Nortel Networks

Overview

Nortel Networks' operations include two operating segments: Carrier and Enterprise. The Carrier segment includes: products which are used by telecommunications operating companies to interconnect access lines and transmission facilities to provide local or long distance services, products to address wireless communications and products which transport voice, data, image and video communications between locations within a city or between cities, countries or continents. The Enterprise segment products are primarily private digital switching systems, usually located on the customer's premises, which permit voice, data, or multimedia terminals to communicate with each other, with or without the use of wide-area public telephone networks. While Nortel Networks reports its results in U.S. dollars, all amounts presented here are in Canadian dollars, except where otherwise noted.

Earnings

Excluding special items, primarily the non-cash gain on the reduction of BCE's ownership interest, BCE's share of the amortization of Bay Networks intangible assets and purchased in-process R&D assets from other acquisitions and one-time gains and charges, Nortel Networks contributed $679 million to BCE's earnings in 1998, representing an improvement of $103 million compared with last year. The $103 million improvement in earnings primarily reflected a substantial increase in operating earnings and investment and other income - net, partially offset by a substantial increase in interest expense.

The following discussion of Nortel Networks' results is based on results for the full twelve months of 1998. BCE's financial statements only reflect these results on a line-by-line basis up to and including August 31, 1998.

Product Line and Geographic Revenues

Revenues of $26,270 million for 1998 were 22% higher than the same period last year due to an increase in sales volume of approximately 19% and a weaker Canadian dollar of approximately 8% (Nortel Networks' revenues are translated from U.S. dollars to Canadian dollars; therefore, a weakening of the Canadian dollar positively impacts revenues), partially offset by price reductions of approximately 3% and divestitures of approximately 2%.

Tables 5 and 6 above show details of Nortel Networks' revenues by principal product lines and by geographic areas.

Carrier segment revenue growth of 22% in 1998 was largely driven by the growth in revenues of Nortel Networks' optical networking solutions and also reflected growth in all carrier lines of business. This revenue growth was attributable to a volume increase of approximately 17% and a weaker Canadian dollar of approximately 8%, partially offset by price reductions of approximately 3%. The 44% increase in broadband networks revenues in 1998 was driven by considerable growth across all regions. Wireless networks revenues increased 16% over 1997 levels as a result of considerable growth in sales in the Caribbean and Latin America (CALA) region, significantly increased sales in the United States, and substantially increased sales in Asia Pacific. This increase was partially offset by a significant decline in European revenues and substantially lower Canadian sales. Public carrier networks revenues increased 9% in 1998 as a result of higher sales in the United States and strong growth in Europe, offset by considerably lower sales in Asia Pacific and CALA, and significant decreases in Canada. North American revenues from traditional public carrier products are expected to continue to be negatively affected by the shift in capital spending from public carrier products to high bandwidth broadband products.

Enterprise segment revenues in 1998 increased 36% over the same period in 1997. This increase was due to growth across all major products and was primarily driven by the Bay Networks transaction. The increase in Enterprise segment revenues was attributable to a volume increase of approximately 27% and a weaker Canadian dollar of approximately 10%, partially offset by price reductions of approximately 1%. Enterprise networks revenue growth was a result of a considerable increase in revenues in the United States (primarily as a result of the Bay Networks transaction) and strong revenue increases in all other regions, except Canada which had moderately lower revenues.

United States
The increase of 28% in revenues from the United States was primarily the result of substantially increased revenues in enterprise networks, reflecting the acquisition of Bay Networks, substantially increased revenues in broadband networks and a weaker Canadian dollar. Revenues increased in public carrier networks, significantly increased in wireless networks, and declined substantially in Other (primarily the result of the WilTel Transaction). The increase in revenues from the United States over 1997 was also the result of substantially higher sales to interexchange carriers (IECs), independent telephone operating companies (IOCs), other United States customers and distributors (the latter two increases were primarily a result of the Bay Networks transaction). Excluding the contribution of Bay Networks, revenues in the United States increased significantly.

Canada
Revenues in Canada increased 7% compared with 1997 due to a weaker Canadian dollar and substantially higher sales in broadband networks, partially offset by considerably lower sales in wireless networks and significantly lower sales in public carrier networks. Sales to Bell Canada and other subsidiaries and related companies of BCE Inc. declined from their 1997 level, and sales to other Canadian customers showed a modest increase for the year.

Other countries
Revenues in Europe, Africa and the Middle East (including the Commonwealth of Independent States) increased 15% from 1997 due to significantly increased revenues in enterprise networks, considerably increased revenues in broadband networks and a weaker Canadian dollar, partially offset by substantially lower revenues in Other (primarily the result of the MET disposition and the sale of the GSM Terminals business to the Nokia Group) and significantly lower revenues in wireless networks. Public carrier networks revenues increased from 1997.

Revenues in other markets, comprising CALA and Asia Pacific, increased 23% in 1998 when compared with 1997. In CALA, sales in wireless networks increased substantially and both enterprise networks and broadband networks sales rose significantly from 1997. Public carrier networks sales fell considerably compared with 1997. Revenues in Asia Pacific increased significantly in 1998, when compared with 1997, primarily driven by considerable increases in wireless networks revenues, partially offset by a sharp decrease in public carrier networks revenues. Sales in 1998 when compared with 1997 were considerably higher in broadband networks and significantly higher in enterprise networks.

The recent devaluation of the Brazilian real is expected to slow economic growth in 1999 for the CALA region. Although demand for Nortel Networks' products is expected to be impacted in the short-term, Nortel Networks anticipates that the long-term growth prospects for the region remain strong.

The Asia Pacific region has been, and is expected to continue to be, affected for the foreseeable future by unstable economies caused in part by the volatility of certain currencies. Revenues from the Asia Pacific region (excluding China) were less than 3% and 4%, respectively, of the consolidated revenues for the years ended December 31, 1998, and 1997. The current economic crisis in the affected Asia Pacific countries resulted in lower than anticipated demand for Nortel Networks' products in the second half of 1998 and it is expected that demand will continue to be impacted by the crisis. In addition, the current economic crisis has spread to other countries, including countries in CALA, and this, together with global financial market uncertainty, may also impact demand generally for Nortel Networks' products.

Gross Profit

Gross margin for 1998 was 42.8% of revenues compared with 41% of revenues for 1997. The 1998 increase in gross profit over 1997 was primarily the result of increased sales volume in both the Carrier and Enterprise segments, partially offset by lower sales volume in Other, primarily due to the 1998 dispositions. Within the Carrier segment, sales volume increased in broadband networks, wireless networks and public carrier networks. Improvements due to product mix offset price reductions in both segments.

Improved gross margins in the Enterprise and Carrier segments contributed to the higher 1998 gross profit. Within the Carrier segment, gross margins increased in public carrier networks, wireless networks and broadband networks. Gross margins in 1998 were positively impacted by the Bay Networks transaction.

Although competitive pricing pressures continue, particularly in wireless networks, Nortel Networks has been able to offset such pressure through the sale of higher-margin products and manufacturing and other cost-reduction programs. Gross margin is also affected by the level of software sales. Gross margin was negatively affected by the introduction of new products, the continued expansion into new markets, and the increase in products manufactured by other suppliers in network solutions offered by Nortel Networks.

Operating Expenses

In 1998, selling, general and administrative (SG&A) expense increased by 23% to $4.63 billion for 1998 compared with 1997. As a percentage of total revenues, however, SG&A expense remained flat compared with 1997 at 17.6% of total revenues. The 1998 increase in absolute dollars reflected the funding of North American and international market investments across both operating segments, as well as increased investments supporting Nortel Networks' global marketing programs and operations systems to simplify and streamline Nortel Networks' business processes, ongoing investment in computer systems infrastructure related to the global supply chain management system, the preparation for the Year 2000 and a weaker Canadian dollar. The lower SG&A expenses in Other are the result of divestitures, primarily resulting from the WilTel Transaction. SG&A was also impacted by the provision for customer financing risk.

Nortel Networks' research and development (R&D) expense for 1998 increased by 23% to $3.66 billion compared with 1997 while R&D expense as a percentage of total revenues remained essentially flat. The increased level of investment in absolute dollars in 1998 reflects ongoing programs across the Carrier and Enterprise segments for new products, process development, advanced capabilities, and services for a broad array of applications.

Amortization of Intangibles

The amortization of purchased in-process R&D amounted to $1,865 million for 1998 compared with nil in 1997 primarily reflecting the charges related to the acquisitions of Bay Networks, Broadband Networks Inc. (BNI), Aptis Communications, Inc. (Aptis) and Cambrian Systems Corporation. The capitalized amount of purchased in-process R&D as at December 31, 1998, was $779 million. The amortization of acquired technology of $351 million compared with nil in 1997 reflects the charge related to the Bay Networks transaction. The capitalized amount of acquired technology as at December 31, 1998 was $2.79 billion. Goodwill amortization primarily reflecting investments in Bay Networks, STC plc, Matra Nortel Communication S.A.S. (MNC) and MICOM Communications Corporation was $366 million for 1998 compared with $66 million in 1997. The capitalized amount of goodwill as at December 31, 1998 was $5.04 billion.

Special Charges

Special charges aggregating $679 million were included in the results for 1998. Included in the special charges for 1998, was a provision of $574 million related to steps taken to streamline management layers, gain operational efficiencies, and realign resources and investments. Included in the provision was $397 million representing the cost of severance and related benefits for approximately 4,100 employees worldwide, which includes $107 million for individuals in R&D activities. The majority of Nortel Networks' business functions, job classes, and geographic areas were impacted, with a majority of the reductions taking place in the United States and Canada. Also included in this provision was $142 million in non-cash expenses for capital asset and other write-downs, and $35 million in facilities and other costs, primarily related to wireless networks and enterprise networks. The anticipated benefits of these activities began to materialize in Nortel Networks' consolidated results of operations during the fourth quarter of 1998. All of these activities are expected to be substantially completed by September 30, 1999.

Investment and Other Income - Net

Investment and other income - net, including equity in net earnings of associated companies, increased by $324 million in 1998 compared with 1997. The increase was primarily the result of a pre-tax gain of $118 million relating to Entrust Technologies Inc.'s (Entrust) initial public offering concurrent with a secondary offering of Entrust common shares by Nortel Networks and a pre-tax gain of $108 million from the sale of Lagardère SCA's shares. Also contributing to the increase in 1998 compared with 1997 was an increase of $52 million in interest income, primarily resulting from higher cash balances following the Bay Networks transaction and higher levels of short-term investments due to increased cash flows from United States operations.

Nortel Networks continues to expand its business globally and, as such, an increasing proportion of its business will be denominated in currencies other than U.S. dollars. As a result, fluctuations in foreign currencies may have an impact on Nortel Networks' business and financial results. Nortel Networks endeavors to minimize the impact of such currency fluctuations through its ongoing commercial practices and by attempting to hedge its exposures to major currencies. In attempting to manage this foreign exchange risk, Nortel Networks identifies operations and transactions that may have foreign exchange exposure, based upon, among other factors, the excess or deficiency of foreign currency receipts over foreign currency expenditures in each of Nortel Networks' significant foreign currencies. Nortel Networks' significant currency flows for the year ended December 31, 1998, were in U.S. dollars, Canadian dollars, United Kingdom pounds and French francs. For the year ended December 31, 1998, the net impact of foreign exchange fluctuations was a loss of $110 million as compared with a loss of $70 million for the same period of 1997. Given the devaluation of the Brazilian real and its continued volatility and Nortel Networks' exposure to this market and other international markets, Nortel Networks continuously monitors all its foreign currency exposures. As Nortel Networks cannot predict whether foreign exchange losses in Brazil and other countries will continue to increase in the future, significant foreign exchange fluctuations may have an adverse impact on Nortel Networks' results from operations.

Interest Expense

Interest expense increased by $109 million in 1998 compared with 1997. The increase is mainly due to the increased use of short-term debt, primarily in Colombia and Brazil, increased use of commercial paper, and an increase in short-term interest rates, which was partially offset by lower interest on long-term debt.

Streamlining of Business Processes

On January 13, 1999, Nortel Networks announced the acceleration of its operations strategy designed to better meet the rapidly changing needs and values of its customers worldwide. The strategy will simplify and streamline Nortel Networks' businesses and operations processes, including Nortel Networks' order-entry and fulfillment, delivery, service, and manufacturing systems over the next three years.

The operations strategy will involve plant divestitures, manufacturing rationalization, greater reliance on outsourcing, and redeployment of employees. Approximately 10% of Nortel Networks' workforce will be affected by the program. Divestitures, retraining, and attrition will minimize employee impact. The efficiencies generated by the program are not expected to significantly impact 1999 results from continuing operations, but will position Nortel Networks for future growth. Over the coming years, the impact of the operations strategy is intended to contribute to Nortel Networks' presence in the marketplace, growth in market share, higher revenue growth, and, ultimately, higher earnings growth.

Litigation

See notes to consolidated financial statements, Note 11(d).

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