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Nortel Networks Corp. (NT)

Q2 2007 Earnings Call

August 2, 2007, 8:30 AM ET

Executives

Terry Glofcheskie - VP of IR

Mike S. Zafirovski - President and CEO

David Drinkwater - CFO-Interim

Analysts

Mark Sue - RBC Capital Markets

Brantley Thompson - Brantley Goldman Sachs

Chris Umiastowski - TD Newcrest

Paul Silverstein - Credit Suisse

Kenneth W. Muth - Robert W. Baird & Co., Inc.

Paras Bhargava - BMO Nesbitt Burns

Nikos Theodosopoulos - UBS Warburg

Vivek Arya - Merrill Lynch

Timothy Daubenspeck - Pacific Crest Securities

Scott Coleman - Morgan Stanley

Presentation

Terry Glofcheskie - Vice President of Investor Relations

Good morning everyone. Thanks for joining us on the call this morning to discuss our second 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.

But 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 not on chart four, the non-GAAP measure comments.

With that, I would like to turn it over to Mike for his comments. Mike?

Mike S. Zafirovski - President and Chief Executive Officer

Thank you, Tony. Good morning and thank you for joining us. In today's call we're going to cover as normal, our current quarter results. Also we will provide an update to our guidance. And also, we will spend a few minutes to provide you an update on the steps which we will continue to take to drive our business forward, both on a short-term basis and as well as our building a foundation for the long term.

But first let me provide you with an update on the quarter and some of the perspectives on the important steps which we are taking to move the business forwards. On page number six, this is the financial highlights. Let me give an overall perspective. I believe a good progress is being made to reshape Nortel, balance the key indicators of our financial health and moved in a positive direction in the quarter. And most notably the gross margin was 41.1%, the highest in eight quarters, and we are up 264 basis points from the last year. The operating margins were 1.3%, up 291 basis points from the last year, on a year-to-date basis, 448 basis points. This is the fourth consecutive quarter of a significant year-over-year operating margin expansion.

And for the year, we now expect operating margins to be around 5%. This is the lower range of what we had said previously of 5% or higher and I will provide some more detail on this later on the call. Our revenues are down 8% for the quarter, principally as a result of the UMTS divestiture. When adjusted for that, revenues will be down 1%. This is principally is a result of timing of contract completion. On a year-to-date basis revenues are down 2%, and adjusting for UMTS, Access revenues are up by 5%. We are reconfirming our prior full year guidance for revenues of being flat to slightly down for the year. Now, as with respect to operating and our clash flow, there's an outflow in the quarter of $120 million and so on a year-to-date basis an outflow $96 million. On a year-to-date basis, we are at favorable $186 million to the previous year and actions which we are taking we feel confident that we are on track for a significant total year improvement in operating... in working capital.

And moving on to orders, page seven; the book to bill is 1.05 and this is the third consecutive quarter our book to bill is about 1% and all segments this quarter were above 1%. Backlog increased to $5.4 billion up $100 million sequentially. And deferred revenues stayed at $3.4 billion, as the previously anticipated decline in these accounts did not materialize. We should point out that we do expect deferred revenues to be down by approximately 10% by year end and of course an offset to this will be in higher revenues.

Now before discussing them, the specific financials by segment; I am on page eight. Let me provide you the highlights and commentary both on the quarter and year-to-date results. As I indicated, the revenues are down in Q2 but we are on track for the year and to be flat or slightly down for the year, there's a good customer momentum. We are very pleased over the gross margin improvement as well as a very strong growth in Enterprise, we will discuss that in a few minutes. This is fourth quarter in a row where we have had a strong growth.

With respect to our Metro Ethernet results, you will note they will be reporting a year-over-year decline. This is as a result of timing of contact completions and deferred revenues are impacting the results. This is masking a very strong trend in both Carrier Ethernet and in Optical. I indicated backlog is very strong, it's $5.4 billion, and also we have a very good outlook for CDMA for the here and I will make some additional comments in few minutes. And we continue to see very strong momentum with customers; both in actual orders and just as positive discussions, so with our customers it's the way the company is going and investments which we are making.

With respect to specific wins for the quarter, Social Security, a very exciting win of $300 million announced earlier this week, and also we are chosen to be the supplier to Vancouver Olympics and a number of other various significant Enterprise wins. We're able to win a Leap Wireless transaction of $135 million of CDMA. T-Mobile a GSM expansion of $150 million, and some other new activities we signed a WiMAX transaction with Chunghwa Telecom in Taiwan. And also on a PBT, we have another win with Frontier to the part of Sasken Communication Group, and Beltier [ph] also will deploying our Metro Ethernet Manager. It's a very nice combination of wins both on existing products and also some of the new technologies.

Also we're very pleased with the progress which we're making with R&D effectiveness and quality of this. It's resonating with our customers and on one hand we have made a commitment publicly that we will be driving our R&D to be 15% of revenues and it's the dream quarter, we will be discuss in few minutes we're in good shape to achieve that in 2007, and at the same time we're shifting significantly enhancing the quality of that span. Means we are doubling our span in new business segments like Unified Communications, WiMAX application in a long-term evaluation and also we are significantly increasing our percentage spend on new on core segments with a significant offsetting decline in legacy products.

Also we're very pleased with the continuous strong progress on the accounting front. We completed our SAP, the Phase 1 implementation in this quarter. This is mostly for accounting purposes and as you recall we were able to reduce our material weaknesses down from 5 to 1 last year and there are a number of deficiencies which we're tracking internally, we go up from 5600 deficiencies at year end 2005 to a big improvement to 627 at the year end 2006 and that number now is in double-digits down to 43.

The business transformation remains on track, with significant improvements at productivity, material cost reduction, pricing and also go to market activities and very specifically, with respect to Enterprise. We've some work to do on general and administrative expenses. We are making progress, but not as fast as anticipated, as investments which we're making to improve systems, to drive the remedial plans on accounting and in financial controls are taking long than we anticipated and we've made a commitment to have a world class financial systems and records and we will not be compromising those commitments.

And last a small comment; we're making strong progress on the regulatory and litigational front. The OSE settlement was concluded only in the quarter. I think it was very constructive and positive. We're making good progress with the SEC and as you see in the press release and as we're going to discuss in a few minutes, we have booked an accrual for the settlements. This is not done this simply the best estimate of what that is going to be. But the discussion is going to be very constructive and we have told the SEC with the same objectives in minds. So we will make sure that we run the company in the best...to the best interest of our shareholders. And as you know, the litigation settled in 2006 and the cash was put in escrow in the first quarter and the stock issuance commenced this quarter and it will be completed before the 2007 is over.

So this is a Dackle and Joe comments [ph] when you have not moved to your more specific financials by business segment. Starting with Carrier Networks, the revenues were down 60% in a quarter. Adjusting for UMTS revenues are down by 5% versus previous year. CDMA was flat at $494 million. On a year-to-date basis, CDMA is up 14%. During quarter end, I know for people looking to update your guidance, we do significant growth in CDMA on a year-over-year basis and also as you recall, second half last year was very with a significant deployment of ADDL [ph]. Our GSM and UMTS was down 28%. This is mostly due to UMTS divestiture as GSM regularization will increase year-over-year as result a significant countries completions in both EMEA and in CALA.

Our Circuit, Packets, Voice And Applications were down 22% for the quarters and as the TDM Voice declines which was 46% decline versus previous years outpaced the significant increases in VoIP which were up at 28% and also significant revenues which we recognized in Q2 of last year. Again important for the people updating your guidance, we expect the second half revenues here to be above higher results. So that intersection points of VoIP outpacing the decline in TDM. And we had a good constructive discussions on WiMAX and LTE with customers and look forward to be making announcements on those fronts in coming months and quarters.

Enterprise Networks on page 12; our revenue is up 23% for the quarter, 27% for the year. This is a fourth quarter of a strong year-over-year growth. In Circuit and Package Voice the volume increase was broad based, it was in IP products, BCM and applications. In particular strength was in EMEA and CALA. Data Networking Security was up 39%; the strong increases were in North America and EMEA and here we benefit from timing of countries introduced in second quarter. But we are seeing good momentum with customers and partners. Earlier this month we celebrated our one year anniversary with announcing Innovative Communications Alliance with Microsoft, and a positive impact both in terms of their results and the original discussions Enterprises has been very, very significant. And also in second quarter we unveil the new Enterprise data strategy, which we are calling Business Optimized Networking. So we are focused on creating the network that seamlessly sustains and enhances the communication tools and applications required in today's hyperconnected world and it's resonating both internally and of course even more important externally.

Global Services page 13; our revenues were down 9% but adjusting for UMTS 3%, part of reason for this decline is lower GSM-related revenues. Our Network Management Services actually were up 19% over the last year, with a strong performance in North America and in Asia. The book to bill here is above one for a third consecutive quarter and actually were 1.2 to 2 on a year-to-date basis and this reflects the successes which we have in placing orders which are longer term nature with customers.

Our miscellaneous was down 16% for the quarter, up 1% on a year-to-date basis and again as I indicated a few minutes ago, the decrease is principally due to significant contract completions which we had in our Data Networking and Security business, in second quarter and the third quarter of last year. Part of this decline which you saw in Q2 you also will see in Q3 and this masks as I indicated the very strong performance in Optical Networking and particularly strong growth in North America and CALA and more specifically with our Metro DWDM products where we had the strongest performance to-date. I also strong momentum in Carrier Ethernet with our new PBT and our Metro Ethernet Manager wins.

Our geographic revenues, this is on page 15; as we will see, we are down 1%. UMTS adjustments on a year-over-year basis and for the quarter and on a year-to-date basis we have 5%. Couple of comments on a year-to-date basis by region; North America was up 6%, giving a very strong growth in Enterprise and also Optical and Global Services. Here I just want to take few moments to thank, Dion Joannou. We made a comment yesterday that Dion will be moving on to different activities. It's at the end of this month and I mean Dion has done a fantastic job leading our North American for last couple of years. He was in a very good job, prior to that in a strategic group in driving CALA. As we have looked yesterday Dion is leaving for us to personal matters, but he will on full time with us at the end of this month. And again we thank him personally for Nortel and also being a very strong partner with me for them... for the time that I have been with Nortel.

EMEA the reported results down significantly of course without exits from UMTS. On a year-to-date basis we are up 7% and very strong. Very strong results both in Western Europe as well as Middle East, African and Eastern Europe as we are driving lots of new solutions. Asia is down 6% on year-to-date basis primarily as a result of recognizing previously deferred revenues in GSM and Optical in the second quarter of 2006. And growth in CALA is driven principally by our growth in Optical and GSM contracts.

Let me move on to gross margin; here we improved sequentially on a year-to-date basis. As I indicated it was the highest in eight quarters and I think a very favorable to trends which we're seeing in the market place in general. We are benefiting from some improvements in productivity and in mix, even more specifically from productivity improvements. I had indicated in the previous calls that our productivity has been in the low to mid single-digits from most of the 2001 to 2005 timeframe. Last year productivity was up in the high single-digits. In 2007 we expect this to be in the low to mid teens and again very good progress in the first of six months, and we do expect the second half gross margin to be higher than the first half of gross margin. And I will pass it on now to Dave to discuss some of the other elements of the income statement and balance sheet and I'll come back again.

David Drinkwater - Chief Financial Officer-Interim

Thanks Mike. Turning to SG&A. You'll see we're down almost $20 million year-over-year, although up somewhat as a percentage of revenue. Cost savings we experienced in the quarter on the UMTS Access divestiture were about $13 million. We also had lower spending related to internal control and finance transformation of about $14 million. This was partly offset by foreign exchange for about $6 million as well as some increased investment on the Enterprise sales front and variable sales comp of about $10 million. In short we're making progress on SG&A, but as Mike said this has been offset by investment in sales and other marketing activities, and there is more work to do on this category.

Turning to R&D, We're making good progress on this front, down $75 million or 138 basis points year-over-year, significant cost savings from the UMTS divesture but also through the BT programs. This was also offset partially by foreign exchange of about $4 million in the quarter. And as Mike, indicated we have minus side to our goal of 15% R&D for the year as a percentage of total sales.

Turning to operating margin, we are continuing the trend year-over-year improvement, $78 million or almost 300 basis points year-over-year included in that is almost a $100 million, $94 million in improved OpEx spending year-over-year.

Turning to other items, you will see we have significant other income. This has been in part because of an increased interest income from the proceeds from our convertible debt issues early in the year but particular in this quarter, due to strong currency gains which I will talk a little bit more about in a moment.

Turning to some other significant items. Restructuring charges in the quarter principally in relation to our 2007 and 2006 plans of $36 million. Mike made reference to the SEC, we accrued $35 million this quarter in relation to discussions with the SEC towards finalizing our issues that are outstanding with them and we are making good progress in that front, hence the decision to make the accrual. We also had a modest gain on the sales of some assets in Asia and then a significant transactional gain, almost $70 million in the quarter on the ¦Fx front, so let me just speak a little bit about that to help you with it. Our principle Fx exposure is the Canadian dollar. We do have exposure to some other currencies such as the euro and the pound. But we are more naturally hedged in relation to those currencies.

For the Canadian dollar, however, there are two components that we routinely hedge to minimize the impact to the P&L. One is the Canadian payroll which as I have indicated in early discussions can impact both the R&D and the SG&A. But in terms of the operating margin impact around that we also get some benefit on the revenue side, so the impact on operating margin of that is generally not that significant. However, in addition to the Canadian payroll based on the structure of our various accounts, we do have some inter-divisional payments within our books that are in Canadian dollars and that, that Canadian dollar receivable gets a mark-to-market over the course of the quarter. That receivable is a bit difficult to predict and it increased significantly in the quarter. That combined with the significant movement in the Canadian dollar resulted in us being somewhat less hedged than we would conventionally be in a quarter. And as a result, we had a significant gain.

We'd like to immunize the P&L from those sorts of movements, and we're looking it going forward on whether we can move the characterization of that receivable such that it will be a balance sheet impact as opposed to a P&L impact. And so we're looking at ways to deal with that.

Turning to cash, we ended the quarter in a strong cash position, almost $4.5 billion, down $80 million in the quarter, as Mike indicated the most significant element being uses of cash and working capital. And within that the most significant component was an increase in inventory built up for ramping up for some new products but also trying to improve customer service levels by having faster availability of products.

You will see in the 10-Q the outline for principal uses of cash over the next 12 months but the most significant and immediate one is the planned repayment of the 1.1 billion of our 4.25% notes this coming September.

Turning to operating metrics, you will see that our DSO has improved by a couple of days over Q1 and in fact, seven days better year-over-year. The net inventory days is two days worse than it was in Q1 but if you look at year-over-year it's five days better. And days payable outstanding is in fact four days worse due in part to the timing of invoices compared to Q1 versus Q2. But in all I think when you look at these metrics and look at the progress we've made over the prior year we are on track to continue to make improvements to working capital.

Mike has covered the other items on the slide. So let me turn to our guidance. With respect to the full year, we continue to expect revenues to be flat to down slightly compared to 2006. We also continue to expect the gross margins to be in the low 40s. And we now expect operating margins to be around 5% of revenues for the year.

Looking at Q3, we expect revenues to be down in the mid single digits compared to the year ago quarter, with gross margin around 40% for the quarter and operating expenses to be down slightly compared to the year ago quarter.

I'll now turn it back to Mike for some further comments.

Mike S. Zafirovski - President and Chief Executive Officer

Thank you, David. I will just make a couple of comments on our current status, on priorities and strategy. And I do appreciate that David that you like to get to Q&As very quickly. So I'll honor that. So I want to keep our comments as no more to 30 minutes or less.

In terms of our planned framework, it remains consistent. In terms of our short-term priorities, the business transformation is on track. I'll make some comments on that in the next page. Integrity renewal, both the letter and the spirits of that initiative is becoming a very much a big part of our company, it's not only the progress with them. The last source [ph] in the OSC and the SEC but how we conduct our business and again we're very confident that we're becoming a very good practice for other companies. In the growth imperatives, we've seen nice traction in NET enterprise and Metro Ethernet, some of the services orders but also as we're shifting our R&D expense to become more relevant in discussion shaping the future investments including 4G.

The six point plan, the foundation is becoming firmer which is during the first three points of our longer term plan to re-create Nortel into a very significant company, and we are spending much of our time right now targeting growth with short term but of course our longer term as well.

Page 28 is the business transformation progress and I am not going to go through the details on it but we are at or slightly above... everything in the space. But there is a some timing challenge with respect to the joint initiative, any particular the financial... in the financial front, the savings to be realized $400 million by year end 2008. We're obviously working very aggressively to get the right controllers, the right processing place, the right systems and a competitive cost structure. And we will continue to make progress and so against... we'll make a... we'll provide an update as our plans are being implemented.

But for the quarter, on a year-to-date basis we have $270 million in savings and in a simple math if you look at our $5 billion plus in revenues on six months year-to-date basis, 450 basis points improvement in operating margin year-over-year, I mean you'll quickly get to most of this number. And as the year unfolds in our 5% operating margin target for a year, business transformation does play very, very significant part of that effort.

Page 29 our strategy has been very consistent. We are mapping our strengths to high growth segments in this new world which we're just discussing hyper-connectivity in the coming quarters and years focusing the three areas: first of all, those being Transformed Enterprise, seeing good traction, and the combination of unified communications becoming much more significant to verticals solutions particularly in healthcare, financial services and the government, spending more time on applications or discuss our data strategy on business optimized networking.

Next one is the next-generation mobility and convergence, we're making the right investments and putting the correct span team [ph], carrier voice-over-IP, CDMA to make investment to be relevant in 4G. Also taking carrier voice-over-IP to become commercial relevant in fixed-mobile convergence and applications and of course, optical business and Metro Ethernet under the IP transport category. I've said we had confirmed our revenue guidance for the year as this is a transition year with the exit from UMTS and of course the natural decline in GSM. And as we try to optimize the year while at the same time making investments for long term and of course significant increase in our expertise in services and solutions.

Summary page, the last one before Q&A and on a year to-date we are actually on plan. Revenues were slightly ahead of internal plan [ph] in the first quarter, as I discussed some of the contract completions but in terms of the revenues, cash, operating margin, gross margin we are within few percents on each one of those for internal plans. We do realize our second half has to be significantly stronger, typically in our industry and very specifically within Nortel.

There is a strong momentum in enterprise and also a very, very good CDMA outlook. I know there are lots of people concerned over what's going to happen with our CDMA revenues particularly based on the strong second half last year. Based on what we've seen so far confirm with customers in total capabilities, we do expect second half CDMA to be higher than second half last year.

Customer momentum is very robust, en route [ph] to both in North America and in Europe and the doors being opened. Quality of discussions now versus year ago is very much of a night and day comparison. We do have deferred revenue on a [indiscernible] and also very strong backlog, much longer than companies in our industry. And just to reiterate, we do expect deferred revenues to be coming down to approximately 10% as the year unfolds.

I am very pleased we're delivering measurable progress on margins. This is evidence of our processes and productivity improvements and, but also pricing discipline. And we're bringing value with a great level of discussions. We're improving productivity. Obviously we're not increasing prices but there is a disciplined process and I think we're demonstrating we're able to deliver strong... and also I need to comment on enhanced R&D spending goal. R&D spending is coming down by a nominal amount. We have a clearly cited a 15% and much more exciting for investors should be that's the quality of their spans is much more consistent towards, growth for the future and also to be investing in the current core activities.

I am very pleased with the progress on regulatory and accounting fronts. I think we can quote [ph] to my wish of being a normal company. You get up in the morning and you worry about customer sales taxes and competition. Employee motivations approach and a number of the other activities which we've had to worry for the last number of years, not completely out of that, which we're not going to lose sight of that. Once you get to the solid foundation, you have to maintain a bear [ph]. If I can just tell you this is a very different company on that front.

Very committed to delivering the profitability model, this is gross margin getting very closer to 43% which we say we will get it in couple of years, a clear sight to the R&D of 15%. We said, what to do on increasing the size of the company and on G&A that we will accomplishment as well. We're very focused on growth opportunities. Some of those particular... and they do not happen overnight. The investments are resonating with our customers. And so certainly we do plan to continue to shifting [ph] the company for the rest of 2007.

Before going to Q&A, before Terry makes the concluding comments here for this part of the call, I do want to thank both Terry Glofcheskie for many years of great service to Nortel and also to our Treasurer Kate Stevenson who has been always in this room. And he is doing a excellent job dramatically improving the quality of [indiscernible], I think both Terry and Kate for your contribution over many years to Nortel. Terry?

Terry Glofcheskie - Vice President of Investor Relations

Thanks Mike. Thank you, Mike and Dave. Operator if you could open the lines for Q&A, greatly appreciated and we will take our first question.

Question And Answer

Operator

Thank you. [Operator Instructions]. And our first question comes from line of Mark Sue from RBC capital Markets. Please proceed with your question.

Mark Sue - RBC Capital Markets

Thank you. Extrapolating your current results seems to indicate a big ramp in the latter part of the year. And we were just hoping Mike if you could just talk qualitatively of how we get there, maybe on your backlog and some of your big projects that you are working on so that we should get a big sequential ramp in the December quarter?

Mike S. Zafirovski - President and Chief Executive Officer

Mark, thank you very much. I mean first of all, that's what we had experienced last year as well. The couple of points that the enterprise revenue will continue to grow, and obviously that's activity of gross margin is more favorable than enterprise portfolio. CDMA grew significantly in the first quarter, flat Q2, combination of timing and some delivery issues that we do expect to have a long year-over-year growth in the second half in CDMA. We did say the gross margin will be higher in the second half relative to the first half. And if you see that that's what happened last year as well in particularly with the higher volume which we do anticipate to be most noticeable in the fourth quarter, was only planed to be leveraging at volume growth both in terms of a gross margin and of course SG&A and R&D levels. And our deferred revenues, again we have predicted deferred revenues to be going down. Actually it's good news. It has not because it does that level of deferred revenues in the balance sheet but as we are giving a better visibility on contract completions with the software releases or fulfilling other contracts we see a clear visibility. And we do expect to have a meaningful increase in our Q3 and very specifically Q4 activity.

Mark Sue - RBC Capital Markets

Got it. And Mike, separately any thoughts on our replacement for North America timing?

Mike S. Zafirovski - President and Chief Executive Officer

I mean this is a... it just takes anyway from two weeks to eight months to get the right people on board. So this is... we will not comment on it but again I am very comfortable that we've been able to attract and promote great people in Nortel [ph] positions into... and we'll continue to do that in North America and other jobs that may be opened.

Mark Sue - RBC Capital Markets

Thank you, Mike.

Terry Glofcheskie - Vice President of Investor Relations

Thanks Mark. Next question please.

Operator

Our next question comes from the line of Brant Thompson from Goldman Sachs and Company. Please proceed with your question.

Brantley Thompson - Brantley Goldman Sachs

Hi. Mike, I just wondered if we could get a little bit more cover on the change into the further revenue balance that you expect and just some idea what the composition of that looks like. And some of your prior accounting restatements that the deferred revenue balance overall increased pretty significantly. And I am trying just to get my head around how much of the drawdown this year is related to business that was kind of one book and ships a while ago, years ago that were just... had this long tail of recognition related to accounting issues, how much left does that balance relate to that? And how much of the balance of deferred revenues is really current business, something that is really one in the last 12 months, it's on a more regular timeframe. I want to be able to ultimately strip that out from your revenues and look at kind of what the real business run rates are. Thanks.

Mike S. Zafirovski - President and Chief Executive Officer

I mean couple of comments. I mean a big part of that the deferred revenues is rather new which has to do with the LG and joint venture and as we have been changing our processes and contracts to be able to recognize revenues from Korean GAAP to U.S. GAAP. So that certainly is part of that but we are pretty confident that number one, we will... always we will have a deferred revenue balance per se. This is just the nature of them, nature of the business where we need to make commitments to customers for software operator and things of that nature. But quite a bit of that deferred revenues ramp up and down, actually happens... already have happened.

And the new deferred revenue balances have been quite current. The best way to look at this, it will be actually looking at them and I am going to look at royalty. We do report short term and long term deferred revenues on the balance sheet. And I don't have the number in front of me, not sure if we can provide that to Brant. But it is not... the level of the deferred revenues is not based on, if you will, older revenues, it's simply taking into consideration the accounting rules and to make sure that we do have revenue recognition and all our liabilities have been fulfilled.

David Drinkwater - Chief Financial Officer-Interim

Mike its David. The one comment, people could look at the fact is that the while it's relatively flat the portion in long term is coming down. So it's come down about $200 million year-over-year. So while we continue to have fair amount, we're putting on the balance sheet we're going to be able to take it off of the balance sheet more quickly than we have in the past.

Terry Glofcheskie - Vice President of Investor Relations

This one obviously... this is Terry. This is a long term increases that, it does reflect the fact that quite bit of our new revenues also have significant deferred revenue impact. Brant, that's a good question. We'll provide a more specific update on this at the next call.

Brantley Thompson - Brantley Goldman Sachs

Thank you.

Terry Glofcheskie - Vice President of Investor Relations

Next question please.

Operator

Our next question comes from the line of Chris Umiastowski from TD Newcrest. Please proceed with your question

Chris Umiastowski - TD Newcrest

Hi, thanks very much. I guess, Mike, I was hoping that I could get a bit more explanation from you guys on what's going on with your SG&A line. If I look at the different business transformation teams, the teams that... I am guessing maybe you can tell me if this is right. But it looks like about $500 million of the $1.5 billion in savings that you're planning actually would hit that SG&A line. Maybe if you could us walk through some of the major milestones and you expressed disappointment that things aren't moving as fast as you'd like. What's going to happen specifically in maybe Q3 and Q4? And how much savings you think you're going to actually achieve on that line in terms of the business transformation goals?

Mike S. Zafirovski - President and Chief Executive Officer

Couple of comments. Chris, thank you for that question. A big part of them, savings of approximately 200 million of debt was supposed to be within the finance organization. We are reducing the finance expenses in 2007 and also there is a projection of savings in 2008 but there's probably an $80 million pressure between the two years of how much finance costs would be able to reduce. This is as simple as the result of giving assistance and to be able to fulfill all the remedial actions. Obviously foreign exchange is falling on the SG&A line but we are corresponding our positive impact on the revenues as well. Also is... as we're driving their systems and processes we will see a meaningful decrease in fourth quarter and first quarter but Chris, we'll probably be better positioned to provide update on this as the year unfolds.

Chris Umiastowski - TD Newcrest

Just to clarify, did you say $80 million of pressure on the targets for 2007 or you mean 2007 and 2008?

Mike S. Zafirovski - President and Chief Executive Officer

Combination of both. Initially we discussed the finance savings typically from $400 million down to $200 million. Based on the latest look for the three years, we do expect a threshold of approximately $80 million, which upholds the finance organization as well as our external expenses. Specifically they are coming... couple of comments. One is that, we have had a terrific progress in gross margin. So if you are looking at the four major elements, gross margins is tracking at or above expectations, R&D very much on track to where we wanted to be, SG&A certainly it will not be growing, so we will continue to be decreasing the SG&A numbers and off course as the revenue starts moving to a positive territory as the UMTS pressure goes behind, we will be seeing increases there as well. But what's the up to us is to be able manage the upsides in some areas with the possible pressures in short-term, plus we should be able to deliver what we have promised. The pressure for 2007 is rather minimal. What we have said is that 5% or above Q4 right now seems to be 5% which belongs to the very strong performance in the current environment.

Chris Umiastowski - TD Newcrest

Okay, so does that mean that the pension changes and the low cost movement that you have made with Mexico in terms of all those things were on track with the SG&A line?

Mike S. Zafirovski - President and Chief Executive Officer

Absolutely. And quite a few of those things are also helping gross margins. I means this is a... certainly we have, I mean those activities are very much a big part of our savings on the gross margin line as well.

Chris Umiastowski - TD Newcrest

Okay, thanks very much.

Terry Glofcheskie - Vice President of Investor Relations

Thank you. Next question please?

Operator

Our next question comes from the line of Paul Silverstein with Credit Suisse. Please proceed with your question

Paul Silverstein - Credit Suisse

Mike if I could return to Mark's question just with respect to the ramp, it looks like you are using the guidance... if you were to come flat last year, I would assume it was 30% sequential increase. So we'd achieved three guidance and even if you assumed a slight decline, it's still pretty hefty 20 plus percent ramp. Can you give us a little bit more color in terms of what you are looking at in the fourth quarter?

Mike S. Zafirovski - President and Chief Executive Officer

I mean, you are discussing sequential or

Paul Silverstein - Credit Suisse

Based upon the Q3 guidance you are giving, year guidance shift to Q4 appear to be flat a slightly down depend how one interprets slight for on the annual guidance. We were suggesting very large ramp in the fourth quarter sequentially off the third quarter guidance on the revenue line?

Mike S. Zafirovski - President and Chief Executive Officer

Paul I think for that question, we do have a seasonality in our business and if you are looking at last year's revenue, that's well over $3 billion.

Paul Silverstein - Credit Suisse

Yes, Mike but the seasonality has been in the low teens I think in the past couple of years. You are now talking about 25% to 30% size sequential growth?

David Drinkwater - Chief Financial Officer-Interim

If you look at the normalized our view of Q4, to take out the significant amount Rev C we are going to experience in Q4, it s pretty close to what we experienced in Q4 last year.

Paul Silverstein - Credit Suisse

Okay, and just clarification. Can you all give us any quantification or somewhere insight on the impact of LG or Microsoft?

Mike S. Zafirovski - President and Chief Executive Officer

I mean the Microsoft relationship has been both positive both the contracts leased with more than 100 countries wins but also has been very, very promising in terms of opening doors. So the Microsoft relationship has been a very positive in general, and as we have indicated before has been a big drive for the increases in our Enterprise revenues. The impact of LG on the quarter is not significant versus the previous year.

Paul Silverstein - Credit Suisse

Thank you.

Mike S. Zafirovski - President and Chief Executive Officer

Thanks Paul.

Terry Glofcheskie - Vice President of Investor Relations

Next question please.

Operator

Our next question comes from the line of Ken Muth from Robert W. Baird; please proceed with your question.

Kenneth W. Muth - Robert W. Baird & Co., Inc.

Hi, on the CDMA acceleration we are going to see; can you just give us maybe a sense of geographies of where you expect; obviously Alcatel-Lucent doesn't share kind of the same sentiment as they're looking experiencing [ph] flat business. So could you just help us out in what you see in the U.S. market or CALA or India that looks for this big acceleration?

Mike S. Zafirovski - President and Chief Executive Officer

I think you cannot... this is a...we would just say when our growth second half of this year versus second half last year, so I would not... so the big acceleration will be on sequential basis as opposed to a year-over-year; we will grow on a year-over-year basis. But it's rather a balance. We have a very strong continued presence in North America, but also our CDMA business both in Korea in Vietnam. But of course, we have more than 80% of our revenues are in North America and we see continued good progress there and also we were giving out some market share gains in Sprint last year as we were able to win some of the original business. We continue to have a disproportionate gain and with a new entrant into the marketplace, Leap Wireless has been a very specific example where our market share with the newcomers has been significantly greater than our market share with the tier-one players. It's a good progress but also good progress with Leap, continued good performance with Verizon and CDZ and good revenues anticipated in Korea and in Vietnam.

Kenneth W. Muth - Robert W. Baird & Co., Inc.

And maybe just a one quick follow-up on the Verizon stuff and the EV-DO Rev A. Verizon made a comment that they are going to be 100% done with that network now; how does that kind of play into your thoughts or impact your outlook on the CDMA? Does that business have any impact on the second half or not?

Mike S. Zafirovski - President and Chief Executive Officer

I mean actually I've spent pretty much all yesterday with management team of Verizon. Look we are as they are going to says that CDMA spend will be rather robust by 2015. CDMA not going any place we grew our CDMA last year. I think it was 70%, we will grow CDMA nicely this year again and as we are looking at beyond 2008, we do not expect double-digit growth per se but we do expect to CDMA to the main...to remain rather stable, modest growth which is a good foundation for us to be obviously driving a relationships with key customers like Verizon, Sprint, Dell and TelLabs[ph], Alltel, and obviously some other customers in Asia.

Kenneth W. Muth - Robert W. Baird & Co., Inc.

Great thank you.

Terry Glofcheskie - Vice President of Investor Relations

Thanks Ken, next question please operator.

Operator

Our next question comes from the line of Paras Bhargava from BMO Capital Markets.

Paras Bhargava - BMO Nesbitt Burns

Good morning gentlemen. A clarification on your growth margins, they were strong sequentially up but CDMA was soft. Did the Fx have any impact on the GMs positive growth margin progression in this quarter or were there any other, if you could just give some color? And then secondly drawing forward Mike in the current environment how much of next year's 2008 cost cutting do you expect to fall at the bottom line. It looks like about 75% to 80% of it's falling to bottom line this year. Would you expect the same sort of ratio next year? Thanks.

Mike S. Zafirovski - President and Chief Executive Officer

I mean the CDMA margins have been rather robust on an ongoing to basis 2006 and 2007. You could have some level of a fluctuations based on the contract completion, but this is areas we have been very robust. So at a gross margin level there certainly has not been any significant change both in the current use of data environment, nor as we look at total year-over-year. So this simple just to make that correction. We're not going to make any comments on next year's fall-through, but as we have said for this year, it's around $15 million. It's trackable numbers which we have done a very good job on year-to-date basis. Some of the offsets will be the fact that compensation in those calculations in previous years were not a level where we anticipate first to have in 2007 and the of course there is some modest pricing pressure which we indicated. So although that did level off, estimation is not unreasonable per se. And we will be not making any comments on 2008 at this time.

Paras Bhargava - BMO Nesbitt Burns

Alright thanks. Mike.

Mike S. Zafirovski - President and Chief Executive Officer

thanks you Paras.

Terry Glofcheskie - Vice President of Investor Relations

Next question please

Operator

Our next question comes from the line of Nikos Theodosopoulos from UBS Warburg. Please proceed with your question

Nikos Theodosopoulos - UBS Warburg

Hi, can you hear me? Hello.

David Drinkwater - Chief Financial Officer-Interim

Yes we hear you, fine.

Nikos Theodosopoulos - UBS Warburg

Okay great. Just a couple of clarifications on the deferred revenue that you said would be down 10% in the second half. Is that pretty broad based at 10% or is it in one particular area like Enterprise or CDMA. Can you comment on where the variable will come down in the second half?

David Drinkwater - Chief Financial Officer-Interim

Actually it is pretty broad based. EMEA comments... just let me see it. We are pretty comfortable at this new estimate. We've said this, we have made a comment before on deferred revenues coming down because the good news is that we've been to have enough new activity for that number not to go down but this is a... I am looking at Terry or Roy [ph], if there is any.

Nikos Theodosopoulos - UBS Warburg

Freefallbase.

Mike S. Zafirovski - President and Chief Executive Officer

It's freefall base. I know based on the reviews of the budgets, so this has been a pretty much obviously enterprise business which we include part of... the LG continued progress to getting them contracts and the processes they are consistent with U.S. GAAP. And of course then we have some significant contracts in optical and CDMA as well. You should not expect from a gross margin standpoints any differences as actually our gross margin deferred revenue is slightly higher than what we have in our current gross margin. As we've made comments before I mean that can be obviously the... there is a wide range of gross margins both in current basis as well as in deferred revenues in totality which in deferred revenues is at or slightly higher than our current gross margin.

Nikos Theodosopoulos - UBS Warburg

Okay. And Mike just a question on the market. If you look at the second quarter, Ericsson, Alcatel-Lucent, Nortel and the Nokia Siemens infrastructure JV, pretty much all meets Wall Street expectations for various reasons. And a lot of people thought with consolidation in the sector, these build-outs for video that the market environment with being pretty healthy for the equipment vendors and it's not really showing up. What's your sense in the market? It just seems to be more difficult than perhaps people would have thought going into the year given the consolidation among the vendors and the spending cycle of the carriers. Can you comment on it please?

Mike S. Zafirovski - President and Chief Executive Officer

There is just a couple of comments and I hope we did a reasonably good job articulating our performance on carrier cycle though on one hand it's showing a pretty meaningful decrease that CDMA business both on six months year-to-date in a total year we feel very good with our CDMA performance. GSM for us actually increased Q2 this year versus Q1 last year. We're seeing a better traction than we anticipated in GSM.

On our VoIP business we did have a rather significant decline in TDM but there was a 28% plus increases in VoIP. And we do expect based on orders we have to be reversing in the second half. So from the perspective of our carrier business or timing of CDMA but we're pretty comfortable that we'll be where we said we're going to be for the year.

You're asking a broader question in terms of a spans like carriers and of course there has been a very, very significant activity and pressure for all those are going to be reducing... to be reducing prices and obviously for carriers not to be reducing their span. I do think they may even level off pricing that people wish they will do over again. We believe we're being pretty disciplined in that process and most of our discussion on what can we do, how can we deliver additional value? And some of them... anticipation is some of my comments, which you hear from industry is that people, other people will also be more disciplined going forward. So I do think some of the wounds have been self-inflicted. And so I think based on what we're hearing is that people will be wiser on how they price in the future

Nikos Theodosopoulos - UBS Warburg

All right. Thanks Mike.

Mike S. Zafirovski - President and Chief Executive Officer

Thank you.

Terry Glofcheskie - Vice President of Investor Relations

Thanks Nikos. Next question please.

Operator

Our next question comes from the line of Vivek Arya from Merrill Lynch. Please proceed with your question.

Vivek Arya - Merrill Lynch

Good morning. Mike, I am still struggling to see where on the business transformation has made any tangible progress. For example, there is a good improvement in gross margin but I assume that a big part of that is related to your UMTS divestiture and within the second quarter there were some push-out of some lower margin optical sales to the next quarter which is why you are guiding gross margins to again go back to closer to 40%. And second, your OpEx has come down year-on-year but when you look at OpEx to sales it's still around 40%, you know the same as what it was last year. Am thinking about this the right way like where is the tangible sign that business transformation has made any progress whatsoever?

Mike S. Zafirovski - President and Chief Executive Officer

Just couple of comments first of all, with respect to UMTS, our margin in UMTS was not the issue, was simply the level of revenues in R&D side. So the UMTS exit had absolutely no impact on our Q2 margins. I mean in Q2 last year, UMTS was about 37% gross margin, in Q3 it was 42% gross margin. So the UMTS exit had zero, I mean very, very modest impact on our gross margins. So the gross margin impacts are real to go from 38 to 39% but in our long term goal is to be at 43%.

So if the question is, if you are looking at, are gross margin wrong? The short answer is absolutely. Second big impact is on R&D, to go from 18% to 19% down to 15%. I mean we will be able to achieve that including in 2007 and that is to go from zero to 5% operating margins, are those two elements. SG&A is coming down as you indicated revenues are down and particularly this quarter as I indicated 8% but we do anticipate revenues to be down... revenues to be flat to slightly down.

Somebody I guess asked the question before, it was slightly down, certainly it's between zero and 5%. And with... there is I think the conventional definition of slightly and we obviously are looking to... for the actual results to be much closer to the lower number as opposed to the higher number within that range. And SG&A expenses will be coming down. We will not be comprising commitments on the remedial actions but the comments on the improvements on business transformation, I said, we've grown from a minus five in the sense, the first half of last year to slightly positive this year. And we need to continue to maintain 500 basis points year-over-year improvement in the second half of the year, work to be done and I do not want to give you a wrong impression that work is done. I mean there is lots of heavy liftings to be done at this point of time. Some progress is starting to show but we have risk [ph] ahead of us and we are very much up to that challenge.

Vivek Arya - Merrill Lynch

Okay. A quick follow up. Mike in the past you have said that you will only stay in those businesses where you have 20% better market share. So as you look at your current portfolio how do you measure that against that metric? And do you think you will need to pursue any M&A to remain relevant long term in the industry? Thank you.

Mike S. Zafirovski - President and Chief Executive Officer

Thank you for your question. We of course are making investments to be relevant in the spaces where we are competing. Services and solutions is obviously different, it depends how you define services and solutions but obviously we will be very relevant in the carrier spaces where we operate and compete and same thing in enterprise as well. We have made some small acquisitions last year. This is the LG and [indiscernible] but really for the last 18 months the view is that lots of work have to be done to improve the foundation of the company to be running effectively, let alone to be integrating significant other activities. We think the foundation is much firmer right now, of course as I indicated before, we used to go but we are now much more open to the opportunities. We believe we can do well in our own. I think smart introduced activity, properly priced and properly integrated can in fact be quite helpful for us.

Vivek Arya - Merrill Lynch

Great. Thank you, Mike.

Terry Glofcheskie - Vice President of Investor Relations

Thank you, Vivek. Next question please.

Operator

Our next question comes from the line of Tim Daubenspeck from Pacific Crest Securities. Please proceed with your question.

Timothy Daubenspeck - Pacific Crest Securities

Thank you very much. First question is in regards to Metro Ethernet a little bit soft, I understanding it's lumpy. Was that a positive or negative impact on the gross margins in the quarter? And how do those margins compared to the overall business?

Mike S. Zafirovski - President and Chief Executive Officer

TheMetro Ethernet business in general has a lower gross margin than rest of the portfolio. But there is a very nice quarter-over-quarter improvement in that business, combination of a mix as well as increased productivity. So from Q1 to Q2 there is a nice improvement in Metro Ethernet team [ph] but overall that business does have a lower gross margin than our carrier business or our enterprise business.

Timothy Daubenspeck - Pacific Crest Securities

And in terms of enterprise you guys have put up some pretty nice numbers here in the enterprise. How much do you think that's driven just by more focused better execution relative to just the overall enterprise being a little bit ever?

Mike S. Zafirovski - President and Chief Executive Officer

I mean the enterprise market obviously has been quite healthy and the 70% growth I think is the conventional estimates by various bodies. I think in the very first call back in early 2006, we did see that our products... our portfolio of customers and our very rich group of partners should be producing much more Enterprise for a Nortel. One of the business transformation projects is indicative for 75% of PBT projects have been focused on productivity but also there are two projects, in particular one in Services one in Enterprise. So we last year in addition to Tasman acquisition and the LG joint venture I mean there is a significant increase in R&D. They are almost $100 million last year and we have created a global accounting led by John Canney [ph] and I cannot tell you the level of discussions with global financial services players that are coming to Nortel. We've clarified our rules of engagement with partners who are not perfect, we've clarified those. We started to increase some investments in marketing, and we will be long term but we have kicked off a so called tornado marketing campaigns in four cities; Chicago, Mexico City and Singapore and London and we are tracking those results when they just happen within a last couple of weeks.

So this a we spend much more time if you will with Enterprise customers. So focus of course here has been very helpful. It should also indicate you there have been some timing of deferred revenue which has been favorable this year. But overall trend has been very positive, obviously the Microsoft Alliance and the relationship with IBM as well. And all those things have increased the visibility and the confidence that the Enterprise is not only going to be a business within Nortel, I think can we survive and we deliver real value, but after it become a truly foundational business for the company.

Timothy Daubenspeck - Pacific Crest Securities

Great thank you very much.

Mike S. Zafirovski - President and Chief Executive Officer

Thank you. Operator we will take one more question please.

Operator

Our final question comes from the line of Scott Coleman form Morgan Stanley. Please proceed with your question.

Scott Coleman - Morgan Stanley

Thanks guys, maybe just one clarification if you could. Relative to your guidance revenue fell short by a few $100 million this quarter, almost all of it in the breadth of carrier businesses, Enterprise, the one real of strength, now obviously not all of that is a reduction in deferred, but I just want to understand where... this isn't one particular product area or one particular geography that seems to fall short of expectation this quarter. Where is the confidence coming from that you don't have to lower your full year numbers. Its certainly has to come from just the fact that you didn't lower deferred this quarter. So what are seeing out there that gives you the confidence given the breadth of weakness across the carrier side of the business this quarter? Thanks.

Mike S. Zafirovski - President and Chief Executive Officer

I mean for starters, Scott, you said that there is CDMA and said that if you look at last years second half results, there was a big ramp up in EVDO and so this that what we are saying not only going to be matching but we are comfortable, we will be ahead of the CDMA revenues from last year. There is a big, big impact that's throw second half revenues last year and we will be driving second half revenues this year. As an example, we've get out, if you look at last year's CDMA revenue were 645 in the first quarter, 732 in the fourth quarter and what we just said that we are comfortable, and we will be above the second half CDMA levels last year. Enterprise has been growing double-digits for the last four quarters. We see that trend continuing. So you can see double-digit growth at Enterprise coupled with very strong growth at Enterprise last year, we did see the Optical side and Metro Ethernet there was a significant revenue recognition in Q2 and Q3 last year and to put some pressure here again in Q3, a clear visibility to improvement in the fourth quarter. LG we keep accruing a significant number of their revenues and we believe that we will be complete with both the actual delivery of products along with contractual requirements. So as said in the first quarter as we indicated there is a level of a performance of slightly ahead than the expectations that we have not moved that in the full year that we will be flatly and slightly down really what was seen and obviously this is already a month plus into the third quarter definitely now we are more confident in those numbers.

David Drinkwater - Chief Financial Officer-Interim

In the second quarter it was in fact the things we see deferred later in the year as opposed to things that aren't going to come back. Also we had some products that we hope would be available to ship in Q2 that will be available later in the year. So some of this is deferred into the back of the years as opposed to something that just didn't show up at all.

Scott Coleman - Morgan Stanley

So your deferred revenue balance was flat quarter-over-quarter, I think you said in the prepared remarks. So did you drawdown some of what was in deferred this quarter and resell it. Meaning you did have a little bit of a churns businesses this quarter or was it really not a whole lot of put and takes in the balance sheet accounts?

Mike S. Zafirovski - President and Chief Executive Officer

We see a continuous inflow of deferred revenues and this is not... I mean virtually most parts of the carrier business you have elements of deferred revenues. So this is a very, very rich and frequent activity in deferred revenues and that's all going to stay there. We've said before is that our... the level of our deferred revenues are higher than competition based on our practices or ability to identify the costs or pricing levels for some of the services on the market, is I think has become more sophisticated. They will be decreasing but there's a very robust activity in deferred revenues. And so as I said, there has been replenishment which will continue to be on an ongoing basis.

Scott Coleman - Morgan Stanley

Right, of course maybe two quick follow-ups, I realize that we are pushing up against the time limit. One is given what you expect to recognize in the back half of the year what's the deferred cost associated with that revenue? Or if you have a margin profile that you can give us that will be helpful. And second, Mike, from your answer it's fair to imply that you'll obviously draw down the current balance of deferred revenue by far more than 10% but you expect some significant inflows as well?

Mike S. Zafirovski - President and Chief Executive Officer

The view is that even assuming there's no decrease in the deferred revenue balances overall. Certainly there will be much more than 10% in and out of that account. And there is lots of activity which we have on an ongoing basis. So there's a delicate [ph] of that account, it is quite active. But for balance we expect that number to be in a 10% range and again we are pretty comfortable with that. And as I indicated before the gross margin elements of deferred revenues is slightly higher than the gross margins which we have in the business in totality, not materially but they just do not -- when people expect that rate significant up or down mainly as a result of the deferred revenue is going down.

Scott Coleman - Morgan Stanley

Great. I appreciate the answers guys. Thanks.

Mike S. Zafirovski - President and Chief Executive Officer

Thanks Scott. Let me just... first of all thank you for your interest this morning, and said from our internal plans for the year we are very much on plan with revenues, gross margin and operating margin for the year. We do understand the questions that are coming in front of those. We can tell you is that the theme is very driven on driving customer discussions, getting to a level of revenue after adjusting for the UMTS divestitures to be moving into the positive territory. And we're comfortable that will happen as 2007 unfolds and as we move into 2008.

I do not want to underscore the great progress being done on gross margins and R&D spans as well as the composition of that. On the G&A costs in particular, some new if you will realization of votes [ph] possible driving the progress and the commitments which we have made externally and we will not be compromising those deliverables but the G&A cost will come down in the appropriate time and there is a great deal of focus on them. And thank you for your interest on big group [ph] on the call this morning. We appreciate that.

Terry Glofcheskie - Vice President of Investor Relations

Thank you, Mike. That concludes the conference call for today. And as always the Investor Relations team will be available to answer any further questions that you may have. And finally, thank you for your interest this morning and I would like say a special thanks for your support over the years. As Mike indicated this is my last call. Have a great day and good bye.

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Source: Nortel Networks Q2 2007 Earnings Call Transcript
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