Application of critical accounting policies
Our unaudited consolidated financial statements are based on the selection and application of accounting policies, generally accepted in the United States, which require us to make significant estimates and assumptions. We believe that the following accounting policies may involve a higher degree of judgment and complexity in their application and represent our critical accounting policies. The application of these policies requires us to make subjective and objective judgments. These accounting policies include estimates and assumptions associated with revenue recognition, provisions for receivables, provisions for inventory, tax asset valuation, goodwill valuation, pension and post retirement benefits and other contingencies.
There have been no changes to our critical accounting policies since December 31, 2002, other than the material changes in the recorded balances and other updates noted below. For further information relating to our critical accounting policies, see our Annual Report on Form 10-K for the year ended December 31, 2002 filed with the SEC.
Revenue recognition
In November 2002, the Financial Accounting Standards Board, or FASB, Emerging Issues Task Force reached a consensus on Issue 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables”. We will be applying this guidance prospectively for all revenue arrangements entered into after June 30, 2003 and expect that the adoption of this pronouncement will not have a material impact on our business, results of operations and financial condition. For additional information, see “Significant accounting policies” in note 1(d) of the accompanying unaudited consolidated financial statements.
Provisions for receivables
We recorded receivable (recoveries) provisions, relating to continuing operations, of $(42) in the first half of 2003 compared to $119 in the first half of 2002. The receivable recoveries in the first half of 2003 primarily related to net customer financing bad debt recoveries of $51 primarily as a result of favorable settlements related to our sale or restructuring of various customer financing related receivables and adjustments to other existing provisions. The following table summarizes our accounts receivable and long-term receivable balances and related reserves of our continuing operations, as at:
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Throughout 2002, we recorded significant provisions related to receivables from our continuing operations. In the first half of 2003, we recorded net recoveries primarily due to our subsequent collections of certain customer financing receivables for amounts exceeding our original estimates of net recovery. Given the current market conditions and creditworthiness of some of our customers, it is difficult to determine the extent to which this trend will continue in the future.
Provisions for inventory
We recorded inventory provisions and other provisions related to our contract manufacturers and suppliers, relating to continuing operations, of $110 in the first half of 2003 compared to $349 in the first half of 2002. The following table summarizes our inventory balances and related reserves of our continuing operations, as at:
During the remainder of 2003, we believe that we will continue to see restrictions on capital expenditures by our customers. As a result, we will continue to closely monitor our inventory reserves to ensure that our provisions appropriately reflect the current market conditions. However, the inventory provisions we have recorded in the past may not be reflective of those in future quarters.
Tax asset valuation
We currently have deferred tax assets resulting from net operating loss carryforwards, tax credit carryforwards and deductible temporary differences, all of which will reduce taxable income in the future. We assess the realization of these deferred tax assets quarterly to determine whether an income tax valuation allowance is required. Based on available evidence, both positive and negative, we determine whether it is more likely than not that all or a portion of the remaining net deferred tax assets will be realized. In evaluating the positive and negative evidence, the weight given to each type of evidence must be proportionate to the extent to which it can be objectively verified.
If market conditions deteriorate further or future results of operations are less than expected, future assessments may result in a determination 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.
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Liquidity and capital resources
Cash flows
The following table summarizes our cash flows by activity and cash on hand, as at:
As of June 30, 2003, our primary source of liquidity was our current cash and cash equivalents, or cash. At June 30, 2003, we had cash of $4,190 excluding $115 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 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 and support facility 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 $209 due to a net loss from continuing operations of $150, less an adjustment of $343 for non-cash related items, plus a net cash outflow of $402 from operating assets and liabilities. We generated cash inflows of $186 from accounts receivables due to increased cash collections. Cash inflows of $117 from inventories were primarily due to product shipments exceeding additions to inventories during the first half of 2003. Net cash inflows from income taxes were $5. As a result of previously incurred tax losses, we do not expect that we will have to make significant cash income tax payments for the foreseeable future. The net cash outflows of $710 from the remaining operating assets and liabilities were primarily due to:
Cash flows from investing activities were $301 and were primarily due to a net decrease of $186 in long-term receivables primarily due to cash inflows of outstanding customer financing amounts associated with two customers, a decrease of $144 in restricted cash and cash equivalents held as cash collateral for certain bid, performance related and other bonds, proceeds of $21 from the sale of plant and equipment and proceeds of $8 from the sale of certain investments and businesses. These amounts were partially offset by $56 in plant and equipment expenditures. For the year 2003, we now expect that our plant and equipment purchases will decline substantially from the $335 in purchases we made in 2002.
Cash flows used in financing activities were $114 and were primarily due to $94 used to reduce our long-term debt and a reduction of our notes payable by a net of $18.
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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.
We expect to incur approximately $300 to $400 in restructuring work plan related cash outflows during the remainder of 2003. For the entire year 2003, we currently expect to incur approximately $650 to $750 in restructuring work plan related cash outflows.
The remaining balance sheet reserve of $332 relating to workforce reduction initiatives is expected to be substantially drawn down by mid-2004. The remaining balance sheet reserve of $655 related to contract settlement and lease costs is expected to be substantially drawn down by the end of 2010.
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 SEC.
In the second quarter of 2003, we repaid $51 related to an outstanding loan. In the first quarter of 2003, we purchased $39 of our 6.125% Notes due February 15, 2006. Also, we plan to repay the remaining $164 of our 6.00% Notes due September 1, 2003 in the third quarter of 2003.
We enter into bid, performance related and other bonds in connection with various contracts. Bid bonds generally have a term of 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.
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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 obligations under bid and performance related bonds and may reduce the requirement to provide cash collateral to support these obligations. On July 10, 2003, Nortel Networks Limited and EDC entered into an amendment to the support facility which extended the termination date to December 31, 2005 from June 30, 2004. All other material terms of the support facility remained unchanged. This facility provides for up to $750 in support, of which $300 is committed support for these bonds. In addition, any bid or performance related bonds with terms that extend beyond December 31, 2005 are currently not eligible for the support provided by this facility. 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 support facility” 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 for the year ended December 31, 2002 filed with the SEC.
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.
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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 second quarter of 2003, we entered into certain agreements to either sell or restructure various customer financing and related receivables. As a result of these transactions, we received cash consideration of approximately $199 to settle outstanding receivables of approximately $503 with a carrying value of approximately $111. Additional non-cash consideration received under one such restructuring agreement included a five year equipment and services supply agreement and the mutual release of all other claims between the parties.
Also in the second quarter of 2003, we recorded net customer financing bad debt recoveries of $51 primarily as a result of the favorable settlements described above and adjustments to other existing provisions.
In the first quarter of 2003, our gross customer financing receivables 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 half of 2003, we reduced undrawn commitments by $134 reflecting commitment expiration, cancellations and changing customer business plans. As of June 30, 2003, approximately $100 of the $667 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 is focused on the strategic use of our customer financing capacity and on reducing the amount of our existing and future customer financing exposure.
Subsequent to June 30, 2003, we renegotiated an agreement with a certain customer and reduced our undrawn commitments by approximately $509, leaving approximately $158 in aggregate undrawn commitments.
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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.
As was previously discussed in our “Recent developments”, on October 19, 2002 we entered into a number of put option and call option agreements as well as a share exchange agreement with EADS, our partner in three European joint ventures. During July 2003, the options and share exchange were exercised which will require us to deliver, subject to final regulatory approval, net consideration of approximately $130 consisting of approximately $48 in cash and an in-kind component of approximately $82 representing the return of a loan note currently owed to us by an affiliate of EADS. The net consideration is payable in euro and is subject to fluctuations between the euro and United States dollar. These transactions are expected to close prior to the end of the third quarter of 2003 and are not expected to have a material impact on our business, results of operations and financial condition.
As of June 30, 2003, accruals relating to our discontinued access solutions operations totaled $84 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 half of 2003, we generated cash of approximately $273 on the disposition of various assets from the access solutions operations.
For additional information related to our discontinued operations, see “Discontinued operations” in note 15 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 June 30, 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 June 30, 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
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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, following an amendment on July 10, 2003, expires on December 31, 2005, provides for up to $750 in support including $300 of committed revolving support for performance bonds or similar instruments of which $123 was utilized as at June 30, 2003. The remainder is uncommitted support for performance bonds, receivables sales and/or securitizations of which $65 was utilized as at June 30, 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 Investor Services, Inc., or Moody’s, has not been downgraded to less than B3 and 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 the $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 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 its rating by Standard & Poor’s returns to BBB (with a stable outlook), the security and guarantees will be released in full in respect of the banks, EDC, the public debtholders and any other party secured under the security agreements at that time. If both the $750 April 2000 five year credit facilities and the support facility with EDC are terminated, or expire, the security and guarantees will also be released in full in respect of the banks, EDC, the public debtholders and any other party secured under the security agreements at that time. Nortel Networks Limited may provide EDC with cash collateral in an amount equal to the total amount of its outstanding obligations and undrawn commitments and expenses under this facility (or any other alternative collateral acceptable to EDC) 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” and “Supplemental consolidating financial information” in notes 7 and 18, respectively, of the accompanying unaudited consolidated financial statements. For additional financial information related to those subsidiaries providing guarantees, see “Supplemental consolidating financial information” in note 18 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 SEC 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 include common shares, preferred shares, debt securities, warrants to purchase equity or debt securities, share purchase contracts and share purchase or equity units (subject
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to certain approvals). As of June 30, 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 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 have conducted certain receivable sales and lease financing transactions through special purpose entities.
Our receivable sales transactions are generally conducted either directly with financial institutions or with multi-seller conduits. Under the criteria set out in FASB Interpretation No. 46, “Consolidation of Variable Interest Entities”, or FIN 46, 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 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 June 30, 2003 were each approximately $181 and represented the collateral and maximum exposure to loss, respectively, as a result of our involvement with these entities.
For additional information, see “Significant accounting policies” in note 1(c) of the accompanying unaudited consolidated financial statements.
Contractual obligations
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 for the year ended December 31, 2002 filed with the SEC. See “Contractual cash obligations” for additional information.
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Contingent liabilities and commitments
See “Customer financing” for additional information on our outstanding customer financing 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 SEC.
See “Joint ventures/minority interests” for additional information relating to the acquisition of the minority interest in two of our joint ventures and the disposition of our equity interest in a 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. For additional information, see “Guarantees” in note 9 of the accompanying unaudited consolidated financial statements.
Market risk
Market risk represents the risk of loss that may impact our consolidated financial statements through adverse changes in financial market prices and rates. Our market risk exposure results primarily from fluctuations in interest rates and foreign exchange rates. To manage the risk from these fluctuations, we enter into various derivative-hedging transactions that we have authorized under our policies and procedures. We maintain risk management control systems to monitor market risks and counter-party risks. These systems rely on analytical techniques including both sensitivity analysis and value-at-risk estimations. We do not hold or issue financial instruments for trading purposes.
For additional information relating to our derivative financial instruments, you should refer to “Significant accounting policies” in note 2(s) and “Financial instruments and hedging activities” in note 11 of the consolidated financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2002 filed with the SEC.
We manage foreign exchange exposures using forward and option contracts to hedge firm sale and purchase commitments. Our most significant foreign exchange exposures are in the Canadian dollar, the United Kingdom pound and the euro. We enter into United States to Canadian dollar forward and option contracts intended to hedge the United States to Canadian dollar exposure on future revenues and expenditure streams. In accordance with SFAS 133, “Accounting for Derivative Instruments and Hedging Activities”, we recognize the gains and losses on the effective portion of these contracts in income when the hedged transaction occurs. Any ineffective portion of these contracts is recognized in income immediately.
We expect to continue to expand our business globally and, as such, expect that an increasing proportion of our business will be denominated in currencies other than United States dollars. As a result, fluctuations in foreign currencies may have a
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material impact on our business, results of operations and financial condition. We try to minimize the impact of such currency fluctuations through our ongoing commercial practices and by attempting to hedge our exposures to major currencies. In attempting to manage this foreign exchange risk, we identify operations and transactions that may have exposure based upon the excess or deficiency of foreign currency receipts over foreign currency expenditures. Given our exposure to international markets, we regularly monitor all of our foreign currency exposures. We cannot predict whether we will incur foreign exchange losses in the future. However, if significant foreign exchange losses are experienced, they could have a material adverse effect on our business, results of operations and financial condition.
We manage interest rate exposures using a diversified portfolio of fixed and floating rate instruments denominated in several major currencies. We manage these exposures using interest rate swaps which reduce interest expense fluctuations. We record net settlements on these swap instruments as adjustments to interest expense.
For additional information on our exposure to foreign currency and interest rate risk, you should refer to our “Market Risk” discussion in our Annual Report on Form 10-K for the year ended December 31, 2002 filed with the SEC.
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.
For additional information related to our legal proceedings, see “Contingencies” in note 16 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 sustained 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 sustained 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/or sustained profitability.
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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.
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:
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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:
Reduced capital spending and negative economic conditions in our industry 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:
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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 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. 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
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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:
Our $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.
Our $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 for 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 December 31, 2005, 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.
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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 existing 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 bid, performance related and other 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.
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.
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The outcome of our comprehensive review and analysis of identifiable categories of assets and liabilities may impact prior periods.
The outcome of the comprehensive review and analysis of identifiable categories of assets and liabilities as more fully described under “Recent developments” above (the “comprehensive review”) may result in the elimination of certain assets and liabilities (including accruals and provisions). As part of the comprehensive review, we are currently assessing the support for liabilities which were initially recorded, along with corresponding charges to income, in prior periods. These liabilities represented less than 2% of our total liabilities as at June 30, 2003. The outcome of the comprehensive review is currently not expected to have a negative impact on our net assets. Reported results in one or more prior periods may be affected, potentially resulting in the non-material reduction of prior period losses. No amounts relating to the elimination of any such assets and liabilities have been included in our results for the second quarter of 2003. The comprehensive review is ongoing, and we expect to substantially conclude it in the third quarter of 2003.
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 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.
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:
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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 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
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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.
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.
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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, for the protection of which we rely on patent, copyright, trademark and trade secret laws. 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.
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.
Investment decisions of our customers could be affected by regulation of the Internet in any country where we operate. We could also be materially and adversely affected by an increase in competition among equipment suppliers or by reduced capital spending by our customers, as a result of a change in the regulation of the industry. On February 20, 2003, the United States Federal Communications Commission, or the FCC, announced a decision in its triennial review proceeding of the agency’s rules regarding unbundled network elements, or UNEs. The text of the FCC’s order including an explanation of the reasons for the decision has not yet been released. Although the decision may affect the decisions of our United States based service
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provider customers regarding investment in telecommunications infrastructure, the extent of the 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 our failure to meet the minimum listing requirements of the New York Stock Exchange which include a minimum share price condition.
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 affect 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 will continue 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
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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 remaining purchase contracts will be between approximately 373 million and 448 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 July 31, 2003, 22,090 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 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, 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.
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Certain customers have been experiencing financial difficulties and have failed to meet their financial obligations. As a result, we have incurred charges for increased provisions 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 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.
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Recent accounting pronouncements
For a discussion of recent pronouncements, see “Significant accounting policies” in note 1 of the accompanying unaudited consolidated financial statements.
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ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
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 “Market Risk” in Management’s Discussion and Analysis of Financial Condition and Results of Operations and in our Annual Report on Form 10-K for the year ended December 31, 2002 filed with the SEC on March 10, 2003.
ITEM 4. Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures
As at the end of the period covered by this report, Nortel Networks carried out an evaluation under the supervision and with the participation of management, including the President and Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of Nortel Networks disclosure controls and procedures. 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, in all material respects, to ensure that information required to be disclosed in the reports Nortel Networks files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required, except to the extent noted in (b) below.
(b) Changes in Internal Control
In light of a period of unprecedented industry adjustment and subsequent restructuring actions, including workforce reductions and asset write-downs, in the second quarter of 2003 Nortel Networks initiated a comprehensive review and analysis of identifiable categories of its assets and liabilities (the “comprehensive review”). The amounts under review were recorded when Nortel Networks balance sheet and income statement were much larger. Specifically, what would have been relatively minor amounts in prior periods may be considered to be material to current periods. The comprehensive review is in addition to reviews normally performed by Nortel Networks in connection with the recording of current period financial results.
The outcome of the comprehensive review may result in the elimination of certain assets and liabilities (including accruals and provisions). As part of the comprehensive review, Nortel Networks is currently assessing the support for certain of its liabilities which were initially recorded, along with corresponding charges to income, in prior periods. These liabilities represented less than 2% of Nortel Networks total liabilities as at June 30, 2003. The outcome of the comprehensive review is currently not expected to have a negative impact on Nortel Networks net assets. Reported results in one or more prior periods may be affected, potentially resulting in the non-material reduction of prior period losses. No amounts relating to the elimination of any such assets and liabilities have been included in Nortel Networks results for the second quarter of 2003. The comprehensive review is ongoing, and we expect to substantially conclude it in the third quarter of 2003.
In connection with the assessment of the liabilities (including accruals and provisions) identified above, Nortel Networks has noted certain deficiencies in documentary support. Nortel Networks continues to address this matter as part of the comprehensive review.
As part of the required communications by Deloitte & Touche LLP (“D&T”), Nortel Networks independent auditors, to the Nortel Networks Audit Committee, D&T informed the Audit Committee that this deficiency constituted a “reportable condition”, but not a “material weakness”, as those terms are defined under standards established by the American Institute of Certified Public Accountants. D&T noted that its assessment was based on such information as was available at the date of its communication to the Audit Committee and the materiality of the underlying amounts in the context of 2003 reported results. Further to discussions between and among Nortel Networks management, the Audit Committee and D&T, D&T's assessment is being taken into account in connection with the ongoing comprehensive review. While Nortel Networks is currently assessing whether any changes to Nortel Networks internal control over financial reporting are necessary, Nortel Networks expects that any such changes would be minor.
There has been no change in Nortel Networks internal control over financial reporting during the quarter ended June 30, 2003 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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PART II
OTHER INFORMATION
ITEM 1. Legal Proceedings
For a discussion of our material legal proceedings, see “Contingencies” in note 16 of the accompanying unaudited consolidated financial statements.
ITEM 2. Changes in Securities and Use of Proceeds
During the second quarter of 2003, Nortel Networks Corporation issued an aggregate of 61,429 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.
ITEM 4. Submissions of Matters to a Vote of Security Holders
The annual and special meeting of shareholders of Nortel Networks Corporation (the “Meeting”) was held on April 24, 2003.
The shareholders elected each of the ten nominees for directors as listed in the Nortel Networks Corporation’s proxy circular and proxy statement dated March 10, 2003 as follows:
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The shareholders ratified the appointment of Deloitte & Touche LLP as the independent auditors of Nortel Networks Corporation. The vote was by way of a show of hands and a ballot was not taken. The proxies received by Nortel Networks Corporation for the Meeting were as follows:
The shareholders approved the special resolution to consolidate the issued and outstanding common shares of Nortel Networks Corporation as follows:
The shareholders approved the reconfirmation and amendment to the Shareholder Rights Plan of Nortel Networks Corporation as follows:
The shareholders rejected the shareholder proposal that stock options shall be phased out as follows:
The shareholders rejected the shareholder proposal that executive compensation policies shall include penalties as well as incentives as follows:
The shareholders rejected the shareholder proposal to change the threshold for nomination of directors as follows:
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ITEM 6. Exhibits and Reports on Form 8-K
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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.
NORTEL NETWORKS CORPORATION(Registrant)
Date: August 11, 2003
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