Nortel Networks Corporation, Q1 2006 Earnings Conference Call Transcript (NT)

Nortel Networks Corporation (NT)
Q1 2006 Earnings Conference Call
June 6th, 2006 8.30 am EST

Executives:

Terry Glofcheskie, Vice President, Investor Relations
Mike Zafirovski, President, Chief Executive Officer, Director
Peter Currie, Chief Financial Officer, Executive Vice President

Analysts:

Nikos Theodosopoulos, UBS Warburg
Mark Sue, RBC Capital Markets
Alex Henderson, Citigroup
Gus Papageorgiou, Scotia Capital Markets
Ehud Gelblum, JP Morgan Securities
(John Chow?), Lehman Brothers
Paul Sagawa, Sanford C. Bernstein & Co.
(Actavian Popescu?), Thomas Weisel Partners

Presentation

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the 2006 Q1 earnings conference call. Operator instructions. I would now like to turn the conference over to Mr. Terry Glofcheskie, Vice President, Investor Relations. Please go ahead.

Terry Glofcheskie, Vice President, Investor Relations

Thank you operator, and good morning everyone. Thank you for joining us on this call this morning to discuss our Q1 2006 results. With me today are Mike Zafirovski, our President and Chief Executive Officer and Peter Currie, our Executive Vice President and Chief Financial Officer. After Mike and Peter make their brief comments, we’ll be happy to take your questions. Just before we get under way, let me remind you that certain comments made in today’s presentation may be characterized as forward-looking 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 and there are a number of other factors that could cause actual results to differ materially from those expressed in any forward-looking statement made by or on behalf of Nortel. Additional information concerning these factors and assumptions is contained in today’s press release and in Nortel’s filings with the United States Securities and Exchange Commission and the Canadian Securities Regulators. At this point, let me turn it over to Mike for his comments.

Mike Zafirovski, President, Chief Executive Officer, Director

Thank you, Terry. Good morning everybody. Thank you for joining us this morning to discuss our Q1 results. Let me begin by saying that we are very pleased that we are current in our financial reporting. We plan to remain as such. Q1 was a tough quarter. Our revenues came in pretty much in line. Our gross margin was lower than we expected. As you hopefully know is my style, we’ll be addressing this in greater detail on today’s call. It’s also important to understand that we continue to expect revenue in operating margin momentum for a business commencing Q2, which is pretty much in line with our previously communicated full year game plan. The rest of the year growth is expected to be very broad-based, particularly strong in CBMA and Optical from a product line perspective and from region in Europe and in CALA. As you’d expect, we also remain very focused on delivering short-term priorities and if you recall, those were our business transformation, our integrity renewal and the short-term growth opportunities concurrent with building a long-term foundation for the new Nortel.

Simply stated, we are driving both improvements in short-term financial results, at the same time we’re making investments for the long-term health of the company. The Q1 2006 highlights on the next page, I will speak on the revenue and gross margins, Peter will speak to the rest of the numbers. Just a couple of comments, we will discuss this segment and regional revenues on the next few pages, but overall, the Q1 revenues of $2.4 billion are relatively flat on a YoverY basis, which is pretty much in line with our expectations. I should point out that revenues were impacted by timing of certain contracts and that both the backlog and the first(?) revenues increased during the quarter. Also, a few of you have expressed interest in trying to identify the incremental impact of acquisitions and joint ventures as well as some of the areas which we decided to exit. The incremental impact of the Nortel LG joint venture and the PEC acquisition which is now part of a Nortel government solution, with approximately $90 million for Q1, whereas revenues from sold(?) exited activities was about $50 million. So the net incremental positive impact was $40 million.

On the earnings side, we were disappointed as we were negative, both on an operating margin basis, 6.9% operating margin percentage. We have a net loss for the quarter for $160 million compared to $140 million last year. The primary shortfall impacting our results was our gross margins, which as indicated I’ll discuss in a few minutes. Historically, Q1 has been and continues to be a very challenging quarter for the company. The whole executive team is not happy with the net loss for the quarter and it reiterates our commitment on implementing the programs which will deliver the 300-500bps improvement per year and ultimately double digit operating margin as at 2008. As I’ve indicated already, we do expect growth for the remainder of 2006 and for this to be a rather broad base, both product line wise and region wise and again on a YoverY basis.

Let’s move on now to revenues by segment. First on our (mobility in converged core revenues?), they were down 4% over the previous quarter. In the product line, CDMA was down 4% primarily due to timing. As already indicated, we do expect very strong CDMA revenues for the year. We continue to be very strong in this line and we remain in a strong number two position globally. We also continue to invest beyond EVDO with MIMO and OFDM which will be the foundation of future mobile access networks. On the GSM and UTMS front, revenues were down 11%, principally down with GSM revenues down, including in North America. This was partially also by growth in UMTS. We have some nice recent momentum in this product line, in Korea, SK Telecom launched its first commercial service with HSDPA handsets geared to consumers. In Israel, Partner Communications launched Israel’s first HSDPA service. In GSM, our product line in the China Ministry of Railway, we reached an agreement covering nearly half of the nation’s railway footprint and as we announced earlier in the year, the three-year voice core GSM UMTS core deal with Cingular.

(Just looking back at the voice?), we have 17% QoverQ, as our succession continues to grow we are up 47%, with growth pretty much in all the regions while TDM was relatively flat. In Q1 2006, our market share remained strong, we remain number one in carrier VoIP with a significant transaction in Spain. We would also like to congratulate (Frank Embark?) the former Sprint wire line business which is one of our lead North American customers. We reached a milestone, with more than 1 million VoIP lines with Nortel. We certainly look forward to our future together. We also in Q1, (Nortel, a cable operator’s customers will pay us?) more than 1 million cable VoIP lines and service. Going forward, we anticipate significant build-outs in GSM, in the emerging markets including increased activity in China as the 3G licenses are delayed. In North America, DVDR(?) rollouts will be coming to an end as we come to the completion of 2006 with the Rev A deployment starting to ramp up before the year is over.

We do look forward to be leveraging our very strong voice and SIP leadership to secure IMS market share, and laying the foundation for future 3G networks. Let me move on now to enterprise solutions impacted revenue segments. We were down 1% from last year. Circuit and packet voice, we were up 5% due to a strong performance, particularly in Europe and in North America. We maintain our number one Enterprise VoIP and TDM leadership in terms of their lines. Recent momentum, we won significant transaction with a leading gaming company in North America, also with a private airline company, also in the Middle East consumer products manufacturing and one of the top banks in China. We do expect to announce some more significant wins in the enterprise space over the next month or so.

In Optical, we have 5% YoverY due to growth in Metro Optical, principally in North America and Europe while long-haul sales remained relatively flat. As reported by Deloro(?), we were number one market share position in Optical in Q1, 14.2%, it’s great to be there. We also sustain our number one market share position in Metro WDM for the seventh consecutive year. This is just one example of the Metro WDM and work is enabling the Australian stock exchange with Ethernet connectivity and the industry-leading storage extension capabilities to secure their mission critical data. Our restricted data networking security, we were down 12% YoverY, primarily due to a decrease in sales of our legacy products and a recent significant transaction in this space was the announcement with Cypress communications, which was one of the largest providers of managed services in the US, and they’ll be using our converged IP network solutions to help simplify the communications services to 29 cities across the United States.

As we look forward in the enterprise solutions effective revenue space, IP is the unifying service delivery for current and emerging applications, while Ethernet is becoming the universal transport of choice. Additionally, video is poised to really flood the networks with bandwidth demands the likes of which we haven’t seen before. We intend to capitalize on those strengths and this is why we created Metro Ethernet networks and I’ll make some additional comments on it just before the Q&A. We’re speaking to enterprise business in general, replacements of voice systems will continue to drive the need for IP telephony and those technologies that support network and applications convergence such as security, unified messaging, IP contact centers and SIP-based collaboration. I have traveled extensively through the world and very specifically to see some of the premier enterprise customers in North America and make some plans for go to market just before the Q&A.

Geographic revenues, on the next page, on a geographic basis, North America revenues were down 3% YoverY, this is due to lower revenues from GSM and UMTS and also lower revenues by CDMA which I indicated before was timing-related. (We did see gains in?) North America in our optical solutions sales and also some of them benefit from the PEC acquisition. Europe, revenues were down 6% YoverY due to a decline in data networking solutions and lower GSM revenues. On GSM, we had very tough comparison to the build-outs in France in Q1 of last year. We saw solid increases in UMTS, optical and packet voice solutions in Europe. In Asia, revenues were 14% due to growth in most of the network solutions and in CALA, revenues were up 31% due to a growth in GSM and optical as a number of new decimal(?) contracts and to existing network expansions. In addition, we saw growth in circuit and packet voice in CALA, partially offset by a decline in the CDMA. As I indicated before, we see growth across most parts of our business, both product line and regionally on a YoverY basis for the year. In particular, we expect strong growth in CALA and in Europe, EMEA.

Our gross margin for the quarter is 3%. As a percentage of revenue this was down four points from Q1 last year and down one point sequentially from Q4 2005. Some of the key drivers; number one is the product mix, including sales of next generation products which tend to have lower gross margins in the early product stages. Also of course the impact of that revenue recognition of several low margin contracts which really we’re expecting later in 2006. Also by the deferral of higher margin contracts into the latter part of the year. We also saw some pricing pressures in Q1, I’m including specifically GSM in the China market and Optical in Europe. Further, there’s a drop in our enterprise applications margin due to a marketing promotion which ended in 2005. We had some deliveries which fell(?) into Q1 2006. And also, last year’s margin was somewhat helped by inventory provision releases resulting from the high consumption of materials in a high-margin GSM contract in North America which were not repeated this year.

As we go forward, we expect the timing items that negatively impacted Q1 on a mixed basis to start reversing partially in Q2 through the remainder of 2006. In addition, increased sales volumes will provide higher fixed costs recoveries in the year. I’ll hand this over now to Peter for some additional details and financial results and then I’ll come back for some additional business comments before the Q&A. Peter?

Peter Currie, Chief Financial Officer, Executive Vice President

Thanks very much, Mike, and good morning everybody. I’m going to start my remarks on page 11 of the material that we made available to you and that’s titled, of course, SG&A. SG&A expense in Q1 increased by $17 million and about 0.8% expressed as a percent of revenues, compared to Q1 2005, and that was primarily due to increased SG&A as a result of the consolidation of PEC and the LG joint venture as well as unfavorable foreign exchange impacts associated with the strengthening of the Canadian dollar which was partially offset by favorable impact associated with the weakening of the euro and British pound against the US dollar in the quarter. It also recognized one time costs from business transformation initiatives which of course are costs for organizing and initiating the program and we’ve talked to you about this previously.

All this was partially offset by lower costs related to restatement-related activities offset by a higher internal control, remedial measures and investment in our finance processes. These costs were approximately $45 million in the quarter. Again, we’ve referenced those in previous calls. On chart 12, in terms of R&D, you’ll see those expenses at $484 million or about 20% of revenue, were relatively flat Q1 2006 versus the comparable period in 2005. The R&D expenses included cost savings associated with our 2004 restructuring program and more effective prioritization and investment in targets, product areas such as data networking products. This was partially offset by increased expenses as a result of the consolidation of the LG Nortel joint venture, as well as the unfavorable foreign exchange impact associated with the strengthening of the Canadian dollar, the same dynamic that we saw in SG&A but a little bit different balance, because of the bias of our research and development resources. We also saw increased investments in target product areas, primarily enterprise solutions and packet network segments.

On chart 13, we summarize our financial results for the quarter and you can see that revenues as Mike indicated were $2.4 billion, relatively flat to last year. Gross margins of 38% were down 4 percentage points from the previous year, as discussed by Mike. Operating expense was $1.1 billion, up slightly from Q1 2005 and a net loss of $167 million was up $63 million from the same period last year. EPS was a loss of $0.04 per share. There were a number of factors that impacted our net earnings, which are beyond a definition of normal operations, and I’ll cover those next. On page 14, you can see the elements included about four in particular. The first is $19 million shareholder litigation expense related to the fair value adjustment of the equity portion of the agreement we have in principle. That’s about $0.005 per share. I’d like to take a moment to expand on this item.

The fair value of the equity portion is adjusted based upon Nortel’s market share price and is evaluated on a quarterly basis and again on the date of settlement. The share price used in the Q1 adjustment was $3.05. An increase relative to this price will generate an expense. A decrease relative to this price will generate income. Continuing with the other three items, there’s a $63 million gain on the sale of certain assets, including the sale of the hook(?) blade server assets and the Brampton real estate facility. It’s about a penny per share. There was $45 million related to our finance transformation and governance activities, about a penny per share, and $5 million in special charges related to certain restructuring activities. In terms of cash flow, as we’ve outlined on page 15, we began the period with a cash of just about $2.95 billion, net cash, that was used in operating activities of about $174 million primarily due to the net earnings loss from continuing operations. We have working capital movements of $262 million including pension payments of $91 million and depreciation of $60 million. There were investing activities, including the acquisition of Tasman networks for $98 million, net of cash acquired, and proceeds from the sales of property plant and equipment of about $87 million, that is predominantly the sale of the Brampton real estate facility as well as expenditures of just under $100 million for plant and equipment in the quarter. That is primarily for test equipment and information technology equipment.

We had financing, in terms of financing we paid a dividend of $18 million and foreign exchange on cash resulted in about $14 million of increase. So cash, at the end of the period, was $2.7 billion. Future uses of cash over the next 12 months commencing March 31st include operating activities, we have a proposed litigation settlement of about $580 million which includes interest, pension and post-retirement obligations of about $425 million, restructuring costs of about $100 million and costs related to the implementation of the finance transformation program and in particular the new SAP software program. We have certain investing activities in terms of capital expenditures of about $280 million identified and financing activities. We have debt service of $150 million coming due in June. In terms of future sources, of course the Flextronics transaction which closed recently, we’ll see somewhere between $575-625 million from that transaction, net of the $380 million received in 2005.

In terms of operating metrics on page 16, you’ll see our DSO at 99 days. That increased 13 days over Q4 2005 and included in this number is the impact of nine days due to the transfer of receivables resulting from the consolidation of the LG joint venture. Net inventory days are 165, increased 33 days over Q4, primarily due to higher inventory levels built up prior to the outsourcing of our Calgary manufacturing facilities to Flextronics and included in our net inventory day metric is the impact of deferred costs associated with the deferred revenues, though title and risk of loss has been transferred to the customer. Excluding the deferred costs, which were $2.1 billion in Q1, our net inventory days was 41 versus 36 days in Q4 2005. Days payable outstanding at 64 days increased by 6 days, primarily due to the continued focus on adhering to standard contract terms across our supplier base. Deferred revenues were $3.7 billion, that’s up $140 million over Q4 2005 and that’s primarily in a non-current balance. The book to bill ratio was 1.1 for the quarter, and order backlog increased by about $250 million to $5.7 billion.

Overall, regarding working capital performance, we started a number of projects to improve our inventory and receivable balances including Six Sigma initiatives such as standard lead time reduction, demand plan accuracy and spend improvement as well as billing terms and process improvements. These are all with a view to materially improving our management of working capital, thereby generating cash. On chart 17, we consider our guidance for the full year 2006. We expect strong revenue momentum for the rest of the year, resulting in high single digit growth for the full year compared to 2005. Again on a full year basis, we expect gross margins to be around 40% as a percent of revenues and operating expenses to be flat to slightly up from 2005 with foreign exchange and growth-related expenses offsetting productivity inefficiencies. In terms of Q2 2006, we expect revenue, gross margin and operating expenses to support our full year guidance. As Mike previously mentioned, we expect growth across most of our business segments and regions on a YoverY basis. With that, I’ll turn the floor back to Mike.

Mike Zafirovski

Thank you Peter. Before we close off today and start thinking about questions, let me just take a minute to provide you with an update on our business plan. As we discussed, we have near-term priorities and longer-term initiatives underway which are underpinned by a comprehensive operating system. I’ll discuss each one of three short-term priorities, the business transformation, the integrity renewal and the growth imperatives in a few minutes, but I’ve some general comments and a six-point-plan on the operating rhythm. The first three points of the six-point plan are to build a strong foundation, starting with a world-class management team and processes. I’m very happy to say that we have narrowed it down to one open position which is the Chief Technical Officer and we’re working to reactively fill that position. We believe there’ll be a team that’s good and I believe better than any in the industry. Focus on strong balance sheet, controls and governance and a world-class cost structure and quality. We’ll see progress on the world-class cost structure and quality as 2006 unfolds.

The last three elements of the growth six point plan is to really focus on growth. We intend to be a growth company, we intend to be truly relevant in our chosen markets. We’ll invest smartly and we do expect to significantly increase our position in applications and services which are then more contemporary requirements from our customers. With regard to the operating system, we finished the people in the organization reviews in April and (actions saver?) have started and they will only accelerate. With respect to the graduate discussions, we finished robust discussions last week and we’re in the process of finalizing the strategic plan. Onto the specifics, again our short-term priorities are first, the business and the financial transformation teams. As we indicated before, we have six full-time teams excluding the financial transformation. We have more than 100 full-time resources working, including people from Mackenzie. Again the goal is to drive an operating margin expansion of $1.5 billion within the next three years including very specifically improvement of between 300-500bps in 2006, 2007 and 2008.

A couple of specific comments on direct materials, we’ve had very good results at this point in time. We’ve been able to specifically identify over 25% of savings in the first $700 million in purchases reviewed and the team has started working on phase two of purchased commodities which aggregate $1.5 billion. We do anticipate that some of these savings will start nominally to the latter part of this year, with acceleration in 2007 and 2008. We do expect to see improvements in gross margin in services and enterprise as we drive the activities from our business transformation activities and with respect to G&A expenses, as we’ve indicated before, we’re above benchmarks in this area. We’ve identified a number of areas, (one of them is the way?) cost structuring opportunities to improve procurement and usage of outside services, (others were the?) layers of the organization. Some actions have started and they will accelerate as Q2 finishes and as we look into Q3.

With respect to the financial transformation, we know we’re the same actual comp, as we’ve indicated before, this will not happen until the latter part of 2007 as we finish the significant requirements which we have in this area. As we look at the integrity renewal, we’re obviously very pleased that we are current in our financial reporting as of last night. We are in the process of issuing a new code of conduct which will be issued later this month. There is a significant expectation of adherence not only to the letter but also the spirit of the code, with high expectations from each one of us along with a consistent and prompt action, actions which we’ve been taking all along. Also, we’re very pleased that we submitted the remedial action plan to the SEC last week. This is a summary of actions taken to this point in time and also a very comprehensive summary of plans which we have underway and we look forward to robust discussions with the SEC on those plans as we obviously look forward to putting the investigation behind us. Again there’s a very, very significant commitment from me, from the finance team, from the whole management team of course, the board, to address those issues and for us to become a best practice as opposed to a lightning rod in newspaper articles.

Now last, there’s a management board renewal along with contemporary corporate governance and again I’m very, very confident that we’ve a consistent, strong progress in this very, very important area for us. Now last and most exciting, growth. When we talk about growth in Nortel, we think of both near-term and long-term opportunities and we’re not confused. We have opportunities in both the near-term and some areas which we frequently believe are low-hanging fruit and we’re going aggressively after them to pick those, if you will. But we identified three near-term opportunities. First, enhancing our enterprise business go to market activities. As I indicated earlier, I had the chance and the pleasure to visit some of the most amazing and contemporary enterprises in the world. The door is wide open for Nortel. Our products frankly are better than our go to market activities have been. This is not our people, this is simply how much we have. We’ve not invested and there’s a very specific action which will be enhancing our go to market activities, including robust treatment around global accounts, increasing our inside sales channel, improving our capabilities with our value-add resellers, and a combination of those activities we do expect to increase our annual revenues between $200-350 million.

Second is to build on our services business. We have had many capabilities but frankly there’s been insufficient focus on it. We have a very, very promising organization in place including a very respected leader which we hired on May 1st and we will be looking to optimize and to streamline the offerings to more coherent offerings to our customers. Lastly, we’re very excited about our Metro Ethernet networks. Today, we’ll be announcing several new product and technology innovations at our GLOBALCOMM in Chicago. For example, we’re announcing the introduction of provider backbone transport, or PBT, which is a new Ethernet technology. We’re leading development of and have already been integrating into our Metro Ethernet Networks portfolio. Nortel developed PBT as a reliable, simple, scaleable and cost effective technology, enabling Ethernet-based Metro Networks to work seamlessly with service providers’ existing MPLS core networks. We are working with several major service providers that are very interested in the potential benefits of deploying PBT as a Metro Networking technology, because of its ability to provide reliability and quality of service very similar to their existing optical networks while retaining the cost and simplicity of Ethernet.

As previously communicated, we have significantly increased the investments this year in video, IMS and WiMax while, as Peter has indicated, keeping the flow of R&D and balancing with last year. Let me just quickly recap. We’re current in our financial reporting, we acknowledge Q1 was a tough quarter. We also expect nice momentum for the business commencing in Q2 this year, both in revenues and in operating margin, which is in line with our previously communicated four-year game plan. We remain very focused on short-term priorities and building the long-term Nortel and we’re not confused, because we believe we can be successful in both of those. Improvements will not happen over night though we set realistic and tough expectations of 300-500bps improvement per year in operating margin per year, which means 2008 should provide some of the best results in Nortel’s history.

We also want to reiterate our growth goal. We intend to grow faster than the market and we will do this while making both strategic moves but also some tactical moves which we have highlighted in terms of the short-term opportunities. With a clear set of criteria for success, achieving market share relevance is fundamental to achieving our goal. All we’ll do, we’re committed to high standards of integrity, and that specifically includes fourth-rate(?) (inaudible) communications with all. Arguably the best asset which the listeners on this call have is what I believe is an organization management team with a passionately relentless pursuit of superior results in doing the right thing. Thank you for your interest, we’ll look forward to your questions.

Terry Glofcheskie

Thank you, Mike and Peter. Before I hand it over to the operator to start the question and answer session, I ask in the interest of all the people in the queue that you would limit yourself to one question. Operator, we’ll take our first question.

Questions and Answers

Operator

Thank you. Operator instructions. Our first question comes from the line of Nikos Theodosopoulos from UBS. Please proceed.

Q - Nikos Theodosopoulos, UBS Warburg

Yes, thank you. My question is on the seasonal patterns of your revenues throughout the rest of the year. Given that this quarter was depressed due to some revenue recognition and other items that you mentioned, do you see Q2 as perhaps being quite strong and that it could actually be the peak quarter for the year? Or do you see the normal seasonal patterns where Q4 would be the highest revenue quarter for the year. Thank you.

A - Mike Zafirovski

Good morning Nikos, I look forward to seeing you tomorrow morning in Chicago. I mean, the short comment is we do expect a strong Q2 but also we do believe that Q4 this year will continue to be the strongest YoverY increase for the year. Peter?

A - Peter Currie

Actually, if you look back over history in this company over, say, a decade or so, it’s hard to find the year when Q4 isn’t the strongest seasonally and our expectation would be that pattern wouldn’t be broken this year.

A - Mike Zafirovski

Not to take away from your comment, but we expect a good Q2 as well.

A - Peter Currie

Correct.

Q - Nikos Theodosopoulos, UBS Warburg

OK. Thank you.

Terry Glofcheskie

Next question, please?

Operator

Our next question comes from the line of Mark Sue from RBC Capital Markets. Please proceed.

Q - Mark Sue, RBC Capital Markets

Thank you. The decline in gross margins and pricing in particular; what part of the price declines is related to an offensive strategy, or is it defensive in nature? And I ask because pricing seems to be a prevalent theme here at GLOBALCOMM. And then, if anything, services, which you are ramping will have even lower gross margin. With that being said, is 40% gross margin in long-term steady state margins for the telecom industry and Nortel in particular, do you think we could see a longer-term rebound into the mid-forties?

A - Mike Zafirovski

Mark, thank you very much. A couple of comments. First of all, the margin is down 1% versus Q4. This is down 4 versus one last year, which had some one-time events - I don’t mean one-time events, but there were some favorable contract dispositions, if you will. Several comments. First, we’re really focused on operating margins as opposed to gross margins. As the services business grows, we do expect for that to be an enhancer of operating margins. Second point, we’ve not been in mid-forties of gross margin in a long time. It certainly hasn’t been since 2001. But having said that, work on a business transformation and again this is from the engineering organizations and particularly from operations, (Saul and his team?), we believe that we’ll be driving costs, we’ll be second to none, so the long term business model, we do anticipate gross margins to be in the low forties, obviously stretched to the mid-forties, but the low-forties is where we’re aiming to arrive within the next 2-3 years. And that’s what we have factored into our business transformation outlook.

Terry Glofcheskie

Peter, you want to add any additional comments in there?

A - Peter Currie

I think that’s a fair assessment. In terms of where the industry’s going, I mean, I don’t think anybody would really want to make a comment on industrial trends because it matters so much about the kinds of products you’re selling and the markets you’re selling in. But to Mike’s point, we’ve put a lot of effort and continue to put a lot of efforts into lowering our costs of materials in terms of the conversion process and lowering our costs of conversion which is one of the primary reasons that we work with our partners, Flextronics, to transition our factories into their domain because they can be more efficient than we can, so this is all in an attempt to bolster gross margins. In terms of pricing, there are a number of effective competitors in the market today so the market is relatively efficient. I’m not sure who I would characterize as price leaders or as price followers, but there is substantial price action in virtually all the product lines in which we participate and it’s hard to stake out a position of premium price in such an efficient market.

A - Mike Zafirovski

But Mark, let me just - I guess I did not answer specifically your question on offensive versus defensive. Assuming we’re now playing offense based on price, that’s number one, we will be protecting key customers in key markets. Again our target is to be approximately 40% this year. We will slowly be aiming to increase that 40% over the next couple of years into the low forties. At the earliest, the mid-forties, but again the targets and the plans will be in the low forties of gross margin.

Terry Glofcheskie

Next question, please?

Operator

Our next question comes from the line of Alex Henderson from Citigroup. Please proceed.

Q - Alex Henderson, Citigroup

Thanks. Just a quick clarification then, I’ve got a question. The company comment about $200-300 million in enterprise revenue improvement, I didn’t catch a timeframe. Could you bit a little bit more clear on what you were saying there? As for the question, can you give us a little bit better handle on how you’re approaching M&A activity or divestiture thoughts? Clearly you’ve made some comments about holding onto businesses where you have 20% market share and can grow faster than the market. As I see it, I don’t think you have a lot of businesses that fit that description. The question is, obviously, what kind of strategic moves are you contemplating, under what circumstances would you take dilution, how much dilution would you be willing to absorb and can you evaluate your financial flexibility to do something like that? Just talk about M&A a little bit?

A - Mike Zafirovski

Alex, thank you very much. We’re expecting the $200-300 million in enterprise and we do believe we’ll be seeing most of it on a running rate basis as 2006 unfolds, so some of it in Q3 and the view is that we’re making investments where we believe that, again from the current running rates of Q5(?) last year and Q1 of this year that is what the global teams, and particularly North America, are signing up for. With respect to M&A activity, I’ll just make a couple of comments. We finished very robust, what we refer to as a (session two strategic discussion?) There was a number of very strong assets within the company. We will be, obviously we will be having discussions externally with parties, but I’m not going to make any premature announcements until any discussion is done and we’re not counting on external activities for us to significantly improve the health of our business, particularly to improve it in the short period of time. And with respect to M&A activities, certainly there are lots of opportunities for the right deals. One message I want to leave you with is that we’re not going to do any silly deals. This is most acquisitions, most joint ventures do not work, either between overpayment or an inadequate job integrating those activities. We’re very rigorous analyzing the opportunities which we have. We do not feel any great pressure to do anything in the short term. We do believe there’s a good game plan ahead of us.

Terry Glofcheskie

Next question, please?

Operator

Our next question comes from the line of Gus Papageorgiou from Scotia Capital Markets. Please proceed.

Q - Gus Papageorgiou, Scotia Capital Markets

Hi, thanks for taking my call. Just a question on your GSM business and how it relates to profitability. You’re saying the GSM revenue was down this quarter and you have stated historically that GSM business itself is much more profitable then UMTS. I wonder, has UMTS become the bigger portion of the business? How soon before we see the cost points on the UMTS base stations match the cost points on GSM and when do you think the UMTS side of the business kind of matches the profitability on GSM?

A - Mike Zafirovski

Overall, the combination GSM and UMTS business actually was profitable last year in totality, which is the first time in a number of years. We said the GSM declining of revenues was partially due to a timing of a few contracts as well as a very strong comparison in Q1 of last year with a build up of few activities in Europe, particularly in France. Frankly, again I’m not prepared to make comments in the long term for us to go to a GSM and UMTS because that’s where most of the pricing pressure was happening, on both of those. And again, this is, as I say, we’re not playing offensively if you will and that’s why, again, we’re addressing very aggressively our cost and quality. We keep hearing that we have some of the best GSM and UMTS performing networks in the world. But is there increased activities? And this is one area where we do see significant pricing pressures and that’s why it’s difficult to predict the long-term profitability of that segment. Thank you.

Terry Glofcheskie

Thanks, guys. Next question, please?

Operator

Our next question comes from the line of Ehud Gelblum from JP Morgan Securities. Please proceed.

Q - Ehud Gelblum, JP Morgan Securities

Hi, good morning. Can you hear me?

A - Mike Zafirovski

Hi, Ehud, how are you?

Q - Ehud Gelblum, JP Morgan Securities

I’m good. Thank you. First I guess, also a clarification, then a question. The clarification on the shareholders settlement: the shareholders settlement both in a cash portion and in a number of shares equity portion. Since that’s not finalized now, was the number of shares set by a dollar amount or by a specific share amount? I guess what I’m going for is as the share price fluctuates, is there the risk that the shareholders settlement can be changed to reflect the new lower share price? That was just kind of a clarification on how that was set up. And then my questions, Mike, when you talk about the different businesses that you look to retain and to really build the business around, you’ve constantly mentioned Enterprise is an area that you think would be very strong. What made you, of all the different businesses you have, sort of be confident that Enterprise is going to be the rock that you build the company off of, versus some of the other businesses that you have? That seems to be the strongest piece in your portfolio that you may want to build around. As you look at your portfolio, how did you choose enterprise to be that one?

A - Peter Currie

Ehud, it’s Peter Currie here. Let me just answer your question on the shareholders settlement. And yes, the settlement was determined in terms of number of shares so that as the share price moves, the final settlement amount will move around a little bit. That’s what I attempted to convey when I was referring to the item on chart 14 there in our presentation. And so until that settles, and we’re actively working with the plaintiffs(?) on that at this time, you will see some movement as the share price moves quarter to quarter. Mike?

A - Mike Zafirovski

Ehud, thank you very much. I thought I did a thorough job communicating to you at your event in San Francisco a couple of weeks ago. Enterprise is certainly a very important element and one where we believe we can be very successful. But again, without going through all the elements of the strategic plan, we see three broad areas which I believe are very complementary. One is next generation Enterprise, and we have a significant legacy history, customer recognition and we surely intend to drive that very aggressively. Next - those are not prioritized, and this is not expanding but this is to be leveraging, opportunities which we assume we have - is a next generation mobility and again the combination of what we truly have in CDMA and in the various evolutions, in some of the most promising and valuable customers in the world in that space. So as we’re looking for that next generation to go beyond Rev A, again we believe we’re as well positioned as anyone in the world. If you’re looking at OFDM MIMO and not only WiMax but what is LTE or next generation networks. I do believe we have a significant capability to leverage technology and wiser commercialization on the next generation mobility, whereas Enterprise is of course still playing with technology but also it’s a play very significantly with what I would argue is the most desirable customer base in the world. The third one really relates to both of those, it’s to select next generation services. We had a board meeting last Thursday and Friday in Ottawa, with a chance to showcase our main R&D set in the world and all of us, all the members of the board, were just blown away by some of the capabilities we have. Again, this is not hardware, this was what you do with it including showing some of the specifics on security, showing how some of our SIP capabilities can be very relevant. We use the example of a doctor in a hospital, so there are significant opportunities and this does not need to go into uncharted waters. We have to be much more effective in again three areas. Next Generation Mobility, Next Generation Enterprise and Select Next Generation Enterprise and security implications. Again we feel good there’s a strong basis for us to be building on.

Terry Glofcheskie

Next question, please?

Operator

Our next question comes from the line of (John Chow?) from Lehman Brothers. Please proceed.

Q - (John Chow?), Lehman Brothers

Thank you very much. Can you hear me OK?

A - Terry Glofcheskie

Perfect.

Q - (John Chow?), Lehman Brothers

OK. Great. I have a question about your LG joint venture and the PEC. I seem to remember at the time when you formed the joint venture with LG, the company - the ARG JV - was on a run rate of $600 million for the year and the PEC was I think on the run rate of $270 million for the year. Please correct me if I’m wrong. It’s just the numbers in the ballpark, the $90 million in Q1, that seems to be a lot lower than that. Could you just talk about that? Or is that just seasonal or just so the new run rate for these two businesses now? And why? Thanks.

A - Mike Zafirovski

Two words. Revenue recognition. US GAAP is much more robust than probably any GAAP in the world, so the two numbers which you stated are correct. You’ve seen this part of the other category in the 10-Q, that is the Nortel Government Solutions which includes PEC. We’ve grown that business and the reason that in the joint venture - which by the way is significantly above last year on an apples-to-apples comparison - we’re seeing a significant flow of revenues because some of the contracts do not fall under the US definition of revenues. Peter?

A - Peter Currie

That’s exactly the explanation and in fact, we still have very strong hopes for both those businesses. Nortel Government Solutions is doing well. Of course, it’s the component that we acquired was a system integration services component and it’s doing well. We’re now developing it as a channel to flow more of our products through to that end user base. In terms of the LG joint venture, Mike’s explanation is exactly right. It has to do with deferral of revenues, not lost revenues. We’re still expecting that to do quite well in the future.

Q - (John Chow?), Lehman Brothers

OK. Thanks.

A - Terry Glofcheskie

Next question please?

Operator

Our next question comes from the line of Paul Sagawa from Bernstein and Company. Please proceed.

Q - Paul Sagawa, Sanford C. Bernstein & Co.

Hi guys. I wanted to ask a little bit about liquidity. You laid out sources and uses of cash over the next 12 months or so. A couple of things though, one is there any expectation that you would or wouldn’t get fines from SEC Ontario Securities Board relative to the mis-statements in the past? I would assume that that would almost certainly be a cash impact? Second of all, you do have the bank debt due in February. Would you anticipate keeping that as a year to year bank debt? Or are you looking for some sort of longer term instrument for that piece of financing on your balance sheet? Then should - in your guidance, it wasn’t clear relative to working capital, whatever you’d anticipate the business would be generating cash from operations in the second half. I wonder if you could comment on that? Thanks.

A - Mike Zafirovski

Paul, thank you very much. I’ll just make a brief comment on the first part of your question, then Peter will go through items two and three. With respect to the SEC or the Canadian Commission, obviously we cannot make any predictions there. But I just want to be sure all the listeners on this call, be they investors or analysts - I mean, it’s tough for me to imagine that anyone would have higher standards than the current management team, on what we want to do with this company, which very specifically includes financial reporting, controls, corporate governance and I believe that we’re summarizing the remedial plan. That’s how we’re behaving and we look forward for Nortel, starting with actions which the board of directors have taken to (see now continue with an aggressive way of being implemented?). First we have best practice of what should happen if the company goes astray and we’re very much looking forward to their discussions with the SEC and first, to be able to this sad saga behind us.

A - Peter Currie

Paul, it’s Peter Currie. In terms of anticipating the finds, we have not build that into our forward-planning at this stage of the game, because we simply don’t know. Based on everything Mike is saying, we’re quite optimistic in terms of our ultimate resolution in that regard. The second element of your question had to do with the debt due within one year, what we call the interim financing by the fact that we describe it that way should suggest that it is our intent to replace that with a permanent financing and we’re assessing the capital markets on a continuing basis right now. We plan to sort that out well before that becomes due. The third element of your question had to do with cash, (it’s all for?) liquidity for the balance of the year. I tried to outline in my remarks that we are very seriously addressing working capital within the company. In fact, we’ve got what we call a Six Sigma team, which is a process improvement team, kind of on steroids, which is looking at elements of working capital right now. Obviously to generate cash. The sales profile that we will realize in the latter part of the year as you can appreciate will in large measure determine our year-end cash position and so I’m reluctant now to say well it’s going to be plus or minus as we end the year, because a lot depends on how the next three quarters of sales materialize. But I can tell you this company has a very singular focus on cash. We’re doing everything within our power to optimize the cash resource within the company and we obviously, as you do, recognize how pivotal it is in terms of being a fuel to drive the company into the future.

A - Terry Glofcheskie

Thank you, Paul. Operator, if we could make the next question our last question?

Operator

Our next question comes from Hassan Imam with Thomas Weisel Partners. Please proceed.

Q - (Actavian Popescu?), Thomas Weisel Partners

Good morning, this is (Actavian Popescu?) for Hassan. I have a question for Mike. It appears that the 3G upgrades in mature markets are pretty much set, with incumbents getting the lion’s share of the expansion and then half the operating contracts. Under this scenario, the growth from emerging market bills becomes even more important to capture and requires a local presence. So my question is, in period of opex cuts, how will you fund such expansion and also what do you expect in terms of margin impact of this emerging market contract? Thank you.

A - Mike Zafirovski

Thank you very much for that question. Of course there’s different elements of our portfolio. In Enterprise, where we have not focused as much on go to market activity as we are and we will be, I mean we actually have seen good growth and reasonably good markets. GSM and UMTS pricing is pretty tough. I mean, I would argue that’s pretty tough right now in developing and developed markets. The things which we’re driving is a significant attack of our cost structure, driving our quality and I think as we do that these are the best options for the business, both for the short term and for the long term. But I do indicate again, we’re taking very, very appropriate actions to drive our quality and our cost items. If I can do a quick summary before Terry wraps it up, number one is that we understand the Q1 results were disappointing, particularly on the gross margin side. I just want to reiterate our expectations for the year stay unchanged, both in terms of revenue growth and operating margin improvement. I believe there’s a company in the management team that’s working very decisively and with purpose and urgency on short-term opportunities. At the same time, we are building a very, very solid future. It’s very easy for any company to be only focused on short-term and also it’s easy just to be focused on the long term with visionary long-term statements, I think it’s much more difficult to find instances where somebody’s been doing both of those at the same time. I believe I know all the questions and concerns which you may have and our investors, of course, and I believe we’re putting lots of best practices from many people in the organization into drive with conviction, purpose and urgency. Short term actions, a lot of the things I’m doing (inaudible) successful long-term. Results will speak for themselves. We are very confident that we are taking or balancing both of those requirements well. Which probably will be evident in the results as 2006 unfolds. Thank you.

A - Terry Glofcheskie

Thank you, Mike and Peter. That concludes the conference call for today. As always, the investor relations team will be available to answer any further questions that you may have. Thank you for your time and interest this morning. Good bye.

Copyright policy: All transcripts on this site are copyright Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY’S CONFERENCE CALL AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE CONFERENCE CALLS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY’S CONFERENCE CALL ITSELF AND THE APPLICABLE COMPANY’S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.