Nortel Networks Corporation. Q2 2008 Earnings Call Transcript

Nortel Networks Corporation (NT)

Q2 2008 Earnings Call

August 1, 2008 8:30 am ET

Executives

Janet Craig - VP IR

Mike Zafirovski - CEO

Pavi Binning - CFO

Analysts

Gus Papageorgiou - Scotia Capital

Paul Silverstein - Credit Suisse

Ehud Gelblum - JP Morgan

Scott Coleman -Morgan Stanley

Mark Sue - RBC Capital Markets

Edward Snyder - Charter Equity Research

Chris Umiastowski - TD Newcrest

Nikos Theodosopoulos - UBS

Mark McKechnie - American Technology

Ken Muth - Robert Baird

Vivek Arya - Merrill Lynch

Brian Modoff - Deutsche Bank

Richard Windsor - Nomura

Michael Urlacher - GMP Securities

Presentation

Operator

Welcome to the 2008 second quarter financial results conference call. Our host for today's call will be Janet Craig. (Operator Instructions).

And now, I would like to turn the conference over to Janet Craig.

Janet Craig

Thank you, Mark and good morning everyone. Welcome to Nortel's second quarter conference call. Before I hand the call over to Mike and Pavi, I just wanted to mention a few things. As you are aware, we do ask callers to keep to one question. We really appreciate if you would help us out with that.

To go into the next slide. Please note that certain comments made in today's call may be characterized as forward-looking statements 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. 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 the Form 10-K. Our Q is expected to be filed later today.

Also please note our non-GAAP measures comments. And I just wanted to mention one housekeeping item here. We have changed the terminology of our performance measurement of operating margin to management operating margin. There is no change in the measure itself, clearly in the terminology. Our definition of management operating margin is gross profit minus SG&A and R&D.

And now, I will turn the call over to Mike Zafirovski.

Mike Zafirovski

Thank you, Janet. Good morning everybody. I'll be kicking off with the highlight of the second quarter. Pavi will then provide a more detailed review of financials and other developments, and I'll come back at the end to discuss the longer term goals for our businesses, which we presented at the Analyst Day and we will also provide some additional contacts of what we are doing to meet our short-term 2008 goals.

But before the discussion of highlights of the quarter, I just want to make a couple of brief comments. On this page 6, the first four points are exactly what I had used in the last earnings call, and I do believe we are making good progress in the first half in a difficult environment, which is generally out there for the industry.

We remain very focused in achieving our 2008 objectives and to repeat those to grow our business for the year in low single-digits to achieve a gross margin of 43% and to grow our management operating margin by 300 basis points. But we continue our unrelenting focus to drive earnings growth ahead of the market and to continue to build markets and customer momentum in the growth areas, which we discussed with you at the Analyst Day.

Brief, we are driving meaningful revenue and management operating margin expansion in Metro Ethernet in the Enterprise businesses including the voice services. This is the goal for 2008. And as we have said, they expect to ramp up in the second half and also to optimize the results in our Carrier business, particularly in wireless as we execute in the transition to next-generation technologies.

Let's move to the specifics, Q2 financial highlights. We are pleased with the performance this quarter. Our Q2 revenues were 2% higher than last year, benefiting from a completion of a deferred revenue release in our Carrier business. Our book to bill for the quarter is 0.82, which is obviously not, where we have been, but I do want to highlight that we are about flat, book to bill if we exclude the Carrier business. We'll make some additional comments on it throughout this presentation.

The macro environment in the US Carrier still continues to be challenging, impacting a particular CDMA orders and revenues. Our Enterprise, MEN, Services businesses, all grew in the second quarter and were from 3% to 9% compared to the previous period. As I've said, a few seconds ago, the book to bill for those three business segments in the aggregate are kind of flat to -- the book is bill is approximately 1.

Gross margin and management operating margin continued to improve year-over-year, 7 and 8 quarters improvements over the period. And Pavi will discuss more detail on both of those in a few minutes.

This chart, page number 8 continues to capture the bigger picture from a financial reference perspective. We have been focused on driving operational and financial performances. We began our turnaround a couple of years ago with almost every measure, we have shown improvements, and these are the numbers that are circled in green. The revenues, gross margin, management operating margin have been up the second half of 2006, 2007 and the first half of 2008.

And as I indicated at the beginning, we are very determined to achieve our growth targets for the year of low single-digits, gross margin of 43% and management operating margin improvement of approximately 110 basis points

With respect to cash flow, we did see a seasonal outflow for the quarter of about $3 million, which brings them year-to-date to $334 million, and Pavi will provide some more some color on this in a few minutes.

Moving on to the business momentum. Ultimately, financial momentum is driven by three activities; business momentum, operational excellence and world-class cost structure. I am very comfortable that we're making a real traction in the last two, on operational excellence and world-class cost structure. And we are starting to see real momentum in our business from our customers particularly in the growth areas. I'll highlight just a couple few more ending numbers, and a number of those who are highlighted in our press release issued earlier this morning.

But first in the Enterprise business, where we are seeing continued success driven around unified communications message. Earlier in the week, we announced London 2012 win and this is end-to-end communications requirements and again is resonated with the modern 2012 Organizing Committee just as it did with Vancouver 2010 that we do have a carrier-grade capabilities to deliver to the enterprises, large or small.

Early in the month, the readers from Computerworld voted our combined Microsoft Nortel Unified Communication as the leading user solution in the marketplace. The Green and Energy Tax campaign has been receiving quite a bit of attention from current and potential customers, and just yesterday, I was very, very pleased to see a very significant increase in the brand awareness, particularly in the C-suite, we have not been very pleasant, and as Lauren discussed at the Analyst Day, we have been trying to give attention to C-suite, the CIOs, the CEOs, the COOs and the numbers will abate from a low base, we are up four, five, ten times, where we had been as recently as a year ago.

In the Metro Ethernet business, we have 20 wins, five or six more since we saw you a few months ago and very important five Tier 1 trials. And as we have discussed at the Analyst Day, a pretty significant Carrier Ethernet award from Verizon early in the quarter.

Our services and solutions are also taking hold of the customers, quite a few of those highlighted in the press release, but not that one particularly pleased with the Deloitte Managed Global Telepresence Services.

Also, as we discussed at the Analyst Day, we are repositioning our Carrier business. While this business is projected to decline over the next several years, and the emphasis varies on our carrier VoIP and the applications activity, which we have referenced as core [multi-medium] applications at the Analyst Day. We are very pleased to announce a new leader for that business, a promotion of Samih Elhage to leading that business as of next week. We look forward to his contributions there.

Also, I'm very pleased with the Alvarion transaction. As we've said, this allows us to leverage R&D in a growing environment. At the same time, it really allows us to focus our internal R&D to work on 4G LTE in wireless applications. Of course, in this environment, we are increasing our cost controls across the board and you'll see some of those results already in the Q2 financials and of course we look forward to continue this increased focus on costs while driving the strategy initiatives for the business.

In summary, I am pleased with our business and the financial performance this quarter. Now, I'll give the call over to Pavi for a financial review and I will come back before the Q & A. Pavi?

Pavi Binning

Thanks, Mike and good morning everyone. Let me start with the profit and loss statement. We achieved management operating margin in the second quarter of $114 million or 4.3%. Our revenue growth was slightly ahead of expectations, and this together with gross margin improvement and expense control contributed to the performance in the quarter. Below management operating margin, there was with a higher minority interest and tax expense related to the LG-Nortel joint venture. We also had higher restructuring charges and net interest expense plus lower FX gains compared to last year.

Our revenues for the quarter were up 2% year-on-year. As I mentioned earlier, revenue was slightly ahead of expectations, as we saw some revenue expected in the third quarter come through in quarter 2. This upside was driven in part by the LG-Nortel joint venture.

While we continue to expect low single-digit revenue growth for the year, looking into the second half, we expect to see greater than normal seasonality between the third and fourth quarters. This is a result of expected revenue recognition of $350 million from contract completions related to a software release in the fourth quarter. As a point of reference, deferred revenue releases in the second half of last year were approximately $290 million.

Gross margin performance is again strong. And we delivered our seventh consecutive quarter of year-on-year growth. Customer mix and productivity improvements were the key factors driving this improvement. Looking forward, we expect gross margins in the third quarter to be broadly in line with our year-to-date performance for the first six months.

As you are all aware, SG&A continues to be an area of focus for us, while foreign exchange continues to create a headwind with a negative impact of about $20 million for the quarter, we continue to bring SG&A down year-on-year. On the G&A side, we reduced spending by 17%, compared to last year, with reductions in finance and IT being the main drivers.

Looking at sales and marketing, we are balancing our need for efficiency, with the requirement to invest in key sales and marketing initiatives. We saw a $15 million increase in R &D this quarter, primarily due to FX.

We are continuing to get efficiencies by moving from high cost to low cost countries and balancing that with investments in key programs that will drive our future growth. R&D is expected to be lower in the second half of the year relative to the first half, with continued investments in key programs.

My next chart shows management operating margin. We achieved a management operating margin of 4.3% in the quarter, that is 302 basis points ahead of last year. Our joint venture with LG contributed significantly and we have seen better than expected performance in the first half of the year.

Moving then on to the performance with our business units and starting with Carrier Networks. As one would expect based on market trends, we saw declines year-on-year in our CDMA business. Looking forward, there is the potential of further reduced Cap Ex spending by key North American CDMA customers, which causes us to take a more cautious view.

On GSM and UMTS, we saw strong growth particularly in Korea. Despite lower volumes this quarter, we were able to keep profitability about flat year-on-year through gross margin improvement and cost control.

In Enterprise, the first half of the year has continued to be a period of investment for the business in sales and marketing, as well as R&D to drive near and long-term growth. Regarding revenue performance, we saw year-on-year growth despite the strong performance last year, which was up over 25% year-on-year in the second quarter.

Turning to our Metro Ethernet business, we saw both top and bottom line growth this quarter. Revenues were particularly strong in our Metro and next-generation long-haul DWDM products. And as Mike mentioned earlier, we have now secured 20, 40 Gig wins, which compared with the 14 we had announced by our Analyst Day in June. The traction on 40 Gig, as well as growth in Metro Optical and our Carrier Ethernet businesses gives us confidence that we'll see growth in the second half of this year.

Turning to Global Services, we saw strong top line growth for the quarter, as well as some bottom line improvement. You may recall that in the first quarter, we saw gross margin declined, as a result of delayed maintenance contract renewals. The contracts have now been renewed and the associated revenue was booked in quarter two. Operating margin improved for the quarter with a 30 basis points increase.

Other income declined year-on-year due to lower FX gains and lower interest income. Similarly, we saw reduced interest expense due to lower debt levels and interest rates. We successfully completed a $675 million senior notes offering in the quarter and used the proceeds to redeem the balance of the note that was due in September 2008.

Minority interest and taxes were impacted by the increased profitability of the LG Nortel joint venture. Taxes were also higher due to revisions to prior period estimates in Brazil and the UK. My next chart shows the summary of the significant impact items that we don't view as being part of our ongoing operations. I won't go into the details, but this chart is here for your information.

Moving on to cash flow. Quarter 2 cash from operations was negatively impacted by our net loss and release of deferred revenue, partially offset by positive working capital. Improvements in working capital generated $154 million of cash in the quarter. Net cash used in investing activities relates to capital expenditure, and net cash used in financing activities relates to the dividend payment on our preferred shares, as well as the net impact of the debt refinancing.

Turning to the outlook. As we move through the year, we are taking a more cautious view both on the global macroeconomic environment and CapEx spending within key North American CDMA customers. Based on our plan of delivering growth in both our enterprise and MEN businesses in the second half and the expected recognition of previously deferred revenue of approximately $350 million in the fourth quarter, we are confirming our guidance for the year of low single-digit revenue growth, gross margin of about 43% and management operating margin improvement of about 300 basis points.

That's the end of my presentation, and I'll now hand you back to Mike.

Mike Zafirovski

Thank you, Pavi. If you to page 26, I will not go through details, but this is a page which I used at the analyst day. And we are moving now from the transformation stage to a growth stage. We know it's not going to be easy, but this is the logical next step. And I also want to highlight the fact that many of the investments for restructured growth, has to been made in the last 18 to 24 months, and given the areas they are related, relevant and where markets are growing.

Here's a quick reflection and summary. These are the three businesses of which we have to be included in the related service revenues. This page shows the percentage of revenues in 2007 and the management operating margin along with CAGR, which we are expecting in these businesses over the next 3.5 years, as well as the 2011 target in management operating margin. Which was also shown on the next page is the further breakdown of the Carrier business, between wireless which we did highlight that we expect for that to be declining, and the core multimedia applications which we're expecting for that business segment to be growing both top line and management operating margin. And starting with the next quarterly report, we will be showing you the progress from, starting with 2007 as the base in how we're making progress towards the 2011 targets.

Somewhat the way we'll be showing the overall revenue gross margin and operating margin improvements for the whole business. You've been asking for that level of transparency, you've been asking for the future growth and profit opportunities for Nortel, and we look forward to ought to be doing that.

And much more practically, let me provide additional context of what we are doing to deliver second half in 2008. The company is fully energizing, engaged with delivery in this environment. Starting with refocused sales efforts in the growth segments; Bill Nelson in the sales organization, increased resources to drive 40-gig in unified communications and to also accelerate the marketing momentum for each generation of pipeline development across the country.

It was less than a year ago, it was our initiative to drive a CRM across the company, and our pipeline is up at least 12% from where we were at the beginning of this year, and again, a great level of emphasis to drive our orders and our revenues.

Our targeted solutions driving growth in enterprise continues as we move from TDM IP Voice Unified Communications, and more and more which you are going to be hearing from us is, communication-enabled applications.

We look forward to be discussing with you a number of wins, which we expect to have this quarter, but also we are driving new product offerings for small and medium-sized businesses and we are seeing increasing momentum with their sales. We are targeting sales efforts in to the areas where we do expect to see significant growth, accelerating the Metro Ethernet Networking Solution adoptions of revenue ramp have indicated with some of the anticipated growth in top and bottom line in MEN in second quarter and Philippe Morin and the sales force will be driving this with additional level of energy in the second half of this year.

The combination of go from trials to wins with our Tier 1 customers, expending the application for the 40-Gig offerings and increased focus in our Carrier Ethernet EDP and offerings. Of course, in this environment there is an increased focus on cost control. We will continue to drive lower SG&A across the company.

We are accelerating the move to centralize the R&D activities consistent with the site strategy, which was announced earlier in the year, and Joe Flanagan in the operations have a number of actions already in place to maintain the double-digit productivity in cost of goods sold. That will happen in the second half of 2006. 2007, we are trying to do that to do that in 2008, and lots of plans, as we have discussed at the Analyst Day to drive this significant productivity in 2009.

Let me just finish with this page with this unrelenting focus on continuing to drive through achieving our 2008 objectives. We have an operating margin improvement ahead of the market. To build the customer and market momentum in the areas, where we are making the investments from growth and which we know we are going to have to achieve to be able to not only finish 2008 strong, but to put a foundation for 2009 and it was just starting to move from the transformational stage to one where we are growing the business.

We understand the market, we understand the industry, we know some of the headwinds facing us and the industry, but also I want to highlight the fact there is a great deal of confidence by the management team and the employees and we look forward to execute in this environment. Thank you.

Now back to Janet for some comments and instructions before the Q&A.

Janet Craig

Great. Thank you. And Mark, if you can provide the instructions for the Q&A, please.

Question-and-Answer Session

Operator

Certainly. Ladies and gentlemen at this time, we will conduct a question-and-answer session. (Operator Instructions) Janet Craig, please go ahead.

Janet Craig

Thank you. First caller, please?

Operator

The first question is from Gus Papageorgiou from Scotia Capital. Please go ahead.

Gus Papageorgiou - Scotia Capital

Well, thanks. Just a question on the Enterprise business, nice to see that most of your businesses in this quarter were profitable, but the Enterprise still didn't have a positive EBIT margin. I'm just wondering as we go into the second half, how confident are you that Enterprise gets into profitable territory and how dependent is your year going to be on that actually happening?

Mike Zafirovski

Gus, thank you very much. The good news on Enterprise in the second quarter was as Pavi indicated, we grew despite the fact there's a 25% growth in the second quarter of last year, and also we're not disclosing gross margin by business segment, the gross margin improved nicely year-over-year within the Enterprise business.

And to answer your question, we do expect both top and bottom line improvements in the Enterprise business in the second half, including it grew specifically to have meaningful management operating margin profitability in the second half. So, yes, that's a very much part of that plain in the guidance. And so, there is lots of efforts and confidence with the team that they will be able to deliver.

Janet Craig

Great. Thank you, Mike. Next caller please?

Operator

The next question is from Paul Silverstein from Credit Suisse. Please go ahead.

Paul Silverstein - Credit Suisse

Thank, Mike and Pavi, I was hoping for a little bit more insight on the book to bill, moreover the point -- is that all related to wireless to Verizon's plan? Were there other aspects, other pieces of business and the weakness?

Mike Zafirovski

Really good question. We tried to be as transparent both in the press release, the comments for today. The short answer is, yes. The book to bill on non-carrier was 1.0. And we have given it (inaudible), and the short answer is, yes. And I think based on the pre award documents to the activities over the last number of months and weeks, yes.

Janet Craig

Great, thank you Mike. Next caller, please?

Operator

The next question is from Ehud Gelblum of JP Morgan. Please go ahead.

Ehud Gelblum - JP Morgan

Hi, thank you. I want to understand a little bit more about this comment you made, Mike and Pavi on the $350 million. Is the way to understand it that because of the lower order growth in CDMA right now, that you would normally have had a lower guidance for the year than low single-digits, but now you are including an extra $350 million that you brought forward from '09, that you weren’t including before and you can therefore maintain the low single-digits? And if that's the case, am I clearly misunderstanding it. What does that do to your '09? And help clarify a little, is there a way that you can give us an operating margin without LG this quarter and possibly the last, see the progression without LG that seems to be obviously making the numbers difficult to track?

Mike Zafirovski

Pavi may give additional perspectives there. The $350 million of differed revenues was always part of our plan, that's been IDM, middle of Q4 software delivery. So there has been a part of our plan Ehud. And also to put it in perspective is that the deferred revenues for second half this year of $350 million are slightly higher than the $290 million deferred revenue releases in 2007. So, at least from a revenue perspective, the second half performance you'll be able to drive the comparison on a reasonably consistent basis. And also, I think it's important to highlight the fact that the first half deferred revenue releases were in significant part, well more than 50% were LG driven. This is where the work was being extended in the half of last year. And obviously, we finished it in the first half of this year, and we did not expect for differed revenues to be a significant material driver for us 2009 and beyond that.

Pavi Binning

Mike, I think you've answered the question actually, as there is not much for me to add to that.

Janet Craig

Okay. Thank you, Mike and Pavi. Next caller, please?

Operator

Thank you. The next question is from Scott Coleman from Morgan Stanley. Please go ahead.

Scott Coleman -Morgan Stanley

Thanks and good morning. Focusing back on segment operating profit, the improvement on a year-over-year basis in dollar terms is coming almost entirely from the other category, and I'm wondering if you could help us understand how much of that is non-allocated but operational, versus some other items because enterprise, as you said had a good quarter in Q2 last year but it's down year-over-year. I'm wondering what the underlying trends are in that category?

Pavi Binning

In terms of the other categories, there is unallocated corporate costs in that category and what we have had without any doubt at all this year is a tremendous focus in terms of reducing the G&A component. So you're absolutely right in terms of the SG&A area in that particular category has come down significantly, but that's driven by the actions as I mentioned earlier on, whether it's finance or IT, some of the corporate functions, we have been examining the costs in that area considerably and taking necessary action to reduce the cost base. That was something that I highlighted as you will recall at the Analyst Day and we will continue that focus as we move forward.

Mike Zafirovski

I want to reemphasize that point, Scott, you asked a pretty probing questions on that element, I think Pavi and I both answered those. Certainly their G&A expenses, which are being driven significantly this year, which look forward to be doing the same thing in 2009 and 2010 in a very determined way.

I also want to highlight the fact that MEN services also improved year-over-year. And I think it was Gus' question, we do expect to start seeing improvements in the Enterprise business in the second half. It has been pretty transparent and all those are requirements for the new Nortel if you will, because as we do understand the headwinds are facing the North American market and carrier space that we are starting to execute on that. Thank you, Scott.

Janet Craig

Great. Thanks, Mike and Pavi. Next caller, please?

Operator

The next question is from Mark Sue from RBC Capital Markets. Please go ahead.

Mark Sue - RBC Capital Markets

Mike, what are the headwinds on the CDMA segment taking another leg down. Why not to be a little more prudent in terms of your guidance, because I'm not sure the decline in orders and deferred revenues help. Aside from the $350 million, where is the other incremental strength coming from and can 3Q be down sequentially or should we expect flat trends and then a sharp spike at 4Q?

Mike Zafirovski

I mean, we obviously, Mark, have taken a very close look at the markets in terms of what's happening in all the business segments, not just the Carrier and those things are reflected in the guidance for us to have the Q2 improvements, and not only for Q2 but also the basis for 2009. The Metro Ethernet business, the Enterprise business and they have to start delivering. We made pretty some significant investments in the last 18 to 24 months, (inaudible) we are obviously with the services attach rates into those businesses both energize and feel the pressure to deliver. That's exactly where you want to have it. In the other category, lots of them, our corporate support costs are coming down and being driven very aggressively by Pavi, Dennis Carey and the rest of the organization. Pavi, I'm not sure, if you want to add some additional perspectives on the questions from Mark.

Pavi Binning

Yeah. No Mark, I mean, it's a good question. The $350 million obviously is an important factor in Q4. But as Mike has highlighted, Enterprise and MEN, we have been investing heavily throughout last year and indeed this year. And there is without doubt the confidence; the sort of trajectory that we are trying to build is beginning to emerge. And we can sort of see the early signs of that in the pipeline. So I think, certainly we have reiterated the guidance today and we wouldn't have done that if we hadn't felt confident about the achievement.

Mike Zafirovski

And when we say Enterprise and MEN, this is of course an end-to-end comment. Sales and marketing have been one of the few areas, we actually have been growing. Pavi had indicated their G&A is down to 15% this year. The sales efforts and marketing efforts within Enterprise on a percentage basis are greater than on the Carrier side, and as we have said the investments have been made training has and is occurring and so that's where we are expecting to see the acceleration of the momentum, which we have seen already this year.

Janet Craig

Great. Thanks, Mike and Pavi. Next caller, please?

Operator

The next question is from Edward Snyder from Charter Equity Research. Please go ahead.

Edward Snyder - Charter Equity Research

Thank you. Good morning. Mike, if you look over this quarter's performance, it looks like you have executed very well along your operational aspects with one exception of course as being at CDMA's was particularly weak. So, cost controls are all kicking in. Is the question then is given the size of that division is the weakness you are see in CDMA, just the economy in the US or are you seeing some of your bigger customers shift to less investment and looking forward to LTE or is it more of a strategic change in your customers base that we can expect to weave through the next year or so, just a weak growth or no growth over declines in actual revenue?

Pavi Binning

It's a great question Ed. Certainly there's some capital constraints in this environment. Capital increased emphasis, including what we do internally without capital expenditures. And, some of it is the economy if you will, but also, there is a without mentioning specific customers, there is a significant North American customer that has certainly shut the door on short-term capital expenditures and there's not much visibility of what's going to happen in the next three, six, nine months. We are having discussions with them on an ongoing basis, but no firm commitments. And we have taken those more conservative views in our guidance for the last six months of this year.

Janet Craig

Great. Thank you, Mike. Next caller, please?

Operator

The next question is from Chris Umiastowski from TD Newcrest. Please go ahead.

Chris Umiastowski - TD Newcrest

Hi. Thanks very much for taking my question. I have a question on the operating margin of the company. I want to really understand from you guys, what the management operating margin would be if we were to exclude the deferred revenues. And the reason I'm really interested in doing that is, I think it's correct to say that the deferred revenues don't have a lot of SG&A and R&D component to them. So, really they help the EBIT margin significantly because it's just revenue minus their COGS?

So, that's going to hurt you next year in terms of a comparable, and it seems like if you are going to have less deferred revenue coming in 2009, then you'll have a tough comparison. And we just want to be prepared to understand what the operating margin changes are going to look like. So, the two factors there, first the deferred revenue coming in from the LG joint venture, I would love to know how much of that actually hits the EBIT line? And then the second factor is it's related. I noticed you reported that FX hurt your operating expense line by about a total of $33 million split between R&D and SG&A. Yet, you did have a $34 million net gain, so there is a delta there, there is a missing $67 million hit somewhere and I'm again curious if that was on the revenue or the COGS line on any part because that would again impact the adjusted calculation for operating margin that I would like to do. If you could help me out with that, that would be great?

Mike Zafirovski

Thank you. I'll try and answer your fourth question. Similar to (inaudible) In our business, we are driving revenues and orders which of course some of them projects do take a longer time to complete and gets the deferred revenue as part of our business and part of our responsibilities to manage the business, as we provide guidance probably reflecting the swings in deferred revenues and we have been very, very transparent in those activities. And I think you should be able to do it back of the envelope calculation on those. But that's even more of an emphasis of driving SG&A down and driving the growth in Enterprise and MEN and we'll be providing guidance on 2009 and beyond in due course.

Pavi may have more comments on it. But in terms of the FX from the management operating margin taking the favorability on revenues, the unfavorable impact on cost of goods sold. SG&A and R&D, the negative impact, which we had obviously reflecting the numbers is $36 million in the second quarter and $73 million on a year-to-date basis. So, that is the overall impact of FX on our operations. And I'm not sure Pavi, is there additional comments you want to make?

Pavi Binning

Chris, I would just emphasize that deferred revenue is a part of this business. We have earned those contracts. We have done work in those contracts and timing of completion of those contracts determines when one recognizes the revenues. So, this is not a freebee, sort of comes along and it is separable from the rest of the accounts.

What I will say is that we disclosed very clearly in the press release the level of deferred revenue releases that we have in the quarter you can easily apply sort of a margin to that. I'm not going to sort of disclose the gross margin on every part of the business. But if you apply the group average margin that gives you a good proxy for the benefit that's flowing through to the bottom line in terms of deferred revenue.

Janet Craig

Great. Thank you, Mike and Pavi. Next caller, please?

Operator

The next question is from Nikos Theodosopoulos from UBS. Please go ahead.

Nikos Theodosopoulos - UBS

Yes, can you hear me? Hello?

Janet Craig

Yes.

Mike Zafirovski

Hi, Nikos.

Nikos Theodosopoulos - UBS

Okay. My question is on, in the fourth quarter you mentioned the $350 million deferred that will be coming in and that it would be more software oriented. So, I would envision that's probably going to have a pretty high gross margin. So, when you look at the guidance for the year on gross margin, would we expect to see a material up tick in the fourth quarter because of this? And does it change your annual outlook on the gross margin? And then, just a quick clarification. There was some comment made in the opening remarks, book to bill comparisons due to the UMTS sale, and when I look at 2Q versus 2Q last year there was no UMTS business. I didn’t understand what point you were trying to make there? Thank you.

Pavi Binning

For the gross margin, Nikos you are absolutely right. In terms of the margins that deferred revenue release will be higher than group average. And so therefore, there will be a spike, you should not therefore modify your numbers for the year, because as we have said earlier that was always in the numbers in terms of the guidance that we had given. So, I think that sort of addresses that particular point.

Mike Zafirovski

And the second one Nikos, there was a misunderstanding, the comment was the book to bill in the second quart was 0.82 or 0.84 and we said is there for the four business segments excluding Carrier, it's approximately one [all]. So, that was not UMTS driven simply to reflect the book to bill was below one in the Carrier business and quite a bit of it based in the CDMA product line.

Janet Craig

Great. Thank you, Mike and Pavi. Next caller, please?

Operator

The next question is from Mark McKechnie from American Technology. Please go ahead.

Mark McKechnie - American Technology

Great, thanks. I appreciate it. Just a quick question for Pavi. The debt deal of $675 million, what was the new rate versus the retired rate?

Pavi Binning

The new rate was 10.9% versus the retired rate of 4.25%, because one was a convertible and one was a high yield.

Mark McKechnie - American Technology

Okay, got you. Thank you.

Janet Craig

Great, thank you. Next caller, please?

Operator

The next question is from Ken Muth from Robert Baird. Please go ahead.

Ken Muth - Robert Baird

Hi. It's been a while now since you guys have gone through the Microsoft partnership here and the joint venture, if you can just maybe give us some of your highlights, Mike, reflecting back of kind of where you thought this deal was going to be at this point in time and kind of the benchmarks that you have against that?

Mike Zafirovski

Ken, thank you. As a matter of fact, we just had a very good discussion with our Microsoft colleagues. Over the last couple of days we used to confirm the targets, which we supposed to be driving for the next 12 months, which is their fiscal year. The Microsoft relationship has been of enormous help to us, opening doors, opening the activities with the CIOs, CEOs and COOs across the company. We believe it's been instrumental in driving the growth, which we have seen in the last 18 months. And also, quite a few of the opportunities to be able to drive significant attach rates for our data business, which was going to be forthcoming.

We are in the process of executing a number of professional services contracts to help people transition from their existing platforms to the unified communications, and this provides us an opportunity to drive applications. A small very exciting example, when I was in Los Angeles earlier this week, a meeting with the CAA; this is a perfect example of what's the combination of a very innovative company along with Microsoft and Nortel can deliver end-to-end unified communications.

So, it's putting us in a forefront of the new areas where we are going to play, and that has been a very, very major part of our transformation of the Enterprise business. We look forward for that to be one of the key pillars to drive the business going forward.

Janet Craig

Great. Thank you, Mike. Next caller, please?

Operator

The next question is from Vivek Arya from Merrill Lynch. Please go ahead.

Vivek Arya - Merrill Lynch

Thank you. Hello Mike. Hello Pavi. Mike, my question is the same that I asked in the last call. Do you think Nortel has the right strategy for growing in 2009 or do you need to make drastic changes right now in terms of ['08] to ensure things don't get worse next year. And I say that because gross margin seem to have peaked. New orders are slowing significantly and operating expenses are not really coming down. So, even though it seems you can do okay in the second half '08 because of your deferred revenues, I'm still struggling to see what the five month plus strategy is especially if this macro economy does not improve? Thank you.

Mike Zafirovski

Vivek, as we had said, on the Analyst Day, we tried to provides some of the perspectives and if you will, the genesis for the growth platform is that we are looking at approximately 55% of our revenues we believe are in the growth markets, where we have more the right to play with capabilities and differentiations that's in the Enterprise, that's in the MEN, that's in the Carrier Voice over IP and applications and really since it is along those.

We had provided, I mean, I thought it's a pretty significant level of granularity and we are looking forward to start demonstrating even more so in the second half of this year, it is the foundation to drive that business in 2009 and beyond. The related synergies on sales and R&D, to drive those and to use the increased level of proof points from the execution of that strategy. One thing that certainly the headwinds in CDMA spend will put even a more of urgency for us to drive the growth strategy even with more purpose and determination and we truly intend to do that, and as you know we did not make any comments on potential inorganic activities. Pavi, I'm not sure, if want to add some comments to that?

Pavi Binning

No. nothing.

Janet Craig

Great. Thank you, Mike and Pavi. Next caller, please?

Operator

The next question is from Brian Modoff from Deutsche Bank. Please go ahead.

Brian Modoff - Deutsche Bank

Yeah guys, following up on that question, you have always had a strong legacy in core networking. In wireless, you are very subscale relative to other large vendors like Ericsson, Nokia, Siemens and even Huawei on an aggregate basis. Yet you do have very attractive customers, especially as we look at moving to 4G, that maybe interesting to the larger vendors in terms of getting access to these customers that they currently don't have access to them. Why stay in wireless?

Mike Zafirovski

Brian, thank you for that question. Look, I agree. In terms of -- that on the wireless side, the competition, we have seven, eight, nine players and that we are pretty transparent at the Analyst Day that, that industry requires consolidation. So, we are partnering, our Alvarion transaction is utilizing in a way to drive consolidation on one space of the wireless industry, so what it has made partnering, joint ventures, bulk (inaudible) JVs and we are obviously looking at opportunities, we will not go into anymore details, but as we are looking for a generation to have you have seven, eight players of size to drive relevance that would not create a robust industry two, three years down the road. And as you said, we do have very attractive assets, and including our LTE and some of the feedback from China Mobile, from Vodafone, from Verizon, we'll certainly have assets that are as good, and better than most. And so, we work hard to be able to do that hence we are also realistic that the industry will not be able to prosper in the current structure

Janet Craig

Great. Thanks, Mike. Next caller, please?

Operator

The next question is from Richard Windsor from Nomura. Please go ahead.

Richard Windsor - Nomura

Thanks so much. I was just wondering if you could comment on your market share in CDMA during the quarter. Did you actually take the market share or did you lose market share? And also, what is the possibility for you to participate in the coming big CDMA spend with China Telecom? Thanks.

Mike Zafirovski

The market shares quarter-by-quarter are not necessarily reflective of the overall transfer. Certainly over the last couple of years we have gained market share, and we certainly do not expect to lose market share in 2008. This is probably the most appropriate answer. I will be going to China later this month and we are certainly looking at China as an opportunity for to us pursue as being the second largest CDMA player in the world.

Janet Craig

Great. Thank you, Mike. Next caller, please?

Operator

The next question is from Michael Urlacher from GMP Securities. Please go ahead.

Michael Urlacher - GMP Securities

Good morning. I understand the deferred revenue that you recognized, but I observed, it's been rising pretty steeply to about 12% in the latest quarter, which is a record. And to an analyst, to an outsider, this really provides a challenge in us trying to interpret what the real trends are on the business? So, I wonder if you could maybe describe to us how you interpret the near term trends, and in particular, what you think the impact is going to be for the company to achieve, cash from operations this year, because my sense of deferred revenue is although it's legitimately earned, it comes in cashless when it's recognized on the income statement. And last year's cash from operations was pretty weak. So, what do you think is the outlook here?

Pavi Binning

I think it's a very fair question that you raised, and in terms of the pressure on cash from operations, was the sort of -- and you saw it in quarter two, we had a pretty strong working capital improvement. We are driving working capital extremely hard, particularly receivables and I'm not happy with the inventory position. And we are taking action in the second half to improve that. But receivables, I was pleased that we were able to reduce receivables by a couple of days.

The net loss and the impact of the deferred revenue are obviously those are the pressures that are effectively are on cash from operations. And clearly, what we need to start doing is driving that earnings line and the only way that we are going to do that is through operating margin performance.

And in terms of deferred revenue, yes, you are absolutely right. It does put pressure in the short-term on our cash from operations. But what we've got to do is drive the other leaders very, very hard with a view to sort of trying to mitigate that impact. Longer term clearly it's going to be performance from the sort of P&L driven right the way through to the bottom line. That will actually drive the improvement in net cash flow that we need.

Janet Craig

Great. Thank you, Pavi. Next caller, please?

Operator

The next question is from Ehud Gelblum from JP Morgan. Please go ahead.

Ehud Gelblum - JP Morgan

Good morning.

Janet Craig

Again, hi, Ehud.

Operator

Mr. Gelblum, your line is now open

Janet Craig

I guess, we'll go to the next caller. Ehud okay?

Ehud Gelblum - JP Morgan

Hi. My questions actually were answered. I was just wanted to rephrase and understand some of the issues. I guess one last thing if I could just bring in, with CDMA weaker and the guidance intact and maybe I missed this. Are there stronger parts that are making up for the CDMA weakness to allow us to still have the same revenue growth versus your prior guidance?

Mike Zafirovski

I mean, we certainly looking to tell, [Ehud], as we provide guidance there is a level of a protection which you have in the plain in support of it. Of course it's as you have developments and you are looking at the overall submissions from the businesses regime, you make the best determination of what is going to transpire in the period ahead of you and based on the very thorough discussions with all our businesses that gave us the confidence to confirm the guidance. And as we have said a number of times during this phone call, what's going to have to happen in the second quarter is for the Enterprise and the Metro Ethernet business, which will deliver per expectations and we are confident that, that will happen.

Janet Craig

Great. Thank you, Mike. Next caller, please?

Operator

The next question is from Paul Silverstein from Credit Suisse. Please go ahead.

Paul Silverstein - Credit Suisse

Hi. Mike, Pavi, I know next year is a long way off and it's hard enough to predict this year. I apologize if you have already addressed this, but if you looked out to '09 in terms of deferred revenue, which is such as a heartland issue, as well as the LG contribution, which I think many of us in the community struggle with both of those issues? Can you give us some sense for what you think will be the level of impact vis-à-vis in '08? The related question. Pavi, you mentioned earlier that deferred revenue is revenue, revenue that you earned back when and it's really no different than revenue today, and albeit, that someone observed earlier it's cashless. That being said, to a certain extent are you trying to have it both ways? I read your comments here in the press release, a number of the product lines you point out that some of the declines will be year-over-year sequentially, because of the benefit of deferred revenue in the prior period. And with the suggestion being that there is somewhat of an artificial aspect and on a more apples-to-apples basis, the growth wasn't as bad as what it would have otherwise been if you had not had the benefit for the deferred revenue in the prior period?

Pavi Binning

Paul, thanks for the question. Good question. In 2009, my sort of expectation normally as we look at historical trends, we have seen $250 million to $300 million dollars of deferred revenue a year and I think that's what my -- sort of, at this stage anyway, my expectation for 2009 would be. That it would be a normal year in terms of deferred revenue. And then clearly, if there were any sort of updates to that, I'll make sure they are communicated to the market.

What we've tried to do in terms of deferred revenue has actually been transparent. So, how is it impacted, whether it's this period or the prior period? So the purpose is not to sort of try and take credit on both sides. It's actually trying to be transparent with the financial markets. So, hopefully that answers your question.

Mike Zafirovski

And probably to factor. There is many other factors and revenues and orders we'll try to be again, one of the commitments which I made to you, back a couple of years ago, when I first started that we would be very transparent, try to be both in performance and to be helpful in the ways you view the guidance going forward.

So, it's certainly not to repeat what Pavi said, not to play both ways, but just not to pretend to be one of that factors as you evaluate the performance of the business and just to repeat what's going to transpire the second half performance, it was also the foundation for 2009, 2010. And I thought there was a pretty detailed review at the Analyst Day of where we see the company moving. We love the wireless business. It's not our performance in it, but certainly we do understand that scale is requiring the business, but we do believe that we have significant assets there and we have 65% of our business. There is a very good foundation. We have more a directed play in differentiation and that's what this team is really excited to be able to execute on.

Janet Craig

Great. Thank you, Mike. And operator, we have time for two more questions.

Operator

Very well. The next question is from Chris Umiastowski from TD Newcrest. Please go ahead.

Chris Umiastowski - TD Newcrest

Okay. Thanks so much. I'm going to just try to hit up the FX question I was answer again, just because I didn't quite understand the answer that you gave me. Really simply, I just want to know, you reported a $34 million net gain from FX this quarter and in the text of your press release and on the call, you've talked about $18 million of that of was SG&A, $15 million of hurt came from the R&D line, $18 million of hurt came from the SG&A line. So that's a total of $33 of negative. To get to a positive $34, I'm missing a $67 million positive that has to hit somewhere. I just want to understand what line items that $67 million of positive impact would come from?

Mike Zafirovski

Chris, it's a fairly straightforward.

Pavi Binning

Yeah. These are two separate things. If you take the lines of the P&L that go to management operating margin, we had a $35 million hit to operating margin, as a result of FX primarily in SG&A and R&D. The $34 million gain is a separate item, which reflects gain on balance sheet balances that we have. So, those are two unrelated items and they are on separate lines of the P&L. So within management operating margin, we are taking a hit of $35, below management operating margins you get to earnings, there is a gain of the $34 million.

Janet Craig

Great. Thank you, Pavi. And Mark, we have time for one last caller.

Operator

The last question is from Edward Snyder from Charter Equity Research. Please go ahead.

Edward Snyder - Charter Equity Research

Thanks for a follow-up here. Mike, we talked a lot about around the CDMA and some of the legacy businesses, and I appreciate your answer on wireless, it suggests that you are not going to power right to an area that everybody else is following into and one of them UMTS. But if we could shift then and look at some of our growth business especially the 40-Gig business, you have announced a few more contracts today. How does this play out in terms of revenue? Are these fairly short-term, are they long-term? And is there any services opportunity associated with some of your 40-Gig contracts or is that pretty much all wrapped up into some of the carriers in that wireless stuff?

Mike Zafirovski

Edward, thank you for that question. I think this is a record 18 questions. We are trying to be pretty succinct in our comments, but the short answer is yes. Lots of the 40-gig wins do have a pretty short window in front of it. So, part of the reason we expect in second half, both MEN to grow and there is an increased cooperation between our services and the business in MEN to be able to provide end-to-end solutions. And we are also increasing the type of customers that are looking at the solutions, so the short answer is, yes, they'll be happy to have you follow up with fleet by Morin, Janet Craig can organize it, but our top job, but we did a pretty good job describing that at the Analyst Day, but we would be very happy to follow-up.

I think this was the last question before Janet wraps it up to say look, we are pleased with our second quarter and the year-to-date performance. We know what has to happen in the second half for us to be able to deliver guidance. We understand the questions facing us for 2009 and beyond and we have tried to obviously anticipate those internally with our Board with the management team. That was the background to the Analyst Day, and we understand that the economy is not getting easier, but this is the strategy that's based very much upon our capabilities and it's the right to play from customers from technologies and from relevance and we are excited to be able to demonstrate the rest of this year and our ability to delivering that. So thank you.

Janet Craig

Great. Thank you, Mike and Pavi. And thank you everyone for joining today's conference call. If you have any questions, please don't hesitate to call the IR team and we'll get back to you as soon as possible.

Operator

Thank you for joining the Nortel 2008 second quarter results conference call. The conference has now ended. Please disconnect your lines at this time. Thank you for your participation. And have a nice day.

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