Nortel Networks Q1 2007 Earnings Call Transcript

TRANSCRIPT SPONSOR

Nortel Networks Corporation (NT)
Q1 2007 Earnings Call
May 3, 2007 4:30 pm ET

Executives

Terry Glofcheskie - VP of IR
David Drinkwater - CFO
Mike Zafirovski - CEO and President

Analysts

Edward Snyder - Charter Equity Research
Nikos Theodosopoulos - UBS Securities
Ehud Gelblum - J.P. Morgan Securities
Paras Bhargava - BMO Nesbitt Burns
Michael Genovese - Citigroup
Phil Cusick - Bear Stearns
Ken Muth - Robert Baird
Mark Sue - RBC Capital Market
Tim Luke - Lehman Brothers
Chris Umiastowski - TD Newcrest
Rob Esarc - Thomas Weisel Partners
Glen Anderson - CIBC World Markets

Presentation

Operator

Ladies and gentlemen, thank you for standing by and welcome to the 2007 First Quarter Financial Results Conference Call. (Operator Instructions). As a reminder, this conference is being recorded today, May 3, 2007. I would now like turn the conference over to Mr. Terry Glofcheskie, Vice President of Investor Relations. Please go ahead, sir.

Terry Glofcheskie

Thank you, operator, and good afternoon, everyone. Thank you for joining us on this call this afternoon to discuss our first quarter 2007 results. With me today are Mike Zafirovski, our President and Chief Executive Officer and David Drinkwater, our Chief Financial Officer. After Mike and David make their comments, we will be happy to take your questions.

Just before we get underway, please note that certain comments made in today's remarks 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 Nortel's filings with the United States Securities and Exchange Commission and the Canadian securities regulators, including Nortel's annual report on Form 10-K. Please note also on chart 4, the non-GAAP measures comments. At this point, let me turn it over to Mike for his comments.

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Mike Zafirovski

Thank you, Terry. Good afternoon, everybody. Thank you for joining us today, and what is covered today will be our standard practice of covering the quarterly results, provide an update on our guidance, and also the few minutes on the steps which we're taking to drive to our business model. And so, let me kick it off first with a general update on the quarter. Overall, we were very pleased. Revenues are up 4% driven by growth in Enterprise, CDMA, and Metro Ethernet. And if we adjust for the UMTS access business divestitures, revenues were up by 12%. Deferred revenue was flat versus Q4 2006. And our orders were down 3% again as a result of the UMTS divestiture but up 4% adjusting for that. Book-to-bill was a positive 1.04 and backlog increased by $103 million to a very healthy $5.3 billion.

Now, we're pleased that actually we were able to go over the 40% gross margin for the quarter and we're at 40.4, the highest margin in seven quarters. Operating margin was 0.4 negative, almost flat in Q1 '07, up significantly over Q1 '06, up by 642 basis points. Operating cash flow for the quarter was a negative 561. If you adjust for the payments of the litigation, payment to shareholders, we're up $24 million positive, again very strong relative to the seasonal trends in the first quarter of the year.

A couple of nice customer endorsements on both our WiMAX Optical and on our healthcare verticals, and I will make some more comments on it on the next page. And also we're progressing rather well with our business transformation, meaning we're on track to achieve the target for the year.

Now, the next page, I will not spend much time going through the details. This just simply highlights some of the deals which we did announce during the quarter starting with January 1. I will just briefly touch upon a few of them. In Enterprise, the New York Times that transaction which we announced in January of this year, and also really nice momentum in the healthcare sector and a combination of a win with a International SOS but also state-of-the-art mobile communications with the Canadian Specialist Hospital of Dubai, and the clinical grade IP network to hospitals in Madrid. In the Carrier space, as we are referring to as the next generation of mobility and convergence, we believe we're becoming the thought leader in 4G.

With Craig Wireless we deliver broadband media-rich content to mobile users, such as streaming video, Internet access and multimedia, using our MIMO-enabled mobile WiMAX solution. Also, a very innovative transaction in with Mobile Satellite Ventures, one of North America's leading providers of mobile satellite communications services and who’ll deploy what we believe will be our first integrated 4G and a satellite broadband trial powered by our mobile WiMAX and IMS technologies.

We announced a trial with TVA, one of the world's leading pay TV companies in Brazil. And also with Wind Telecom, a new network operator in the Dominican Republic. In Metro Ethernet, the very important transaction with BT, which we announced in January. And also upgrades in the Hong Kong exchanges with our optical solution. In the Services business, I will make some comments later on the call on the very strong orders upturn in the quarter but we won a number of very, very marquis customers, Kodak and Rolls Royce. And they are also giving me a nice reaction in Nortel Governments Solutions business.

On the next page, the orders by region, as I said, we're up 4% year over year. Adjusting for the UMTS divestiture, book-to-bill is 1.04. And the key drivers were our services business and also very strong CDMA Rev A orders. Backlog up by $100 million to $5.3 billion sequentially. As I indicated before, deferred revenues are flat sequentially. So, there was neither a positive or negative impact on the orders number. The Q1 2007 financial highlights I mean -- I'm not going to discuss, this is simply a summary page, which is all for additional highlights.

We're going to discuss each one of those individually in the coming pages. But it's very nice to see the year-over-year improvement in all the key drivers for operating margin. Our gross margin was up by 170 basis points year-over-year. In terms of a SG&A, the improvement was 120 basis points. In R&D, the improvement was 350 basis points. So in total, as I indicated before, operating margin improved by 642 basis points. I already mentioned the comments on cash flow and a very strong seasonal performance in Q1.

While, of course we're very pleased with the year-over-year improvement, there should be no misunderstanding. We are committed to execute our plan throughout 2007 as we work to strengthen the Company, and -- but it is very good to have that type of a start which we did have in the first quarter. Let me make a few comments now on business with business, starting with our Carrier Networks. Revenues were down 6% but adjusted for the UMTS divestiture, revenues are up 5% in the quarter.

In CDMA, we had a very strong performance, up 29% over the last year, driven primarily by North America and more specifically by EV-DO Rev. A. GSM was down significantly 38%, a combination of the divestiture impact of UMTS. But also, we did not repeat a very strong Q1 2006 performance in GSM in our CALA region. Circuit and packet voice was down 13% for the quarter. Some had slow CapEx expenditures in North America in the first quarter. But we do expect strong second half growth in this business with the introduction of new releases, and our outlook for orders is also very positive.

Enterprise, on the next page, I mean terrific performance in Q1 this year following a very strong performance in Q4 of 2006. We believe that we grew above market again. And circuit and packet voice were up 15%. Increase in North America was broad-based but principally with strong momentum in BCM. Also a very strong performance in our European, Middle East and Africa region, combination of foreign exchange but also a strong growth in application.

In IVR contact centers and messaging, data networking security was up 73 basis points. Growth in North America and EMEA due to ethernet switching but also completion of a few significant contracts where we had previously deferred revenues. Even adjusting for those previously deferred revenues if you take those contracts out, the growth in data was still very robust 37%.

So since the last couple of calls we have really nice momentum in the Enterprise business. Global Services down 11% year-over-year. Adjusting for UMTS, revenue was up 1%. This is the first quarter we're actually including planning to deploy more formally a Network Integration Services. If you look at our services business and if we were including the Network Integration Services last year, this was a $2.2 billion business. As I said just with Q1, the revenues are up 1%.

There's real nice traction in this business. We have 11 new integration services to ease their customer path in Unified Communications. We introduced for example two new mobile solutions to our Healthcare Solutions. And we do expect to grow faster than market in this space. We did not in the first quarter, as I said revenue was up only 1%. But book-to-bill was a very healthy 1.4. So this gives us confidence that what's going to happen over the last nine months of this year.

And, our last business, Metro Ethernet Networking revenues up a healthy 27%. In Optical Networking, the growth was 25%. Growth was driven by a significant contract completion in EMEA and a good momentum in CALA and also good traction with Comcast and to the MSO market in general. Data Networking and Security, up 34%, benefiting from the completion of a significant contract, again, with some previously deferred revenues on that contract. And the PBT standardization is progressing well.

We did have the win with that BT in January, Shanghai Telecom in 2006, with lots of trails underway and we feel positive as to the developments over the rest of 2007. Some of the geographic revenues, obviously, the numbers in total have not changed but strong growth in North America and Asia, driven by Enterprise, CDMA, the joint venture at LG. EMEA was negatively impacted of course by UMTS. But adjusting for UMTS, EMEA had a very strong 26% growth, which was pretty broad-based. Both Next-Generation networks, as well as Enterprises, as well as the completion of a significant contract. In CALA, the decrease is driven by a very strong Q1 2006 GSM performance, which was partially offset by a very strong performance in Metro Ethernet Networks.

Our gross margin, I'm very pleased that we are able to achieve gross margin above 40%, 40.4% to be exact, the highest in seven quarters. And that's particularly rewarding to see this in the first quarter of the year, when typically with the lowest revenues and the most significant pressure on gross margin. We did have strong productivity in double digits.

We also benefited from a favorable product mix in the Carrier Networks. Strong CDMA on the one hand and also divestitures of UMTS. And of course, a strong growth in Enterprise does help our product mix overall. Partially offsetting this mix was that as recognition of previously deferred low margin revenues in contracts in Optical and Data Networking. I will come back with some closing comments but now it is a pleasure to introduce David Drinkwater, our General Counsel and now the acting Chief Financial Officer.

David Drinkwater

Thanks, Mike. Good afternoon, everyone. We want to turn to the SG&A slide. As Mike indicated, down a 120 basis points year-over-year. And part of that is cost savings from the divestiture of UMTS. In fact, 15 million of attributable to UMTS plus lower corporate costs. This was partly offset by higher sales comp and bonus accruals and also a stronger Euro compared to the dollar.

Turning to R&D, on the next slide, again, a significant improvement, down $70 million, and 350 basis points as a percentage of revenue year-over-year. Again, significant cost savings driven by the UMTS divestiture. In this case, an even higher dollar amount over $50 million, plus lower employer-related costs through our various BT initiatives. Again, this was partly offset by a stronger Euro against the dollar. Turning to some of the other items, other income was higher. We had significantly higher cash balances, as well as increased royalty income from licensing on IP, as well as increased subleasing income through factors such as subleasing part of our facility at [Shadow 4] to Alcatel Lucent as a result of the divestitures. Interest expense is higher. That's principally driven by the $2 billion facility which we put in place in 2006. In addition, increased minority interest expense relative to year-over-year, this is principally driven by the LG joint venture.

Turning to some of the other significant items, we had again an adjustment for the shareholder settlement, a gain this time of $54 million mark-to-market. This is the last quarter that we're going to have these adjustments as we finalize that litigation settlement in the quarter, which means that will be not recurring as adjustments. This also allowed us to move the liability down into equity. In addition, we had restructuring charges of $80 million, 74 of which was attributable to the plan we announced in February of this year.

Turning to cash flow, you'll see we ended the quarter with a very strong cash position, in excess of $4.5 billion. We had of course the $1.15 billion from our convertible note financing we completed in the quarter. But as Mike indicated earlier, perhaps more significantly, when you back out the $585 million for the settlement around the class-action, we actually had positive cash flow of $24 million, which year-over-year is an improvement in excess of 200 million. Turning to some of the operating metrics, DSO went up 10 days from Q4 of '06, which reflects the seasonal adjustment from a strong Q4 to a less strong Q1. We actually had strong collections in Q1 but the revenues for the seasonal factor were significantly lower, which drives the number up. But if you look at the results from Q1 '07 versus Q1 '06, we are improving that metric, the same factors with respect to net inventory days, the seasonal lower revenues and related costs of sales drive that number up. But again, we are improving that when you go back and look at where we were a year ago. And similarly, we have improved progress with respect to days payable outstanding.

As Mike indicated, deferred revenue is basically flat from Q4 but, down about $300 million year over year. A book-to-bill of greater than 1 to 1 and a backlog that is up 100 million over Q4.

Turning then to our outlook, as you will have seen from our press release on Tuesday, we have reconfirmed our guidance for the year, namely revenue is down flat to down slightly to '06. Gross margins in the low 40s and operating margin at 5% or higher. In addition, with respect to Q2, we also contemplating revenues to be flat to down slightly to the comparable quarter a year ago, and gross margin to be around 40%, and operating expenses to be improved by high single digits compared to the year previously.

Now, let me turn it back to Mike for some additional comments.

Mike Zafirovski

Thank you, David. Let me just wrap up with a few pages and we look forward to being engaging with a Q&A with you. Page 23, you've seen this framework. We're following a combination of a short or long-term plan to restore the financial health of this Company. At the Annual Shareholders Meeting yesterday in Ottawa, I went through the specifics of the six-point plan. This is available on our Web site. If you're interested in listening to that, again, we went through the details in a meaningful improvement in each one of those six points. So I'll not go through that on this call. I will just simply provide a brief update on the business transformation, which was the next page. We're very driven as we said to reach our operating model goals by 2008. Our business transformation is a key driver to enable achievement of that goal. It produced operating margin expansion of $100 million in 2006 and resulted in operating margin expansion of $100 million in Q1 of 2007. What you see the highlights on this page in orange color here are the progress in new activities in the quarter. For example, how we have started in earnest the Wave 3, and the direct material process which as we've discussed before in totality. We aim to drive direct material savings by $425 million through 2008. I alluded to the strong double-digit productivity when I was discussing gross margin a few minutes ago. This is of course a major driver for that. And going all the way down to the SAP implementation for the financial system, and as David was discussing, the improvements in SG&A and this is one of the drivers that we're starting to realize the potential business transformation into improved financials. Our goal is to realize the $1.5 billion in operating margin expansion by 2008 with most of it falling to the bottom line.

And as David said, our guidance for 2007 is a 5% or higher operating margin. Most of that impact will be coming from the business transformation. Last page on page 25, I mean we are very pleased with our Q1. Solid in terms of top line, margin, and cash. As I indicated to you the first call, the four most important measurements are, are we going above market, are we making progress towards getting to a double-digit operating margin and to be strong cash flow profitability. The fourth one being stock price. We are very convinced if we do a very good job on the first three, the stock price will follow. There is an absolute commitment to delivering our profitability model. One of the comments I made yesterday at the Shareholders Meeting, accelerate execution will be the name of the game for us in 2007. We look forward to keeping increasing their forthrightness and transparency of our communications from the Investor Relations function but also for many of us on the management team. And we feel good with our focused growth strategy which we're following. A combination of being a leader in the transfer and Enterprise space, driving next-generation mobility and convergence, and to be a relevant player in services.

I'm thrilled to see so many of you coming next Wednesday in Ottawa for our Technology Day. I will be there as well. And we'll go more into details of why we're so confident that we have a game plan that is going to be paying dividends in the quarters and years to come. And, as I said, strong progress in 2007, lots of heavy lifting. 2006, lots of heavy lifting Q1 2007, that's not going to stop. But then you're going to see more and more of a discussion and thought leadership of why not only that we're going to be relevant but that we think we're going to be able to be leading a number of areas on transform Enterprise, Unified Communications plus, and the same thing in next-generation mobility convergence, both in the Carrier space and Metro Ethernet. So, thank you for being here on this Thursday afternoon. We look forward to begin answering your questions now. Thank you.

Terry Glofcheskie

Thank you, Mike and David. Operator, could you please open up the call up for the Q&A and we will take our first question now.

Question-and-Answer Session

Operator

(OPERATOR INSTRUCTIONS). Our first question comes from the line of Edward Snyder of Charter Equity Research. Please go ahead sir.

Edward Snyder - Charter Equity Research

It's Charter Equity Research. Good quarter, Mike. A couple of housekeeping questions first off. A Steep decline in R&D, I know that's from the savings in UMTS, and we've asked this before and we've kind of been ambiguous. Are those savings going to be ploughed into WiMAX and other big projects you've got going? Or do you think this will maintain a relatively low R&D for the next several quarters? And then you said you are accruing sales commissions to SG&A, one of your comments there for a slight uptick. Is that going to be the case in rest of the year so we don't expect a big uptake in the fourth quarter and SG&A [directly passes] 34secs14thbckup the sales commissions are paid out or do we expect (technical difficulty)? Thanks.

Mike Zafirovski

I lost you the last couple of words but I do think I got the essence of both of your questions. Look, with the first one, I apologize if you think we've been ambiguous with our R&D comments. We're aiming to be at 15% of R&D by 2008. We believe that we're definitely going to achieve that and possibly being there very close to that number in 2007. If I can just take a couple of comments and this is a work in progress. But if you look at our R&D spend, traditionally at least over the last couple of years, a big part of the R&D spending has been the legacy products.

Directionally, it was about 55%. In terms of a core product, it's been 35% on a new, new, it has been about 10%. With our business Presidents plus John Roese, our Chief Technology Officer, obviously, our financial organization what I'm driving is to balance that to be much more consistent with the Company focused on both profitability in the short term and growth for the future. And we're going to aiming to change that 55/35 time to 20-60-20. So we're balancing long-term and short-term investment for R&D.

But to answer your question specifically, as our revenues, obviously, are down, and is our R&D percentage of revenues in the last year obviously were substantially above 15%, you'll see the gross R&D spending be much lower this year. And we're aiming to get to the 15% number, and there is a -- and I think that's -- I will stop at that point on R&D. On the second one, with respect to our bonus plans, we have also been pretty clear in the proxy that as a result of our inability to meet financial targets, the bonuses paid in 2000 -- three years ago were zero; two years ago we paid only 33% of target and last year was only 50%.

Our bonus plans for employees is approximately $200 million if we meet targets. And so, last year we would only be 50%. The previous year was 33%, the previous year was zero. And if we keep delivering our results in the way we have in Q1 relative performance year-over-year, we obviously are looking forward to pay our employees at a targeted rate. So, we do expect that first to be accruing bonuses on a pro rata basis throughout the year. The last year based on a significant loss in Q1 we did not record any bonuses.

Terry Glofcheskie

Thank you, Ed. Next question please.

Operator

Our next question comes from Nikos Theodosopoulos, please go ahead.

Nikos Theodosopoulos - UBS Securities

Yes, thank you. I had a couple of questions. Do you have the exchange in short-term deferred revenues from the fourth quarter to the first quarter? I think you gave the overall number, which is a combination of short-term and long-term. I'm wondering if you have the change just in the short-term? And the second question I have is, can you give us some granularity as to the impact of LG -- the LG-JV in the quarter? What was the total revenue contribution let's say in the first quarter of '07 versus the first quarter of '06? Thank you.

Mike Zafirovski

I'm going to have David answer the first question. David?

David Drinkwater

Yes, the short-term deferred revenue in the quarter increased about $300 million.

Nikos Theodosopoulos - UBS Securities

That -- increased from the fourth quarter?

David Drinkwater

Correct.

Nikos Theodosopoulos - UBS Securities

Okay, and then on the second question? Do you have any color on the LG revenues?

Mike Zafirovski

The LG revenues were up -- excluding the UMTS sale were up 12% year-over-year. The LG revenue did not impact that number materially.

Nikos Theodosopoulos - UBS Securities

Do you have the specific contribution of LG in the first quarter of this year versus last year?

Mike Zafirovski

Typically, we do not disclose those numbers, unless they have a material impact on the quarter. I mean that's why we disclosed it in the Q4 last year. And I said, relative to the 12% year over year, the LG impact is not material.

Nikos Theodosopoulos - UBS Securities

Okay. So, it sounds like revenue growth year-over-year excluding UMTS and excluding LG is still about 12%, is that the way to read that?

Mike Zafirovski

It would not be materially different. Correct.

Nikos Theodosopoulos - UBS Securities

Okay. Thank you.

Mike Zafirovski

Thankyou.

Terry Glofcheskie

Next question, please.

Operator

Our next question comes from the Ehud Gelblum, J.P. Morgan Securities.

Ehud Gelblum - J.P. Morgan Securities

It's [Huddy] from J.P. Morgan. Just first a quick clarification on that last question. Mike, I understand that on a year-over-year basis, it does not impact -- LG would have not impacted the year-over-year growth rate materially but because LG was so strong in Q4, I would imagine that it would impact materially on a sequential basis. Is that correct? Just a clarification. It actually hurt you.

Mike Zafirovski

The short answer is yes, I mean I will have Terry just get back with you guys on both of us. I do not have the exact numbers in front of me. But both comments are directionally correct and I will have Terry give you the specifics.

Ehud Gelblum - J.P. Morgan Securities

Great, I just wanted to make sure that I understood that. Appreciate it. Diving a little bit into the different revenue buckets that you said, you have mentioned that CDMA was very strong on a year-over-year basis due to EVDO, GSM was down and in Optical you said that was also very strong, it sounded like because of cable. Can you give us a little sense as to what is going on in each of those three markets?

Was the CDMA both for yourselves as well as Alcatel Lucent has been sort of lumpy on a quarterly basis over the last year. Do you see that CDMA strength continuing beyond this quarter? Or do you think that was just it all kind of lumped into this Q1 and as we move into Q2 and Q3 we should see CDMA start tailing down? I wonder how that trends. Your GSM was down but, again could that be lumpy and that come back a little bit? Or does that kind of -- we're starting to see the decline in GSM? And then if you can talk to us a little bit about the Optical and the Cable business versus Telco -- what are the strength there and the tail is how long does that last?

Mike Zafirovski

I mean, with CDMA, overall, the first two quarters last year, the revenue was somewhat suppressed as a result of expectations for the EVDO buildout which started in Q3. So that's part of the reason that we have a very significant year-over-year improvement in CDMA. We do expect to grow in the CDMA market but, there would -- we do not expect the overall CDMA growth to be above single digits for 2007. We did gain several points of market share last year. Of course, that will also help our revenue comparison 2007 versus 2006.

With respect to the GSM business, we did have a very significant volume revenues in Q1 2006 which did result in a year-over-year unfavorability. But we see pretty good and level GSM volume for rest of this year based on our current trends. And, with respect to the Optical business, we have had a very good penetration within the cable operators, and I said Comcast in particular. I would say that our Optical business is the one that has the greatest level, to use your word, lumpiness as a result of completion of significant contracts.

Last year, we were up with strong double digits I think and now we are over 15%. We said part of that reason was as the result of timing of those contract completion. We did say for us for in 2007, the impact of contract completion totality will be somewhat negative. And so, those are some of the elements which we'll try to work through in 2007. And that's what we've said for the year, in total we believe that our revenues will be at or slightly below the 2006 revenues.

Ehud Gelblum - J.P. Morgan Securities

So that means it has to slow down considerably for the rest of the year after this very strong start?

Mike Zafirovski

I mean, somewhat again when we are discussing 4%, 4% year-over-year growth in a quarter that typically is the lowest growth which has the lowest revenue. So substantially is an overstatement. But, we do believe that in the targeted areas, we will grow above market. That is a course reaction internally. And we do understand that we do have, on a measurement basis, the worst of the two worlds in terms of exiting the UMTS business at least on paper. The UMTS business is supposed to be growing and we have a GSM business that will be declining as an industry. But that was the right call for us to make from an R&D, from a focused standpoint, and that's what I'm pretty prepared to measure our progress for the year relative to growth in the spaces where we compete. And since Q1 was very good for us on that basis.

Ehud Gelblum - J.P. Morgan Securities

So just again making sure I understood, that 4% -- Optical grew 20 something percent, right? 25%, not 4%. So, when you said Optical will be down this year and I meant when it was going to decelerate but --?

Mike Zafirovski

No. In other words, it will be down relative to the strong 15%-plus growth which we had in 2006.

Ehud Gelblum - J.P. Morgan Securities

Okay. So, Optical just grows slower this year than it did last year?

Mike Zafirovski

Correct.

Ehud Gelblum - J.P. Morgan Securities

Starting at 25, getting below 15 as you get through the year. Thank you very much. That's helpful. I appreciate it, Mike.

Terry Glofcheskie

Thank you. Next question please.

Operator

Our next question comes from the line of Paras Bhargava, please go ahead.

Paras Bhargava - BMO Nesbitt Burns

Thanks. Good afternoon. A couple of clarifications, Mike. The backlog dropped year over year. How much of that was become a because of UMTS? How much of that was non-UMTS stuff? And then, just drilling a little deeper into the CDMA piece, clearly, CDMA drives a lot of your margins today. Maybe you could just give a little more detail than you did at the last question. What is -- are you seeing -- you've talked about CDMA share gains and I think you talked about it mostly with respect to new spectrum. In terms of your traditional customers, do you feel you're making any share gains or is it just puts and takes cyclically? I apologize for asking the question twice but I didn't quite understand it. And then thirdly, the 750 million is supposed to drop to the bottom line this year. The difference between that and the 5% plus operating margins that you're talking about, is it all compensation? Is there any other thing? And then, in '08, would you expect to give some of the $1.5 billion back to compensation also?

Mike Zafirovski

Thank you. With respect to CDMA, and if you look at our revenue growth in 2006, relative to competition, we certainly gain market share. So when I'm saying we have gained market share in CDMA, that was the case in 2006. And some of that which included improvements in a few Q1 players as well. And we believe that we will gain modest market share in 2007. And I think we're pretty comfortable with those comments. With respect to the targets for 2007 on an operating margin basis, as I said, our guidance costs for an operating margin of 5% plus. Some of the fall-through from the 750 is – a part of it is compensation.

The other part is a pricing, particularly in the GSM space. But there's been between 5% and $11 billion plus in the 750, the delta is rather modest. So those are the two main items.

In 2008, this is a long-term planning from now. We will have a full day investor meeting with you guys. But nothing has changed from us to be aiming a double-digit operating margin expansion in 2008 with most of the $1.5 billion falling through the bottom line. And, if we meet our targets for this year, then there should not be an additional compensation related adjustment in 2008. Thank you.

Terry Glofcheskie

Next question, please.

Operator

Our next question comes from the line of Michael Genovese, please go ahead.

Michael Genovese - Citigroup

Thanks.

Terry Glofcheskie

Hi Mike.

Michael Genovese - Citigroup

First I want to clarify, just dig deeper on a couple of questions that have already been asked a number of times and then get to my real question. But on the CDMA, specifically, it seems like the strength very strong results in 4Q and 1Q, and that seems specifically related to the Rev A upgrade with existing customers in North America. So, how long can that last? Can I carry on -- can that Rev A specifically carry on throughout the year? Does it then have to slow down in 2008? Is it going to be lumpy? For instance, will it pull back in the second quarter? What are your thoughts there?

Mike Zafirovski

The revenues in CDMA were rather low, the first half of 2006 as a result of carriers expecting to waiting for the EVDO upgrades. We've been very consistent in externally saying that we do not expect material growth in CDMA over the next two or three years. And at the same time, certainly, we're not expecting declines. And on top of it that we have been able to gain a few points of market share last year.

We believe we're going to do well by a point or so in 2007. So, those have been very consistent messages all along. And still we are delivering to what we said both on the Investor Day we will have on the 15. And the biggest reason for the increase in Q1 for such a large expense was the rather low number in Q1 2006.

Michael Genovese - Citigroup

I'll ask the second part of my quick clarification and then my real question all at once. Just on the -- we talked about the LG spike in the fourth quarter impacting first-quarter comparisons. Is that most acute in Enterprise? Is that the reason that your Enterprise business decreased 24% sequentially? Or how much of that decrease is due to that LG comparison? And then, my question is, on your lean manufacturing initiative, which looks like looks to me like you really started in earnest in the fourth quarter, how long do you expect it's going to take you to fully work down your contract manufacturer inventories down to the lean levels -- the just-in-time levels that you're looking for? How many quarters is that process in your planning? Thanks.

Mike Zafirovski

With respect to the comment on LG too, one is that there was a very significant completion of a CDMA contract, which was both in terms of profitability and revenues, which we thought we disclosed in rather full fashion when we discussed the Q4 results. Also, the Q4 LG results, there was an accumulation of revenues deferred over three quarters and that's why the impact of the LG revenue in Q4 is material rather than it's not nearly as material in Q1 when there's only one quarter now being reported pretty much on a regular basis, which we will have on a going forward basis. That's why the reason we did not give all the specific numbers in LG. That's not our plan to do unless the difference is so significant and to be consistent with our transparency of commitment we did in Q4.

With respect to the Enterprise number, that has been for us a very seasonal number, which I believe for the industry as well. There's always a rather large drop-off Q4 to Q1 independent of LG. And, you will see that level of a seasonality including a very significant upturn in our Q4 revenues this year relative to what you're going to see in Q3. So it's nothing unusual this year. That's industry practice and which includes Nortel as well.

With respect to your question on the inventories and lean manufacturing, you are correct that you saw significant results in Q4, which will continue in Q1, the very wrong impression that we started lean manufacturing in Q4. I mean it does take two, three, four quarters to start hitting a meaningful impact after you start a process. One event is in our savings in SG&A, savings on R&D, impact of investing in Enterprise by the time you see the impact in increased revenues and market share gains. The same thing happened in lean manufacturing.

There was a -- John MacNaughton and Joel Hackney maybe working on it pretty much all year. We gave the details on November 15, and we were pleased to see that impact of that starting to come in, in the fourth quarter. We do expect continued improvement throughout 2007. I believe we said we're looking to have $0.5 billion in working capital improvement end of 2006, and through the first half of 2007, based on very strong performance in Q4. Peter Currie on his last earnings call obviously with full concurrence from me and all of us to say he increased target for working capital improvement to 0.5 billion for 2007 and we are working very hard for meeting or surpassing that target for this year.

Terry Glofcheskie

Thank you, Mike. Next question, please.

Operator

Our next question comes from the line Phil Cusick, Bear Stearns, please go ahead sir.

Phil Cusick - Bear Stearns

Hi guys, thank for taking my call. I wonder if you can talk about the LG joint venture? Will revenues be a little more linear in 2007 and can you talk about the margin profile -- how that is affecting the P&L? Thank you.

Mike Zafirovski

The short answer is, absolutely, and absolutely in terms of linearity. The business will grow year-over-year in modest double-digit numbers. And the gross margin overall will be slightly lower than the composite for Nortel.

Terry Glofcheskie

Next question, please.

Operator

Our next question comes from Ken Muth of Robert Baird, please go ahead.

Ken Muth - Robert Baird

Hi. You made a comment in your slide presentation on the circuit and packet under your Carrier Networks revenue that you expect kind of the second half to pick up because the Q1 numbers look a little suppressed. Could you just give us a little bit more clarity on why you think that's going to increase? Are there specific contracts you have or is it just because the product releases?

Mike Zafirovski

It's a combination of both. We have done a really nice job improving our basic quality of product. There are significant quality issues which we have Q1 and Q2 last year. We've been able to put those things behind us. As a matter of fact, it is becoming a significant strength of ours. And also with a renewed focus, and also expanding beyond the North American -- strong footprint which we have. So it's a combination of new products coming out, the team's ability to meet plan of records. And also it's a number of countries, a few of those which we have announced. And a few more which we believe we will be announcing.

Ken Muth - Robert Baird

Okay. Thank you very much.

Mike Zafirovski

Thank you, Ken.

Terry Glofcheskie

Next question, please.

Operator

Our next question comes from the line of Mark Sue, please go ahead.

Mark Sue - RBC Capital Market

Mike, just on the enterprise, one might argue that you could do better with a broader product portfolio and stronger channels and even offset some seasonality. Any thoughts on selling other parts of the business and taking the proceeds to refortify the Enterprise segment? And separately, on the GSM site, is there an element of the UMTS asset sale which is impacting GSM revenues with your existing customers?

Mike Zafirovski

I mean, Mark, on the first one, we absolutely agree that we can and we will do much better in the Enterprise space. I mean, I'm going to leave the comment of selling to be strengthening our Enterprise portfolio. But I think the facts speak that in last year we increased R&D spend $100 million. We did a terrific job as one of the business transformation projects to look our channels, how we go to market, completely redeploy our sales force.

We kicked off a global accounts team and I've met probably with 15 of the 50 teams and most of those global customers over the last three or four months. I mean, there is a terrific traction in the business. Again we've grown strong double digits in Q4 and in Q1. So, there's a pretty nice traction in this space and there's not too many things holding Steve Slattery, who is the President of that business and the go to market team. So, we feel terrific where the business is. And so this is not -- this is not a case of we're starting the business.

The Microsoft IC alliance has been terrific. The quality of discussions of top financial services companies, health care providers, contact centers have been very energizing. Counting today, at least three phone calls today. Hopefully, we will close at least two of those three deals with a phone call just made today. So, this is not -- we're not -- naturally we're not starting the business, and we'll keep investing in it. And, just sorry, Mark, what was your second part of that question?

Mark Sue - RBC Capital Market

Just on GSM, is the decline in the business in any way related to the sale of the UMTS asset? Are customers expressing some dissatisfaction?

Mike Zafirovski

I do not believe so. If anything, this is all internal. But whatever we thought was going to happen with GSM. David just received a letter from Richard Lowe that actually we're going to do better than was initially anticipated. So, we have a good product. If you are a CTIA, this was amazed in the number of people that had a GSM booth and the GSM stand on our booth.

Lots of the cost efficiency products, which we do have. We have a guy called Graham Richardson, who has been running the business now for the last six, seven months. His credibility is very high with the sales force and with the customers. So, it's a business again which does not take significant amounts of R&D. It's a good product. It's profitable, and at the same time, if there is an opportunities to 'win significant business in GSM,' at a negative margin we simply walk away from that.

Mark Sue - RBC Capital Market

That's helpful. Thank you and good luck, gentlemen.

Mike Zafirovski

Thank you.

Terry Glofcheskie

Next question, please.

Operator

Our next question comes from the line of Tim Luke of Lehman Brothers, please go ahead.

Tim Luke - Lehman Brothers

Hi, Mike, I was wondering if you could give us some color on some of the major variables for the gross margin, which seemed to improve I'm imagining with the high percentage from DO Rev A, but you've guided it to remain about 40 for the second quarter. And how we should think about factors helping it or being challenges for the gross margin in the second half of the year. Thanks.

Mike Zafirovski

Tim, boy, I'm honored to have you on the call. I didn't realize you called in for the Nortel earnings call. Thank you for being on the call. I mean look, Steve made the comment before on inventories that we advance lean manufacturing in Q4. Lots of heavy lifting is being done across the organization, from the business Presidents working on a simpler way to design product, Joel Hackney, Joe Flanagan, John MacNaughton are working around the clock on supply chain, making competitiveness and advantage. We're starting to see results, and frankly with it's fashion in some places than we anticipated.

We're not stopping long way to go in terms of a heavy lifting. But we drove the plus 40 in a Q1 with a double-digit productivity. We have in between 3% and 5% productivity 2003, 4, and 5. Last year, the number is in high single digits. And the first quarter, it's in the low double digits. And we think that's going to continue for the rest of the year.

Product mix, we're really concentrating on improving our product mix. Also you've kicked off an unannounced, externally until now I guess, a pricing team to really do a much better job understanding where and how we price, where are the opportunities. We fully understand there's not room in this market for an across the board pricing adjustment. The smart, best-run companies in the world have put some very bright individuals to be working with our sales teams, to identify areas where we can bring value to customers and at the same time improve pricing. And we saw last year 3% was the gross margin. Our target is to be at 43% and if we're working very diligently on multiple fronts to get there and I said in Q1 this year, productivity, product mix were big drivers to help us be able to be about 40%. We think we expect for the year to be about 40%. I also would add, one of the very few companies that has actually been able to grow up gross margin second half last year versus second half of 2005 and probably not too many other companies are growing gross margin Q1 over Q1. But thank you for that question, Tim. Good to have you on the call.

Tim Luke - Lehman Brothers

Thank you.

Terry Glofcheskie

Next question, please.

Operator

Our next question comes from the line of Chris Umiastowski, please go ahead sir.

Chris Umiastowski - TD Newcrest

Thanks. Mike, I just wanted to talk to you about I guess two key areas. One being the business transformation and the other being your services business. So I guess in business transformation, I think if my notes are correct I heard you say you created about $100 million of the savings so far. Was that $100 million in total or are you talking incremental relative to Q4?

Mike Zafirovski

I'm sorry, what is the second question?

Chris Umiastowski - TD Newcrest

Second question, just on your services business, it seems to me like Nortel is still sort of finding itself if I can use the term to some extent. Can you just give me a clear picture as to what do you think differentiates Nortel in services and why you are actually going to be able to show growth there to hit some of the targets? You talked about doubling that business I believe over a three to five-year time-frame. So how is that going?

Mike Zafirovski

Terrific. I mean, on the first one, on the business transformation, the $100 million was consistent with the $750 million for the year, slightly better than which we anticipated in Q1. So this is a -- I'm not sure if the proper comparison is versus Q4. But the $100 million is relative to the 750 for the year and is slightly ahead of our internal plans to be able to get to that number. So we feel terrific on that part. With respect to services, I mean I'm always going to say numbers speak louder than the words. Our book-to-bill in Q1 was 1.4.

Chris Umiastowski - TD Newcrest

In services?

Mike Zafirovski

So we did mark that in the first quarter again, we typically do not disclose orders by business unless it's something is so significant. And that's why I showed that number on that particular page. But we've been able to start articulating both value add services to our channel partners, in select cases, to use the vast knowledge which we have on virtually every part of the communication's ecosystem to be able to drive services. Rolls Royce is a perfect example which we announced in Q1. It's seven years end-to-end services and the CIO from Rolls Royce came to our sales meetings so there was no contest in terms of our ability to serve that business. I think we showed quite a few of them the packages, that Dietmar Wendt and the group are preparing at Investor Day. And to say, what gave me the biggest confidence is that the orders which were booked in the first quarter, was 1.4 to revenues and the goal of accelerating that business to grow well above market for the year is going to require uptake in those revenues and we're comfortable that that's going to materialize.

Chris Umiastowski - TD Newcrest

Thanks very much.

Mike Zafirovski

Thank you. It was good seeing you yesterday at the shareholders meeting and sorry I did not realize that you actually were an investor in Nortel as well. So that was good to hear. Thanks.

Terry Glofcheskie

Next question, please.

Operator

Our next question comes from the line of Hasan Imam, please go ahead.

Rob Esarc - Thomas Weisel Partners

This is actually Rob [Esarc] calling for Hasan Imam. Mike, you talked a little about the LG Enterprise business and that the margins are slightly lower than the rest of the Nortel business. Can you give us a little bit of explanation of what products are being deployed there and what are the expectations of margin recovery there? And just in overall Enterprise business, are you taking any steps to increase the strength of that business and deemphasize some of the other carrier parts of the businesses? Thank you.

Mike Zafirovski

A couple comments. One is that, the gross margins for the LG business are lower than Nortel in general. A part of the reasons is because SG&A and R&D are not as high for that business. So the part of it is this is a -- we're using for quite a few of Enterprise devices, including which you are going to be seeing more and more. So the gross margins are lower than the Nortel averages as are their R&D and SG&A expenses. And the businesses are past the growth targets last year and they're positioned very well to grow again in 2009 and 2007. And I'm sorry, the second part of that question was?

Rob Esarc - Thomas Weisel Partners

What, in terms of rest of your Enterprise businesses, are you taking any steps to increase focus on certain aspects of the businesses, given strengths you're seeing there?

Mike Zafirovski

I mean -- keeping investing more. I love the questions that this is a -- if most of you remember, I think it's probably one of my first comments when I -- in the first-quarter announcement of Q4 2005 results, when we said it was that we thought there are products, capabilities and potential and in the customer base in Enterprise were significantly stronger than the trends in overall revenues, that we were going to invest there significantly. I said a few minutes ago, R&D was up 33% last year. We bought Tasman, a $100 million of our acquisition, February of last year. We added indirect and direct sales teams. We created a whole new team under John [Kenning] 1:4230thfilebackup to drive global accounts.

The Microsoft IC alliance was announced in July last year. We came back six months later in January of this year to discuss a very specific road map and the results are showing. We invested more in the Enterprise business this year than last year. And as the business continues to perform, we're going to keep adding resources there as well. So, I do believe that we're contemplating having a full day sometimes this summer to really showcase in more details, not only Steve Slattery and his product management team but also we do have a very specific go-to-market teams in each region. Cliff [Holts] in North America, Peter Kelly in Europe. We have a team that has really turned down with the momentum and we work very hard because we do have good competition. And we work very hard to keep this momentum, which started nine months ago.

Rob Esarc - Thomas Weisel Partners

That would be great. Thank you.

Terry Glofcheskie

We will take one more question, operator.

Operator

Not a problem. Our next question comes from the line of Glen Anderson, please go ahead sir.

Glen Anderson - CIBC World Markets

Hi guys. Thanks for taking my all. Congratulations on a good quarter. I have one question. With respect to your M&A strategy, the team has spoken in the past that now that some of the financial transformation is behind you, that M&A is a higher possibility than it used to be. Any thoughts on what the strategy would be there, where the focus would be and any changes in your thoughts there? Thanks.

Mike Zafirovski

Thank you again and first of all, thank you for all of you being on the call today, I think we – sort of in record time, we only finished our comments in 25 minutes and we had a full I think 45 minutes of Q&As and I think this is our fourth. Congratulations on a good quarter. That was good to hear. We have tried pretty hard to become a normal Company, including finishing our annual shareholders meetings in less than two hours, which we did yesterday. And being able to make acquisitions is also being part of being -- coming back to the 'normal Company.' How to grow the business.

Everything has been the same of course you're going to grow organically. But I'm very comfortable with the acquisitions I've been in my whole life, professional life. And also I understand why 80% of the acquisitions fail. People overpay or people do a very poor job integrating companies. So simply making the acquisition does not necessarily equate to prosperity, on the contrary, turmoil and lots of disappointments. I believe the management team, the operations are becoming much stronger and if we can make a smart acquisition, surely we will not shy away from doing it.

The question is where. My preference of course will be to become stronger in places where we are as opposed to looking at diversifying activities. So, as an example, although broadband access may be a very attractive area to be if you're not there, that would not necessarily be the first place to look at. And whatever we said is that our priorities are to become very, very, very relevant in the transformed enterprise space. We've made significant internal investments. We have a nice growth. So if there's an opportunity to do something we obviously will be there. We have also said we're going to be very strong in the converged -- in the next-generation mobility and converged space.

We do have a terrific CDMA business, which will be here for the next two, three, four years, but we have taken a good position in driving WiMAX into LTE. I do not see how acquisition will help us there because we do have very strong patterns. So this is -- that's obviously internal capabilities. In terms of a converged fixed mobile convergence, our voice-over-IP and IMS activities are developing nicely. If there is something complement with there, obviously we would look at. And services, we have a very nice momentum. But if this -- some complementary place we're going to look at.

But would I want people what are your value or growth investment of call, we're not going to do anything silly. We've had chances to acquire companies before during my stay here. We were not ready or the price was too high. And with the right activity we will look at it. But very few people will be looking at those activities. Most of 33,000 people are very strongly oriented toward improving the operations of the Company and that's not going to change.

Thank you again, for all of you on the call and I look forward to seeing a number of you are here. Now it's 75 or 80, coming to Ottawa next week. Ice is gone. I think the snow has melted and -- people that have not signed up, they're really interested in our technology, and how we plan to commercialize it. The invitation is there for all of you, it's going to see us next week in Ottawa. Thank you for being on this call. Terry?

Terry Glofcheskie

Thank you, Mike and David. Just before we break on the call, everyone, just to answer Nikos and Ehud's earlier question, as you know, last year, after we acquired LG, we did a fair amount of work on converting from Korean to U.S. GAAP. And I could say in Q1 last year because of that we had low revenues that were under $100 million for Q1.

In this year, in the first quarter, we've had revenues greater than $100 million. Hopefully, that answers everyone's question there. And if you do want to follow up, Nikos and Ehud, please give me a call. With that, thank you, Mike and David. And that does conclude our call today. And as always, the Investor Relations team will be available to answer any further questions that you may have. Thank you and good evening.

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