Nortel Networks Corporation (NT)
Q2 2006 Earnings Conference Call
August 3, 2006 8:00 am ET
Terry Glofcheskie - Vice President, Investor Relations
Mike Zafirovski - President, Chief Executive Officer, Director
Peter Currie - Chief Financial Officer, Executive Vice President
Mark Sue - RBC Capital Markets
Ehud Geldblum – JP Morgan
Gus Papageorgiou - Scotia Capital
Scott Coleman - Morgan Stanley
Nikos Theodosopoulos - UBS
Ken Muth - Robert Baird
Jiong Shao - Lehman Brothers
Hasan Imam - Thomas Weisel Partners
Ladies and gentlemen, thank you for standing by. Welcome to the 2006 second quarter financial results conference call. (Operator Instructions) I would now like to turn the conference over to Mr. Terry Glofcheskie - Vice President, Investor Relations. Please go ahead, sir.
Thank you, operator and good morning, everyone. Thank you for joining us on the call this morning to discuss our Q2 2006 results. With me today are Mike Zafirovski, our President and Chief Executive Officer; and Peter Currie, our EVP and Chief Financial Officer. After Mike and Peter make their comments, they will be happy to take your questions.
Just before we get underway, 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 statements 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.
Thank you, Terry. Good morning and thank you for joining us this morning. On today’s call we will cover Q2 results, we will update our guidance. Also, before we close off, I will spend a few minutes to provide you with an update on the steps which we continue to make to progress our business both for short-term priorities in how we are building this business for the long term.
First let me provide you with a general update on the quarter, as well as perspectives on some of the important steps we are taking to move the business forward.
First of all, we had very strong orders in the quarter, they were up 22%. Sales were up also 5% and our backlog increased to $5.9 billion, a very healthy increase, $194 million during the quarter. Now we keep discussing and giving you more information in the region, and you can see there that the timing of contract completion and revenue recognition is going to impact some of the year-over-year comparisons, and we will do our best to give you the information for you to make the appropriate assessments.
I continue to make many customer visits, with the restrictions being lifted as of July 1. Those visits have increased and they are very positive. We discuss tactics and strategies with customers all over the world. We had a number of very encouraging wins during the quarter, which I will comment as I go through the presentation.
Gross margin for the quarter is 38.8%, up 70 basis points from Q1 but below the 40% target which we had set for ourselves and below last year. I should point out that the increase during the quarter in gross margin from Rev-A is the only one in the industry. Rest assured that we remain entirely focused on our gross margins.
We had several very nice completions during the quarter. First was a Microsoft alliance which I will make comments on later in the presentation. Debt refinancing was completed, and a transfer of the manufacturing facility to Flextronics, so we are completely done with that process.
Also, just to take a few seconds to make a couple of comments on the management team. We have spoken on it in the last few calls, it is completed. We have 18 direct reports, we have a terrific team. 64 were promoted or hired into the Cabinet during the second quarter. A few of those, as discussed before were Lauren Flaherty and [Dick Miwise] both started on May 1. Lauren is off to a terrific start as the Chief Marketing Officer, brings a whole new perspective to how we look at our business and how we are driving it.
[Dick Miwise] who also joined us from IBM has done a really terrific job of driving the service mentality throughout the Company and also focusing on the areas where we can be able to add appropriate increased value to our customers.
Mike Pangia, a long-term Nortel executive, both on the operational side and most recently as the CEO in Asia, was promoted to run Asia in June. [Philippe Moran], also a long-term Nortel executive who had run the optical business was promoted to run Metro Ethernet Networks as of June as well. We have hired John Roese, a person with a terrific industry recognition and experience in a number of areas – in network convergence, in merchant technologies, VoIP, machine-to-machine communications, and the list goes on. John joined us earlier in June. And last, Darryl Edwards a 14-year executive with Nortel, just a wonderful respect by employees and customers, a track record unsurpassed, frankly, within our go-to-market teams. Dale was promoted to run the Europe business.
We will miss Steve Pusey, a person who has spent 24 years with Nortel, but we are delighted that he actually will be going to one of our great customers, Vodafone.
Also we announced earlier in the quarter programs to improve our competitiveness, both to simplify the business, to improve our cost structure, and to address our benefit programs to be more in line with competition. Our business transformation, our Six Sigma programs, the employee engagement programs are gaining real traction across the Company, and those are the keys to drive our operating margin expansion, both short term and long term.
As you may have seen in the press release, we do expect the full year revenues and gross margin to be in line with prior communications.
On to orders, we saw nice momentum in most regions. Orders were up 22%, $2.9 billion versus $2.4 billion last year. This is the second quarter in a row where book-to-bill is at 1.1 and the backlog right now is $5.9 billion. This is up $515 million year-to-date, and as you may remember in our call at year end, we did indicate that we thought the backlog from year end to year end would actually go down, so as you do your models, this is to provide some perspective for you.
A few comments by region. North America, the orders were up 19%, very healthy. The biggest single driver is CDMA, and very significant increases in orders for CDMA product line.
In Europe, orders were up 21%, the most significant increases were in optical, in data networking solutions. And in Asia, the increase was significant, 56%. A significant part of this is due to the Nortel and LG joint venture which as a reminder, we indicated in our last call that most of the revenues for the LG and Nortel joint venture will actually be recognized later in the year, as a result of the revenue recognition practices.
Our financial highlights, this is data which shows the variance lines of the operating statements. In the following pages, I will discuss in detail the revenue and gross margin numbers, and Peter will discuss the rest of the financials.
Let me make a quick comment before diving into the details. Although earnings were for the quarter were $366 million, this was driven primarily by the mark-to-market adjustment related to the shareholder settlement rather than ongoing operations. Including the adjustment, our operating margin is still at a loss of 0.7% with low gross margin offsetting revenue growth and operating expenses.
We remain focused on delivering improved revenues and financial performance throughout the rest of 2006 and as we already have said, there are a number of growth opportunities that we see in the remainder of 2006. We expect growth across most of our businesses and regions on a year-over-year basis.
Let me move on now to the revenues by business. I will start with mobility and convergence core revenues, MCCN increased 7% on a year-over-year basis. Comments by product line, CDMA was down 5% from a very strong Q2 2005. For your information, the second quarter of last year was the highest revenue quarter in 2005. We do expect as orders would indicate, a strong pick up in CDMA for the rest of this year.
We do view the CDMA market to be relatively steady for the next number of years, but as I had indicated we do expect to have growth within our business for the rest of this year.
GSMA and UMTS was up 28%, growth driven in part by recognition of a previously deferred contract. [Inaudible] were down 6%. The decline is due mostly to revenue timing, there is a good momentum in this product line, and again, we do expect strong second half growth there.
A couple of comments on the overall momentum within MCCN. First of all, the CDMA 1X EV-DO Rev A was signed with Verizon earlier in the quarter and we do expect to start making shipments starting with Q3, this quarter. We are the lead systems integrator for IMS ready next generation solutions for the Israeli Telecom. We signed a three-year general purchase agreement with Liberty Global. We are deploying HSDPA networks with JTF in Korea.
Now let me move on to the enterprise solutions business. We are down 1% on a year-over-year basis and if I could just make comments by product line. Voice was down 21%, but this does not tell the momentum story. The revenues in Q2 were the highest we have had in the last four quarters and the decline versus last year was the tough Q2 2005 comparison, the significant revenue recognition from a software upgrade program.
The recent momentum is for converged IP solutions, and again we have orders and we do anticipate strong second half growth.
One good example of our efforts in this area is the Rolls Royce transaction which awarded Nortel a managed voice services agreement which is going to include a complete upgrade of their telephony network, and a complete servicing of their capabilities with advanced surveillance and other features.
Optical network grew by 7%. We see continued growth in this line. We are number one in Metro WDM for the second consecutive year, 26% market share, tied with a very close tie for number one in the overall optical business.
A number of very significant wins during the quarter, one of those examples is the win with a Spanish telecom provider, TeleCable, where we are enabling TeleCable to provide Internet virtual private network services to a large regional savings bank in Spain, so a single converged network based on our Metro Ethernet network capabilities.
Data networking security, we are up 23% for the quarter, a combination of good demand as well as recognition of previously deferred revenues. On the basis that we continue to see increased demand for our IP-based services and next generation routing solutions, partially offset by the decrease in our legacy products.
Geographic revenue, somewhat of a mixed story here. Quite a bit of it impacted by the timing of revenue recognition, which I have already commented upon on the previous pages by product line. We are up 5%. The timing of income recognition had an adverse impact on North America and a positive impact on Europe and Asia, but as you saw, the order intake is very consistent broad-based, and we do expect broad revenue growth for the rest of 2006, both our region and our product line.
Let me move on to the gross margins. Gross margin was $1.1 billion for the quarter, 38.8% as a percentage of revenues, up 70 basis points sequentially and down 4.5 points from last year. The primary impact versus last year was the regional and product mix, including the timing of certain contracts, the competitive pricing pressures and increased costs associated with compliance of the European Union environmental directive.
So more specifics to the mix, the Q2 is impacted by a lower proportion of North American revenues, which historically carry higher margin. As noted previously, the revenues in North America were down in Q2 and I expect them to be higher for the remainder of 2006.
Also increase in next generation wireless product sales, typically has a negative impact because the products in the early stages of the lifecycle do carry lower margins. Further, there was a margin drop in our Enterprise voice applications segment, compared to 2005, due to the recognition last year of previously deferred revenues in the software upgrade program which was not repeated in 2006.
We remain very, very focused in this area as we move to a more favorable mix on a geographic and product basis, that we do anticipate an uptick in this area for the remainder of 2006. In addition, increased sales volume will provide higher fixed cost recoveries.
Peter will cover now the rest of the financials, I will come back with my comments on the short and long-term business plan update. Peter.
Thank you very much, Mike and good morning, everybody. Selling, general and administrative expenses were slightly higher in terms of the quarter, and 80 basis points better as a percent of revenues in the second quarter 2006 compared to the second quarter of 2005. That was mainly due to a variety of factors.
One was the ongoing cost containment initiatives which we have talked to you about before, and that was offset by increased investment in our European enterprise sales and marketing organization, some increased SG&A expenses as a result of the consolidation in the second quarter of this year, comparatively, of PEC, now Nortel Government Solutions, and the LG joint venture, as well as some unfavorable foreign exchange impact associated with the strengthening of the Canadian dollar versus the U.S. dollar.
We turn to the chart on R&D we will see that R&D expenses of $489 million or 18% as a percent of revenues were flat in the second quarter compared to the same period last year on a dollar basis, and one point better as a percent of revenues. The R&D expenses included cost savings associated with our 2004 restructuring plan, which we have discussed previously, and a more effective prioritization of investments in targeted product areas such as data networking products.
This is partially offset by increased expenses as a result of the consolidation of the LG Nortel joint venture, again in this year, not in the second quarter last year and the unfavorable foreign exchange impact, given that we have a large portion of our research and development activities in Canada, where there is a strengthening dollar.
Summarizing our financial results for the quarter, as Mike touched on earlier, revenues were $2.7 billion or just under a 5% increase compared to the second quarter of 2005. Gross margins were 38.8% which is down 4.5 points from the previous year, although up from the previous quarter. Operating expenses are at $1.1 billion were flat to the same period last year, and net income was $366 million, which is up $399 million from 2005. EPS at $0.08 on a diluted basis were up $0.09 from the previous year, and on a year-to-date basis our revenues of $5.1 billion or 2.4% were up obviously versus 2005. Net income on a year-to-date basis at $199 million is also up $336 million from 2005.
Now there are a few factors that impacted our net earnings, and I will cover those on the next chart. The most significant is the $510 million shareholder litigation gain related to a fair value adjustment of the equity portion of the agreement that we discussed previously. As explained in our first quarter results call, the fair value of the equity portion is adjusted based upon Nortel's market share price at period end and is evaluated on a quarterly basis and again on the date finalizing the settlement. The share price used for the Q2 adjustment was $2.24.
The other two items obviously are smaller in magnitude. One of them was a $45 million restructuring charge taken in the quarter, and we announced this separately, primarily related to the reduction in headcount that was disclosed in June. There a $10 million loss related to the sale of assets.
Turning to cash flow, cash at the beginning of the period was $2.7 billion, and net cash used in operating activities were about $108 million, and the change in operating assets and liabilities were substantial, but really included cash payments for pension funding of about $71 million, certain restructuring payments of $29 million and movements in working capital of about $182 million.
Obviously reflected in the statements is also the impact of the revaluation of the litigation settlement which I mentioned but that's not a cash item.
Investing activities include the transfer of the cash portion of the shareholder settlement into escrow, and that amounted to about $575 million plus accrued interest. In addition, there were expenditures of about $78 million for plant and equipment.
Financing activities included the repayment of a long-term note of $150 million and foreign exchange on cash resulted in about $39 million inflow. So cash at the end of the period was $1.9 billion.
Future uses of cash over the next 12 months commencing June 30 include pension and post-retirement obligations of about $455 million, restructuring costs of approximately $100 million and of course costs related to our ongoing investment in the finance transformation program or the SAP conversion of our financial information infrastructure that we have discussed extensively previously.
In terms of investing, we anticipate capital expenditures of up to $300 million over the next 12 months, although we are looking for ways to economize that.
Now let me remind you that we announced the closing of the $2 billion offering of senior notes on July 5 and that $1.3 billion of the proceeds have been used to repay the $1.3 billion one year credit facility that was entered into in February of this year.
On the next chart, on operating metrics there are a number that I would like to touch upon. DSOs or days sales outstanding at 91 days decreased eight days from the first quarter. This reflects the impact of the increased focus on timely collections across all regions of our Company, as well as revenue deferrals in the first quarter that were not repeated during the second quarter. This is partially offset by the increase in notes receivable related to the transfer of our Calgary manufacturing operation to Flextronics without a corresponding increase in revenues.
Net inventory days of 148 decreased 17 days in the first quarter, mainly due to the higher cost of sales in the quarter and the impact of our divestiture of the Calgary manufacturing facilities to Flextronics. I would just point out, as we did in our last call, that our net inventory days metrics is the impact of deferred costs associated with the deferred revenues. If we exclude deferred costs, which were $2.1 billion in the quarter, the net inventory days was actually 34 versus 39 days in the first quarter of this year.
Days payable outstanding at 56 decreased by eight days, mainly due to the one-time impact on our accounts payable balance, again associated with the divestiture of the Calgary facility, and deferred revenues at $3.7 billion were effectively flat quarter to quarter. As Mike mentioned, the book-to-bill ratio was 1.1 and order backlog was $5.9 billion, up approximately $200 million from the first quarter.
Overall we have made some progress on our working capital initiatives, and we will continue to focus on overall operating cash flow. We expect to see fluctuations on a quarter-to-quarter basis due to volumes and movements of our deferred revenues, as well as associated inventory balances.
Now I would like to spend just a moment discussing a topic which has received some recent interest in certain media regarding our deferred tax asset. At the end of the second quarter, our deferred tax asset was approximately $4 billion. That was up $84 million from the first quarter of 2006. The increase was primarily due to the effects of foreign exchange, partially offset by a drawdown of deferred tax assets in profitable jurisdictions.
So, in accordance with U.S. GAAP, we thoroughly assessed the level of our deferred tax assets every quarter. We do this on a jurisdiction by jurisdiction basis and we consider all of available evidence, including recent history of cumulative profits or losses, the carryforward period of the asset, tax planning strategies and expectations of future earnings. We, of course, review this in detail with our external auditors.
If we deliver on our plans to increase profitability -- and we believe we will -- we will restore some of these assets to their full value in the future. If we don't, we will evaluate further writedowns in future quarters.
In considering guidance for the full year of 2006, we expect strong revenue momentum for the rest of this year, resulting in high single-digit growth for the full year compared to 2005. For the full year, we expect gross margins to be around 40% as a percent of revenues, and operating expenses to be flat to up slightly from 2005 with foreign exchange and growth-related expenses offsetting productivity and efficiencies.
In terms of the third quarter, we expect revenue growth in excess of 10% compared to the third quarter of last year, and gross margin and operating expenses to be in line with our full year guidance. As Mike previously mentioned, we expect growth across most of our business segments and regions on a year-over-year basis.
At this point, I would like to turn the podium back to Mike.
Thank you, Peter. Before we close out today, let me spend a few minutes on our game plan, which we have discussed with you previously, and some of the actions taken during the last three months.
You probably have seen this chart before. It is a combination of our short-term priorities; business transformation renewal and growth imperatives. The six-point plan which are driving each one of those points, the first would be in foundational in nature, and the last three driven towards growth and increased value for our customers and the operating rhythm for our Company.
I will just spend a few minutes on business transformation and growth imperatives and then we will go onto Q&A.
First with business transformation, I believe most of you have seen this chart before. It covers the six separate teams all led by a Cabinet member and a full-time champion to deliver $1.5 billion in operating margin expansion over the three-year periods. The next page will provide you with an update on what we have been able to achieve during the second quarter.
The first team with direct materials we have identified the first $200 million in savings. Savings on that for 2006 will be rather minimal as we are working through inventories on hand and some of the changes in vendors, but we do see significant incremental impact in both 2007 and 2008. As I believe you know, we're starting to evaluate the second level of commodity purchases.
On services this quarter we announced the implementation of the Operations Centers of Excellence program. The hiring process is starting in Mexico, and the plans are being finalized in Turkey. We also have implemented a policy change regarding the provision for services to partners to be in line with the market, and this will be increasing our revenues and margin.
On enterprise we've made significant changes in our go-to-market model, which I'm going to talk more in the next few pages, but we are starting to see nice traction in our revenues and engagements with customers.
With respect to our G&A and organizational initiatives, we made announcements in June regarding to changes on pension plan, some delayering and other simplification within our business to improve our cost structure. The pension plan changes are expected to result in an estimated annual operating margin and cash savings of approximately $100 million per year. The other annual savings from the organizational simplification actions are targeted to be approximately $100 million in 2007 and approximately $175 million in 2008.
Finally, our financial transformation program continues full steam to improve our financial systems processes to eliminate material weaknesses. The SAP implementation is on track, and as we have indicated before, the current $400 million plus spend in finance costs will be below $200 million in 2008. Peter Currie and the team are doing a really nice job on that.
In the last pages are growth imperatives. Q2 is also very much about putting in place the things that will help us drive near-term and long-term growth. We have done a good job. We're going to take you through some highlights on four fronts.
Number one, we took significant steps to change the trajectory of our enterprise business. We have strengthened our channel programs, increased our investments and launching eight new initiatives to drive momentum such as new training, order management and reporting tools.
Also, we've boosted our go-to-market capabilities for the SMB market, investing in three value-added distributors who will accelerate our channel growth and development. We've also expanded our product portfolio to serve the SMB market.
We have also launched IPT 123. This is a program to help existing customers convert to VoIP, and this will be our biggest sales and marketing program in North America this year. We announced it earlier in June. We went live just a couple of days ago, and the early feedback has been great. Our beta partners have already made some incremental sales. To support IPT 123 in the enterprise program in general, we're adding indirect sales support to be able to help our go-to-market activities.
With respect to our global services, we are making great progress. We are aligning with industry's best. Some of the examples we have established a new operational model for global services business that is more suitable for competing in a services market. We are investing in the evolution of our services tools and core processes. We have strengthened our regional services education, execution and delivery. We have added the security services to our portfolio of products.
As I move onto Metro Ethernet networks, we launched this business unit early in the quarter with a great traction. We have created three market development teams for the business, and their focus will be driving solutions and winning in three growth segments: wireless back haul, residential services and business services.
We've introduced a number of sales program to help drive second-hand sales. We've introduced a new product, for example, the BCS 3000 and a series of product enhancements to the Metro Ethernet network portfolio to drive the sales for the second half and beyond.
Of course, I do want to make a couple of comments on our strategic alliance with Microsoft. The deal is so significant because it is going to help drive more than $1 billion in incremental revenues over a three-year period, which will enable us to drive our growth in software and services.
The deal spans deep technology collaboration, joint marketing and joint sales and channel development. The Microsoft deal will help us reach more enterprise customers than ever before, and we believe we will generate significant pull-through data sales.
Steve Balmer has said that this partnership it could be as significant as what they are doing with HP and Intel, and those are, of course, some significant partnerships. In my view, this was a gutsy move for Nortel, and we're proud of it. We recognized a key industry inception point, and we said before we tend to lead and not to react.
So you can see that we have and will continue to take bold moves with an eye toward near or longer-term growth, and this with financial strength in the foundation we are building for the future.
There are really three simple building blocks, something which will make the business made simple mantra a reality. Leveraging our heritage of innovation in a very desirable installed base. We intend to be a leader in the evolution of business in mobile communications and services. We will discuss this in much greater detail in the upcoming analyst meeting which we may have early in the fourth quarter, but this is a brief statement on each.
Mobility and convergence. Our mobility investment strategy is anchored by our industry-leading IP, intellectual property and our innovations in QT technologies, OFDM and MIMO, which we see as a fundamental enabler for all future wireless connections, including the evolution of CDMA where we already are a leader, in LTE, in WAN and WiMAX.
In enterprise transformation we're creating a powerful ecosystem of disruptive partnerships to reinvent voice and to transform the enterprise network in our marquee installed base and for new customer opportunities.
Last in services and solutions, our services offers will range from a deployment of complete network outsourcing. Rolls Royce is a terrific example of this. We also are partnering with systems integrators to extend the market reach of our main services. We also are expanding our focus on SOA and web services, which are becoming a dominant framework for creating and delivering applications.
So in closing off, let me just give a very brief recap, and I look forward to your Q&A. In Q2 we improved revenues. We grew margin versus Q1. As we indicated, we are not where we want to be. There are strong plans to drive continued business performance improvements, both for the short term and for the long term. We are putting in a great foundation to rebuild and re-create a new Nortel. There is a passionate and relentless pursuit from management team and from the employees to achieve superior results, accelerate the progress and to be doing the right thing. Thanks for your interest, and we will go to your questions.
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, can we take our first question, please?
(Operator Instructions) Your first question comes from Mark Sue - RBC Capital Markets.
Mark Sue - RBC Capital Markets
Good morning, Mike. Good morning, Peter. Was the biggest component in the backlog growth related to the EV-DO upgrade in the LG JV, or was it more balanced in that?
Separately, are you rethinking the wireless business overall is the GSM UMTS business still in the review, or will you continue to invest in both wireless standards?
Thank you Mark. Two great questions I'm sure in the minds of most of you. The order backlog and the input was, frankly, very robust across the line. CDMA was significant. Again part of the timing for Q2 results in North America versus where we stood the rest of year. So CDMA and LG are the top two drivers of the growth increase. As we indicated before, there's substantial additional broad-based increases including very specifically optical and data networking in Europe.
On the second one, and I'm obviously aware of lots of the speculations out there, let me just make a couple of comments. We continue to focus on prioritizing our portfolio roadmap. Solving the issue of how we play wireless is a key part of that decision. We are committed to mobility and convergence, and we tend to be a leader.
We are focused on a parts of the wireless business where there is significant market share or a clear path in market leadership. As I indicated a few minutes ago, we see the future in wireless and we invest heavily to both preserve and to benefit from our technologies and position in CDMA, in LTE wiMAX and OFDM and MIMO. We've recently determined that our UMTS solutions and GSM solutions businesses will start operating as separate businesses within our MCCN segment. They are really very different businesses in different market stages, and they have different business characteristics.
Our GSM business is a sound and profitable business. However, we are going to make a decision about our UMTS access business, either bulking up, partnering or divesting, and this process is well underway.
Please note this does not encompass UMTS core or LTE. And we look at LTE of course, as the next generation, next evolution of UMTS. Whatever we're going to do, most importantly, is we're going to be working closely with our customer to ensure that their needs are met. When a final decision has been reached, you will be the first ones to know, all the people on this call. Until that time, we really think it would be inappropriate to make any additional comments on this topic. Thank you, Mark.
Our next question comes from Ehud Geldblum – JP Morgan.
Ehud Geldblum – JP Morgan
My question has more to do with the gross margin line and understanding the mix that goes into that and what it looks like going forward.
First, when you define your targets and guidance, this gross margin around 40%, I'm curious if where it is right now, is that considered around 40%, or is that still kind of below where you think it will go?
As you look at where your incremental revenue is coming from, it appears more of it probably comes outside of North America, especially with the LG joint venture, putting aside CDMA for the moment. Wouldn't that put pressure on the gross margin going forward? So how do you raise into the 40% plus range, and what are the movements there?
Then if I could touch quickly on the last question, how integrated is your UMTS and GSM and CDMA products in terms of the design of the base stations across all three and the components that go into there?
I always was under the impression back in the '03, '04 timeframe when Nortel was doing extremely well that one of the benefits you had in UMTS was that your UMTS product was based on your CDMA product and, therefore had a lot in common with it, and it is a highly integrated piece. If you could comment on the integration across those product lines, it would be very helpful.
A couple of comments. Obviously I didn’t do a good enough job the first time. We do expect CDMA to be up in the second half of year. The biggest driver for increased orders were in CDMA North America. The 1X EV-DO announcements which we made earlier with Verizon, so CDMA will play an important role for revenues and gross margin activities for Q3 and Q4 this year.
The LG enterprise, our Nortel LG joint venture, most of the orders are going to backlog because in U.S. GAAP, it is much stricter than most international, European included, GAAPs if you will. That is an enterprise product, and as you know, quite often the enterprise business carries a higher gross margin than the carrier segments that also should not be a detriment.
Those are the two key elements and again we are at 38.8% in Q2. So we believe we are the only Company I have seen so far that actually grew margin in Q2 over Q1, so the market is tougher now than it was six or seven months ago. But as situation changes, of course, maybe you can complain or you can simply take actions to be addressing it. I mean that is fully reflected in our view that again we're talking targeting to be in the 40% range, and frankly we do not see upsides to that. I think as we get closer to that I think it will be a job well done in this environment, and that is what we are very committed to doing.
Ehud Geldblum – JP Morgan
The 38.8 is not around 40% yet?
That is what I said. This is 38.5% for the first half, so we need to be someplace and someplace above 40% in the second half to be approaching 40% so we can do the math very easily as well, and that has been reflected in the forecast.
With respect to the leveraging CDMA and UMTS, you know on paper that opportunity is there for the industry. We have had some leveraging of that activity, but frankly, it has been minimal. As we have been discussing at the Analyst Day, we do not have the level of common platforms, common parts in general across the Company, including within R&D, which we see as a significant opportunity for our business going forward.
So I guess there was some, but again that was rather insignificant, and most of the leveraging was done between GSM and UMTS. So there would not be a material impact on our gross margin.
Ehud Geldblum – JP Morgan
Our next question comes from Gus Papageorgiou - Scotia Capital.
Gus Papageorgiou - Scotia Capital
Thank you. Just taking a look, it looks like most of the growth came from your GSM, UMTS and data and security businesses, which I assume are a result of the LG joint venture and the PEC acquisition from last year. So am I right to assume that if I exclude those two items that the organic growth is relatively flat year-over-year?
The LG orders have been very, very strong. There is a nominal impact from the LG joint venture in Q1 and Q2. Based on completion of requirements, which were in the contracts and based on U.S. GAAP, the Nortel LG revenues will start hitting our income statement in a meaningful way in the fourth quarter, so again LG is virtually a very, very nominal impact. The PEC impact is some, so they will reduce our 5% growth to a somewhat smaller number.
As I tried to indicate also, there's quite a few items that were there last year in terms of a recognition of software upgrades that were not repeated this year. Simply, as a comment, as you analyze our results is that our order backlog is up by $500 million on a year-to-date basis.
As we have indicated earlier in the year, we did expect the backlog to actually be down year-end to year-end. So that should give you some sense of the growth already built in based on the actual performance over the first six months, and that is what gives some of the confidence for the guidance that Peter had indicated earlier in the call.
Gus Papageorgiou - Scotia Capital
So GSM/UMTS growth year-over-year, as far as excluding Nortel LG, it is mostly just Nortel organic growth then?
Yes. Again in some cases we had a negative impact on timing of recognition within GSM and UMTS. As we indicated, there was a recognition of revenues that had previously been deferred, so there was that impact of a large contract with a European customer. But we deal with those ins and outs of the backlog and the deferred revenues on an ongoing basis, and the important point to take is that in totality that number has increased during the quarter.
Maybe I can just direct your attention to Chart 11, which is our geographic revenue chart in response to your question. You can see from that the year-over-year growth in the quarter on revenues is coming substantially or significantly from Europe and Caribbean and Latin America, neither of which are materially impacted. Nortel Government Solutions does not affect either of those theaters, and LG does not either. Asia, as Mike has indicated, there is some impact, but it is relatively smaller.
So I think what you want to look at is the growth of the underlying businesses in our more established markets of Europe, Middle East and Africa and the Caribbean and Latin America, offset by some of the dynamics you saw or Mike talked about in North America.
Our next question comes from Scott Coleman - Morgan Stanley.
Scott Coleman - Morgan Stanley
Just one follow-up on gross margins, and then I have another question if that is all right. It looks like according to your Q, some of your reserves went up in Q2 from Q1. Do you expect those to reverse as you go into the second half of the year, and that should help get your gross margin up north of 40%?
I missed that.
Scott Coleman - Morgan Stanley
I gave a quick read to your Q when it came out this morning. I apologize if I m getting the details wrong, but it looks like some of your inventory receivables and warranty reserves went up modestly on a sequential basis. I'm just wondering if you expect those to reverse in the second half of the year and you could get some margin benefit from that, or do you expect the margin benefit to come entirely from the business in the second half?
The change in the reserves that you mentioned in terms of account receivables or bad debt reserve, inventory, obsolescence and that sort of thing, they are largely formulaically driven. They are driven by either flows of revenues to various customers and the aging of receivables, or they are driven by the regular review we do of our inventory positions and our stock positions.
You should not expect that to have a material impact either way on the going rate gross margins. Mike's comments around gross margin strengthening for the balance of the year, you would think it would come and you should think it would come from underlying business dynamics, including product and geographic mix, as well as scale. Scale efficiencies are economies in the latter half of the year.
Scott Coleman - Morgan Stanley
That is what I thought Peter, but I just wanted to confirm. I appreciate it.
Then just a follow-up question on the cash side. If you were to make an asset sale, what would your priorities be for the cash? The Q indicates $850 million cash cost over the next 12 months for pension, CapEx, restructuring and the like. You also have some converts coming in 2008. How are you thinking about either your sources or uses of cash over the next year or so?
In terms of potential asset sales, and as Mike has indicated, if something transpires, we will let you know, but we certainly don't count on that as a source of operating cash. What we are relying upon for operating cash, as we have indicated previously, is two things.
First of all, substantially improved working capital in the areas of accounts receivable and inventory management, and we have programs underway to address that right now, as well as improved net earnings. We have the objective in the window of a 300 to 500 basis point improvement in operating margins in each this year and next year and the year after, and we would, of course, expect that to bolster the bottom line and help substantially bolster our operating cash position.
Our next question comes from Nikos Theodosopoulos - UBS.
Nikos Theodosopoulos - UBS
I had two quick questions. You commented earlier that you expect the backlog to be down year-over-year from the beginning of the year as we go through the year. Can you give the same assessment on deferred revenue?
My second question is on pricing and gross margin. You commented in the commentary that pricing has gotten more aggressive in certain areas. Can you be more specific and say where has the price aggressiveness become more intense since the last reporting that you did after first quarter results? Thank you.
We anticipated both the backlog and differed revenues based on estimation of where the customer contracts were going to come from, plus an execution of work to be done on backlog and previously deferred. We see it right now, they both will be going down. I think if you look at the details of our 10-Q, you will see that our deferred revenues short term increased almost $0.5 billion over the last six months. So both of those are supposed to be going down.
With respect to the pricing, GSM and UMTS are very, very competitive and also some of the enterprise products, particularly in Europe are the two at the top of my mind, but this is again a very competitive industry. So I did not mean to say that there is not a competitive environment for others, but those are the two. Peter, do you remember anything else?
No, I think you hit the highlights. I would only point out in terms of backlog there are three primary components of backlog, as we all know. Deferred revenue has two components, two primary components, which are long-term deferred and current deferred or short-term deferred, which is what is in the next 12 months, as well as the conventional orders on-hand, which those are the primary components of backlog.
As we recognize revenue in accordance with U.S. GAAP, from quarter to quarter you are going to see some quarterly deferral of revenue from one period to the next, and that is some of the dynamics you see in the first two quarters of this year. Certainly as we go through the balance of this year, we would expect that $5.9 billion backlog number to come down.
As Mike said, we expected deferred revenue to come down, and we have already discussed with you the dynamics associated with both deferred revenue and backlog as a result of the third restatement that we discussed earlier this year.
On backlogs, although not as significant as the timing of time to completion, another impact on our backlog has been the recent move of our Calgary facility to Flextronics. I mean that factory was the most complicated which we have had since enterprise carrier and that transfer happened May of this year.
The best transfer we have had to this point in time, but having said that, still we always do have a certain level of issues, particularly on the enterprise side. So we did see some deferral of deliveries from Q2 to Q3, and we think that is also going to help our revenue and margin performance in Q3.
Nikos Theodosopoulos - UBS
Just to clarify, do you think both backlog and deferred will be lower at the end of the year than where they were at the end of '05?
Yes, if I was not clear before, that is what I meant to indicate right at the beginning of this call. The $).5 billion for backlog we have said all along that there was an indication based on the analysis that we thought that that number would be going down.
Some of the events have turned out a little bit differently. Frankly, it was never meant to be as $0.5 billion in the first half of this year but yes, the short answer is yes.
That remains our expectation. Yes.
Our next question comes from Ken Muth - Robert Baird.
Ken Muth - Robert Baird
Just to expand a little bit on the enterprise comment, Mike, you made in Europe is looking at the EBT as you guys break it out in the Q, and year-over-year the revenue is pretty flat at about $1.068 billion this last quarter, but the EBT went from $60 million in '05 to $12 million or implies 1.1%. Can you comment on how you might try to turn things around there to get that business more profitable?
There was a significant demand to revenues in Europe, and Peter may have some more specifics on it, but that was driven by GSM and UMTS, which do have a significantly lower margin, particularly on the UMTS side than the rest of the business. So I would think that was the single biggest factor for that result. Peter, do you want to add some additional comments?
Yes and you have to remember too year-over-year enterprise had some favorable product mix in the second quarter of last year that was not repeated this year. So it is on a quarter-to-quarter basis we can see substantial swings and roundabouts as a result of our product mix.
As Mike indicated in his opening remarks, we have taken a number of steps to bolster our enterprise go-to-market activities. We have bolstered our distribution organization in Europe specifically, and we expect to see that result in more robust revenues and hence returns in that market in particular.
Ken, I'm sorry. Is your question based on Europe profitability, or is that enterprise profitability globally?
Ken Muth - Robert Baird
I misunderstood, but the biggest single reason is there is a very significant recognition as Peter had indicated of a software upgrade. I mean the revenues are more than $100 million, very significant profit margin in the 70% to 80% range, so that is the single biggest reason for the year-over-year impact both on revenues and profitability within enterprise as I had indicated.
The enterprise, particularly in voice, we had the strongest quarter in the last four in Q2. This year the momentum is very good, better than before. Some of the marketing enhancements, which I had indicated, are kicking off in the latter part of Q2. So we feel good as to what was being done globally with our enterprise business.
Our next question comes from Jiong Shao - Lehman Brothers.
Jiong Shao - Lehman Brothers
Thank you very much. I have a question about your enterprise business as well. It is down 1% year-over-year, but sequentially it seems to be very strong. Could you first talk about just overall enterprise demand environment? We seem to have heard some mixed comments from different IP vendors. Also, would you talk about some of the drivers behind these trends in Q2 from Q1?
Thank you very much for that question. I believe we have been pretty consistent saying that we have the most desirable customer base in the industry. Our products on balance have been very good. Our issue has been having enough at bat against opposition.
When we go at bat, we do well for a number of reasons, the way we have been organized or how we are using our value-added resellers or the programs which we have provided. So I would have said all along that we believe this is one of the opportunities within our business.
In the IPT 123, certainly a very simple elegant program to make it easy for current customers to be able to be able to convert to VoIP. The work of one of the business transformation teams is revenue stimulation. A number of requests have come in including more indirect sales, a different way to approach our direct sales force. Laura Flaherty has been working with the team on increased marketing programs.
I went earlier this year to speak with our INNUA members. I mean very, very positive expectations as we look at them down the road. I think the Microsoft relationship opened lots of eyes to that, and we tend to lead to make it easy for our customers to be contemporary as opposed to having the concerns that they are on a legacy platform. So this is among the couple of reasons. As we have indicated, there is a good momentum as we look at the second half of year.
Jiong Shao - Lehman Brothers
Do you expect to see similar growth year-over-year in this current quarter when compared to your total corporate top line?
At least, yes. The question was, do we expect to see continued growth opportunity in Q2 for the rest of the year? The answer is yes actually for that growth to accelerate.
Our final question comes from Hasan Imam - Thomas Weisel Partners.
Hasan Imam - Thomas Weisel Partners
So we have all been waiting for real operating margin improvements, and previously you commented that some impact of cost-cutting would flow through the model by year end. With the recent comments of flat operating margins, that does not seem to be the case any longer at least for 2006.
So did I misinterpret your comments, or has the timing changed due to external factors like gross margins or because of strategic decisions to add costs in certain areas?
It is a great question. We have looked long and hard as to current status, the current momentum, and as we are looking at orders on hand, business prospects and this is with a pretty in-depth analysis where we have made the comment that we do expect, as I said in Q3, revenues to be above 10%. That is for the year.
Take into full consideration, as Edward reminded me, the gross margin was in the mid-38 for the first six months that we do look at both margin and revenues to be in line with what we said previously.
It is tougher now, granted, across the market. It was also noted but there is a full commitment for the team to drive to the best of our abilities all along we are looking at hard as to what we have in orders. Actions started on business transformation and elsewhere, and there is a good sense that we will be able to achieve what we said previously.
Hasan Imam - Thomas Weisel Partners
In '07 and '08 then?
Say again. Would you repeat that?
Hasan Imam - Thomas Weisel Partners
Real operating margin improvements you are expecting, is that more in 2007 then?
Let me just expand on that a little bit. First of all, when we announced our objective of improving the operating margins substantially this year, next year and the following year, we said it would gain traction in 2006, but you should expect momentum to build primarily in 2007, 2008. We have not backed off on that.
Mike gave I think a very good update on where we are today at the end of the second quarter on the transformational programs. I think you're seeing that reflected in the operating margins. If you look on a year-over-year basis, they are improved. If you look on a quarter-over-quarter basis, they are improved, and we're not backing off that either as an objective or as a commitment to our shareholders.
There is no question that when you start a program of this nature, it takes a little bit of time to gain traction. It is gaining traction. We have demonstrated that in the direct materials area. We're demonstrating it in the revenue enhancement area, and we're demonstrating it in management of general administrative expenses with the various announcements we have made in the last couple of quarters.
So I think everybody wants things to happen faster than maybe is practical, but we're doing this as quickly as we possibly can, and there has been no relaxation on the commitment.
Thank you, Peter, and thank you, Mike and thank you all for joining us on the call today. This does conclude the conference call. As always, the Investor Relations team will be available to answer any further questions you may have, and again thank you for your interest this morning. Good bye.
Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect all lines. Thank you and have a good day.
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