Nortel Networks Q4 2006 Earnings Call Transcript

TRANSCRIPT SPONSOR

Nortel Networks Corporation (NT)
Q4 2006 Earnings Call
March 19, 2007 8:30 am ET

Executives

Terry Glofcheskie - Vice President, Investor Relations
Peter Currie - Executive Vice President, Chief Financial Officer
Mike S. Zafirovski - Chief Executive Officer, President

Analysts

Ittai Kidron - CIBC World Markets
Mark Sue - RBC Capital Markets
Vivek Arya - Merrill Lynch
Gus Papageorgiou - Scotia Capital
Paras Bhargava - BMO Capital Markets
Kenneth Muth - Robert W. Baird
Hasan Imam - Thomas Weisel Partners

Presentation

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the fourth quarter and year-end 2006 earnings conference call. (Operator Instructions)

As a reminder, this conference is being recorded today, March 19, 2007. I would now like to turn the conference over to Mr. Terry Glofcheskie, Vice President, Investor Relations. Please go ahead.

Terry Glofcheskie

Thank you, Operator, and good morning, everyone. Thank you for joining us on this call this morning to discuss our fourth quarter and 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 comments, we will be happy to take your questions.

Now, 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 our earnings press release dated March 16th 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.

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Mike S. Zafirovski

Thank you, Terry. Good morning, everybody and thank you for joining us. Today’s call is going to cover a few things: Q4 results, of course; Peter will touch upon the recently completed restatement with the impact to prior periods; we will provide an update on our guidance; and before we close off, I will spend just a few minutes to provide an update on the business transformation progress, both again aim to improve short-term as well as to the foundation for the long-term. Of course, we look forward to your questions.

Before I go into the details, let me just give you a very quick update in general terms on the fourth quarter. Overall, we had a very good quarter. Strong revenue growth across most businesses, with a particular strength in our enterprise business, partially offset by a decline in GSM and UMTS revenues on a year-over-year basis. Deferred revenues did come down sequentially and on a year-over-year basis, but frankly the decline was less significant than what we anticipated before.

Orders were 5% up compared to the previous year and the book-to-bill was a 1.03.

The combination of deferred revenue impact and the orders result in an increased backlog from $5.1 billion to $5.2 billion in the quarter.

Overall, we were very pleased with the momentum on the top line as we move into 2007.

Gross margin in the quarter was approximately 40%, up 140 basis points from the third quarter and the highest which we have had in eight quarters. We benefited from a higher percentage of CDMA sales, also higher enterprise revenues and higher recognition of the LG joint ventures. We remain very, very focused on improving our gross margins.

Operating margin also came in at 4.2%, highest in eight quarters. On a full-year basis, we broke even. On an operating margin basis, up slightly from 2005.

Operating cash flow was up significantly in the fourth quarter and frankly ahead of our expectations. The cash flow was $520 million up for the quarter and $237 million for the year, which is the highest and first positive cash flow since 1998. Our cash balance was even higher as a result of the completion of the transfer of the UMTS access business to Alcatel at December 31st.

With respect to our control environment, we have implemented remedial actions to significantly improve our control environment, which resulted in the elimination of four out of the five material weaknesses which we had at the beginning of the year. So the one that is left right now is the revenue-related material weaknesses.

We also announced significant customer wins. Most specifically, the $2 billion CDMA contract with Verizon and the PBT win with British Telecom. Also, a number of very significant wins in the enterprise side and we made very, very good progress with the Microsoft ICA alliance. On February 7th, we announced some additional actions to improve our competitiveness and I will make some comments on it at the end of the talk.

Again, overall a very good and balanced Q4.

A couple of comments, before getting into the details, on the customer wins. Customers are investing in the future with Nortel, starting with the enterprise. A few examples among many which we have announced. For example, The New York Times and the Montreal Canadiens wins. Also, key hospitality wins all over the world. A few examples; the Louisiana Super Dome, also with Kernzer International, the Intercontinental in Saudi Arabia and also a nice win in Dubai with Silicon Oasis.

In mobility, a strong series of wins highlighting our municipal wireless portfolio, as well as continuing progress in the Middle East, including the American University of Cairo. We provide all communications services, voice-over-IP, multimedia, and WiFi.

Metro ethernets, we are getting traction above and beyond the British Telecom, with a nice win with MTC, the leading mobile provider in the Middle East and Africa. Also, a win with Sonofon, Denmark’s second-largest mobile operator and with National Telewest, the U.K.’s largest cable operator, a combination of solutions for triple play of voice, video and data.

On services, we had nice wins with both Eastman Kodak and Rolls Royce, and also nice progress we are making with the Nortel Government Solutions. A couple of examples, to operate and maintain the visual systems for the U.S. Nuclear Regulatory Agency, and to create a wireless secured architecture for the U.S. Navy Space and Naval Warfare System Center.

Let’s move on to the numbers, starting with orders. We saw orders increase compared to the previous year. Orders were up 2% over the previous year and the book-to-bill is 1.03. Drivers were higher CDMA revenues and LG orders, as well as enterprise. Backlog was up by hundreds of millions of dollars to $5.2 billion, and deferred revenues were down $200 million to $3.4 billion sequentially. We do expect deferred revenue balances to come down gradually through 2007.

Let me move on to the Q4 2006 financial highlights. This is simply the financial highlights page. As we have done in the previous calls, I will comment upon revenues by business and gross margin, and Peter will be discussing the other numbers. But let me just make a comment on the Q4 operating margin. It was up 282 basis points from the previous year. It follows a trend of increasing operating margins throughout 2006 as we are able to leverage our growth. We remain very, very focused on improving our operating margins during 2007 and to enable Nortel to be a double-digit operating margin company in 2008.

Let’s move on to revenues, starting with the mobility and converged core business, or maybe a simpler, carrier networks. The revenues were down 5%, driven by a significant decrease in our GSM and UMTS revenues. GSM in particular was down significantly from the previous year as a result of timing of a contract in India and the timing of a contract in North America, which we did not repeat in the fourth quarter of 2006. As we of course know, the UMTS business was sold on December 31, 2006.

We had very strong growth in CDMA, up 37%, a combination of EVDO Rev A and also some CDMA business which we had in Asia, including our joint venture with LG. Circuit and packet voice was flat, a nice growth in succession, offset by declines in TDM.

Moving on to enterprise revenues, we had a terrific quarter. The revenues were up 61%. The numbers were being impacted severely by the LG joint venture, which contributed 33 points of the 61 points of growth. At the same time, we had a very, very robust 20% growth in all of our other activities.

Circuit and packet voice, with the highest revenue in 12 quarters, significant contributions to North America from a combination of programs, including the IPT 123 and the BCM program, and of course the LG joint venture. We see the benefits of the investments which we said we were going to make in the enterprise business, the combination of increased R&D, increased go-to-market resources and improved alliances.

Data networking and security also were up, 62%. We saw nice growth in ethernet switching and mobility products.

We believe that we gained market share in the enterprise business, even without the benefits of the LG joint venture, for the second quarter in a row and we feel good by the trajectory of this business.

Metro ethernet networks revenue, up 18%. In optical, we were up 22%, as you can see on the page. Nice wins in Hong Kong and also Telewest. We did have favorability from completing contracts with Comcast and Optus. Obviously Comcast in North America and Optus in Asia, which added to the favorable revenue results for the quarter.

In data networking and security, up 9% from the previous year. As you can see, nice wins with British Telecom as well as Sonofon and Easynet. So nice momentum again in the metro ethernet revenues.

Global services were up 2%, personally impacted by timing of contracts in the restatement but there is a very, very nice momentum with orders and doors being opened for our capabilities in maintenance, operate and advanced services, and we are focusing on new business areas -- managed services, optimization and interoperability.

The Microsoft-Nortel ICA added 11 core integration services to help customers build, deploy, and support joint unified communications solutions. Simply as a reminder, we will start reporting planning deployed revenues as part of the services business as of the first quarter of this year, which in essence will be almost doubling the size of the reported services revenues.

With respect to the geographic revenues on slide 13, we are up 10% for the year. As you can see, particularly strong growth in North America, up 13%, driven by CDMA, enterprise and also in EMEA. As a point of reference, which we showed last time, the LG joint venture and NGS produced approximately $364 million in incremental revenues, which overall was largely offset by the decline in UMTS and GSM for the quarter.

The last page for me before Peter discusses some of the operating expense numbers, gross margin, we are very pleased that the gross margin was approaching 40%, 39.8%. We saw improved sequential and year-over-year gross margin, and the highest in six quarters. The wireless margins increased due to a favorability of product mix but also customer mix. We had significant revenues from a particular customer in Asia in the fourth quarter of 2005. Gross margins of course being also helped by very strong enterprise revenues, which do carry a higher gross margin than the company’s averages. This was partially offset by unfavorable optical product mix. On a sequential basis, gross margin improved across all businesses with the exception of MEN.

Now I will turn it over to Peter and look forward to closing the comments and opening for Q&A in a few minute. Peter.

Peter Currie

Thanks very much, Mike, and good morning, everybody. I will begin my remarks talking about SG&A, so those of you following on the charts, this is chart 15. SG&A expenses were $11 million higher in terms of dollars and 170 basis points better as a percentage of revenues in the fourth quarter 2006 compared to the fourth quarter 2005. That was primarily due to increased SG&A expenses as a result of the consolidation of the LG joint venture, as well as higher employee compensation costs resulting from increased sales compensation due to higher sales volumes and year-end bonus plans.

To expand on the bonus plan costs, those payouts as a percent of the target were 50% in 2006 compared to 33% in 2005 and zero or nil in 2004. These increases were partially offset by lower restatement and internal control overlay costs, lower employee benefit plan costs, and lower executive recruitment and retirement costs.

Research and development expenses at $488 million, or 15% expressed as a percent of revenues, were up $31 million in the fourth quarter 2006 compared to a year earlier on a dollar basis, and they were 40 basis points better as a percent of revenues.

The fourth quarter R&D expenses included increased investments in IMS and WiMAX, increased expenses as a result of the consolidation of the LG-Nortel joint venture, and higher employee compensation costs resulting from the year-end bonus plan I just referred to, and that was partially offset by lower employee benefit plan costs.

The next chart on other items serves to help explain some of the dynamics of the P&L, which may not be visible otherwise. Other income in the fourth quarter at $34 million was primarily driven by interest and dividend income included in the interest from the restricted cash balance associated with the shareholder litigation settlement. This amount corresponds to a cost in our interest expense line.

Our fourth quarter 2006 other income was down $79 million from the fourth quarter 2005, mainly due to a one-time gain recognized last year from our investment in Axtel.

Interest expense in the fourth quarter at $97 million is $40 million higher than the fourth quarter 2005, mainly due to the higher interest rate and increase in total debt resulting from the refinancing of the interim facility that we completed in 2006 and which we reported on in some detail previously.

Minority interest in the fourth quarter 2006 at $58 million was $56 million higher than a year ago, mainly due to increased profitability of the LG-Nortel joint venture, resulting from the recognition of previously deferred revenue. Although we expect improved annual performance from the LG-Nortel joint venture in 2007, the strong performance in the fourth quarter of 2006 is not expected to be repeated to the same extent in quarters throughout 2007.

The next chart reiterates the fourth quarter highlights that Mike touched upon. Revenues were up, were $3.3 billion, or 10% up from the fourth quarter 2005. Gross margin was 39.8%. That is up 70 basis points from the previous year. Operating expenses at $1.2 billion were up $100 million from the fourth quarter 2005.

Operating margin continued to improve from the first quarter 2006 through to the fourth quarter, and in the fourth quarter the operating margin was 4.2%. That is up 282 basis points compared to the fourth quarter a year ago.

Net loss was $80 million, and that is an improvement of $2.2 billion from 2005, which of course included the shareholder litigation settlement costs.

EPS was a loss of $0.19 a share on a diluted basis and an improvement of $5.07 from the previous year.

On a full-year basis, our revenues were $11.4 billion, or 9% up from 2005. Operating margin was break-even for the full year and was up approximately 21 basis points. Net earnings were $28 million, and again that is an improvement of $2.6 billion from a year ago. EPS at $0.06 a share on a diluted basis was an improvement of $6.08 from the previous year.

There were a number of factors that impacted our net earnings. I would like to just touch upon them in the next few charts.

A significant transaction in the fourth quarter was the divestiture of the UMTS access business to Alcatel Lucent and that culminated on December 31st. In order to provide transparency on the impact of the revenues, this chart -- and I am referring here to number 19 -- provides a quarterly breakdown of the business for 2006, including the services but excluding the LG-Nortel joint venture UMTS access sale, which will continue to flow through Nortel as the financials are consolidated.

In addition, book-to-bill in 2006 was about 1 for UMTS access. We acknowledge that there is the potential that the UMTS access sale may have a negative impact on our underlying GSM business prospectively.

Other factors on the next chart that impacted our net earnings included the $234 million shareholder litigation expense related to the fair value adjustment of the equity portion of the agreement, as we have touched on in the previous results calls. There is a $29 million restructuring charge taken in the fourth quarter, primarily related to the 2001, 2004, and 2006 restructuring programs. There was a $164 million gain on the sale, which closed in the fourth quarter, resulting from the completion of the UMTS access divestiture, and there was a $15 million tax recovery related to evaluation allowance releases in our LG-Nortel joint venture and in our German businesses.

Now I would like to provide an update on the pension plan, given two material events in the fourth quarter. First of all, in accordance with the changes in pension accounting requirements announced in 2006, Nortel adopted SFAS-158, which requires the full un-funded status of pension plans to be recorded on the balance sheet. The fourth quarter impact of this was a $142 million charge to shareholders equity.

The second item, our un-funded pension status in the fourth quarter decreased to $2.1 billion from $2.5 billion in the fourth quarter 2005. This decrease was primarily due to the pension plan changes that we announced in the course of 2006 plus the contributions made during the year and an improved return on assets on plans throughout the world. Cash funding in 2006 was $354 million and is expected to be about $365 million in 2007 for pensions.

Now I am going to turn to the cash flow chart and as we discussed on November 15th at our analyst day, earnings are important to companies but companies actually do run on cash. I noted that we have been challenged as a company over the past few years to optimize our cash and in particular, in the areas of accounts receivable management and inventory. So we are very pleased that our fourth quarter cash flow is beginning to show the results of some of the actions that have been taken.

Summarizing the cash position, the cash at the beginning of the period was $2.6 billion. Net cash from operating activities significantly improved to $520 million, and that included the net loss, of course from continuing operations, the adjustment for non-cash items, such as the shareholders settlement mark-to-market adjustment that I referred to a moment ago, pension and other accrual changes, amortization and depreciation, as well as the recognition of the gain on sale of business.

Working capital improved significantly as a result of the accounts receivable collections, which were actually up but offset by the increase in billing volumes in the quarter, inventory reductions through the outsourcing of manufacturing, and improved trade payables as a result of better inventory management.

Investing activities reflect the net proceeds, primarily driven by the sale of investments and businesses, including the UMTS access business and the transfer of the Calgary facility to Flextronics, partially offset by expenditures for plant and equipment in the quarter.

Financing activities were a net use of $6 million, mainly driven by the increase in notes and dividends payable, and foreign exchange on cash actually resulted in a $35 million increase in cash.

So cash at the end of the period was $3.5 billion.

Future uses of cash over the next 12 months, as disclosed in our 10-K: pension and post-retirement obligations of about $440 million; restructuring costs of about $275 million, related to the announcement that we made last month for our restructuring program, as well as carry-over restructuring costs of about $115 million related to previously announced restructuring programs; costs associated with the divestitures of our manufacturing facilities and UMTS business, which carry over as a result of those arrangements; as well as capital expenditures, which we expect to be in the range of about $300 million for 2007.

The next chart deals with operating metrics and there are a number that I would just like to touch upon: day sales outstanding, or DSO, at 75 days are improved by 11 days from the third quarter of 2006 and as Mike indicated, that reflects the actions that we have undertaken to substantially fortify our focus on this area; net inventory days, which excludes deferred costs, were 22, which is a six-day improvement from the third quarter; the days payable outstanding at 49 days increased by three days, and that is a good thing with payables, due to an increase in accounts payable resulting from a spending increase in the fourth quarter, as well as reflecting the impact of inventory management; and deferred revenues, as Mike indicated, were $3.4 billion, which is down about $152 million compared to the third quarter of last year.

Overall we have made pretty substantial progress on our working capital initiatives and we will continue to focus on overall operating cash. We expect to see fluctuations on a quarter-to-quarter basis due to volumes and movements in our deferred revenues and associated inventory balances.

Before I speak to the outlook, I will take a moment just to provide some insight into the recently completed restatement. There were three primary elements in the restatement. We have touched upon most of this in previous discussions. There was a pension expense change due to a third party actuarial error. There was a series of adjustments related to revenue recognition timing and there was a tax expense adjustment. Again, these are all outlined in some detail in our 10-K, beginning on page 45, so I draw your attention to that.

In total, across all prior periods, the impact was a decrease of $65 million in revenues, which will be subsequently recognized in future periods. The net earnings impact across all periods was a decrease of $69 million, driven primarily by the third party actuarial calculation errors in the North American pension plans.

The impact of the restatement was not material to any period and had no material impact on our fourth quarter 2006 operating performance.

In considering our outlook for 2007, on the full year, we expect revenues to be flat to down slightly compared to 2006 and that reflects a decrease in revenues as a result of the sale of the UMTS access business. We expect full year 2007 gross margin to be in the low 40’s as a percentage of revenue and operating margin to be 5% or higher of revenues.

For the first quarter of 2007, we expect revenues to be about flat compared to the same period in 2006. Again, that reflects a decrease resulting from the UMTS access disposition. For information, last year, i.e. the first quarter of 2006, UMTS access revenues were about $170 million.

We also expect first quarter 2007 gross margin to be in the high 30’s; that is, between 37% and 39% as a percent of revenues and operating expenses to be down modestly compared to the first quarter of 2006.

With that, I will turn it back to Mike to make some other comments on the business transformation.

Mike S. Zafirovski

Thank you, Peter. I will wrap this up quickly. I look forward to the Q&A.

I first prepared this chart a year ago, highlighting both our short-term priorities and longer term plans to truly create a great company again on multiple fronts, both from a competitiveness and go-to-market perspective. We made good progress since that time.

We have introduced and implemented many programs to deliver the $1.5 billion operating margin expansion by 2008. I will make a few comments on that on the next page. We also issued growth programs, such as the Microsoft ICA. We have changed the trajectory of the enterprise business. We formed a metro ethernet networks division with very significant wins, British Telecom. We have formed our global services and solutions business.

Also, we have improved the focus and commitment of our R&D spend and our focus on growth areas, such as WiMAX, 4G wireless, IMS and mobile video, and we have divested businesses where we are not going to achieve market leadership, such as the UMTS access.

In governance, overhanging issues are being addressed, such as the new code of conduct, resolving shareholder litigation, consolidation and significantly reducing our material weaknesses.

In 2006, we completed some of the heavy lifting to both deliver a competitive cost structure and to start driving strategic new growth for the company.

Let me just make a couple of comments on the business transformation progress. This page is not new. You saw it at the November 15th investor day. We show it here just to simply reinforce our commitment to the $1.5 billion improvements in operating margin in 2008, and also to highlight some of the key activities which have taken place in the last three months. Hopefully if you have a color screen, the changes are highlighted in the orange color.

We delivered approximately $100 million savings in 2006 and we have programs in place to deliver $750 million of savings in 2007. I will just quickly highlight some of the updates on activities over the last three months.

Within direct materials, we have completed the negotiations and work has been made on wave 1, underway on wave 2, and we have kicked off the approach for wave 3.

With services, very good progress, including our new centers of excellence. Hiring is pretty much underway in Mexico and we are finalizing plans for Turkey. I will be there in early April to kick off the center of excellence. Great support there from the government and from a significant number of applicants for those very attractive positions.

We also have implemented policy within services that starts charging for services, very consistent to what the industry practice is. We have very good results to this point in time.

With respect to revenue stimulation and pricing, we did a terrific job last year in redesigning go-to-market, particularly in the enterprise and voice-over-IP areas. The big focus through 2007 will be to improve our pricing architecture globally. We will be institutionalizing pricing initiatives and currently we are 85% completed.

Good progress within our R&D effectiveness, investing more and more into areas where we can be able to lead and we have completed so-called clinch-hitting approach for a good part of the portfolio and about to start phase 3.

In the February 7th announcement, we had further highlighted the activities with a move to lower-cost countries.

Both with respect to G&A, organization and finance costs, we are making very good progress, whether it is implementing the previously announced spans and layers, or within finance to be driving the SAP implementation. It probably will be done in April of this year and the second phase will be done in July and August of this year as well.

If we can move on to the next page and the financial overview, there is the same $1.5 billion highlighted among the five teams and the announcement which was made on February 7th, $400 million of the $1.5 billion were the specific actions communicated on February 7th. Half of those savings will be realized in 2007 and the remaining will be realized in 2008. As you can see, for example, $80 million out of $400 million will be in the revenue and services arena; $140 million within G&A organization and so on. And a combination of programs here as well as previously announced activities will drive the $750 million of operating margin improvement in 2007.

Let me just provide a quick summary. We had a very strong fourth quarter. Combination of solid revenue growth across the businesses, improved operating margin, very strong cash flow, and I simply want to make an additional commitment on our business model, which we highlighted at investor day, and the very specific criteria which will be defining our success.

There is a strong and passionate pursuit of improving our financial results and to doing the right things and for us to keep increasing our transparency and reporting.

Thank you for your interest this morning. We saw a number of your write-ups, since you have prepared those since we published our results on Friday evening, and Peter and I look forward to answering your questions. Thank you.

Terry Glofcheskie

Thank you, Mike and Peter. Operator, if you could please open the lines for Q&A and we will take our first question.

Question-and-Answer Session

Operator

(Operator Instructions)

The first question comes from the line of Ittai Kidron from CIBC. Please proceed.

Ittai Kidron - CIBC World Markets

Good morning, gentlemen. A couple of questions; first one for you, Mike, with regard to your 2007 outlook. Could you give us a little bit more color? I think most folks were hoping for a little bit more growth this year. What do you see as slightly more disappointing going into the year versus a couple of quarters ago?

Second, a question for you, Peter; one of the greatest areas where there is a lot of volatility as far as the forecasts are concerned when you look at the different analysts’ models seems to be around the op-ex, number one, and two around the interest income. Could you give us a little bit more color and perspective on how should we think about the progression of dollar op-ex through the year? Also, with regard to the interest income, considering the cash outlays you need to pay out, could you give us a little bit better clarity with regard to the timing of those, what would be more front-loaded versus back-end loaded in the year? How should the interest income/expense line change through the year?

Mike S. Zafirovski

Thank you for that question. I believe, reading through the various analyst reports and reflecting what we have said previously, I think the biggest disconnect may have been the size of the UMTS business access. We said we are between 6% and 7% and the simple math -- we have put the numbers between $600 million and $700 million for 2006. But if we look at our key business areas, whether that is going to be on the CDMA or that is going to be enterprises, services and MEN, we believe that we will be growing above market in 2007. That is what we are targeting internally, thus we feel very confident we will be able to do that.

I do not want to give you a pro forma revenue number but if you simply looked at the market trajectory for GSM in thinking of the UMTS revenues, by simple deduction, we show that our guidance would indicate a revenue growth of high single digits. I think that speaks well of what we have positioned the business, the customer momentum, and including our go-to-market activities.

From our perspective is that for us to be able to be at or close to the 2006 revenues, which will be much more attractive margins, we think will be a good demonstration of our ability to grow in areas which we have said that we will be able to grow.

Peter.

Peter Currie

Thank you. I will address the other two portions of that question, which deal with operating expenses and interest income and expense. Let me talk about op-ex first of all. You have seen this company focus on operating expenses pretty relentlessly and we are starting to get some traction in that area now. Operating expenses are defined as SG&A and research and development.

The components are kind of complicated, because in SG&A, as you heard Mike talk about, we have addressed very aggressively the general and administrative portion of that expense category. That will start to show benefit as we go through 2007. We are in fact investing in the selling and marketing activities and again, we highlighted that at some length in our investor day and in other forums.

So I would say if you look at the SG&A expense on a net basis in the fourth quarter, that is not a bad proxy for the momentum of the business going forward. In terms of R&D, the R&D program will change somewhat in the course of 2007 obviously because with the divestiture of UMTS access, the components of the program have changed a bit but we are investing also in WiMAX, IMS, and other programs.

In terms of other income and expense, again there is some complexity in that, partially because included in interest income, you have the income recurring as a result of the restricted cash that has been put in escrow for the shareholder settlement and that is netted out in interest expense.

If you look on a net basis, the primary driver is going to be the increased cost of debt. We referred to that in our remarks and the fourth quarter is a full quarter run-rate of that increased balance and debt cost on a percentage basis, so that again should be a fairly reasonable proxy prospectively on a quarterly basis for 2007.

Mike S. Zafirovski

We have not made operating margin guidance before. We have started pretty much with a broad revenue and some comments on gross margins. But part of the additional transparency to share where we are aiming the business, we estimate it is going to be 5% or higher in 2007, so that should give you a pretty good proxy of plans which we have, which are a combination of gross margin and of course, cost of operations.

Terry Glofcheskie

Next question, please.

Operator

Thank you. The next question comes from the line of Mark Sue from RBC Capital Markets. Please proceed.

Mark Sue - RBC Capital Markets

Thank you. So if the overall revenues for 2007 do not materialize, will you accelerate the expense reductions so that you can still exit the year over the 5% operating margins?

Separately, Mike, any thoughts on the future of the GSM business? If you could, would you sell it? Are there any bidders for this segment and are customers expressing some dissatisfaction because of the UMTS divestiture?

Mike S. Zafirovski

The first one, the 5% or above operating margin is very much of a target which we have, so that is not in lieu of revenue growth. This is to grow 5% operating margin in this environment. Of course, it is not going to be easy. To use a basketball term, it will not be a lay-up. There are very specific programs on pricing, on costs, on customer wins. It is a very, very strong commitment for that within the business.

GSM, it is within our portfolio. We are not looking to sell it. Frankly, we think the biggest value of monetizing it, it is within Nortel. Of course, the same as any other portfolio, it is a mature or declining stage, same as on the TDMs or PBXs. Of course, the investment in R&D is rather modest compared to other areas we are investing.

It is a profitable business. It is helping keep relationships with customers. As I have indicated before, there has been no negative reaction whatsoever from our customers by exiting UMTS. The views I am paraphrasing is to say, is that the door is always open. Nortel has been there before on many significant breakthroughs. For a number of reasons, we did not have a strong position in UMTS and to the extent we can deliver what is going to be WiMAX or LTE or Rev C, I am very, very confident that we have looked at the customers straight in the eyes and to the extent we can deliver, there will be no penalty boxes against this only North American player left in the world in this space. On the contrary, people are really pulling for this company to be successful and that is what we aim to do.

Terry Glofcheskie

Thanks, Mark. Next question, please.

Operator

Thank you. The next question comes from the line of Vivek Arya from Merrill Lynch. Please proceed.

Vivek Arya - Merrill Lynch

Thank you. Mike, a two-part question; first is relating to product mix and the impact on gross margin. As your mix in 2007 just to more metro and optical and is probably less growth from your LG joint venture and CDMA with your higher margin businesses, what do you think about the impact on gross margin? Do you think you can materially improve gross margin in ’07 versus the fourth quarter of ’06?

A second question is perhaps related; if I look at your balance sheet, you have about $3.5 billion in cash but you also have cash obligations for your 10-K of about $3.3 billion in 2007 and 2008. So my question is do you think you will need to come to the market again to issue a debtor equity to improve the balance sheet?

Mike S. Zafirovski

I will answer the first question. I will have Peter answer the second question. People still -- the second-biggest business which we have today is enterprise. As we said before, it grew 61% in the fourth quarter, 28% without the LG joint venture. Enterprise revenues are higher than the company averages in this one area where we remain bullish that we will be able to grow at or above market. You know what our market is.

Services also, we do have a good cost structure and the gross margins there are pretty much at our company’s averages. We do expect gross margin to improve in 2007. I guess the net or the $64 billion question is, what is material? And this we have indicated within the guidance that we do anticipate gross margin to be in the low 40s. We have said a longer term target is 43%. That is not going to happen in 2007 but we do see op-ex margin improving in totality in 2007 over 2006. We have set a number. We are aiming in the low 40s. Peter

Peter Currie

Thanks, Mike. In terms of liquidity or the cash portion of that question, in fact, yes we do have $3.5 billion of cash on the balance sheet at the end of 2006 and there are a number of potential uses of that cash over the course of the next couple of years, and it really divides into two areas.

One is operating, and that is about half of the amount that was referenced in your question a moment ago, and the operating cash requirements are in areas such as financing growth and funding pensions and things of that nature, plus capital expenditures. The other aspect of course has to do with the convertible instrument that becomes due in September of 2008 and becomes current September of this year, 2007.

Let me talk about them in separate streams. The first is operating. We have outlined I think very openly our plans to substantially improve our cash-generating capacity within this company by two main activities. The first is improving profitability and I will not recover that ground here. I think Mike did a great job of it a few minutes ago. That really stems from the improving operating margin within the business. Also by improving our working capital management; that is, improving the velocity of our accounts receivable, improving our effectiveness in terms of accounts payable, and reducing our net inventory positions. We have made a commitment to increase working capital by $500 million this year. We did that back in November and we stand by that, of course. That will essentially in our view fund our operating requirements prospectively, absent the debt portion.

Now, in terms of the maturing debt, we obviously want to address that proactively and are so doing. Will we go to the market and refinance it? It is entirely possible we will go to the market and refinance a portion of that amount but we also look very aggressively to being able to use our surplus cash that we would generate to pay down portions of that before it becomes in fact due.

Terry Glofcheskie

Next question, please.

Operator

Thank you. The next question comes from the line of Gus Papageorgiou from Scotia Capital. Please proceed.

Gus Papageorgiou - Scotia Capital

Thanks. Just on the enterprise business, you had a great quarter. Can you tell me, was there any one-time recognition of software in the quarter that boosted the revenue numbers?

Secondly, Peter, just a question for you; on the working capital days, we did see improvement this quarter. Going forward as we are forecasting receivable inventory payable days, would we generally expect them to be down or improved year over year from 2006?

Mike S. Zafirovski

Gus, thank you, a very good question. By the way, we do try to make specific comments, whether that is helping or hurting “current comparisons” if there is a significant completion of a contract. We made a couple of comments on MEN, for example. We made a couple of comments on GSM on this call, so we do try as a matter of practice to give you that level of granularity.

With respect to the enterprise business specifically, there is nothing unusual for the 28% year-over-year growth. LG, of course, as we have indicated on previous calls, the contracts in Korea, although they would have been revenues under Korean GAAP, were not sufficient, were not appropriate to allow revenue recognition. We have worked very diligently throughout 2006. A great team, great job with the local team to renegotiate the contracts with customers. We were finally able to do that in the October-November timeframe, so we did have a very significant recognition of revenues which had been deferred before. So part of the LG joint venture revenues were in fact recognized in previously deferred revenues.

I do want to go back to the strong growth in Q3 and the strong growth in Q4, 28% without LG. Again, we feel good that the $100 million investment in R&D which we made last year. In enterprise, the Tasman acquisition, the great business transformation work that was being led from North America which is being adopted in many parts of the word, how to improve our indirect sales, how to work much more collaboratively with the channel partners, improved marketing programs, communicating the business made simple concept, or the how to make complicated technology simple to use for our customers, are starting to pay dividends. We feel good about where we are.

Gus Papageorgiou - Scotia Capital

As a result, would it be fair to assume that given your overall guidance for 2007 that the enterprise as a portion of the mix would probably be up relatively materially over 2006 into 2007?

Mike S. Zafirovski

Yes, it is a safe assumption.

Peter Currie

In response to the second portion of your question relative to working capital metrics or tracking, if you will, you were asking should you continue to look for relative improvements in each of those measures as you have seen in the fourth quarter. I would remind the group that day sales outstanding or accounts receivable, for example, ended the year at 75 days. That has been as high as 99 days over the past few quarters, and certainly our goal is to drive that lower. The same thing with net inventory days, which has been in the mid-30s, ended last year at 22 days. And days payable at 49, which has been as high as 59, which of course is a good measure.

Certainly we are driving to achieve improvements in each of those areas and make ourselves fully competitive, and so you should expect to see ongoing improvements but you will see choppiness quarter to quarter, and the choppiness has to do in receivables with the mix of not just products but jurisdictions in which we sell our markets. It also has to do obviously with the forward view of revenues and so forth, because that influences the DSO calculation. The same thing with inventory. There are a number of factors that influence inventory, not the least of which is product mix and introduction of new products.

But yes, you should expect to see ongoing improvements and that is why we stand by our working capital objective of $500 million in terms of improvement year over year.

Terry Glofcheskie

Thanks, Gus. Next question, please.

Operator

Thank you. The next question comes from the line of Paras Bhargava from BMO Capital Markets. Please proceed.

Paras Bhargava - BMO Capital Markets

Good morning. Mike, you talked about the cost reductions that you are expecting this year and next year. I just wanted to clarify some of the numbers you have put forward. The $400 million that you are expecting from the latest restructuring, is that in addition to the prior programs you have talked about or included in the prior programs? I believe you said included. I just want to make sure it still is.

Mike S. Zafirovski

Yes and yes, you are correct. We announced that obviously in the early part of 2006, gave you details in November and in addition to the announcement, of course, was the impact on employees. I want to give the employees time to look for alternatives, including internally. But the short answer is the $400 million is absolutely a part of that $1.5 billion.

Paras Bhargava - BMO Capital Markets

I believe on the call you mentioned a $750 million number. Previously you have mentioned a $650 million number. How much total in cost reductions do you expect to fall to the bottom line in ’07? How much of that do you think you may have to give back, or are you willing to give back to customers to help the top line?

Mike S. Zafirovski

That is a great question but that is the biggest part of that 5% or greater operating margin. This is simply we are looking for operating expenses to be down in a material fashion. Also, quite a few of the business transformation numbers will be impacting the gross margin. A minor part in pricing, but directionally speaking, our productivity from 2001 to 2005, and again this is directional numbers based on the -- perform within our areas for activities between 3% and 5%. In 2006, the number was 9%, and we are looking for a very healthy double-digit productivity in 2007.

We are not looking to improve pricing. We are not looking to improve operating margin or gross margin based on price increases but to answer your question, this is a -- that is a big, big part of the operating margin improvements in 2007, and for that matter, in 2008.

Paras Bhargava - BMO Capital Markets

So in ’07 and ’08, you would not expect to give back a material portion of these savings that you are outlining to customers to help the top line? I just want to be clear on that.

Mike S. Zafirovski

We will be -- and this is -- there used to be a very famous procurement chief, Joan Miller, she says pricing is the market, you subtract what you are looking for the operating margin, and the difference as to the cost. So we plan to be competitive. We are not driving prices down whatsoever. We have more controls right now and reviews internally. We will be very competitive in all our spaces, as I said. Our productivity will be rather significant in 2007. Some of that of course will be reflected in lower prices to our customers but there is a great obsession with improving gross margin and operating margins and we are very confident that we will be able to achieve that in 2007.

Paras Bhargava - BMO Capital Markets

Okay, one final question, Mike; in terms of your portfolio, if you look in every one of your big four segments, you have some things coming down from a revenue basis and some things going up. Do you expect to make any big portfolio actions this year? You did a lot last year. Are you happy to proceed organically, or do you expect to make any big portfolio actions, whether it is divestitures, acquisitions, partnerships, any of those?

Mike S. Zafirovski

The LG joint venture was made December, 2005. We made the Tasman acquisition in February of this year. The Microsoft alliance was huge. It was not necessarily an acquisition but very significant resources from both sides. I think what is being done with IBM will be very, very significant as well and I do believe we have an organization in place right now that is able to do more.

We are going to be very targeted toward any inorganic activity to make sure it drives customer value, it is in the targeted areas which we have identified, and we are not going to over pay, and we will be prepared to do a very terrific job in integration. But we are not counting on that.

Maybe just to make a comment -- we have been trying to become a normal company as quickly as possible. That is not to have any mature weaknesses, not to have any deficiencies, obviously to be reporting our financials on a very timely basis, for our quality to be world-class levels. I am very comfortable with both organic and inorganic growth activities. You have to be ready for it and I think as 2007 unfolds, that we will become more active in discussions with partners. Of course, I cannot be any more specific on that on this call or any private calls. You will be the first one to know as soon as we do something.

Terry Glofcheskie

Thank you, Paras. Next question, please.

Operator

Thank you. The next question comes from the line of Ken Muth from Robert W. Baird. Please proceed.

Kenneth Muth - Robert W. Baird

Good morning. Just on the Q1 guidance you gave, on the lower gross margins and the op-ex metrics you provided us, that seems to yield a pretty substantial negative, just operating margins and then operating profit for that quarter. As you gave your 2007 guidance then, and you said you would be above 5%, I guess I kind of look at this and say your second-half ’07 margin profile has a meaningful increase, the second-half versus the first-half. I just want to make sure, first of all, that you are looking at it the same way.

Mike S. Zafirovski

Ken, as I commented when I saw you in November at the investor day, you did a very thorough analysis. You are correct on all the statements which you have made. A couple of clarifying points; if you look at our results in 2006, very dramatic improvement from quarter to quarter to quarter to quarter. You can expect a similar activity in 2007. Of course, the challenge will be for each quarter to be substantially higher than the previous year. That is point number one.

Point number two, and even when Peter was discussing a couple hundred basis points difference, is that we will have some pretty significant contracts to be completed over the next two or three quarters. In order to be able to complete everything on March 31st versus April 2nd or conversely, is going to have a pretty significant impact on our gross margin.

We will not be reporting this on an ongoing basis but since you asked a very good question, the gross margin or deferred revenues is several hundred basis points higher than what we have been reporting. So as we realize those revenues in the future, the gross margin on those contracts has been higher than the 38%, 39% of gross margin, which we had in 2006.

However, within that -- say the number is in the low 40s. There are some significant contracts at zero margin and there are some very, very significant contracts at 70%, 80% margin and those items will have a material impact on any quarter-over-quarter gross margins.

But to your overall question, yes, the Q1 gross margin, the Q1 operating margin will be the lowest one in the year. We have plans, including the cost actions, to drive significant improvement sequentially every quarter in 2007. Thank you.

Terry Glofcheskie

Operator, we will take one more question, please.

Operator

Thank you. The next question comes from the line of Hasan Imam from Thomas Weisel Partners. Please proceed.

Hasan Imam - Thomas Weisel Partners

Thank you. My question has to do with the LG joint venture. A significant part of your margin expansion seems to be coming from that, but you indicated that going forward, it may not be so strong. Can you shed some light on what drives that volatility in the joint venture? Will cost cutting in the core Nortel business offset some of that volatility going forward?

One other question; in terms of Q1 guidance as we see it, weaker than normal seasonality. I am just wondering, is there an impact of slow-down in CapEx, particularly in the U.S., related to operator consolidation that you are seeing? Thanks.

Mike S. Zafirovski

Quick comments on the LG joint venture; first of all, the impact on earnings, I think as we have tried to highlight in the press release, and hopefully you find the press release is more useful. We are trying to be more and more transparent on what is driving the results in the key customer and other activities. We did say that a favorability from the LG joint venture profitability was largely offset by one-time expenses that typically would not be in the normal quarter. So that is the impact on the operating margin in Q4.

But the main reason that the LG revenues were so significant in the fourth quarter is because, as I indicated in one of the previous questions, is that the revenues under the previous contracts did not qualify as revenues under U.S. GAAP. That has been corrected and as a result of this, there was the recognition of the previously deferred revenues. That will not be repeating itself in 2007. You will see much more even revenues throughout 2007. So that is on the enterprise revenues. On top of it, we did have one-time -- not one-time, but we had a completion of a CDMA contract which also helped the LG revenues in Q4, and of course that will not repeat itself in 2007. But that has been reflected in the overall guidance which we did provide for this year. Peter.

Peter Currie

Thanks, Mike. Hasan, just to build on what Mike was saying for a moment, relative to LG and Nortel, we need to recall that this is a joint venture, so we will -- we do and will continue to fully consolidate revenues and all expense items for LG and Nortel, and then we back out the LG Electronics interest in that below the line under minority interest. So when you look at this, you have to recognize there is that potential distortion versus a normally fully integrated core business.

The other point you raised was relative to seasonality in the first quarter, and actually, I think if you look at our quarterly profiles and you take out the impact of the UMTS access divestiture, you would find that what we are indicating to you is not abnormally -- there is no abnormality versus what you would have seen in previous quarters if you did a regression analysis Q1 to Q1 to Q1 to Q1.

Mike S. Zafirovski

Thank you again for your interest and participation. In sum, lots of heavy lifting in 2006. We are not confused with what is happening in 2007. There is a very good understanding and commitment for us to deliver on the business model goals for the company and there is also a relentless follower-ship from our teams towards customers into inviting growth in the targeted areas, which you saw in the latter part of 2006.

Thank you for your interest and we look forward to be speaking with you very soon.

Terry Glofcheskie

Thank you, Mike, Peter, and all of you on the line. 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 interest this morning. Goodbye.

Operator

Thank you, ladies and gentlemen. That does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines. Thank you and have a good day.

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