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Executives

Janet Craig – Vice President, Investor Relations

Mike Zafirovski – Chief Executive Officer

Pavi Binning – Chief Financial Officer

Analysts

Vivek Arya - Merrill Lynch

Nikos Theodosopoulos - UBS

Jeff Kvaal – Barclays Capital

Ehud Gelblum - JP Morgan

Ken Muth - Robert Baird

Gus Papageorgiou - Scotia Capital

Scott Coleman -Morgan Stanley

Michael Urlacher - GMP Securities

Paul Silverstein - Credit Suisse

Sundar Varadarajan – Deutsche Bank

Todd Copeland – CBIC World Markets

Mark Sue - RBC Capital Markets

Richard Windsor - Nomura

Richard Kramer – Arete Research

Nortel Networks Corporation (NT) Q3 2008 Earnings Call November 10, 2008 8:30 AM ET

Operator

Welcome to the 2008 third quarter financial results conference call. Our host for today's call will be Janet Craig. (Operator Instructions)

And now, I would like to turn the conference over to Janet Craig.

Janet Craig

Thank you and good morning everyone. Welcome to Nortel's third quarter conference call. Before I hand the call over to Mike and Pavi, I just wanted to mention a few things. As you are aware, we do ask callers to keep to one question and I would really appreciate if you would do that.

Please note that certain comments made in today's call may be characterized as forward-looking statements under the United States Private Securities Litigation Reform Act of 1995 and under Canadian Securities Legislation. Certain material factors and assumptions were applied in making these statements. There are a number of other factors that could cause actual results to materially differ from those expressed in any forward-looking statements made by or on behalf of Nortel.

Additional information concerning these factors and assumptions is contained in Nortel's filings with the United States Securities and Exchange Commission and the Canadian Securities Regulators, including Nortel's Annual Report on Form 10-K. Our 10-Q is expected to be filed later today.

Also please note the non-GAAP measures comments.

And now, I will turn the call over to Mike Zafirovski.

Mike Zafirovski

Thank you for joining our conference call this morning. When we last spoke on September 17, 2008, we indicated that it was clear that the business environment in which Nortel operates was seeing a sustained and expanding economic downturn and that there was a pressure on both the carrier capex spending as well as that certain enterprise customers were deferring new IT and optical investments.

We knew and communicated at that time that given our financial results, given our current balance sheet and the tough economic environment, that status quo was not an option for Nortel.

We announced that we were undertaking a comprehensive review of our business and that we were in the process of planning further restructuring to significantly reduce our cost base to achieve a more competitive business structure.

What we have seen in the almost two months since our September 17 announcement is the actual deterioration of the business environment in which we operate. I don’t see a need to reiterate the worsening conditions which you have heard from many other companies or the extreme volatility in financial foreign exchange and credit markets globally.

Like the surge of a sense of urgency which we had in mid-September has only accelerated these last few months. Today, along with our announcing of financial results and expectations, we are going to outline where focus and efforts are in reshaping Nortel and also the decisive action we are taking in the environment of decreased visibility and also decreased customer response.

Before getting in the details of our action plan, I will quickly review Q3 results and our Q4 expectations. As you may remember, on September 17 we provided a preliminary review of our third quarter results. We also revised the full year guidance.

Our numbers for Q3 are in line with the preliminary view. In fact we are actually a bit ahead of these numbers based on staff reduction and operating expenses. These results are disappointing on their own, but against the backdrop of the current environment, not surprising.

Revenues were down 14% year-on-year. The significant decline was in carrier and that was down 24%. We had declines in MEN services, enterprise adjusted for different revenues, was essentially flat. We did report a positive operating margin of almost 4% for the quarter and [inaudible] based on tight expensive payments.

The Q3 opex was lower by over $100.0 million, both sequential and over the previous year. Pavi is going to provide more details this, including how to think about our current opex running rates as you try to project for the future. But in short, the actions which we have taken over the last couple of years, and accelerated over the last six months, are showing up in the opex line.

Orders of $2.0 billion remain under pressure given the weak macro environment, with carrier making up the majority of the decline on a year-over-year basis. Both MEN and global services grew on a year-over-year basis with MEN book to bill at 1.1.

Our cash and cash equivalents, which includes a reclassification of some our cash to short-term investments, was $2.6 billion.

While the economic environment has continued to deteriorate, based on what we see today we believe that we will come in at around the low end of our guidance for the year. On the revenue side this is principally driven with the stronger U.S. dollar.

But it will be a decline of full year revenues of around 4% on a year-over-year basis and a corresponding operating margin improvement for the year of about 125 basis points over 2007. And just to help you do the math, this would imply Q4 revenues of approximately $2.7 billion and a corresponding operating margin of approximately 9%.

Given the environment we currently operate in, it is important to note some of the progress which we have made in the last three years in the operating statistics, while at the same time we have made some pretty significant investments, trying to change Nortel to become a much more relevant company for future technologies and solutions.

Things like unified communications and enterprise, 4G wireless investments, the investments in 40 and 100 gig technologies, carrier evaluated services, multimedia, and other solutions.

You will note the operating margin improvements in the second half of 2006 and 2007 and we are fortunate to continue to work on that very important metric.

On the operating cash flow, we did have positive operating cash flow in the second half of 2006 and for 2007 and the first positive cash flows which we have had in many years. As you will note, on 2008 year-to-date operating cash flow is a negative $478.0 million and Pavi will discuss this in more detail in a few minutes. There should be no confusion, improving cash and cash flow is a top priority for the company.

Let me discuss our financial position. We currently have cash and short-term investments of $2.6 billion. We believe we need under normal business conditions about $1.0 billion in cash. This does not include the cash and joint ventures in China and this $1.0 billion plus the cash requirements for China is required to run our business effectively, and Pavi is going to provide much more details and key assumptions here.

Our next debt maturity is not until 2011 and we do not have any specific maintenance covenants on that debt.

Given the current environment, we are making aggressive actions to change and changes to reduce our costs and to preserve cash, including a suspension of the declaration of preferred dividends.

Let me discuss the actions that we are taking. The progress which we have made over the last two years has not been only financial but also the operational foundation as well. We are taking several years of consistent progress and leveraging it to make the necessary changes in this environment.

There is a strong biased reaction, both within the company and with the management team, and today we are announcing some specific actions to reshape Nortel, including reducing cost and to preserve cash.

Our first and new operating structure, we are moving to a vertically integrated business model that allows us to streamline our business and to reduce costs. It will also allow us greater accountability, agility, and effectiveness, and this will result in the departure in early 2009 of several senior executives who had been leading various corporate functions.

It is highlighted in the press release the contributions from these executives have been exceptional, including building capabilities that will last a long time as well as developing people ready for broader responsibilities. I am very appreciative of their efforts and I know that they will continue to provide leadership through the end of the year and I know that they will be very successful and will do well in future endeavors.

We are also announcing a reduction of an additional net 1,300 positions. These positions will be across the organization and result in $140.0 million of savings in 2009. When combined with the previously announced restructuring plans, the total positions eliminated through the end of 2009 is 2,500 and a savings of $260.0 million for the year. Pavi will describe the structuring costs associated with this effort.

We have also been taking additional costs in payment actions and the results in some of these actions are already noted and reflected in Q3 and Q3 results of this year. We are continuing and accelerating these action and some of the examples, for example, the employment freeze has been in place for the last four to five months and this will continue for the foreseeable future, probably for all of 2009.

There will be some exceptions to the freeze in the customer interfacing positions but we think those exceptions will be rather modest and the impact of the employment freeze on the cost line will be above and beyond the restructuring actions announced above, but they will not require a restructuring cost.

Also we are suspending annual salary increases for the remainder of 2008 and all of 2009. In addition, we are focused on taking all unnecessary costs out of the business by significantly reducing discretionary spend, the incomprehensive review of all real estate, and of course, reviewing consultant and professional relationships.

In totality we believe that a combination of the above actions will result in $400.0 million of gross annual savings in 2009. This savings impacts opex to a more significant degree and the cost of goods sold to a lesser degree.

Also to provide some more detail on our new operating structure, but to start it would be helpful to share what our organization has looked like and in essence we have been running a matrix. These are four separate businesses and you are familiar with them, Herian networks, enterprise services, MEN and global services, and we also have four regional go-to-market activities.

In addition, we do have a corporate structure which above and beyond the normal corporate activities of finance, legal, HR, and strategy, has a pretty significant responsibility. For example, for central R&D, the chief marketing global operations, as well as driving global fields.

A lot of the improvements have been accomplished over the last several years in this structure but we do believe it is time for a change.

Our new structure will be simpler, streamlined, and appropriate for a business today. For starters if you are looking at this page you can see significantly fewer functions at the corporate level, more typical activity, finance, legal, HR, and strategy. Starting January 1, 2009, we will have three vertically integrated business and two of those will be serving our service provider customers and there is going to be Carrier Networks, Metro Ethernet, and the enterprise business which will be fully dedicated and focused on that part only as the main indicator enterprise customers.

And the activities within the business which we have known and as global services will be folded into the three new business units and I really believe with the changing customer and market focus on end-to-end solutions, we’re building business structures combining equipment, software solutions and services, it is the right structure for the business. In essence, all three business units will have that.

A tad more detail. The enterprise customers will be served by highly-focused and dedicated business that is going to have complete product and portfolio development responsibilities, all the R&D resources, all marketing and sales and associated functions.

The business will be led by Joel Hackney and is going to include the entire communications solutions portfolio of voice data, unified communications, including the related software, value-added services and solutions.

As the two business they are serving, the service providers will have full responsibility for all product, services, applications, marketing, and the R&D functions. The two business are the Metro Ethernet Networks, led by Philippe Morin, and Carrier Networks, led by Richard Lowe. And obviously big activities underneath that Carrier Networks, the broad wireless portfolio and the carrier value-added services.

We will have a dedicated global sales service organization to support both MEN and Carrier Networks and the global sales activities will be led by Darryl Edwards.

And we really believe that these changes will provide management with a heightened focused in their respective businesses and clearer lines of accountability in this environment and as I said, we will have significantly fewer functions at the corporate level.

Let me also make a few comments on the other significant announcements which were made today, the write-down in deferred tax assets and the write-down in the goodwill account.

As required, we perform periodic reviews of these assets and there were trigger events that required impairments in Q3 as well. Given our current market capitalization and the continued market challenges, we reduced the longer-term growth in income projections. We thought it was very prudent to do that.

We also made more prudent assumptions. For example, we have reduced the number of years which we estimated to recover future tax assets and also using a higher discount rate to value the future income and cash proceeds.

And next, we are taking a Q3 charge against goodwill of $1.1 billion and a charge of $2.1 billion including a valuation allowance against the deferred tax assets. Pavi is going to provide more details, but it is important to know that this is our, of course, non-cash charges and that the gross amounts of deferred taxes, including the $5.8 billion valuation allowance remains available to shield tax on future profits.

Business momentum is very important. While we are reshaping Nortel, we are not losing focus on our customers. We are continuing to see important multi-year customer wins in the key areas of our business, validating the investments which we have made in driving innovation to enable Nortel to be much more relevant in the new environment.

As you can see from the slide we have announced a number of important wins across our Q3. With unified communications we have announced important wins with HSBC, the New York Mets, Vancouver Canucks, Bloomberg, and a number of other companies to really driving content in their product line.

Also, Deloitte chose us as their tele presence global partner in the optical business of 40-gig count is now up to 31 wins with recent announcements with companies like Bell Canada and Southern Cross.

In the carrier space we have solid momentum including very important LTE’s wins including not only in North America but also the announcements, we got T-Mobile in Europe and Asia and just this morning we saw renewed TD spend in China, starting with the significant China Telecomm win, to upgrade portions of their network.

We are very committed to our customers and we are taking the necessary steps to ensure that they continue to benefit to the value and innovation they have come to rely on from Nortel. I am also confident we will be announcing important wins in the coming months in these important areas of focus for us.

Before turning things over to Pavi, let me say that I understand that this is a critical time for Nortel. These aggressive, necessary, and swift actions are focused on allowing Nortel to manage through this tough environment while at the same time positioning ourselves to move forward.

We are balancing several major objectives. We understand that the combinations of reducing our cost structure, increasing the intensity of managing the business for cash, motivating our employees, organizing our business for its effectiveness, while at the same time continuing to meet and exceed customer demand. We are not underestimating the challenges in these combined undertakings; the management team and I are fully committed to them.

Pavi Binning

I am going to focus the first part of my presentation on the third quarter results. I will then cover goodwill, deferred tax assets, cash flow, and liquidity. I will also provide details of our cash requirements for 2009, as well as talk about the impact of restructuring and expense control initiatives.

Starting with the profit and loss statement, we achieved management operating margin in the third quarter of $17.0 million, or 0.7%. As Mike indicated, our revenue and gross margin came in line with our preliminary view announced mid-September.

Our expenses came in lower than expected, with continued focus on cost cutting and some favorability on incentive and sales commission costs. There were some significant items below the line that I will cover in detail later. These items were non-cash goodwill and deferred tax asset write-downs.

Moving on to the next chart, our revenue was impacted by the challenging economic environment across many markets and reduced capex spend by customers. This impacted all of our businesses, and overall, revenue was down 14% year-on-year.

Gross margin came under pressure in the quarter. After several quarters of growth [audio break] of lower volume and product mix, particularly in our carrier business, drove a decline in gross margin to 39.2%.

The next chart shows our progress on SG&A. [audio break] we reduced spending year-on-year with structuring and cost reduction initiatives being important drivers. In the third quarter [audio break] saving programs were initiated, including reductions [audio break] travel and a hiring freeze.

Looking at sales and marketing, we reduced spend primarily in our carrier business. In addition [audio break] Walla favorability relating to annual incentive and sales commission costs of approximately $40.0 million and in decline by $39.0 million in the third quarter. We continue to drive efficiencies and have reduced spending in legacy products while increasing investments in next-generation technologies.

In addition, we also had favorability in R&D from incentive costs of approximately $23.0 million.

My next chart on management operating margin shows a year-over-year decline. This decline reflects our sales performance and unfavorable mix, which was only partially offset by the reduction in SG&A and R&D costs.

In Carrier Networks, market conditions continued to deteriorate due to the global economic slowdown and significant capex cuts by North American operators. As a result, revenue declines across our carrier business by 24%. Year-to-date we are down 2% compared to 2007 and we continue to hold a strong number two position in CDMA and a number one position in carrier Voit and applications.

We continue to make good progress on next generation technologies. For example, the first live air LT handover with T-Mobile.

Moving on to enterprise, excluding the favorable impact of deferred revenue in data last year, our enterprise business was essentially flat in the third quarter. As you know, our strategy is to become the preferred partner in unified communications through leading products, software, and services. We continue to invest in these areas and expand our strategic partnerships with Microsoft, IBM, and Dell.

In MEN the optical business is being impacted by the present economic downturn and lower spending by carriers, primarily in North America. We continue to see good traction in our long haul DWDM segment, driven by 40-gig. We now have 31 customer wins, up from 20 at the end of the second quarter.

Our services business was impacted by the declines in the other segments as our support and plan and deploy business has declined. Our managed services business continue to grow, with strong performance again this quarter and on a year-to-date basis.

We have made some changes to the presentation of the P&L this quarter to make it more reader-friendly, including separating out interest and dividend income from the other income line.

Other income in the third quarter reduced by $116.0 million, primarily due to FX gains in the prior year. We saw reduced interest income due to lower cash levels and interest rates. Similarly, interest expense was lower due to reduced borrowing costs. Tax expense reflects the non-cash write down of our deferred tax assets.

As I mentioned earlier, we took a non-cash charge against goodwill of $1.14 billion. The charge represents a full write down of the goodwill associated with enterprise and MEN. We test goodwill for possible impairment on an annual basis in October of each year. We are also required to test if at any other time circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value.

The review of goodwill in the third quarter was triggered by the decline in our market capitalization following our September 17 update and the challenging market conditions highlighted in the update.

The test for impairment is a two-step process. As a result of this exercise, we wrote down goodwill related to our MEN and enterprise businesses. I would emphasize, this charge has no effect on the company’s cash balance.

Also in the third quarter we took a non-cash charge of approximately $2.1 billion to reduce our net deferred tax assets. The charge increased the valuation allowances against the Canadian tax asset by $1.1 billion, the U.S. tax asset by $816.0 million, and the U.K. tax asset by $150.0 million.

While our gross deferred tax assets as of the third quarter was $6.8 billion, the increase in the valuation allowance resulted in a net deferred tax asset of $1.1 billion at the end of the third quarter. The reason for the write down was that we determined, under the required accounting principles, that we will not be able to use all of our net deferred tax assets within a reasonable time frame.

While we are required to weight out many factors, this resulted primarily from reducing our forecasts of future taxable income, particularly in the near term. We took a count of the uncertainties created by the current economic environment and shortened the time frame over which the forecast is considered.

I would stress that these tax assets continue to exist and remain available to reduce Nortel’s future tax liabilities and as with goodwill, this charge has no effect on cash.

As Mike mentioned, we are announcing today the details of a new restructuring plan. We are balancing our need to preserve cash with the requirements of significantly reduced headcount in order to achieve a competitive cost structure moving forward.

The new 2009 plan includes a net headcount reduction of around 1,300 people. The P&L and cash charge for this restructuring is expected to be approximately $130.0 million with annualized savings of about $190.0 million.

Looking at Q4, we expect the combined restructuring plans, including the one announced today, will result in a cash cost of about $75.0 million and a P&L charge of around $90.0 million. For 2009 we expect the combined plans to have a total cash restructuring cost of approximately $270.0 million with a P&L charge of $135.0 million.

As we look into 2009, we expect the total savings from all restructuring to be about $260.0 million. We also plan to take further cost out of our business through additional cost measures across the organization. Mike has already mentioned some of the actions we are taking, which together with the restructuring savings, will have gross annual savings of approximately $400.0 million.

The next chart shows a summary of the significant impact items that we don’t view as part of our ongoing operations. I have already talked to most of these items so I won’t go into the details, but the chart is here for your information.

Our cash balance and short-term investments totaled $2.65 billion at the end of the third quarter. This was a reduction in the cash balance of $421.0 million in the quarter. Of the reduction, $99.0 million related to an adverse translation adjustment. This was caused by the recent appreciation of the U.S. dollar against the Euro, sterling, and Korean won. I would emphasize, this is only a translation adjustment, as we report in U.S. dollars.

In the quarter we also two one-off payments. The first was a payment of $70.0 million to Flextronics, which was a contractual commitment made at the time we transferred our factories to them. The payment covered severance and restructuring costs relating to the closure of factories in North America. The second payment of $51.0 million was to LG and related to an earn-out agreement with LGE.

The remaining cash outflow of $220.0 million related to restructuring costs, pension costs, capex, and earnings, partially offset by favorable working capital.

Let me provide some background on the reclassification to short-term investments. We had invested $362.0 million in the Reserve Primary Fund, a AAA-rate fund, which is one of the oldest and largest funds in the United States, with $62.0 billion of assets. This is a fund in which we have invested for many years.

Our cash management strategy is to invest in institutional and government money market funds, which are considered highly liquid and which we account for as cash and cash equivalents.

Due to holdings of Lehman debt, the fund, on September 19 filed with the SEC an application to temporarily suspend rights of redemption and announced it would liquidate the fund and return proceeds to investors over a period of time. As a result, we have reclassified this investment from cash to short- and long-term investments and taken an impairment of $10.0 million based on the impact of the Lehman debt on the overall fund.

We also understand that the fund has applied to be included in the Treasury’s money market guarantee program.

On October 31 we received $184.0 million back from the fund. The fund is liquidating its holdings and returning cash to investors as the individual investments in the fund mature or are sold. We currently expect to receive an addition $80.0 million prior to year end, with the balance during 2009.

Before I close with our guidance, let me discuss liquidity. It is clear that we are in challenging times and Nortel continues to experience significant pressure on its business. This in turn puts pressure on our cash and liquidity position and the continued weakening of the economic environment makes things even tougher.

As a result of these pressures, we are absolutely focused on preserving cash and maintaining liquidity. And as you heard earlier from Mike, we are taking significant cost containment and reduction actions.

In order to meet our working capital needs, our cash is invested primarily in AAA securities. Slightly more than half of our cash balance is held outside of the United States and is used to meet the operating needs in our various geographies. The majority of our cash is generally available, with just over 20%, including cash in China and in our joint ventures, that is less accessible.

As the health of financial institutions has changed, we have completed a thorough review of our investments and our cash in concentrated in the highest quality banks globally and government money market funds.

When we gave our revised cash guidance in September we indicated that we expected between $2.6 billion and $2.9 billion at the end of the third quarter and year end. Our cash and short-term investment balance at the end of September was $2.65 billion.

Our current expectations for the year end have decreased and we now expect cash and short-term investments to be about $2.4 billion. Our reduced expectation results from being around the low end of our guidance range and the negative impact of FX on our cash balances outside the U.S.

As I mentioned earlier, the U.S. dollar has strengthened significantly against other currencies in recent weeks and based on current rates we expect a further translation impact of just over $100.0 million in the fourth quarter. This is over and above the translation impact of $99.0 million in the third quarter. And again, let me say that this is a translation impact only.

As we have indicated previously, we estimate that we require about $1.0 billion to operate our business, not including cash in our joint ventures or China of just over $500.0 million. Also, we are constantly working to ensure our cash is in places where we need it globally, but sometimes this is challenging due to regional needs and regulatory considerations in each country.

Looking into 2009, we are not going to be providing revenue and operating margin guidance today, but I wanted to update you on our major uses of cash in 2009. Firstly, pensions. In 2008 the cash pension cost to fund deficits in the U.K., Canada, and U.S. is expected to be about $250.0 million. We will be doing a full review of our pension funds as of December 31, and given declining asset performance, the pension funding costs may have to increase next year.

Next, restructuring. As I said earlier, we expect the cash costs associated with restructuring next year to be around $270.0 million. Net interest expense is also expected to be about $270.0 million, which reflects a lower cash balance as well as lower interest income. In terms of capex, we generally plan for about $200.0 million in capex, but we have plans underway to reduce this up to 50%. Cash taxes are expected to be in line with this year, at about $140.0 million.

We also announced today our decision to suspend a declaration of dividends on our preferred shares. The total cash savings on this will be approximately $50.0 million next year.

And as for debt maturities, we do not have any maturities until July 2011 and there are no maintenance covenants.

These are clearly challenging times for all companies. Economic and financial conditions have deteriorated significantly in recent months and visibility is low. As a result of this and continued negative pressure on revenue from FX, our current forecasts indicate that we expect to be around the low end of the guidance that we gave on September 17. We do, however, feel that there may be risk to this if economic conditions continue to deteriorate, or if FX moves against us. However, this is our best view right now.

In closing, our primary focus is to preserve cash and liquidity, execute on the new operating model and move Nortel forward.

And with that I will hand you back to Mike.

Mike Zafirovski

Before we go to Q&A I only have a very few closing comments but do want to take a minute to thank our employees, customers, and partners. We are very deeply committed to our customers and to the suppliers and partners. We are taking the necessary actions to ensure that they continue to see the benefits of our value and innovation, which they have come to rely on from Nortel. We are becoming a more customer-focused organization but also simple organization and ultimately a better partner.

In closing, we are not standing still. Our comprehensive business review continues and we definitely continue to review the potential divestiture of our MEN business. As you can appreciate, providing an update prior to any potential transaction would be premature and we will not make any additional comments on it but to say that we are investigating this potential divesture and we are talking with interested parties.

As Pavi and I have discussed over the last 35 minutes, we are focused on driving the company forward and as [inaudible] indicates, a combination of aggressive and necessary reactions and a cost equation as well as [inaudible] business for cash and concurrently driving significant emphasis and care with our customers.

Let’s open it for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Vivek Arya - Merrill Lynch.

Vivek Arya - Merrill Lynch

First, Pavi, if you exclude the cash that you’re holding in your overseas joint ventures, and you look at I think roughly $800.0 million of cash burn that you detailed for next year, do you foresee a need to come back to the capital markets.

And Mike, on the question in right-sizing your cost structure and all the restructuring, what assumptions are you making for sales and gross margins for next year?

Pavi Binning

In terms of the cash outflows that I highlighted, obviously one of the sort of things that is important to note is we also have depreciation and amortization of about $350.0 million, which will obviously be a partial offset to that.

But I think that what I would sort of say is that our earnings performance is absolutely important in terms of as we look forward, and that is what we are focusing on, that’s what these measures that we have put in place are today.

I don’t rule out any other actions that we need to take to preserve the cash and liquidity position of the company, but we are absolutely focused on driving performance of the business and those are the steps that we have outlined today.

Mike Zafirovski

Just as clarification, pension expenses are also part of operating margins to a significant degree, so this is both an operating margin and cash activity.

We are not providing any guidance for 2009 at this point in time. With the FX rate and the environment, we provided the view as Pavi indicated, some Q4, we provided the best view where we see our businesses and at this point in time it would be inappropriate to make any views on 2009.

Operator

Your next question comes from Nikos Theodosopoulos – UBS.

Nikos Theodosopoulos - UBS

I realize that you are not giving any guidance for 2009 but maybe just on one thing. This year it looks like, if I did the math right, that deferred revenue comes down about $1.0 billion to $1.1 billion and I think prior comments was that next year would come down about $300.0 million. So my questions is, all else equal, what is the gross margin impact of the fact that in 2009 there will be a much smaller recognition of deferred revenue? Can the company still offset that in cost reduction and other actions to keep the gross margins stable or will this decline in deferred put downward pressure on the gross margin next year?

Mike Zafirovski

We are not going to provide any guidance for 2009, but just a couple of comments. The productivity, which we have driven without any reference to deferred revenues, has been strong double-digits for the last couple of years and the operations team is very motivated and to the plans which we have seen for 2009 for continued strong productivity in 2009 and beyond. And I think their numbers which you quoted for different revenues for both this year and for next year are accurate.

Asking for clarification, typically the gross margin on deferred revenues has been typically in the same range as our gross revenues for business. You may have deviations one month versus another. It used to be more pronounced difference but I think your comments along with my additional clarifications, that’s a pretty good basis for you to make some projections for 2009.

Operator

Your next question comes from Jeff Kvaal – Barclays Capital.

Jeff Kvaal – Barclays Capital

I was wondering if you could comment a little more on what macroeconomic challenges have worsened for you over the past couple of months. A lot of your comments have been year-over-year so any more recent specifics would be super.

Mike Zafirovski

On the carrier side, when we made the announcements in early September actually a few of the carrier customers even chided me for possibly portraying a picture that is more negative than what you are seeing internally. Within two or three weeks some of the CEOs called up and said on second thought they were taking costs down as well. So on the carrier side, which started to typically hand-select customers in North America, things have become much more broad-based as people are trying to protect their downsides in this environment, both 2008 and 2009.

On the enterprise side, we have a terrific customer advisory board. I was just with them a couple of weeks ago at the New York Stock Exchange. The first session we had was at MIT just to try to provide the customers with an open forum to comment on our road mapping and also for us to get a better feel for what are the challenges facing mostly CIOs of large companies.

And without any question what we were hearing is that things getting approved in the businesses were things that had otherwise, not typically in 12 months but otherwise would be the current fiscal year. Some of the customers do have fiscal years different than January 1. And that commitments on value on revenues if they were pretty strong commitments, either by how much is the revenue and customer satisfaction means business will be moving up.

So what we have seen in the last couple of months, since September 17, is a much more cautious view and to purchase orders being eliminated and/or at minimum deferred. What we are doing internally, I believe it is a microcosm, what many companies are going through, in a stage of de-leveraging of their businesses.

I do not necessarily believe that this will be a multi-year process but we do think that this activity will be there for Q4 and a good part of 2009 and that is how we are running our business and also driving our solutions for customers that would make them more competitive in this environment.

And the comments which we are getting on our unified communications, since this was a customer advisory board and the cost saving ideas resonated, so even with more limited sales and marketing program expenses, we will be driving our company to be addressing those values for our customers.

Operator

Your next question comes from Ehud Gelblum - JP Morgan.

Ehud Gelblum - JP Morgan

The restructuring that is pushing the services business down into each of the different product units, is that something that would then allow you later on to split the business future than just the MEN business and at some point be able sell of immersion to either the carrier, apart from enterprise, or within carrier take wireless from wire line? Is that being reorganized in a way that would make further splitting up like that easier?

And how do you know that the 1,300 headcount reduction announced today is enough? And what is the headcount today and what will it be after that? And how do you know that the right number isn’t more like 3,000 to 5,000, just so that you can get ahead of that falling knife instead of following it as it’s falling?

Mike Zafirovski

I will have Pavi provide the numeric answers to your questions.

First of all, we are convinced that the new structure makes the most sense for us to be running the business, including end-to-end services, software, hardware, and applications for Internet, if you will. At the same time it does provide maximum flexibility for whatever we decide to do, but in terms of the flexibility to become much faster in this environment, we believe this is the right structure and it is being put in place to be running the business as we had articulated.

With respect to restructuring, to be honest with you, this is a combination of taking the actions that we know we can take in the short term and at the same time try to manage our cash requirements. Restructuring does carry with itself a pretty significant cash flow impact, which Pavi articulated. And that’s why it was very important that we highlighted the two related difficult items, that we are running the company to survive and to prosper.

After that the employment freeze is above and beyond the restructuring. So you can take a guess, 4% to 8% normal attrition. Most high-tech companies between 6.5% and 7%. We have done a very rigorous job of optimizing the business. As people decide to leave the company for whatever reasons they will continue and that’s above and beyond restructuring activities.

And also we said there will be typically a $70.0 million to $80.0 million a year are typical salary increases. We are pretty competitive generally speaking, globally, with our salary structures but we thought in this environment it was prudent to announce not only the preferred stock dividend stoppage, if you will, but also we announced earlier this morning to our employees that we will suspend salary increases for next year. And with all those views for next year that we will get ahead of that curve, as opposed as to being behind it.

Pavi Binning

I just endorse those comments that Mike has made there. What we are trying to do is obviously balance the cost/cash equation, but more importantly, reduce costs with incurring restructuring charges. Dennis Curry and I are looking aggressively at all areas of cost in the business and what we want to do is obviously reduce the overall cost space, particularly looking at opportunities we have, without incurring restructuring costs.

In terms of the headcount numbers, our headcount at the end of September was just under 25,000, prior to these actions being taken place. And Mike outlined the restructuring actions that we had carried over from the previous plans and indeed, the new one that we are implementing. So that’s the sort of starting part in terms of those reductions.

Mike Zafirovski

Those various employment numbers Pavi is quoting is full-time, 100% company. We do have a pretty meaningful number of employees with our joint venture partners in Turkey and China and other places. The 31,000 you have heard does include joint venture partners. Again, the number which Pavi has quoted is 100% full-time Nortel employees.

Operator

Your next question comes from Ken Muth - Robert Baird.

Ken Muth - Robert Baird

Could you give us any updates on where you are with the Microsoft joint venture and how you feel that’s going right now and the number of wins you might have under that relationship?

Mike Zafirovski

I do not have the number of wins at my fingertips here but Steven [Eloff] is the lead executive on the day-to-day things between Microsoft and Nortel. And I have met a number of times with Joel Hackney and Richard [Prosod], we have developed a pretty aggressive plan for the combined plan to fit within Microsoft’s fiscal year, which was July 1, 2008, to June 30, 2009. So that relationship is progressing well. What’s interesting, in our last customer advisory meeting, we had people like Creative Artists, HSBC, and Bloomberg and all commenting very well in terms of the combination of efforts from both Microsoft and Nortel actually adding to the solutions to those customers. We will be happy to organize a call between you and Joel Hackney to give you even more specific details.

Operator

Your next question comes from Gus Papageorgiou - Scotia Capital.

Gus Papageorgiou - Scotia Capital

On the unified communications business, can you give us a sense of traction on that business? Can you give us an indication of how it’s tracking year-over-year or year-to-date this year versus last year? And given the current focus liquidity and the balance sheet, do you think that will have any impact on customer demand for unified communications from Nortel?

Mike Zafirovski

I do not have the specific numbers here with me. I will be happy to have you check with Joel. But the impact is pretty profound, particularly with the investments which we have made in the software business model. I think Joel did a good job articulating that at the analysts day.

But I can tell you one of the comments that came from a customer directly is that we still have not done nearly as good of a job as we can, highlighting the 12-month advantage we have versus most of our customers, and the comments they had was that we should be putting even more emphasis on sales, marketing, and communications efforts to really address both the cost savings and the value-added activities that unified communications is bringing to enterprises and it is bringing that today.

So I am pretty comfortable that we will continue to make investments in unified communications and that the future for the enterprise business, although revenues in general will be coming down from where we thought they would be back in June, which is pretty consistent with most other companies. I do believe we will be doing well and that in this new structure we will be able to drive it with more rigor and faster than we have done over the last six to nine months.

Operator

Your next question comes from Scott Coleman -Morgan Stanley.

Scott Coleman -Morgan Stanley

What do you expect deferred to end the year at, and then you announced the China Telecom win this morning, are you already taking orders against that win, and when do you expect to begin revenue? And when you look across your customer base today, what are you most concerned about over the next one to quarters, your enterprise end market or your service provider end market?

Pavi Binning

In terms of deferred revenue I expect it to end the year at just over $2.0 billion.

Mike Zafirovski

For the Q4 deferred revenues, both this year and last year, last year it was almost $300.0 million, this year, as we have indicated in the guidance, it’s about $320.0 million. We thought deferred impact for 2009 will be in the $300.0 million range, which is obviously a much higher number this year.

CDMA, the orders started coming in just over the last couple of days and we expect the revenues, the first phase, to start being recognized the first half of next year as we fulfill all the requirements. I guess we will be clearing deferred revenues in the short term and revenues will be recognized sometime in the latter part of the first half.

The concerns of enterprise versus carrier, frankly it’s more geographic. Starting in North America, parts of Europe where we started to see in early September, and right now it’s broader, in the developing markets. And frankly, I was very pleased to see the significant China bailout plan that was announced earlier this morning and hopefully, with all the actions they announced with governments all over the world will take, could be a very protracted multi-year downturn into something that is going to be over in 2009. But the visibility with customers and expense is limited with us at Nortel as it is for most of the other economists and other companies.

Operator

Your next question comes from Michael Urlacher - GMP Securities.

Michael Urlacher - GMP Securities

Could you share with us the thought process at the executive level, as well as if it is appropriate, the thought process at the board level? The way I look at this situation is it’s something like a leaky boat and you have a choice, as a management team, to either fix it, to sell it, or to fix it now and sell it later. And so I wonder if you could just share with us how you weight these sorts of decisions, and in particular if you could maybe offer context with respect to the announcement of the sale of MEN in September, which I would have to say looks a little bit curious.

Mike Zafirovski

We will not be making any comments on any organic activities but I will make a comment on the rationale behind the MEN announcement in September. First of all, I would argue that the actions which this management team has taken in the last two to three years, whether it was a legal exposure, whether it was a cost structure, whether there was investing 55% of our R&D legacy in dying technologies has been changed dramatically. We have always viewed that it would be a strong, biased reaction and to a lot of things which we no longer talk about: having [inaudible] be a part of the foundation and we have worked with a great level of determination to have assets and technologies that would drive the company forward, they will be driving growth.

And then maybe some investments which we have made in the last 18 months, we have communicated some of those at the analysts day in June. The world has changed. We saw some of the downturns start happening late August, early September and at that point in time we looked long and hard as to taking a business that there was, although very valuable and we think we have a pretty significant advantage over competition, there was less related to the other business activities within Nortel and we thought it was the appropriate time to shore up the balance sheet and also to give us some powder, if you will, to add some assets and capabilities in the other businesses.

And the world has changed since then, as you have seen valuations of a number of companies that we are proceeding with discussions with a smaller group of players for the possible divesture of MEN and we will make the final decision. Certainly we will communicate that immediately. But the perspective is to fix the fundamentals of the company and to have a base to be growing from and we believe that that process is underway.

And we have also said, as a consolidation will be important, but in the carrier space and whether that consolidation takes the place of partnerships or other activities, certainly we are not blind to those potentials, but everything which is being done right now I believe both makes the company stronger and provides us with maximum flexibility to drive value for the shareholders.

Operator

Your next question comes from Paul Silverstein - Credit Suisse.

Paul Silverstein - Credit Suisse

In terms of linearity of the quarter, right through the end of October, given that you now have the benefit of an additional month in terms of visibility on your business, can you give us some additional insight into what you’ve seen in October relative to what you saw in September.

Mike Zafirovski

Obviously activity did slow down in September. What Pavi and I have indicated, we have provided a guidance for Q4 to lower our range. There are many pluses and minuses but the single largest item there was the strengthening U.S. dollar relative to where it was at September 17. We provided here that our revenues were in the $2.7 billion range, which brings us to the lower level of the previous guidance. It’s tracking pretty much the way a quarter normally would track from that number.

Paul Silverstein - Credit Suisse

Was October just marginally worse than September or was it meaningfully worse than September?

Pavi Binning

The trends that we saw at September and why we put out the announcement in the middle of September have continued. We have obviously got a lot of economic pressures out there and the financial industry in particular is very challenged at the moment, hence causing impact on for the company. So all I would sort of say is that the conditions continue to exist and the situation, certainly at the moment from what we see, is about the same and deteriorating.

Operator

Your next question comes from Sundar Varadarajan – Deutsche Bank.

Sundar Varadarajan – Deutsche Bank

On the housekeeping side, could you tell us, based on you had some one-time benefits on the opex line, where do you expect to be from an operating expense in the fourth quarter? And as you kind of look at the current environment, really it is time to talk about operating margin targets, but from a free cash flow perspective, at what levels of revenue do you think you can achieve a free cash flow break-even defined as cash from operations less capex and do you think the current business environment kind of supports free cash flow generation on a consistent basis?

Pavi Binning

In terms of the cost actions that we are announcing today, I do expect to see reduction in the fourth quarter in relation to overall open, from some of the actions. There are a lot of variables here at play, though, because one of those other variables, and I highlighted it as I went through the presentation earlier, is incentive costs and sales commission cost, which are accrued, effectively in line with revenues. So partly because the revenue is higher, there would be an upward pressure as a result of those.

Secondly, also in terms of cost base that we have, FX begins to sort of impact that. So in terms of the overall headline numbers, they will depend on a number of factors but what I can assure you is the cost reduction actions and the restructuring actions that are taking place now will have an impact. I will obviously provide clarity on that as we present our results for year end.

And in terms of the sort of cash flow, I have obviously set out the numbers for 2009. Obviously earnings performance and operating margin performance, as I have said previously, is absolutely critical to overall cash generation moving forward. And that’s what we are absolutely focused on and driving very, very hard in the business, particularly in light of the announcements we have made today.

Mike Zafirovski

I think just the opex of Q4 is typically higher than Q3 for the reasons that Pavi mentioned, but if you are looking at versus previous years, you should expect to see a pretty significant improvement, like what you saw in Q3.

Operator

Your next question comes from Todd Copeland – CBIC World Markets.

Todd Copeland – CBIC World Markets

I was wondering if you can comment on whether or not this restructuring makes the MEN business for attractive in the M&A process you are going through.

Mike Zafirovski

The restructuring, which includes all businesses, MEN very specifically included, we certainly believe is going to make our company stronger in all elements, including MEN. We are looking differently, with the investment environment, at both R&D and program expenses and I do believe that MEN will be a stronger business in 2009 than it otherwise would have been but for the restructuring actions.

Operator

Your next question comes from Mark Sue - RBC Capital Markets.

Mark Sue - RBC Capital Markets

If you could, would you consider an asset swap with another company so perhaps you can bulk up the enterprise while maybe divesting wireless? It seems it will be easier once the realignment is done.

Mike Zafirovski

We are not going to make any specific comments on organic activities but as we said, in both the enterprise and the carrier space, consolidation will be important for them, for the industry and for the business. We have looked at some opportunities in the past and we are not going to stop but I think the actions which we are taking will make Nortel stronger and I won’t make any additional comments on organic potential activities.

Operator

Your next question comes from Richard Windsor - Nomura.

Richard Windsor - Nomura

Just looking at this contract you have announced with China Telecom, assuming that China Telecom goes ahead with its significant increase in capex, would you actually, based on the contract you have won with them, would you expect your market share of CDMA to increase, decline, or stay the same over the next couple of years?

Mike Zafirovski

Pretty much stay the same. I think some people have lost market share. I think our market share position with them is pretty much where it was before. I think our team has done a pretty good job negotiating that so I think that overall our position there will be pretty consistent.

Operator

Your next question comes from Richard Kramer – Arete Research.

Richard Kramer – Arete Research

Can you help us understand the $1.0 billion of goodwill that is allocated currently to services? As you split up the services business, how will that get allocated among the other divisions and will some be allocated to MEN? And as we think about MEN going forward, are there any further charges you think you need to take to prepare that for the disposal you have already outlined?

Pavi Binning

In terms of the goodwill, as you say there is about $1.1 billion in relation to services. As we re-segment the business, which we will do next year, there will be goodwill allocated to the other segments and at this point in time I can’t comment on any further for the charges. I am not expecting any but obviously when we do divesting at the time that we go into our new segments, if there is any movement we will obviously make that clear to the market. But certainly, we will be doing that segment change effective January 1.

Mike Zafirovski

Most of our services revenues are in the carrier business and rule of thumb, most of the goodwill will be going to the carrier activity but as Pavi indicated, that’s a Q1 to-do for us.

Janet Craig

We are out of time for questions right now.

Mike Zafirovski

We appreciate all of you listening to the call this morning. It simply summarizes that we are taking decisive actions, which I think will make Nortel stronger, short term and long term, both a combination of taking [inaudible] cost and increasingly so for cash and the new structure is going to help us operate well in this environment and at the same time we are very committed to our customers and to the solutions and investments which we have made and we will be speaking with you early next year.

Operator

This concludes today’s conference call.

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Source: Nortel Networks Corporation Q3 2008 Earnings Call Transcript
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