Amendment to Annual Report — Form 10-K Filing Table of Contents
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14: EX-24 Power of Attorney HTML 13K
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(Exact name of registrant as specified in its charter)
Canada
Not Applicable
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
8200 Dixie Road, Suite 100,
L6T 5P6
Brampton, Ontario, Canada (Address of principal executive offices)
(Zip Code)
Registrant’s telephone number including area code:
(905) 863-0000
Securities registered pursuant to Section 12(b) of the
Act:
Title of Each Class
Name of Each Exchange on Which Registered
Common Shares without nominal or par value
4.25% Convertible Senior Notes Due 2008
New York Stock Exchange
New York Stock Exchange
The common shares are also listed on the Toronto Stock Exchange
in Canada
Securities registered pursuant to Section 12(g) of the
Act: None
Indicate by check mark if the registrant is a well known
seasoned issuer, as defined in Rule 405 of the Securities
Act.
Yes o No þ
Indicate by check mark if the registrant is not required to file
reports pursuant to Section 13 or Section 15(d) of the
Act.
Yes o No þ
Indicate by check mark whether the registrant (1) has filed
all reports required to be filed by Section 13 or 15(d) of
the Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been
subject to filing requirements for the past 90 days.
Yes þ No o
Indicate by check mark if disclosure of delinquent filers
pursuant to Item 405 of
Regulation S-K is
not contained herein, and will not be contained, to the best of
registrant’s knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this
Form 10-K or any
amendment to this
Form 10-K.
o
Indicate by check mark whether the registrant is a large
accelerated filer, an accelerated filer, or a non-accelerated
filer. See definition of “accelerated filer” and
“large accelerated filer” in
Rule 12b-2 of the
Exchange Act. (Check one)
Large accelerated
filer þ Accelerated
filer o Non-Accelerated
filer o
Indicate by check mark whether the registrant is a shell company
(as defined in
Rule 12b-2 of the
Exchange Act).
Yes o Noþ
On April 17, 2006, 4,335,644,313 common shares of Nortel
Networks Corporation were issued and outstanding. Non-affiliates
of the registrant held 4,333,778,951 common shares having an
aggregate market value of $12,004,567,694 based upon the last
sale price on the New York Stock Exchange on April 17,2006, of $2.77 per share; for purposes of this calculation,
shares held by directors and executive officers have been
excluded.
This Form 10-K/A (the
“10-K/A”) is
being filed to correct a typographical error in
Exhibits 31.1, 31.2 and 32 of the Company’s Annual
Report on
Form 10-K for the
Year Ended December 31, 2005 (the
“10-K”) filed
with the Securities and Exchange Commission (the
“SEC”) on April 28, 2006. Inadvertently, the
certifications in Exhibits 31.1, 31.2 and 32 included as
the date
“[ l
], 2006”
instead of “April 28, 2006”, the actual date of
the signed certificates.
This 10-K/A replaces
the 10-K in its
entirety. The Company is re-filing the entire
10-K as part of this
10-K/A for it believes
this approach is consistent with the view of the Staff of the
SEC. Except as described above, no change has been made to the
10-K.
Nortel Networks Corporation previously announced the need to
restate its consolidated financial statements for the years
ended December 31, 2003 and 2004 and the first nine months
of 2005.
The consolidated statements of operations, changes in equity and
comprehensive income (loss) and cash flows for the years ended
December 31, 2004 and 2003 and the consolidated balance
sheet as of December 31, 2004, including the applicable
notes, contained in this Annual Report on Form 10-K have
been restated. Nortel has also included in this report restated
unaudited consolidated financial information for each of the
first three quarters of 2005 and each of the quarters
in 2004.
In addition, the Third Restatement involved the restatement of
Nortel’s consolidated financial statements for 2002 and
2001. Amendments to Nortel’s prior filings with the United
States Securities and Exchange Commission would be required in
order for Nortel to be in full compliance with Nortel’s
reporting obligations under the Securities Exchange Act of 1934.
However, any amendments to Nortel’s Annual Reports on
Form 10-K for the years ended December 31, 2004 and
2003 and the Quarterly Reports on Form 10-Q for the
quarterly periods ended March 31, June 30, and
September 30, 2005 and 2004, respectively, would in large
part repeat the disclosure contained in this report.
Accordingly, Nortel does not plan to amend these or any other
prior filings. Nortel believes that it has included in this
report all information needed for current investor understanding.
Nortel has not restated the separate consolidated financial
statements of Nortel’s indirect subsidiary, Nortel Networks
S.A., originally presented in Nortel’s Annual Report on
Form 10-K for the year ended December 31, 2003 or the
supplemental consolidating financial information presented in
Nortel’s Annual Report on Form 10-K for the years
ended December 31, 2004 and 2003 (as well as in relevant
Quarterly Reports on Form 10-Qs during the applicable
periods). As certain guarantee and security agreements that gave
rise to the requirement to present this information under
applicable rules under the Securities and Exchange Act of 1934
were no longer in effect as at December 31, 2005, Nortel is
not required to present this information in this Annual Report
on Form 10-K and Nortel believes that the restatement of
this information would not be relevant for current investor
understanding. The previously filed consolidated financial
statements of Nortel Networks S.A. and supplemental
consolidating financial information should no longer be
relied upon.
For a description of the restatements, see
“Restatement” in note 4 of the accompanying
audited consolidated financial statements and “Item 7
Management’s Discussion and Analysis of Financial Condition
and Results of Operations — Restatements; Nortel
Networks Audit Committee Independent Review; Material
Weaknesses; Related Matters” contained in this Annual
Report on Form 10-K.
Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters
241
ITEM 13.
Certain Relationships and Related Transactions
241
Indebtedness of Management
241
ITEM 14.
Principal Accountant Fees and Services
242
Audit fees
242
Audit-related fees
242
Tax fees
242
All other fees
242
PART IV
ITEM 15.
Exhibits, Financial Statement Schedules
243
SIGNATURES
250
All dollar amounts in this document are in United States
dollars unless otherwise stated.
NORTEL, NORTEL (Logo), NORTEL NETWORKS, the GLOBEMARK (Logo),
NT, and NORTEL >BUSINESS MADE SIMPLE are trademarks of
Nortel Networks.
MOODY’S is a trademark of Moody’s Investors Service,
Inc.
NYSE is a trademark of the New York Stock Exchange, Inc.
SAP design mark is a trademark of SAP Aktiengesellschaft
S&P and STANDARD & POOR’S are trademarks of
The McGraw-Hill Companies, Inc.
All other trademarks are the property of their respective owners.
ii
PART I
ITEM 1. Business
Overview
Nortel is a global supplier of communication equipment serving
both service provider and enterprise customers. We deliver
products and solutions that help simplify networks, improve
productivity as well as drive value creation and efficiency for
consumers. Our technologies span access and core networks,
support multimedia and business-critical applications, and help
eliminate today’s barriers to efficiency, speed and
performance by simplifying networks and connecting people with
information. Our networking solutions consist of hardware,
software and services. Our business activities include the
design, development, assembly, marketing, sale, licensing,
installation, servicing and support of these networking
solutions. As a substantial portion of our business has a
technology focus, we are dedicated to making strategic
investments in research and development, or R&D. We believe
one of our core strengths is strong customer loyalty from
providing value to our customers through high reliability
networks, a commitment to ongoing support, and evolving
solutions to address product technology trends.
During 2005, our business was organized into four reportable
segments: Carrier Packet Networks; Code Division Multiple
Access, or CDMA, Networks; Global System for Mobile
communications, or GSM, and Universal Mobile Telecommunications
Systems, or UMTS, Networks; and Enterprise Networks. We refer
you to the descriptions of each of these segments below.
On September 30, 2005, we announced a new organizational
structure that we expect will strengthen our enterprise focus,
drive product efficiencies, and enhance our delivery of global
services. The new alignment includes two product groups:
(i) Enterprise Solutions and Packet Networks, which
combines optical networking solutions (included in our Carrier
Packet Networks segment in 2005), data networking and security
solutions and portions of circuit and packet voice solutions
(included in both our Carrier Packet Networks segment and
Enterprise Networks segment in 2005) into a unified product
group; and (ii) Mobility and Converged Core Networks, which
combines our CDMA solutions and GSM and UMTS solutions (each a
separate segment in 2005) and other circuit and packet voice
solutions (included in our Carrier Packet Networks segment in
2005). By creating two product groups, we expect to simplify our
business model and create new cost efficiencies by leveraging
common hardware and software platforms. We expect these two
product groups to form our reportable segments commencing in the
first quarter of 2006.
We are also in the process of establishing an operating segment
that focuses on providing professional services in five key
areas: integration services, security services, managed
services, optimization services and maintenance services; which
are currently a component of all of our networking solutions. We
expect this operating segment to become a third reportable
segment in the second half of 2006.
For financial information by reporting segment and product
category, see “Segment information” in note 6 of
the accompanying audited consolidated financial statements and
“Results of Operations — Continuing
Operations — Segment Information” in the
Management’s Discussion and Analysis of Financial Condition
and Results of Operations, or MD&A, section of this report.
The Company’s principal executive offices are located at
8200 Dixie Road, Suite 100, Brampton, Ontario, Canada,
L6T 5P6, telephone number
(905) 863-0000.
The Company was incorporated in Canada on March 7, 2000
under the name New Nortel Inc. On May 1, 2000, the Company
participated in a Canadian court-approved plan of arrangement
under which, among other things, the Company exchanged its
common shares for all of the outstanding common shares of Nortel
Networks Limited (previously known as Nortel Networks
Corporation); Nortel Networks Limited, or NNL, became the
principal operating subsidiary of the Company; and the Company
changed its name to Nortel Networks Corporation. The Company is
not a foreign private issuer, as defined in
Rule 3b-4 under
the U.S. Securities Exchange Act of 1934, as amended, or
the Exchange Act.
Where we say “we”, “us”, “our” or
“Nortel”, we mean Nortel Networks Corporation or
Nortel Networks Corporation and its subsidiaries, as applicable.
References to “the Company” mean Nortel Networks
Corporation without its subsidiaries. Where we refer to the
“industry”, we mean the telecommunications industry.
The Company makes its Annual Reports on
Form 10-K,
Quarterly Reports on
Form 10-Q, Current
Reports on
Form 8-K and all
amendments to those reports available free of charge under
“Investor Relations” on our website at
www.nortel.comas soon as reasonably practicable after we
electronically file this material with, or furnish this material
1
to, the United States Securities and Exchange Commission, or
SEC. Information contained on our website is not incorporated by
reference into this or any other report filed with or furnished
to the SEC.
Developments in 2005 and 2006
Our Business Environment
With the growth of data, voice and multimedia communications
over the public telephone network, the public Internet and
private voice and data communications networks, disparate
networks are migrating to converged high performance packet
networks that can support most types of communications traffic
and applications. Converged voice and data networks
incorporating packet-based technologies provide an opportunity
for service providers to offer new revenue-generating services
while reducing annual operating costs and an opportunity for
enterprises to become more cost effective and productive. We
believe our key advantage lies in our ability to transition and
upgrade our enterprise and service provider customers’
voice and data networks to multimedia-enabled Internet Protocol,
or IP, networks with carrier grade reliability.
The demand for voice over IP, or VoIP, and broadband access to
IP based networks and third generation, or 3G, wireless networks
were a source of industry growth in 2005, and we expect spending
in these areas will continue to expand the market for services
and solutions provided by communications equipment vendors. We
anticipate this demand to lead to further investment in network
infrastructure, including optical technologies, and application
convergence. Regulatory developments, including the anticipated
grant of new national licenses for 3G wireless services in
China, are also expected to have a positive impact on industry
demand for next generation wireless services.
At the same time, the market for traditional voice and second
generation wireless technologies is expected to continue to
decline. These significant technology shifts have resulted in
service providers and enterprises limiting their investment in
mature technologies as they focus on maximizing return on
invested capital, requiring communications equipment vendors to
leverage their installed base in legacy markets. Furthermore,
pricing pressures continue to increase as a result of global
competition, particularly from suppliers situated in emerging
markets with low cost structures like China. Consolidation among
customers, leading to fewer and larger customers, many of whom
are focusing on improving the efficiency of their combined
networks rather than network expansion, is also increasing
pricing pressure. In addition, significant consolidation among
communications equipment vendors is commencing and is expected
to continue.
While we have seen encouraging indicators in certain parts of
the market, we can provide no assurance the growth areas that
have begun to emerge will continue in the future. See the
“Risk Factors” section of this report for factors that
may negatively impact our results.
Third Restatement and Related Matters
As part of the remedial measures described in the “Controls
and Procedures” section of this report and to compensate
for the unremedied material weaknesses in our internal control
over financial reporting, we undertook intensive efforts in 2005
to enhance our controls and procedures relating to the
recognition of revenue. These efforts included, among other
measures, extensive documentation and review of customer
contracts for revenue recognized in 2005 and earlier periods. As
a result of the contract review, it became apparent that certain
of the contracts had not been accounted for properly under
accounting principles generally accepted in the United States,
or U.S. GAAP. Most of these errors related to contractual
arrangements involving multiple deliverables, for which revenue
recognized in prior periods should have been deferred to later
periods. In addition, based on our review of our revenue
recognition policies and discussions with our independent
registered chartered accountants as part of the 2005 audit, we
determined that in our previous application of these policies,
we misinterpreted certain of these policies principally related
to complex contractual arrangements with customers where
multiple deliverables were accounted for using the
percentage-of-completion method of accounting under
SOP 81-1. In
correcting for these application errors, the timing of revenue
recognition was frequently determined to be incorrect, with
revenue having generally been recognized prematurely when it
should have been deferred and recognized in later periods.
Management’s determination that these errors required
correction led to the decision by the Audit Committees of our
and NNL’s Boards of Directors, or the Audit Committee, on
March 9, 2006 to effect a restatement of our consolidated
financial statements for the years ended December 31, 2004,
2003, 2002 and 2001 and the quarters ended March 31, 2005
and 2004, June 30, 2005 and 2004, and September 30,2005 and 2004, or the Third Restatement.
2
The following are the key developments as a result of the
foregoing matters and the delayed filing of this report with the
SEC:
•
An event of default occurred under our $1.3 billion
one-year credit facility, or the 2006 Credit Facility.
•
An event of default occurred under our $750 million support
facility, or the EDC Support Facility.
•
We and NNL are not in compliance with our obligations to deliver
our SEC filings to the trustees under our public debt indentures.
•
We suspended, as of March 10, 2006, the grant of any new
equity and exercise or settlement of previously outstanding
awards under various Nortel employee plans.
•
On April 10, 2006, the Ontario Securities Commission issued
a final order prohibiting all trading by our directors, officers
and certain current and former employees in our and NNL’s
securities.
•
We are in breach of the continued listing requirements of the
New York Stock Exchange, or NYSE, and the Toronto Stock
Exchange, or TSX.
•
We postponed our Annual Shareholders’ Meeting for 2005 to
June 29, 2006 due to the delay in filing this report.
•
We announced the need to delay the filing of our and NNL’s
Quarterly Reports on Form 10-Q for the quarter ended
March 31, 2006, or the 2006 First Quarter Reports. We now
expect to file the 2006 First Quarter Reports no later than the
week of June 5, 2006.
For more information on the Third Restatement and the above key
developments, see “Restatements; Nortel Audit Committee
Independent Review; Material Weaknesses; Related Matters”
in the MD&A section of this report, the “Risk
Factors” section of this report and note 4 of the
accompanying audited consolidated financial statements.
Our Strategy
We continue to drive our business forward with a renewed focus
on execution and operational excellence through (i) the
transformation of our businesses and processes;
(ii) integrity renewal and (iii) growth imperatives.
Our plan for business transformation is expected to address our
biggest operational challenges and is focused on simplifying our
organizational structure, reflecting the alignment of carrier
and enterprise networks, and maintains a strong focus on revenue
generation as well as quality improvements and cost reduction
through a program known as Six Sigma. This program contemplates
the transformation of our business in six key areas: services,
procurement effectiveness, revenue stimulation (including sales
and pricing), R&D effectiveness, general and administrative
effectiveness, and organizational and workforce effectiveness.
Employees throughout our organization are engaged in supporting
various objectives in each of these areas.
We remain focused on integrity renewal through a commitment to
effective corporate governance practices, remediation of our
material weaknesses in our internal controls and ethical
conduct. We have enhanced our compliance function to increase
compliance with applicable laws, regulations and company
policies and to increase employee awareness of our code of
ethical business conduct.
Our growth imperatives are motivated by a desire to increase
profitable growth and focus on areas where we can attain a
leadership position and a minimum market share of twenty percent
in key technologies. Some areas in which we plan to increase our
investment include products compliant with the Worldwide
Interoperability for Microwave Access, or WiMAX, standard, the
IP Multimedia Subsystem, or IMS, architecture, and IPTV. As part
of this strategy, we have decided to redirect funding from our
services edge router business and to sell certain assets of our
blade server switch business unit.
We have developed our strategy with a view to maximizing the
effectiveness of our strategic alliances and capturing the
benefits of growing technology convergence in the marketplace.
We believe our strategy will position us to respond to evolving
technology and industry trends and enable us to provide
end-to-end solutions
that are developed internally and through our strategic
alliances. We expect to continue to play an active role in
influencing emerging broadband and wireless standards.
Furthermore, we believe cooperation of multiple vendors is
critical to the success of our communications solutions for both
service providers and enterprises.
Recent key strategic and business initiatives include our
finance transformation project, which will implement, among
other things, a new information technology platform
(SAP) to provide an integrated global financial system;
growing our business with U.S. government clients through
PEC Solutions, Inc. (now Nortel Government Solutions
Incorporated), or PEC, which we acquired in June 2005;
establishing a greater presence in Asia Pacific through our
recently established joint venture with LG Electronics, Inc., or
LG; strengthening our
end-to-end convergence
solutions and focus on the enterprise market, including the
acquisition of Tasman Networks, Inc.; and evolving our supply
chain strategy.
3
Significant business developments
Some of our activities and other business developments in 2005
and 2006 included:
•
On February 24, 2006, we acquired Tasman Networks, an
established networking company that provides a portfolio of
secure enterprise routers, for $99.5 million in cash;
•
On February 14, 2006, we entered into the 2006 Credit
Facility and used the net proceeds primarily to repay the
outstanding $1,275 million aggregate principal amount of
NNL’s 6.125% Notes that matured on February 15,2006;
•
On February 8, 2006, we first announced that, as a result
of the previously announced mediation process we entered into
with the lead plaintiffs in two significant class action
lawsuits pending in the U.S. District Court for the
Southern District of New York and based on the recommendation of
a senior Federal Judge, we and the lead plaintiffs have reached
an agreement in principle to settle these lawsuits, or the
Proposed Class Action Settlement;
•
On November 9, 2005, we and Huawei Technologies Co., Ltd,
or Huawei, entered into a Memorandum of Understanding to
establish a joint venture for developing ultra broadband access
solutions;
•
Mr. Mike S. Zafirovski was appointed president and chief
executive officer, effective November 15, 2005.
Mr. Zafirovski succeeded Mr. William A. Owens as chief
executive officer;
•
On November 2, 2005, we formed a joint venture with LG
named LG-Nortel Co. Ltd., or LG-Nortel, that will offer
telecommunications and networking solutions to customers in the
Republic of Korea and other markets globally;
We continued the planned divestiture of substantially all of our
remaining manufacturing operations to Flextronics, as described
in detail below under “Sources and availability of
materials”.
For information on these and other developments in 2005 and
2006, see “Acquisitions, divestitures and closures” in
note 10, “Long-term debt, credit and support
facilities” in note 11 and “Subsequent
events” in note 23 of the accompanying audited
consolidated financial statements and “Developments in 2005
and 2006” in the MD&A section of this report.
Networking Solutions
Our networking solutions include network equipment, software and
other technologies that enable communications between two or
more points defining a network through the use of data, voice
and multimedia networking. Our networking solutions also consist
of related professional services which may include: strategic
planning; network design and engineering; network optimization;
network operations planning and consulting; and installation and
ongoing technical support.
Networking solutions can be circuit-based or packet-based. Our
circuit-based networking solutions consist of technologies that
require a separate network circuit to be maintained for each
communications signal for the duration of the transmission. Our
packet-based networking solutions consist of technologies which
involve the conversion of a data, voice or multimedia
communication signals into pieces, or “packets”, that
are directed or routed through the network independently and
then re-assembled at the destination. This enables large numbers
of communications signals to be directed or routed
simultaneously and more efficiently than in circuit networking.
Our data networking solutions consist of products and services
designed to enable the transport of data information across a
network. Our security solutions consist of products and services
designed to ensure that information can be securely transported
across a network and to prevent unauthorized users from being
able to disrupt the network.
Networking
In our industry, networking refers to:
•
the connecting of two or more communications devices, such as
telephones, personal computers and wireless devices, across
short or long distances to create a “network”;
•
the connecting of two or more networks; or
•
the connecting of equipment used in a network.
4
Network components
A telecommunications network generally consists of equipment and
software that enable network access, core networking and network
services.
Network access
Network access equipment and software enables information to
enter or exit a network, and resides with or near an end-user of
the network. Network access can be obtained through the use of
either wireline cable (such as fiber optic, copper wire or
coaxial) or wireless radio signals.
Wireline access technologies includes traditional wire Plain Old
Telephone Service, optical wavelengths, Synchronous Optical
Network, or SONET, and Synchronous Digital Hierarchy, or SDH,
optical interfaces, Asynchronous Transfer Mode, or ATM;
Ethernet; and IP access for digital subscriber line and cable
users.
Radio network access equipment uses radio waves to provide
wireless access to the subscriber’s device, enabling the
wireless subscriber to connect to the network to send and
receive data, voice and multimedia communications. The key
network elements in radio access are base station transceivers
or access points and base station/radio network controllers. We
offer our customers a wide range of wireline and wireless access
solutions including base station transceivers and base station
controllers for all of the wireless standards that we support.
Core networking
Core networking equipment and software direct, route or
“switch” the data, voice and multimedia communications
signals from one part of the network to another. Core network
equipment and software also transport communications signals to
and from network access equipment and other core networking
equipment located in another location. These functions are
carried out primarily through the use of routers, circuit and
packet switches and fiber optic and wireless technologies.
Network services
Network services consist of various user capabilities that are
enabled through the use of software elements in a network. User
capabilities may be configured to extend throughout the network
and include features such as location-based services, security
services, calling features and multimedia services. Network
services can be personalized to suit the user’s needs and
to support various applications.
Wireless networking solutions
Wireless networking, also known as mobility networking, refers
to communications networks that enable end-users to be mobile
while they send and receive voice and data communications using
wireless devices, such as cellular telephones, personal digital
assistants and other computing and communications devices. As
described above, these networks use specialized network access
equipment and specialized core networking equipment that enable
an end-user to be connected and identified when not in a fixed
location.
The key network elements in the core of a wireless
communications network are mobile switching centers, home
location registers and packet gateways.
•
Mobile switching centers direct or “switch” data,
voice and multimedia communications signals from one network
circuit to another and also support advanced voice services
including three-way calling, calling party number/name delivery,
call holding and call redirection.
•
A home location register is a database that contains subscriber
data, such as provisioning and service information, and dynamic
information, such as the wireless handset’s current
location.
•
Packet gateways are hardware and software network equipment
elements that aggregate and manage data communications between
wireless subscriber devices and public/private data networks,
such as the Internet. Packet data serving nodes can deliver
valuable network services including content-based billing,
security, virtual private networks and quality of service. These
services provide support for applications being delivered across
the wireless network.
Our mobile switching centers, home location registers and packet
gateways support all of the primary international standards for
wireless communications networks.
5
We support the primary international standards for wide-area
wireless networking through our GSM and UMTS Networks segment
and our CDMA Networks segment, as well as emerging broadband
wireless standards, described in greater detail below. The
technology for wide-area wireless communications networks has
evolved and continues to evolve, through various technology
“generations”.
Our existing wide-area wireless solutions span second and third
generation wireless technologies and most major global digital
standards for mobile networks. The majority of wireless
communications networks existing today are still based on second
generation, or 2G, wireless technologies, which consist of
circuit switching technology with modest data transmission
capabilities. However, 3G networks have been launched in several
regions. 3G wireless technologies consist of packet networking
technology with high-speed data, voice and multimedia
transmission capabilities. Emerging broadband wireless networks
based on the IEEE 802.16 series of standards are expected to
develop over the next few years. We continue to dedicate
significant resources to develop our wireless technology as we
expect customers to accelerate their demand for broadband data
access using 3G and emerging wireless technologies.
For more information about our networking solutions, please
refer to our segment descriptions below which are based on our
reportable segments in 2005. A brief description of our new
reportable segments commencing in the first quarter of 2006 is
provided above.
Markets and Customers
Our networking solutions enable our service provider and
enterprise customers to provide their own customers or employees
with services to communicate locally, regionally or globally
through the exchange of data, voice and multimedia information.
Our service provider customers include local and long-distance
communications companies, wireless service providers and cable
operators. Our networking solutions enable our service provider
customers to deploy reliable networks that create opportunities
to provide revenue-generating services and cost savings. Our
enterprise customers include large and small businesses,
governments and institutions. Our networking solutions enable
our enterprise customers to deploy secure networks with seamless
connectivity that provide opportunities for cost efficiency and
increased productivity.
None of our customers represented more than 10% of our
consolidated revenues in 2005.
GSM and UMTS Networks
Products
GSM and UMTS Networks offers network solutions including
professional services using the GSM and UMTS standards. GSM is a
2G wireless standard supported globally. GSM networks have
evolved to carry data, as well as voice, using the General
Packet Radio Standard, or GPRS. GPRS is viewed as a 2.5G
technology that provides faster and therefore increased data
transmission capabilities. Enhanced Data Rates for Global
Evolution, or EDGE, is a further evolution of GSM systems to
support higher data speeds. In addition to higher data speeds,
EDGE provides increased voice capacity for existing GSM
operators. An additional variant of the GSM standard, called
GSM-R, focuses on the delivery of communications and control
services for railway systems. The GSM technologies have now
evolved to embrace Wideband CDMA, or WCDMA, which is also
referred to as UMTS. UMTS combines WCDMA-based radio access with
packet switching technology to provide high capacity, high speed
wireless networks for data, voice and multimedia communications.
Product development
In the GSM and UMTS Networks segment, our wireless networking
products in development include the next evolution of our GSM/
GPRS/ EDGE, GSM-R and UMTS products.
•
There are several GSM/ GPRS/ EDGE products that are being
developed to allow GSM operators to use their existing network
and spectrum allocations more effectively. An example of this is
Adaptive MultiRate, or AMR, which allows service providers to
use the radio spectrum allocated to them more efficiently to
support more customers on the same network.
•
Our EDGE base station transceivers, including both hardware and
software, are generally available and are being deployed by
several customers in the United States and Europe. Our BTS 18000
product permits the integration of GSM and UMTS technologies and
gives our service provider customers greater deployment
flexibility.
6
•
Our UMTS radio network access and core networking products are
generally available and have been launched by several operators
in the EMEA region, Asia and in the United States. We are
continuing to develop our UMTS solutions for use in the Asia
Pacific (including Greater China) region.
•
We continue to work on developing access technologies such as
High Speed Downlink Packet Access, or HSDPA, and High Speed
Uplink Packet Access, or HSUPA, Orthogonal Frequency Division
Multiplexing, or OFDM, and Multiple Input Multiple Output, or
MIMO, antenna technologies to increase the speed and efficiency
of broadband wireless access from 3G networks deployed today. We
are also working on 802.16 d and e standards in the development
of WiMAX networks.
•
We are intending to pursue strategic relationships with other
companies for research, development and manufacturing of
equipment that conforms to the Chinese
3G TD-SCDMA
standard.
Markets
We anticipate that industry demand for GSM and UMTS wireless
networking solutions will be impacted by continued subscriber
growth in developing markets requiring network expansion to
accommodate an increase in network traffic. In developed
markets, a significant number of service providers are evolving
their networks with enhanced voice and data capabilities
provided by AMR and EDGE technologies. UMTS networks are being
deployed by service providers to meet expected growth in usage
levels. Certain service providers are also focusing on upgrading
their UMTS networks to support HSDPA technology which provides
greater download speeds and interactivity with end users. We
offer HSDPA as a software upgrade to existing UMTS networks. The
market for wireless data services is expected to continue to
grow.
Customers
Our GSM and UMTS Networks customers are wireless service
providers, and their customers are the subscribers for wireless
communications services. The top 20 global wireless service
providers collectively account for the majority of all wireless
subscribers around the world. We are currently focused on
increasing our market presence among the top global wireless
service providers.
Competition
Generally, the vendors that compete in the GSM market are the
same vendors that compete in the UMTS market. In the GSM and
UMTS market, our major competitors are Telefonaktiebolaget LM
Ericsson, or Ericsson, Nokia Corporation, Siemens
Aktiengesellschaft, or Siemens, Alcatel S.A., or Alcatel,
Motorola Inc., Huawei and ZTE Corporation. Lucent Technologies,
Inc., or Lucent, Samsung Electronics Co., or Samsung, NEC
Corporation, or NEC, and LG also offer UMTS solutions. Cisco
Systems, Inc., or Cisco, also competes in the area of wireless
data core network equipment. Global factors of competition
listed under CDMA Networks below are also applicable to this
segment.
CDMA Networks
Products
CDMA Networks offers network solutions including professional
services using the CDMA and, to a lesser extent, the Time
Division Multiple Access, or TDMA, standard. CDMA is a 2G
wireless standard, also known as
IS-95 or cdmaOne, and
is supported globally. CDMA networks are evolving to 3G
according to the CDMA 3G 1xRTT (single channel (1x) Radio
Transmission Technology) standard, also known as CDMA2000, for
voice and high-speed data mobility. CDMA 3G
1xEV-DO, or Evolution
Data Optimized, are extensions of CDMA 3G standards for high
speed wireless networks for data, voice and multimedia
communications. TDMA is a 2G wireless standard supported mainly
in the United States, Canada and CALA. Our CDMA Networks segment
is also developing products and services to compete in the
emerging broadband wireless segment based on OFDM and commonly
known as WiMAX.
Product development
In the CDMA Networks segment, our wireless networking solutions
in development include the next evolution of our CDMA 3G
products, as well as other new 3G broadband networking products.
•
Our CDMA 3G 1xRTT products are generally available and have been
deployed in several commercial networks in all our geographic
regions. Our CDMA 3G
1xEV-DO product is
currently being deployed by several large operators in the
United States and Brazil and is generally available for
commercial deployment.
7
•
We continue to work on developing and evolving additional access
technologies in 1xEV, or single channel evolution, to increase
the speed and efficiency of broadband wireless access including
the 1xEV-DO Rev. A
standard.
•
We are developing products and services based on WiMAX
standards, which includes OFDM along with MIMO antenna
technologies to provide wireless broadband data access to
complement our 2G and 3G wide-area wireless networks.
Markets
We anticipate that industry demand for wireless networking
equipment will be impacted by continued subscriber and network
traffic growth, and the effectiveness of 2.5G and 3G wireless
networking systems including those based on CDMA 3G and UMTS
spread spectrum technology. The migration from 2G to 2.5G and 3G
wireless communications technologies in various markets is also
largely dependent on the effective transition from circuit
switching technologies in 2G core networks to packet-based
networking technologies in 3G core networks. We believe that our
extensive experience in deploying CDMA wireless communications
networks combined with our expertise in packet-based networking
for wireline networks is a competitive strength during the
migration from 2G to 2.5G and 3G wireless communications
networks, and in emerging broadband wireless networking
segments. Commercial CDMA 3G networks have been launched in the
United States, Canada and certain countries in the CALA, Africa,
Middle East and the Asia Pacific regions. CDMA networks
operating in the 450 MHz radio spectrum are also expanding
into Central and Eastern Europe.
Customers
Our CDMA Networks customers are wireless service providers, and
their customers are the subscribers for wireless communications
services. The top 20 global wireless service providers
collectively account for a majority of all wireless subscribers
around the world. We are currently focused on increasing our
market presence among the top global wireless service providers.
Competition
Our major competitors in the global wireless infrastructure
business in CDMA technologies have traditionally included
Motorola and Lucent with each focusing to varying degrees on the
international standards. More recently, Samsung has emerged as a
competitor in the sale of CDMA systems, and Huawei and ZTE
Corporation have emerged as competitors in the sale of CDMA
systems in China and various developing countries. Cisco also
competes in the area of wireless data core network equipment.
The primary global factors of competition for our CDMA Networks
solutions and GSM and UMTS Networks solutions described above
include:
•
technology leadership, product features and availability;
•
product quality and reliability;
•
conformity to existing and emerging regulatory and industry
standards;
•
warranty and customer support;
•
price and cost of ownership;
•
interoperability with other networking products;
•
network management capabilities;
•
existing and emerging supplier relationships;
•
regulatory certification; and
•
provision of customer financing.
We intend to compete with our traditional and emerging
competitors as the global market for wireless networking
equipment migrates to 3G technologies.
Enterprise Networks
Products
Enterprise Networks provides: (i) circuit and packet voice
solutions and (ii) data networking and security solutions
which provide data, voice and multimedia communications
solutions to our enterprise customers. We also provide our
enterprise customers with related services. Our enterprise
solutions can be used by customers building new networks and
customers
8
who want to transform their existing communications network into
a more cost effective, packet-based network supporting data,
voice and multimedia communications.
Circuit and packet voice solutions
Our portfolio of circuit and packet voice communications
solutions includes:
•
Our communications servers and remote gateway products which
provide converged data, voice and multimedia communications
systems, using VoIP or session initiation protocol, or SIP, for
service providers and enterprises. SIP is a standard protocol
for initiating an interactive user session that involves
multimedia elements such as video, voice, chat, gaming and
virtual reality. We provide a broad range of VoIP based
telephone devices for use in offices and conference rooms,
mobile devices for use in wireless local area networks, or WLAN,
and personal data assistants and softphones for use in personal
and laptop computers.
•
Our customer premises-based circuit and packet telephone
switching systems which are designed for small, medium and large
commercial enterprises and government agencies. These systems
provide or can be configured with multiple applications,
including voice communications features, such as voice
messaging, call waiting and call forwarding, as well as advanced
voice services, converged multimedia applications and other
networking capabilities.
•
Our customer contact center, messaging and interactive voice and
web service solutions which are advanced communications tools
designed to work with our customer premises-based solutions.
These tools enable employees to efficiently and productively
communicate with business contacts and other employees
regardless of where they are located, the applicable time zone
or whether they choose to interact over the telephone or the
Internet.
Data networking and security solutions
We offer a broad range of data networking (packet switching and
routing) and security solutions for our enterprise customers.
Our packet switching and routing systems include:
•
Our data switches, secure routers and associated security
products which provide data switching designed to allow our
customers to provide Internet data security and IP services
including IP routing, virtual private networks, deep packet
inspection, firewall applications, policy management and data
traffic flow management. These products also enable our
customers to manage and prioritize the Internet content that is
provided to end-users and balance the amount of communications
traffic on multiple Internet servers.
•
Our Ethernet switch portfolio which is a series of high
performance packet switches for our enterprise customers’
small to large local area networks that use the Ethernet, a
standard computer networking protocol for local area networks. A
portfolio of Ethernet switches also supply standards-based
Power-Over-Ethernet (PoE) to various devices, including IP
telephones, WLAN access points, security cameras and compatible
remote devices.
•
Our multi-protocol routers which offer high-speed, high-capacity
and medium-capacity data switching to support a wide range of
data communications technologies, including multi-protocol label
switching, ATM, IP and frame relay services. Our Ethernet
routing switches deliver IP routing and switching.
•
Our portfolio of WLAN service switching products which are
designed to provide secure and efficient transmission of WLAN
data and voice traffic for mobile users. Our wireless mesh
network solution incorporates the latest security standards to
protect both user access and network access by providing
security between wireless access points. A wireless mesh
solution is ideal for WLAN coverage of large open areas, both
indoor and outdoor and in areas where Ethernet cabling does not
exist and is prohibitive to install. Our WLAN voice products
integrate with our communications servers and gateway products
to provide a wireless VoIP solution for our customers.
•
Our portfolio of optical network switching products which are
designed to extend the range of storage area networks to enable
our customers to consolidate their data servers. Our products
enable enterprises to deploy these storage area networks in
alternate locations, providing geographic redundancy as part of
their business continuity strategy.
9
Product development
We are currently focused on developing products that support the
continuing evolution of voice and data communications systems
toward converged or combined data, voice and multimedia
networks, including:
•
The continued development of our multimedia communication server
for enterprise, a product that provides the capability to
deliver converged data, voice and multimedia applications and
enhanced networking capabilities.
•
Additions to the applications in our communications server
products to allow integration of VoIP, voice extensible markup
language, new operating systems and servers, and voice
recognition speech products.
•
New developments in data networking products that will deliver
resiliency, enable increased data network traffic and provide
suitable service levels and network connectivity and power to
devices over the same line.
•
Updates to our customer premises-based telephone systems to
support our software that enables those systems to function
entirely as a packet-based system or as a hybrid packet and
circuit switching system.
Markets
We offer Enterprise Networks solutions to enterprises around the
world. We believe enterprise customers are focusing more on how
their communications needs integrate into their overall business
processes. As a result, we anticipate that global demand for
packet-based networking equipment that supports the convergence
of data, voice and multimedia communications over a single
communications network and that provides greater network
capacity, reliability, speed, quality and performance will
continue to increase. Globally, enterprise customers continue to
invest in equipment for their communications networks, primarily
for network security and resiliency, for VoIP, WLANs and for
virtual private networks.
Customers
We offer our products and services to a broad range of
enterprise customers around the world, including large
businesses and their branch offices, small businesses and home
offices, as well as government agencies, educational and other
institutions and utility organizations. Key industry sectors for
our business customers include the telecommunications,
high-technology manufacturing, government (including the defense
sector), and financial services sectors. We also serve customers
in the healthcare, retail, education, hospitality, services,
transportation and other industry sectors. We are currently
focused on increasing our market presence with enterprise
customers. In particular, we intend to focus on leading
enterprise customers with high performance networking needs.
Certain of our service provider customers, as well as system
integrators, distributors and resellers also act as distribution
channels for our Enterprise Networks sales.
Competition
Our principal competitors in the sale of our Enterprise Networks
solutions are Cisco, Avaya Inc., Siemens, Alcatel, and NEC.
Avaya is our largest competitor in the sale of voice equipment
while Cisco is our largest competitor in the sale of data
networking equipment to enterprises. We also compete with
smaller companies that address specific niches, such as Juniper
Networks, Inc., or Juniper, 3Com Corporation, Extreme Networks,
Inc. and Enterasys Networks, Inc., in data networking. We expect
competition to remain intense as enterprises look for ways to
maximize the effectiveness of their existing networks while
reducing ongoing capital expenditures and operating costs.
The principal global factors of competition in the sale of our
Enterprise Networks solutions include:
•
product quality and reliability;
•
conformity to existing and emerging regulatory and industry
standards;
•
price and cost of ownership;
•
the ability to leverage existing customer-supplier relationships;
•
interoperability with other networking products;
•
technology leadership, product features and availability;
•
sales distribution and channel marketing strategy;
•
warranty and customer support;
•
installed base of product;
•
alternative solutions offered to enterprises by service
providers; and
•
the availability of distribution channels.
10
Carrier Packet Networks
Products
Carrier Packet Networks provides: (i) circuit and packet
voice solutions, (ii) data networking and security
solutions and (iii) optical networking solutions. Together,
these solutions provide data, voice and multimedia communication
solutions to our service provider customers that operate
wireline networks. Our Carrier Packet Networks portfolio
addresses the demand by our service provider customers for cost
efficient data, voice and multimedia communications solutions.
These service provider customers include local and long distance
telephone companies, wireless service providers, cable operators
and other communication service providers. Our wireline
solutions, including related professional services, simplify
network architectures by bringing data, voice, multimedia and
emerging broadband applications for revenue generating services
together on one packet network.
Circuit and packet voice solutions
We are a leader in the development and deployment of highly
scalable circuit switched and secure voice over packet solutions
such as VoIP for wireline and wireless service providers around
the world. Our voice over packet solutions offer service
providers opportunities for new revenue sources and operating
and capital cost reduction, as well as high levels of
reliability and network resiliency. Our solutions include the
following:
•
Our wireline voice over packet network solutions for service
providers, which include softswitches and media gateways. The
portfolio provides the complete range of voice over packet
solutions, including local, toll, long-distance and
international gateway capabilities, and enables voice
applications to run on the multi-service packet network. These
solutions leverage more efficient packet-based, as opposed to
circuit-based, technologies that drive reduced capital and
operational costs for service providers and provide a platform
for the delivery of new revenue-generating services, such as
Centrex IP and VoIP virtual private networks.
•
Our multimedia communications services portfolio allows our
customers to deploy new, enhanced multimedia services, including
video, collaboration as well as call control and call management
services. The portfolio consists of a
SIP-based application
server that can enable an interactive user session involving
multimedia elements. For example, users are provided with the
flexibility to customize their communications by selecting the
medium over which they wish to receive a particular message
(such as wireline or wireless telephony,
e-mail and instant
messaging) and by setting screening criteria such as time of day
and day of week, month or year.
•
Our portfolio of digital, circuit-based telephone switches
provides local, toll, long-distance and international gateway
capabilities for service providers. These systems enable service
providers to connect end-users making local and long-distance
telephone calls. These products can evolve to voice over packet
solutions.
•
Our Nortel Networks Developers Partner Program develops
solutions to drive the interoperability of our VoIP multimedia
communications and our digital, circuit-based telephone switch
portfolios with third party vendors including infrastructure and
application companies.
•
Our IMS solution is designed to enable fixed, mobile and cable
operators to create a converged core network and rapidly deploy
a wide variety of new services. The IMS solution currently is in
trial in multiple countries in Europe.
These solutions work alone or in combination with each other to
provide traditional voice services, advanced packet voice
services and enhanced multimedia services to service providers
around the world.
Data networking and security solutions
We offer a wide range of data networking solutions to our
service provider customers. Our wide area network, or WAN,
solutions, Carrier Ethernet and IP service platforms enable our
service provider customers to offer connectivity solutions and
high value services to both enterprises and residential
customers. Connectivity solutions include packet services such
as: IP, Ethernet, frame relay and ATM. High-value services, such
as IP virtual private networks, enable an enterprise to connect
with other enterprise sites and remote users and to securely
connect with business partners. These high-value services also
provide enhanced network capabilities, such as network security,
network address translation and class of service, that enable
service providers to offer a wide range of networking services
beyond basic connection to the network.
11
Optical networking solutions
Our optical networking solutions efficiently transform our
customers’ networks to be more scalable and reliable for
the high speed delivery of diverse multimedia communication
services. These solutions include next generation photonic
Coarse/ Dense Wavelength Division Multiplexing, or C/ DWDM,
transmission solutions, multiservice synchronous optical
transmission solutions, optical switching solutions and network
management and intelligence software. We also offer our
customers a variety of related professional services. Our
solutions include the following:
•
Our next generation photonic networking C/ DWDM solutions allow
multiple light wave signals to be transmitted on the same fiber
optic strand simultaneously by using different wavelengths of
light to distinguish specific signals, thereby increasing the
capacity and flexibility of a network.
•
Our multiservice synchronous optical transmission systems use
traditional optical standards, including the SONET standard,
which is the most common standard in the United States and
Canada and some countries in the Asia Pacific region, and the
SDH standard, which is the most common standard in the EMEA and
CALA regions and many other countries. Our multiservice SONET/
SDH solutions comprise optical platforms that integrate diverse
protocols and technologies to deliver services over a cost
effective, scalable and reliable converged services network.
•
Our optical switching solutions enable communication signals in
optical fibers to be selectively directed or
“switched” from one network circuit to another.
•
Our network management software and intelligence solutions are
designed to give our customers the ability to monitor and
improve the performance of their networks.
Product development
Research and development investments are focused on creating
new, and improving existing, packet-based residential and
business services for wireline and wireless service providers.
Also, we continue to develop products that support the evolution
of data, voice and multimedia communications systems toward
converged or combined voice and data networks, including:
•
Enhancements to our voice over packet solutions that will allow
service providers to connect any business telephone system,
using standard VoIP protocols, into a common dialing plan with
connectivity to the public switched telephone network.
Additional enhancements to our packet voice solutions will
continue to focus on interoperability with other
manufacturers’ equipment, including gateway and integrated
access device manufacturers, as well as on meeting the needs of
the Asian and European markets. We continue to make improvements
to our softswitch portfolio by utilizing the latest commercial
technology to provide our customers with converged wireline and
wireless service support, superior application choices,
integrated network management and linear scalable capacity.
•
Enhancements to our multimedia communications portfolio, that
will allow a service provider to offer intelligent multimedia
services across any manufacturer’s circuit switches.
Additionally, development will focus on increasing the breadth
and usability of multimedia communications applications.
•
Additions to the digital, circuit-based telephone switch
portfolio that will allow service providers to offer and manage
IP voice and multimedia (Centrex IP) services to those
businesses that use traditional business telephones as well as
businesses that use next generation telephones designed for use
in IP networks.
•
A focus on cable standards compliance to enhance our solutions
for the cable operator markets in the United States, Canada and
EMEA, including support for the open cable standard protocol for
cable media gateways.
•
Enhancements to our WAN switch portfolio to strengthen the
solutions we bring to carrier data services, wireless radio
access networks, and government and secure private networks.
Development will focus on enhancing the migration to converged
networks which simultaneously support data, voice and multimedia.
In the case of our optical networking solutions, we are focused
on developing packet optical converged SONET/ SDH systems and
next generation C/ DWDM solutions. We have:
•
integrated Ethernet switching into our multiservice Sonet/ SDH
platform enabling the convergence of multiple platforms onto a
single architecture, lowering network costs, enhancing
functionality and delivering consistent service quality and
scalability to satisfy service provider requirements while
providing carrier grade reliability;
•
integrated electronic Dynamically Compensating Optics (eDCO)
into our photonic solutions to assist our customers to lower
their network costs by providing improved optical performance
with reduced network planning and engineering costs;
12
•
introduced enhanced Reconfigurable Optical Add-Drop Multiplexer
(eROADM) capabilities managed by the domain optical controller
into our common photonic layer product to facilitate the
deployment and operation of regional and long-haul optical
links; and
•
introduced a variety of packet optical access devices enabling
comprehensive packet optical network solutions.
We also continue to invest in core technologies, such as
efficient service adaptation, aggregation, switching and
management, that enable our customers worldwide to deploy
innovative optical networking services which we believe will
lead the networking transformation towards high performance
packet-based networks.
Markets
The market for our Carrier Packet Networks solutions is global.
Service providers are expected over the long term to continue to
modernize with packet-based networks and converge voice and data
communications networks in order to deploy new
revenue-generating services. We anticipate an increased emphasis
by service providers towards end-user networks in addition to
their efforts to modernize the inter-connection of those
networks. Cable operators and new Internet service providers are
entering the voice and data markets and are increasing the
competitive pressure on established service providers. For
example, cable operators provide high speed data services as
well as voice services by using VoIP technology. Similarly,
established service providers are using existing broadband
networks and expanding those broadband networks to offer bundled
services such as telephone, high speed Internet and television
services across those broadband networks. As a result of this
increased competitive pressure the consolidation among service
providers in the United States has continued.
To meet the growing demand for new revenue generating services
and network efficiency, we anticipate growth in demand for
packet-based networking equipment that supports the convergence
of data, voice and multimedia communications over a single
communications network and that provides greater network
capacity, reliability, speed, quality and performance. We
anticipate a continued increase in deployments of service
provider VoIP networks worldwide. While we anticipate growth in
VoIP networks, we also anticipate a decline in traditional voice
networks. The outlook for optical equipment sales may be
impacted by service providers preferring to lease excess network
capacity from others or purchase assets from other operators
rather than making capital investments in their own networks. We
expect that any additional capital spending by our customers
will continue to be directed toward opportunities that enhance
customer performance, generate revenue and reduce costs in the
near term. Furthermore, where a few service providers account
for a significant percentage of the industry, the building of
national optical network infrastructures is largely complete.
However, as service providers begin to more effectively utilize
and eventually exceed their network capacity, we expect that
they may incrementally enhance that capacity. The timing and
impact of these developments remain difficult to predict.
Customers
We offer our Carrier Packet Networks solutions to a wide range
of service providers including local and long distance telephone
companies, wireless service providers, cable operators, Internet
service providers as well as other communication service
providers. We are currently focused on increasing our market
presence with key service provider customers worldwide, which we
expect to account for a substantial proportion of service
provider optical capital spending.
We also offer applicable data networking and security solutions
and optical solutions to enterprises for private enterprise
networking, as well as to service providers and system
integrators that in turn build, operate and manage custom
dedicated and shared networks for their customers such as
businesses, government agencies and utility organizations. We
leverage numerous distribution channels for delivering optical
networking solutions to enterprises from our own direct sales
force for large enterprises and governments and through
distributors, resellers and partners to offer our solutions to
medium-sized enterprises and smaller enterprises.
Competition
Our principal competitors in the Carrier Packets Networks
business for circuit and packet voice solutions and data
networking and security solutions are large communications
companies such as Siemens, Alcatel, Cisco and Lucent. Our major
competitors in the sale of optical networking equipment also
include Fujitsu Limited, Ericsson (which acquired Marconi in
2005), Huawei, NEC, Ciena Corporation and ADVA International
Inc. In addition, we compete with smaller companies that address
specific niches within this market, such as Sonus Systems
Limited, BroadSoft, Inc. and Tekelek (which acquired Taqua Inc.
in 2004) in packet and Internet-based voice communications
solutions; Ciena Corporation in
13
multiservice WAN solutions; and Redback Networks Inc. in
aggregation products. Certain competitors are also strong on a
regional basis, such as Huawei and ZTE Corporation in the Asia
Pacific region. Some niche competitors are partnering with
larger companies to enhance their product offerings and large
communications competitors are also looking for these
partnerships or alliances to complete their product offerings.
Market position in the global market for optical networking
equipment can fluctuate significantly on a quarter-by-quarter
basis. However, we continue to be a leading global provider of
optical networking equipment. No one competitor is dominant in
the Carrier Packet Networks market.
The primary global factors of competition for our Carrier Packet
Networks solutions include:
•
technology leadership, product features and availability;
•
price and total cost of ownership;
•
ability to create new revenue-generating services for service
providers and cable operators;
•
conformity to existing and emerging regulatory and industry
standards;
•
installed base of products and customer relationships;
•
network management capabilities;
•
product quality and reliability;
•
warranty and customer support;
•
interoperability with other networking products;
•
existing and emerging supplier relationships, particularly in
EMEA and the Asia Pacific region; and
•
regulatory certification, particularly for incumbent local and
long-distance telephone companies.
Competition remains intense as a result of reduced investment in
existing traditional networks by service providers, the
continued consolidation in the service provider industry, and
the continued focus by suppliers on growing revenue in new
broadband and IP technologies. Our focus is on increasing market
share relative to our competitors.
Sales and distribution
All of our reportable segments use the Nortel direct sales force
to market and sell to customers around the world. The Nortel
global sales force operates on a regional basis and markets and
sells our products and services to customers located in the
following regional areas: Canada; United States; CALA; EMEA; and
Asia Pacific. Our sales office bases for our direct sales force
are aligned with our customers on a country and regional basis.
We have dedicated sales account teams for certain major service
provider customers. These dedicated teams are located close to
the customers’ main purchasing locations. In addition,
teams within the regional sales groups are dedicated to our
enterprise customers. Our Enterprise Networks sales teams work
directly with the top regional enterprises, and are also
responsible for managing regional distribution channels. We also
have centralized marketing, product management and technical
support teams dedicated to individual product lines that support
the global sales and support teams.
In the Asia Pacific region, particularly in China, we also use
agents to interface with our customers. In addition, we have
some small non-exclusive distribution agreements with
distributors in EMEA, CALA and the Asia Pacific region. In
Enterprise Networks, certain service providers, system
integrators, value-added resellers and stocking distributors act
as non-exclusive distribution channels for our products.
Backlog
Our backlog was approximately $5.4 billion and
$5.1 billion as of December 31, 2005 and 2004,
respectively. Our order backlog consists of confirmed orders and
our deferred revenues as reported in our consolidated balance
sheets. Our backlog for December 31, 2004 was previously
reported as $4.1 billion and has been restated in this
report to reflect the impact of the Third Restatement. A
majority of backlog consists of orders confirmed with a binding
purchase order or contract for our network solutions typically
scheduled for delivery to our customers within the next twelve
months. Our orders are subject to possible rescheduling by
customers. Although we believe that the orders included in the
backlog are firm, we may elect to permit cancellation of orders
without penalty where management believes that it is in our best
interest to do so. Prior to including orders in backlog,
customers must have approved credit status. However, from time
to time, some customers may become unable to pay for or finance
their purchases in which case the order is removed from our
backlog. A significant portion of backlog may include orders
that relate to revenue that could be deferred for periods longer
than twelve months. We do not believe that backlog, as of any
particular date, is a reliable indicator of future performance.
In addition, the concept of backlog is not defined in the
accounting literature, making comparisons with other companies
difficult and potentially misleading. There can be no assurance
that any of the contracts comprising
14
our backlog presented in this report will result in actual
revenue in any particular periods or that the actual revenue
from such contracts will equal our backlog estimates.
Product standards, certification and regulations
Our products are subject to equipment standards, registration
and certification in Canada, the United States, the European
Union and other countries. We design and manufacture our
products to satisfy a variety of regulatory requirements and
protocols established to, for instance, avoid interference among
users of radio frequencies and to permit interconnection of
equipment. For example, our equipment must satisfy the emissions
testing requirements of the United States Federal Communications
Commission, or FCC, and must be certified to safety, electrical
noise and communications standards compliance. Different
regulations and regulatory processes exist in each country.
In order for our products to be used in some jurisdictions,
regulatory approval and, in some cases, specific country
compliance testing and re-testing may be required. The delays
inherent in this regulatory approval process may force us to
reschedule, postpone or cancel introduction of products or new
capabilities in certain geographic areas, and may result in
reductions in our sales. The failure to comply with current or
future regulations or changes in the interpretation of existing
regulations in a particular country could result in the
suspension or cessation of sales in that country or require us
to incur substantial costs to modify our products to comply with
the regulations of that country. To support our compliance
efforts, we work with consultants and testing laboratories as
necessary to ensure that our products comply with the
requirements of Industry Canada in Canada, the FCC in the United
States and the European Telecommunications Standards Institute
in Western Europe, as well as with the various regulations of
other countries. For additional information, see
“Environmental Matters.” The operations of our service
provider customers are also subject to extensive
country-specific telecommunications regulations.
Sources and availability of materials
Since 1999, our manufacturing and supply chain strategy has
evolved and has resulted in the gradual transformation of our
traditional manufacturing model, in which our products were
primarily manufactured and assembled in-house, to primarily an
outsourced model which relies on electronic manufacturing
services, or EMS, suppliers. By the end of 2003, most of our
manufacturing activities had been divested to leading EMS
suppliers. In 2004, we entered into an agreement with
Flextronics regarding the divestiture of substantially all of
our remaining manufacturing operations and related activities,
including certain product integration, testing, repair
operations, supply chain management, third party logistics
operations and design assets. Commencing in the fourth quarter
of 2004, and throughout 2005, we completed the transfer to
Flextronics of certain of our optical design activities in
Ottawa, Canada and Monkstown, Northern Ireland and our
manufacturing activities in Montreal, Canada and Chateaudun,
France. We expect to transfer the remaining manufacturing
operations in Calgary, Canada to Flextronics by the end of the
second quarter of 2006. We and Flextronics have agreed that we
will retain our Monkstown manufacturing operations and establish
a regional supply chain center to lead our EMEA supply chain
operations.
For recent developments in the evolution of our supply chain
strategy, see “Developments in 2005 and 2006 —
Evolution of Our Supply Chain Strategy” in the MD&A
section of this report.
We believe that the use of an outsourced manufacturing model has
enabled us to benefit from leading manufacturing technologies,
leverage existing resources from around the world, lower our
cost of sales more quickly adjust to fluctuations in market
demand and decrease our investment in plant, equipment and
inventories. We continue to retain in-house all strategic
management and overall control responsibilities associated with
our various supply chains, including all customer interfaces,
customer service, order management, quality assurance, product
cost-management, new product introduction, and network solutions
integration, testing and fulfillment.
Through our existing manufacturing model, we are generally able
to obtain sufficient materials and components from global
sources to meet the needs of our reportable segments. In each of
our reportable segments, we:
•
make significant purchases, directly or indirectly through
contract manufacturing suppliers, of electronic components and
assemblies, optical components, original equipment manufacturer,
or OEM, products, software products, outsourced assemblies,
outsourced products and other materials and components from many
domestic and foreign sources;
•
develop and maintain alternative sources for certain essential
materials and components; and
•
occasionally maintain special internal inventories of components
or assemblies or request that they be maintained by suppliers to
satisfy customer demand or to minimize effects of possible
market shortages.
15
In 2005, we continued to purchase, manufacture, or otherwise
obtain sufficient components and materials to supply our
products, systems and networks within customary delivery periods.
For more information on our supply arrangements, see
“Commitments” in note 14 of the accompanying
audited consolidated financial statements and “Developments
in 2005 and 2006” and “Liquidity and Capital
Resources — Future Uses of Liquidity —
Contractual cash obligations” in the MD&A section of
this report.
Seasonality
In 2005, we experienced a seasonal decline in revenues in the
first quarter of 2005 compared to the fourth quarter of 2004,
followed by growth in the second quarter of 2005 compared to the
first quarter of 2005 in all of our reportable segments.
Revenues in all of our segments in the fourth quarter of 2005
were highest compared to the other quarters in 2005. The
quarterly profile of our business results in 2006 is not
expected to be consistent across all of our reportable segments.
We typically expect a seasonal decline in revenue in the first
quarter but there is no assurance that our results of operations
for any quarter will necessarily be consistent with our
historical quarterly profile or indicative of our expected
results in future quarters. See “Results of
Operations — Continuing Operations” in the
MD&A section and the “Risk Factors” section of
this report.
Strategic alliances, acquisitions and minority investments
We use strategic alliances to deliver certain solutions to our
customers. These alliances are typically formed to fill product
or service gaps in areas that support our core businesses. We
believe strategic alliances also augment our access to potential
new customers. We intend to continue to pursue strategic
alliances with businesses that offer technology and/or resources
that would enhance our ability to compete in existing markets or
exploit new market opportunities. As the information technology
and communications markets converge, we expect that our rate of
forming strategic alliances will increase in order to fill the
need for complimentary technology and network integration skills.
In 2005 we acquired PEC, formed a joint venture with LG and
announced the acquisition of Tasman Networks, and in the future
we may consider selective opportunistic acquisitions of
companies with resources and product or service offerings
capable of providing us with additional enhancements to our
networking solutions or access to new markets. For information
regarding the risks associated with strategic alliances and
acquisitions, see the “Risk Factors” section of this
report.
We continue to hold minority investments in certain
“start-up”
businesses with technology, products or services that, at the
time of investment, had the potential to fulfill key existing or
emerging market opportunities. When minority investments are no
longer required to maintain our strategic relationship, or the
relationship is no longer strategic to our core businesses, we
intend to exit such investments at an opportune time.
Our investment activity remained at a low level in 2005. We may
make selective minority investments in
start-up ventures and
certain other companies where we believe the relationship could
lay the foundation for future alliances that would support our
customer solutions. In certain circumstances, we may also
acquire an equity position in a company as consideration for a
divested business. See “Developments in 2005 and 2006”
in the MD&A section of this report.
Research and development
In order to remain among the technology leaders in anticipated
growth areas, we intend to continue to make strategic
investments in our research and development activities. Our
research and development activities — specifically,
research, design and development, systems engineering and other
product development activities — represent focused
investments to drive market leadership across our product
portfolios. We refer you to the four “Product
development” discussions contained in the descriptions of
GSM and UMTS Networks, CDMA Networks, Enterprise Networks and
Carrier Packet Networks above.
Our research and development investments are focused on network
transformation and next generation products and solutions
including wireless voice and data, voice over packet, multimedia
services and applications, broadband networking and network
security. We also conduct network planning and systems
engineering on behalf of, or in conjunction with, major
customers. Although we derive many of our products from
substantial internal research and development activities, we
supplement this with technology acquired or licensed from third
parties.
16
Our research and development forms a core strength and is a
factor we believe differentiates us from many of our
competitors. As at December 31, 2005, we employed
approximately 13,345 regular full-time research and development
employees (excluding employees on notice of termination)
including approximately:
•
4,760 regular full-time research and development employees in
Canada;
•
4,055 regular full-time research and development employees in
the United States;
•
2,055 regular full-time research and development employees in
EMEA; and
•
2,475 regular full-time research and development employees in
other countries.
We also conduct research and development activities through
affiliated laboratories in other countries.
The following table sets forth our consolidated expenses for
research and development for each of the three fiscal years
ended December 31:
2005
2004
2003
(Millions of dollars)
R&D expense
$
1,856
$
1,960
$
1,968
R&D costs incurred on behalf of
others(a)
28
40
72
Total
$
1,884
$
2,000
$
2,040
(a)
These costs included research and development charged to our
customers pursuant to contracts that provided for full recovery
of the estimated cost of development, material, engineering,
installation and all other applicable costs, which were
accounted for as contract costs.
Intellectual property
Our intellectual property is fundamental to Nortel and the
business of each of our reportable segments. In particular, our
success is dependent upon our proprietary technology. We
generate, maintain, utilize and enforce a substantial portfolio
of intellectual property rights, including trademarks, and an
extensive portfolio of patents covering significant innovations
arising from research and development activities. In all of our
reportable segments, we use our intellectual property rights to
protect our investments in research and development activities,
to strengthen our leadership positions, to protect our good
name, to promote our brand name recognition, to enhance our
competitiveness and to otherwise support our business goals and
objectives. However, our intellectual property rights may be
challenged, invalidated or circumvented, or fail to provide us
with significant competitive advantages. See the “Risk
Factors” section of this report. The duration and level of
protection of our intellectual property rights are dependent
upon the laws and requirements of the jurisdictions providing or
controlling those rights. As of December 31, 2005, we had,
on a consolidated basis, 3,877 United States patents and 4,972
patents in other countries, which includes 177 United States
patents and 3,172 foreign patents owned by our new joint venture
with LG Electronics.
Our patents outside of the United States are primarily
counterparts to our United States patents. We have entered into
some mutual patent cross-license agreements with several major
corporations to enable each party to operate without risk of a
patent infringement claim from the other. In addition, we are
actively licensing certain of our patents and/or technology to
third parties. We also occasionally license single patents or
groups of patents from third parties.
Our trademarks and trade names, Nortel and Nortel Networks, are
two of our most valuable assets. We sell our products primarily
under the Nortel and Nortel Networks brand names. We have
registered the Nortel and Nortel Networks trademarks, and many
of our other trademarks, in countries around the world. On a
consolidated basis as of December 31, 2005, we owned
approximately 90 registered trademarks in the United States, and
approximately 1,955 registered trademarks in other countries. In
addition, as of December 31, 2005, we had approximately 330
pending trademark registrations worldwide.
Employee relations
At December 31, 2005, we employed approximately 35,370
regular full-time employees (excluding employees on notice of
termination), including approximately:
•
13,390 regular full-time employees in the United States;
•
7,775 regular full-time employees in Canada;
•
6,905 regular full-time employees in EMEA; and
•
7,300 regular full-time employees in other countries.
17
We also employ individuals on a regular part-time basis and on a
temporary full-time basis. In addition, we engage the services
of contractors as required.
In 2004, we announced plans to divest to Flextronics certain
operations located in Canada, Brazil, France and Northern
Ireland. Approximately 170 employees in the optical design
business, located in Ottawa and Monkstown, were transferred to
Flextronics in the fourth quarter of 2004. Approximately 1,270
employees associated with the manufacturing operations and
related activities in Montreal, Chateaudun and Campinas were
transferred in 2005. It is anticipated that approximately 680
additional employees associated with manufacturing operations
and related activities will transfer to Flextronics in 2006.
In addition, following the announcement of our work plan in the
third quarter of 2004, we reduced our employee workforce by
approximately 3,600 employees. Approximately 64% of the
workforce reductions were completed in 2004, with the remainder
completed by the end of 2005. These workforce reductions were
partially offset by hiring in certain strategic areas such as
the finance organization and increases in headcount due to our
acquisition of PEC and joint venture with LG. For additional
information, see “Sources and availability of
materials”, “Special charges” in note 7 of
the accompanying audited consolidated financial statements and
“Results of Operations — Continuing
Operations — Consolidated Information —
Operating Expenses — Special charges” in the
MD&A section of this report.
At December 31, 2005, labor contracts covered approximately
two percent of our employees worldwide. At the same date, five
labor contracts covered approximately three percent of our
employees in Canada including:
•
one labor contract covering approximately 30% of Canadian
unionized employees which was renewed, ratified and became
effective February 26, 2006 and is for a three year term;
•
one labor contract covering less than one percent of Canadian
unionized employees which expires in August 2006;
•
one labor contract covering approximately 18% of Canadian
unionized employees which expires in 2014;
•
one labor contract covering approximately 11% of Canadian
unionized employees which expires in 2007; and
•
one labor contract covering approximately 40% of Canadian
unionized employees which expires in 2008.
At December 31, 2005, labor contracts covered approximately
three percent of our employees in EMEA and all of our employees
in Brazil. These labor contracts generally have a one year-term,
and primarily relate to remuneration. In the United States, we
have one labor contract covering less than one percent of our
employees in the United States. These employees are employed by
a subsidiary of PEC. The labor contract covering these employees
was renewed, ratified and became effective May 23, 2005 and
is for a three-year term.
We believe our employee relations are generally positive.
Employee morale, satisfaction and career development continue to
be important areas of focus. Although the recruitment and
retention of technically skilled employees in recent years was
highly competitive in the global networking industry, the
economic conditions during the past few years have lessened the
competition for skilled employees in our industry. We believe it
will become increasingly important to our future success to
recruit and retain skilled employees. During 2005, approximately
2,330 regular full-time employees were hired. See the “Risk
Factors” section of this report.
Environmental matters
Our operations are subject to a wide range of environmental laws
in various jurisdictions around the world. We seek to operate
our business in compliance with such laws. Nortel is and will be
subject to various product content laws and product takeback and
recycling requirements that will require full compliance in the
coming years. We expect that these laws will require us to incur
additional compliance costs. Although costs relating to
environmental matters have not resulted in a material adverse
effect on our business, results of operations, financial
condition and liquidity in the past, there can be no assurance
that we will not be required to incur such costs in the future.
We have a corporate environmental management system standard and
an environmental program to promote compliance. We also have a
periodic, risk-based, integrated environment, health and safety
audit program. As part of our environmental program, we attempt
to evaluate and assume responsibility for the environmental
impacts of our products throughout their life cycles. Our
environmental program focuses on design for the environment,
supply chain and packaging reduction issues. We work with our
suppliers and other external groups to encourage the sharing of
non-proprietary information on environmental research. For
additional information on environmental matters, see
“Contingencies — Environmental matters” in
note 22 of the accompanying audited consolidated financial
statements.
18
Financial information by operating segment and product
category
For financial information by operating segment and product
category, see “Segment information” in note 6 of
the accompanying audited consolidated financial statements and
“Results of Operations — Continuing
Operations” in the MD&A section of this report.
Financial information by geographic area
For financial information by geographic area, see “Segment
information” in note 6 of the accompanying audited
consolidated financial statements and “Results of
Operations — Continuing Operations —
Consolidated Information — Geographic Revenues”
in the MD&A section of this report.
Working capital
For a discussion of our working capital practices, see
“Long-term debt, credit and support facilities” in
note 11 of the accompanying audited consolidated financial
statements and “Liquidity and Capital Resources” in
the MD&A section of this report.
ITEM 1A. Risk Factors
Certain statements in this Annual Report on
Form 10-K contain
words such as “could”, “expects”,
“may”, “anticipates”, “believes”,
“intends”, “estimates”, “plans”,
“envisions”, “seeks” and other similar
language and are considered forward-looking statements. These
statements are based on our current expectations, estimates,
forecasts and projections about the operating environment,
economies and markets in which we operate. In addition, other
written or oral statements which are considered forward looking
may be made by us or others on our behalf. These statements are
subject to important risks, uncertainties and assumptions, which
are difficult to predict and the actual outcome may be
materially different. In particular, the risks described below
could cause actual events to differ materially from those
contemplated in forward-looking statements. Unless required by
applicable securities laws, we do not have any intention or
obligation to publicly update or revise any forward-looking
statements, whether as a result of new information, future
events or otherwise.
You should carefully consider the risks described below
before investing in our securities. The risks described below
are not the only ones facing us. Additional risks not currently
known to us or that we currently believe are immaterial may also
impair our business, results of operations, financial condition
and liquidity.
We have organized our risks into the following categories:
•
Risks Relating to Our Restatements and Related Matters;
•
Risks Relating to Our Business; and
•
Risks Relating to Our Liquidity, Financing Arrangements and
Capital.
The above categories and the order in which we have listed
our risk factors is not intended to limit your consideration of
the possible effects of these risks on our business or to
categorize or rank our risks by likelihood of occurrence or
severity to our business. Any adverse effects related to the
risks discussed below may, and likely would, have an adverse
impact on many aspects of our business.
Risks Relating to Our Restatements and Related Matters
Our three restatements of our consolidated financial
statements and related events have had, and will continue to
have, a material adverse effect on us.
As described in the “MD&A” and “Controls and
Procedures” sections of this report, we have effected
successive restatements of prior periods financial results. As
described in more detail in our Annual Report on
Form 10-K for the
year ended December 31, 2003, or the 2003 Annual Report,
following the restatement (effected in December 2003) of our
consolidated financial statements for the years ended
December 31, 2002, 2001 and 2000 and for the quarters ended
March 31, 2003 and June 30, 2003, or the First
Restatement, the Audit Committee initiated an independent review
of the facts and circumstances leading to the First Restatement,
or the Independent Review, and engaged Wilmer Cutler Pickering
Hale & Dorr LLP, or Wilmer Hale, to advise it in
connection with the Independent Review. This review and related
work led to a variety of actions, including the termination for
cause of our and NNL’s former president and chief executive
officer, chief financial officer and controller in April 2004
and seven additional individuals with significant
responsibilities for financial reporting in August 2004, and
ultimately to the restatement of our financial statements for
Over the course of the Second Restatement process, we, together
with our independent registered chartered accountants,
identified a number of material weaknesses in our internal
control over financial reporting as at December 31, 2003.
Five of those material weaknesses continued to exist as at
December 31, 2004 and 2005. In addition, in January 2005,
our and NNL’s Boards of Directors adopted in their entirety
the governing principles for remedial measures identified
through the Independent Review. We continue to develop and
implement these remedial measures.
As part of these remedial efforts and to compensate for the
unremedied material weaknesses in our internal control over
financial reporting, we undertook intensive efforts in 2005 to
validate and enhance our controls and procedures relating to the
recognition of revenue. These efforts included, among other
measures, extensive documentation and review of customer
contracts for revenue recognized in 2005 and earlier periods. As
a result of the contract review, it became apparent that certain
of the contracts had not been accounted for properly under
U.S. GAAP. Most of these errors related to contractual
arrangements involving multiple deliverables, for which revenue
recognized in prior periods should have been deferred to later
periods under American Institute of Certified Public Accountants
Statement of Position, or
SOP 97-2,
“Software Revenue Recognition”, or SOP 97-2, and
SEC Staff Accounting Bulletin, or SAB 104, “Revenue
Recognition”, or SAB 104.
In addition, based on our review of our revenue recognition
policies and discussions with our independent registered
chartered accountants as part of the 2005 audit, we determined
that in our previous application of these policies, we
misinterpreted certain of these policies principally related to
complex contractual arrangements with customers where multiple
deliverables were accounted for using the
percentage-of-completion method of accounting under
SOP 81-1.
Management’s determination that these errors required
correction led to the Audit Committee’s decision on
March 9, 2006 to effect a further restatement of our
consolidated financial statements. The need for the Third
Restatement resulted in a delay in filing our and NNL’s
Annual Report on Form 10-K for the year ended
December 31, 2005, or the 2005 Annual Reports, and our
anticipated delay in filing the 2006 First Quarter Reports.
Following the announcement of the Third Restatement on
March 10, 2006, the Audit Committee directed the Internal
Audit group to conduct a review of the facts and circumstances
surrounding the Third Restatement principally to review the
underlying conduct of the initial recording of the errors and
any overlap of items restated in the Third Restatement and the
Second Restatement, or the Internal Audit Review. Internal Audit
engaged third party forensic accountants to assist in the
review. The work underlying the review is substantially
complete. Internal Audit continues to review and assess its work
and upon completion, will report its findings to the Audit
Committee.
For more information on our restatements and related matters,
see the “MD&A” and the “Controls and
Procedures” sections of this report and note 4 of the
accompanying audited consolidated financial statements. As a
result of these events, we have become subject to the following
key risks, each of which is described in more detail below. Each
of these risks could have a material adverse effect on our
business, results of operations, financial condition and
liquidity.
•
We are subject to ongoing regulatory and criminal investigations
in the U.S. and Canada, which could require us to pay
substantial fines or other penalties and we cannot predict the
timing of developments in these matters.
•
It is uncertain at this time if and when the Proposed
Class Action Settlement will be finalized and approved. If
the Proposed Class Action Settlement is finalized and
approved, it would require us to pay $575 million in cash
and would result in the dilution of existing equity position.
•
We are subject to additional significant pending civil
litigation actions, which are not encompassed by the Proposed
Class Action Settlement and which, if decided against us or
as a result of settlement, could require us to pay substantial
judgments, settlements, fines or other penalties and could
result in the dilution of existing equity positions, and we
cannot predict the timing of developments in these matters.
•
Material adverse legal judgments, fines, penalties or
settlements, including the Proposed Class Action
Settlement, could have a material adverse effect on our
business, results of operations, financial condition and
liquidity, which could be very significant.
•
We and our independent registered chartered accountants have
identified a number of material weaknesses related to our
internal control over financial reporting and we have concluded
that our internal control over financial reporting was
ineffective as of December 31, 2005. These material
weaknesses remain unremedied, which could continue to impact our
ability to report our results of operations and financial
condition accurately and in a timely manner.
20
•
Full implementation of the governing principles of the
Independent Review as they relate to remedial measures and the
full remediation of our material weaknesses, internal control
over financial reporting and disclosure controls and procedures
will continue to take significant time and effort.
•
Our credit ratings are below investment grade, and we are
currently unable to access, in its current form, our shelf
registration statement filed with the SEC, each of which may
adversely affect our liquidity.
•
Continuing negative publicity has adversely affected and may
continue to adversely affect our business and the market price
of our publicly traded securities.
•
We may not be able to attract or retain the personnel necessary
to achieve our business objectives.
•
The delay in filing of our and NNL’s 2005
Form 10-K and
related matters caused us, and the anticipated delay in filing
the 2006 First Quarter Reports will cause us, to breach our
public debt indentures and seek waivers from our lenders under
the 2006 Credit Facility and from EDC under the EDC Support
Facility, which may affect our liquidity. We and NNL are
currently in discussions with these lenders and EDC to negotiate
waivers and, although we expect we will reach agreement with the
lenders and EDC with respect to the terms of an acceptable
waiver, there can be no assurance we will obtain such waivers.
Any future delays in filing our periodic reports could cause us
to breach our public debt indentures and our obligations under
our credit and support facilities. In such circumstances, it is
possible that the holders of our public debt or our lenders
would seek to accelerate the maturity of our debt or that EDC or
the lenders would not grant us further waivers.
•
The anticipated delay in filing the 2006 First Quarter Reports
or any other future breach of the continued listing requirements
of the NYSE and/or TSX could cause the NYSE and/or the TSX to
commence suspension or delisting procedures.
•
Our senior management and Board of Directors have been required
to devote significant time to our multiple restatements and
related matters, which could have an adverse impact on our
business and operational activities.
We are subject to ongoing regulatory and criminal
investigations in the U.S. and Canada, which could require us to
pay substantial fines or other penalties or subject us to
sanctions and we cannot predict the timing of developments in
these matters.
We are under investigation by the SEC and the Ontario Securities
Commission, or OSC. On April 5, 2004, we announced that the
SEC had issued a formal order of investigation in connection
with our previous restatement of financial results for certain
periods and our announcements in March 2004 regarding the likely
need to revise certain previously announced results and restate
previously filed financial results for one or more earlier
periods.
On April 13, 2004, we announced that we had received a
letter from the staff of the OSC advising us of an OSC
Enforcement Staff investigation into the same matters that are
the subject of the SEC investigation.
We have also received U.S. federal grand jury subpoenas for
the production of certain documents sought in connection with an
ongoing criminal investigation being conducted by the
U.S. Attorney’s Office for the Northern District of
Texas, Dallas Division. On August 23, 2005, we received an
additional U.S. federal grand jury subpoena in this
investigation seeking production of additional documents,
including documents relating to the Nortel Retirement Income
Plan and the Nortel Long Term Investment Plan. Further, on
August 16, 2004, we received a letter from the Integrated
Market Enforcement Team of the Royal Canadian Mounted Police
advising us that it would be commencing a criminal investigation
into our financial accounting situation.
We cannot predict when these investigations will be completed or
the timing of any other developments, nor can we predict what
the results of these investigations may be. The Proposed
Class Action Settlement does not relate to these ongoing
investigations and related matters.
Expenses incurred in connection with these investigations (which
include substantial fees of lawyers and other professional
advisors and potential obligations to indemnify officers and
directors who may be parties to such actions) could adversely
affect our cash position. We may be required to pay material
judgments, fines, penalties or settlements, consent to
injunctions on future conduct, implementation of further
remedial measures, the appointment of an independent adviser to
review, assess and monitor our accounting practices, financial
reporting and disclosure processes and internal control systems
or suffer other penalties, each of which could have a material
adverse effect on our business, results of operations, financial
condition and liquidity. The reserve recorded as a charge to our
2005 financial results in connection with the Proposed
Class Action Settlement does not relate to these ongoing
investigations and related matters, and we have not taken any
reserves for any potential judgments, fines, penalties or
settlements that may arise from these investigations. The
investigations may adversely affect our ability to obtain,
and/or increase the cost of obtaining, directors’ and
officers’ liability insurance and/or other types of
insurance, which could have a material adverse effect on our
business, results of operations and financial condition. In
addition, the findings and outcomes of the
21
regulatory and criminal investigations may adversely affect the
course of the civil litigation pending against us, which are
more fully described below.
The effects and results of these or other investigations may
have a material adverse effect on our business, results of
operations, financial condition and liquidity.
It is uncertain at this time if and when the Proposed
Class Action Settlement will be finalized and approved. If
the Proposed Class Action Settlement is finalized and
approved, it would require us to pay a substantial cash amount
and would result in a significant dilution of existing equity
positions.
On February 8, 2006, we first announced that, as a result
of the previously announced mediation process we entered into
with the lead plaintiffs in two significant class action
lawsuits pending in the U.S. District Court for the
Southern District of New York and based on the recommendation of
a senior Federal Judge, we and the lead plaintiffs have reached
an agreement in principle to settle these lawsuits.
This Proposed Class Action Settlement would be part of, and
is conditioned on, our reaching a global settlement encompassing
all pending shareholder class actions and proposed shareholder
class actions commenced against us and certain other defendants
following our announcement of revised financial guidance during
2001, and the Company’s revision of its 2003 financial
results and restatement of other prior periods (effected in
2005). Discussions are ongoing regarding a process to resolve
the Canadian actions as part of the terms of the Proposed
Class Action Settlement and we and the lead plaintiffs are
continuing discussions towards a definitive settlement
agreement. At this time, it is not certain that such an
agreement can be reached, that each of the actions noted above
can be brought into, or otherwise bound by, the proposed
settlement, if finalized, that such an agreement would receive
the required court and other approvals in all applicable
jurisdictions, and the timing of any developments related to
these matters is not certain. The Proposed Class Action
Settlement does not relate to the ongoing regulatory and
criminal investigations and related matters and does not
encompass a related Employment Retirement Income Security Act
action, or the ERISA Action, or the pending application in
Canada for leave to commence a derivative action against certain
current and former officers and directors of Nortel, or the
Pending Derivative Action.
Under the terms of the proposed global settlement contemplated
by the Proposed Class Action Settlement, we would, among
other things, make a payment of $575 million in cash and
issue 628,667,750 of Nortel Networks Corporation common shares
(representing 14.5% of our equity as of February 7, 2006).
The cash amount bears interest commencing March 23, 2006 at
a prescribed rate and is to be held in escrow on June 1,2006 pending satisfactory completion of all conditions of the
Proposed Class Action Settlement. In the event of a share
consolidation of Nortel Networks Corporation common shares, the
number of Nortel Networks Corporation common shares to be issued
pursuant to the Proposed Class Action Settlement would be
adjusted accordingly. As a result of the Proposed
Class Action Settlement, we have established a litigation
provision and recorded a charge to our full-year 2005 financial
results of $2,474 million, $1,899 million of which
relates to the proposed equity component of the Proposed
Class Action Settlement and will be adjusted in future
quarters until the finalization of the settlement based on the
market price of the Nortel Networks Corporation common shares
issuable. This quarterly adjustment of the litigation provision
may increase the fluctuations of our financial results and may
have a material adverse effect on our business, results of
operations and financial condition. Any change to the terms of
the Proposed Class Action Settlement would likely also
result in an adjustment to the litigation provision.
On March 17, 2006, we announced that our insurers agreed to
pay $228.5 million towards the settlement and we agreed
with the insurers to certain indemnification obligations. We
believe that these indemnification obligations would be unlikely
to materially increase our total payment obligations above
amounts already agreed to be paid under the Proposed
Class Action Settlement. If we have to indemnify our
insurers under these indemnification obligations, however, any
such payments could be material and have a material adverse
effect on our business, results of operations, financial
condition and liquidity. The insurance payments would not reduce
the amounts payable by us as noted above. We also agreed to
certain corporate governance enhancements, including the
codification or certain of our current governance practices
(such as the annual election by our directors of a non-executive
Board chair) in our Board of Directors written mandate and the
inclusion in our annual proxy circular and proxy statement of a
report on certain of our other governance practices (such as the
process followed for the annual evaluation of the Board,
committees of the Board and individual directors).
The total settlement amount, which would include all
plaintiffs’ court-approved attorneys’ fees, and
expenses incurred in connection with these matters (which
include substantial fees of lawyers and other professional
advisors and potential obligations to indemnify officers and
directors who may be parties to such actions) could have a
material adverse effect on our business, results of operations,
financial condition and liquidity. The equity component of the
Proposed
22
Class Action Settlement would result in a dilution of
existing equity positions, could contribute to volatility in the
market price of Nortel Networks Corporation common shares and
could materially and adversely impact our ability to effect
future financings with equity or equity related securities.
We cannot predict the timing of developments in respect of the
Proposed Class Action Settlement. For additional
information related to our legal proceedings, see the
“Legal Proceedings” section of this report and
“Contingencies” in note 22 of the accompanying
audited consolidated financial statements.
We are subject to additional significant pending civil
litigation actions, which are not encompassed by the Proposed
Class Action Settlement and which, if decided against us or
as a result of settlement, could require us to pay substantial
judgments, settlements, fines or other penalties and could
result in the significant dilution of existing equity positions,
and we cannot predict the timing of developments in these
matters.
In addition to the shareholder class actions encompassed by the
Proposed Class Action Settlement and litigation in the
ordinary course of business, we are currently, and may in the
future be, subject to class actions, other securities litigation
and other actions arising in relation to our accounting
restatements, including the ERISA Action and the Pending
Derivative Action. Any such additional litigation could be time
consuming, expensive and distracting from the conduct of our
daily business.
The adverse resolution of any specific lawsuit could have a
material adverse effect on our ability to favorably resolve
other lawsuits and on our financial condition and liquidity. We
are unable at this time to estimate what our ultimate liability
in these matters may be, and it is possible that we will be
required to pay substantial judgments, settlements or other
penalties and incur expenses that could have a material adverse
effect on our business, results of operations, financial
condition and liquidity, and such effects could be very
significant. Although we maintain certain insurance coverage, a
substantial amount of any such payments may not be covered by
insurance. Expenses incurred in connection with these matters
(which include substantial fees of lawyers and other
professional advisors and potential obligations to indemnify
officers and directors who may be parties to such actions) could
adversely affect our cash position. In addition, the resolution
of those matters may require us to issue equity or
equity-related securities, which could potentially result in the
significant dilution of existing equity positions. The reserve
recorded as a charge to our 2005 financial results in connection
with the Proposed Class Action Settlement does not relate
to these additional litigation matters, and we have not taken
any reserves for any potential judgments, settlements or other
penalties that may arise from this additional litigation.
We cannot predict the timing of developments in respect of these
litigation matters. For additional information related to our
legal proceedings, see the “Legal Proceedings” section
of this report and “Contingencies” in note 22 of
the accompanying audited consolidated financial statements.
Material adverse legal judgments, fines, penalties or
settlements, including the Proposed Class Action
Settlement, could have a material adverse effect on our
business, results of operations, financial condition and
liquidity, which could be very significant.
We estimate that our cash will be sufficient to fund the changes
to our business model in accordance with our strategic plan (see
“Business Overview — Our Strategy and
Outlook” in the MD&A section of this report), fund our
investments and meet our customer commitments for at least the
next twelve month period commencing December 31, 2005,
including cash expenditures outlined under “Liquidity and
Capital Resources — Future Uses of Liquidity” in
the “MD&A” section of this report. In making this
estimate, we have not assumed the need to make any payments in
respect of fines or other penalties or judgments or settlements
in connection with our pending civil litigation (other than
those encompassed by the Proposed Class Action Settlement)
or regulatory or criminal investigations related to the
restatements, which could have a material adverse effect on our
business, results of operations, financial condition and
liquidity, other than anticipated professional fees and
expenses. Any such payments (other than those encompassed by the
Proposed Class Action Settlement) could materially and
adversely affect our cash position, our available cash and cash
flow from operations may not be sufficient to pay them, and
additional sources of funding may not be available to us on
commercially reasonable terms or at all. In addition, we
continue to monitor the capital markets for opportunities to
refinance upcoming debt maturities, as more fully discussed
under “Our high level of debt could materially and
adversely affect our business, results of operations, financial
condition and liquidity.” If we are unable to refinance our
existing debt that is coming due in 2007, should we decide to do
so, the amount of cash available to finance our operations and
other business activities and our ability to pay any judgments,
fines, penalties or settlements, if any, would be significantly
reduced, which could have a material adverse effect on our
business, results of operations, financial condition and
liquidity.
23
These circumstances could have a material adverse effect on our
business, results of operations, financial condition and
liquidity, including by:
•
requiring us to dedicate a substantial portion of our cash
and/or cash flow from operations to payments of such judgments,
fines, penalties or settlements, thereby reducing the
availability of our cash and/or cash flow to fund working
capital, capital expenditures, R&D efforts and other general
corporate purposes, including debt reduction;
•
making it more difficult for us to satisfy our payment
obligations with respect to our outstanding indebtedness;
•
increasing the difficulty and/or cost to us of refinancing our
indebtedness;
•
adversely affecting our credit ratings;
•
increasing our vulnerability to general adverse economic and
industry conditions;
•
limiting our flexibility in planning for, or reacting to,
changes in our businesses and the industries in which we operate;
•
making it more difficult or more costly for us to make
acquisitions and investments;
•
limiting our ability to obtain, and/or increasing the cost of
obtaining, directors’ and officers’ liability
insurance and/or other types of insurance; and
•
restricting our ability to introduce new technologies and
products and/or exploit business opportunities.
We and our independent registered chartered accountants
have identified a number of material weaknesses related to our
internal control over financial reporting and concluded that our
internal control over financial reporting was ineffective as at
December 31, 2005. These material weaknesses remain
unremedied, which could continue to impact our ability to report
our results of operations and financial condition accurately and
in a timely manner.
Over the course of the First Restatement and Second Restatement,
we and our independent registered Chartered Accountants,
Deloitte & Touche LLP, or Deloitte, identified a number
of material weaknesses in our internal control over financial
reporting. In addition, our management assessed the
effectiveness of our internal control over financial reporting
as at December 31, 2005 pursuant to Section 404 of the
Sarbanes-Oxley Act of 2002 and the related SEC rules and
concluded that our internal control over financial reporting was
not effective as at December 31, 2005. Specifically, they
concluded that five material weaknesses continued to exist as at
December 31, 2005. Deloitte also reported on
management’s assessment of the effectiveness of our
internal control over financial reporting as at
December 31, 2005 and also concluded that our internal
control over financial reporting was not effective as at
December 31, 2005. The material weaknesses in our internal
control over financial reporting as at December 31, 2005,
which remain unremedied, are:
•
lack of compliance with written Nortel procedures for monitoring
and adjusting balances related to certain accruals and
provisions, including restructuring charges and contract and
customer accruals;
•
lack of compliance with Nortel procedures for applying
applicable generally accepted accounting principles, or GAAP, to
the initial recording of certain liabilities, including those
described in Statement of Financial Accounting Standards, or
SFAS, No. 5, “Accounting for Contingencies”, or
SFAS No. 5, and to foreign currency translation as
described in SFAS No. 52, “Foreign Currency
Translation”, or SFAS No. 52;
•
lack of sufficient personnel with appropriate knowledge,
experience and training in U.S. GAAP and lack of sufficient
analysis and documentation of the application of U.S. GAAP
to transactions, including, but not limited to, revenue
transactions;
•
lack of a clear organization and accountability structure within
the accounting function, including insufficient review and
supervision, combined with financial reporting systems that are
not integrated and which require extensive manual
interventions; and
•
lack of sufficient awareness of, and timely and appropriate
remediation of, internal control issues by Nortel personnel.
After considering these material weaknesses, among other
matters, our chief executive officer and chief financial officer
have also concluded, most recently as at December 31, 2005,
that our disclosure controls and procedures were not effective
to provide reasonable assurance that information required to be
disclosed in the reports we file and submit under the Exchange
Act is recorded, processed, summarized and reported as and when
required.
We continue to identify, develop and implement remedial measures
and compensating procedures to address these material
weaknesses. These material weaknesses, unless addressed, could
result in accounting errors such as those underlying the Third
Restatement and our prior restatements, as more fully discussed
in the “Controls and Procedures” section of this
report and our 2003 Annual Report. While our Board of Directors
has approved the adoption of all of the recommendations for
remedial measures contained in the “Summary of Findings and
of Recommended Remedial Measures of the Independent Review”
in the “Controls and Procedures” section of our 2003
Annual Report, and our
24
management has adopted a number of measures to strengthen our
internal control over financial reporting and address our
material weaknesses, we have not yet been able to address these
material weaknesses and they may continue to remain unremedied
for some time, which could adversely impact the accuracy and
timeliness of future reports and filings we make with the SEC
and OSC. In its assessment of our internal control over
financial reporting, management observed, among other things,
that (a) many of the reasons for weak internal control over
financial reporting are pervasive and relate to our
infrastructure and organization, (b) without significant
infrastructure changes, including changes to the information
systems and finance organizational structure, we will be
utilizing short-term, time-consuming workaround solutions to
address identified control issues as opposed to streamlining and
building sustainable processes that involve the effective
execution of stronger and more efficient monitoring and
preventative controls, (c) in order to fully remediate the
identified material weaknesses, we will need to put in place a
more rigorous management assessment process while continuing to
remedy deficiencies in the process, (d) a number of control
design deficiencies, including those at the entity level, result
in a control environment wherein the design or operation of the
internal control components would not reduce to a relatively low
level the risk that material misstatements caused by error or
fraud may occur and may not be detected within a timely period
in the normal course (entity level controls include those
controls that have a pervasive effect on the organization), and
(e) at the transaction process level, we need to improve
upon the balance between detective and preventative controls. We
continue to rely heavily on manual and detective controls and
experience a high volume of post-close accounting adjustments,
including out-of-period adjustments, all in the context of
processes that are complex and fragmented. See “Remedial
Measures” in the “Controls and Procedures”
section of this report.
In addition, in part as a result of the compensating procedures
and processes that we are applying to our financial reporting
process, during the preparation of our financial statements for
recent periods (including 2004, 2005 and interim periods in
2005), we identified a number of adjustments to correct
accounting errors related to prior periods, including the errors
corrected by the Third Restatement, as more fully described in
the “Controls and Procedures” section of this report.
As long as we continue to have material weaknesses in our
internal control over financial reporting, we may in future
identify similar adjustments to prior period financial
information. Adjustments that may be identified in the future
could require further restatement of our financial statements.
While we are implementing steps to restore the effectiveness of
our internal control over financial reporting and our disclosure
controls and procedures and to address the material weaknesses
identified above, failure to restore the effectiveness of our
internal control over financial reporting and our disclosure
controls and procedures could continue to impact our ability to
report our financial condition and results of operations
accurately and in a timely manner and could have a material
adverse effect on our business, results of operations, financial
condition and liquidity.
Full implementation of the governing principles of the
Independent Review as they relate to remedial measures, the full
remediation of our material weaknesses, internal control over
financial reporting, and disclosure controls and procedures will
continue to take significant time and effort.
We expect that the full implementation of the remedial measures
contained in the Independent Review Summary and full remediation
of our material weaknesses, our internal control over financial
reporting and our disclosure controls and procedures, will
continue to take significant time and effort, due largely to the
complexity and extensive nature of some of the remediation
required and a need to increase the co-ordination of remedial
efforts within the organization in order to implement one
comprehensive remediation plan with a well defined set of
objectives and agreed upon timelines. Management continues to
assess the internal and external resources that will be needed
to continue to implement, support, sustain and monitor the
effectiveness of our ongoing and future remedial measures. We
expect that our management will continue to devote significant
time to the remedial measures necessary to improve our process
and procedures, which could be time consuming and may disrupt
our business.
Our credit ratings are below investment grade, and we are
currently unable to access, in its current form, our shelf
registration statement filed with the SEC, each of which may
adversely affect our liquidity.
In 2004, after we had announced the likely need to revise
certain previously announced results and restate previously
filed financial statements for one or more periods,
Standard & Poor’s, or S&P, downgraded its
ratings of NNL. Currently, NNL’s long-term corporate credit
rating from S&P is “B-”, its short-term corporate
credit rating is “B-2” and its preferred share rating
is “CCC-”. NNL’s long-term corporate credit
rating from Moody’s is currently “B3” and its
preferred share rating is “Caa3”. On March 10,2006, as a result of the announcement of the Third Restatement,
S&P placed its rating on NNL, including the “B-”
long-term corporate rating, on creditwatch with negative
implications. These ratings are below investment grade. Our
credit ratings could be lowered or rating agencies could issue
adverse commentaries in the future, which could have a material
adverse effect on our business, results of
25
operations, financial condition and liquidity. These ratings and
our current credit condition affect, among other things, our
ability to raise debt, access the commercial paper market (which
is currently closed to us), engage in alternative financing
arrangements, obtain bank financings and our ability and the
cost to securitize receivables, obtain customer bid,
performance-related and other bonds and contracts and/or enter
into normal course derivative or hedging transactions. These
factors also affect the terms under which some customers and
suppliers are willing to continue to do business with us and the
price of our publicly traded securities.
Further, as a result of the delayed filing of our periodic
reports as a result of our multiple restatements, we and NNL
continue to be unable to use, in its current form as a
short-form shelf registration statement, the remaining
approximately $800 million of capacity for various types of
securities under our SEC shelf registration statement. We will
again become eligible for short-form shelf registration with the
SEC after we have completed timely filings of our financial
reports for twelve consecutive months. As a result, our current
ability to access the capital markets is constrained, which may
adversely affect our liquidity.
Continuing negative publicity has affected and may
continue to adversely affect our business and the market price
of our publicly traded securities.
As a result of our multiple restatements, we have been the
subject of continuing negative publicity. This negative
publicity has contributed to significant declines in the prices
of our publicly traded securities. This negative publicity has
and may have an effect on the terms under which some customers
and suppliers are willing to continue to do business with us and
could adversely affect our financial performance or financial
condition. Continuing negative publicity could continue to have
a material adverse effect on our business and the market price
of our publicly traded securities.
We may not be able to attract or retain the personnel
necessary to achieve our business objectives.
Competition for certain key positions and specialized technical
personnel in the high-technology industry remains strong. Our
future success depends in part on our continued ability to hire,
assimilate in a timely manner and retain qualified personnel,
particularly in key senior management positions and in our key
areas of potential growth. The loss of key managers could have a
material adverse effect on our business, results of operations
and financial condition.
An important factor in attracting and retaining qualified
employees is our ability to provide employees with the
opportunity to participate in the potential growth of our
business through programs such as stock option plans, restricted
stock unit plans and employee investment and share purchase
plans. The scope and value of these programs are adversely
affected by the volatility or negative performance of the market
price for Nortel Networks Corporation’s common shares. In
connection with our multiple restatements, we have suspended on
multiple occasions: the grant of any new equity and exercise or
settlement of previously outstanding awards under the Nortel
2005 Stock Incentive Plan, the purchase of Nortel Networks
Corporation common shares under the stock purchase plans for
eligible employees in eligible countries that facilitate the
acquisition of Nortel Networks Corporation common shares; the
exercise of outstanding options granted under the Nortel
Networks Corporation common shares; the exercise of outstanding
options granted under Nortel Networks Corporation 2000 Stock
Option Plan, or the 2000 Plan, or the Nortel Networks
Corporation 1986 Stock Option Plan as amended and restated, or
the 1986 Plan, or the grant of any additional options under
those plans, or the exercise of outstanding options granted
under employee stock option plans previously assumed by us in
connection with mergers and acquisitions; and the purchase of
units in Nortel Networks stock fund or purchase of our common
shares under our defined contribution and investments plans
until such time as, at the earliest, we are in compliance with
U.S. and Canadian regulatory securities filing requirements.
Similarly, in connection with our restatements, the OSC has
issued final orders prohibiting all trading by our directors,
officers and certain current and former employees in our
securities and those of NNL. Our current plan suspensions and
OSC order as a result of the Third Restatement remain in effect.
The OSC order will remain in effect until two full business days
following the receipt by the OSC of all filings required to be
made by us and NNL pursuant to Ontario securities law.
Accordingly, our ability to provide employees with the
opportunity to participate in our stock option plans, restricted
stock unit plans and employee investment and share purchase
plans has been adversely affected and certain employees have not
been able to trade in our securities. These plan suspensions and
OSC trading restrictions, and any future suspensions or trading
restrictions, may have a material adverse effect on our ability
to hire, assimilate in a timely manner and retain qualified
personnel.
In addition, in 2004, we terminated for cause our former
president and chief executive officer, former chief financial
officer, former controller and seven additional individuals with
significant responsibilities for financial reporting. We also
commenced litigation against our former president and chief
executive officer, former chief financial officer and former
controller, seeking the return of payments made to them under
our bonus plan in 2003, and as part of the Proposed
Class Action Settlement, we agreed to contribute one-half
of any recovery in these actions to the total settlement amount.
26
In August and September 2004, as part of our strategic plan, we
announced an anticipated workforce reduction of approximately
3,250 employees. Substantially all of the employee actions
related to the focused workforce reduction were completed by
September 30, 2005. In addition, in 2001, 2002 and 2003, we
implemented a company-wide restructuring plan, which included a
reduction of approximately two-thirds of our workforce over the
three-year period.
We may find it more difficult to attract or retain qualified
employees because of our recent significant workforce
reductions, business performance, management changes,
restatement activities and resulting negative publicity and the
resulting impacts on our incentive programs and incentive
compensation plans. If we have not properly sized our workforce
and retained those employees with the appropriate skills, our
ability to compete effectively may be adversely affected. We are
also more dependent on those employees we have retained, as many
have taken on increased responsibilities due to workforce
reductions. If we are not successful in attracting, recruiting
or retaining qualified employees, including members of senior
management, we may not have the personnel necessary to achieve
our business objectives, including the implementation of our
remedial measures. There also can be no assurance that our
management changes and workforce reductions will not have a
material adverse effect on our business, results of operations
and financial condition.
The delay in filing of our and NNL’s 2005
Form 10-K and
related matters caused us, and the anticipated delay in filing
the 2006 First Quarter Reports will cause us, to breach our
public debt indentures and seek waivers from our lenders under
the 2006 Credit Facility and from EDC under the EDC Support
Facility, which may affect our liquidity. There can be no
assurance that we will receive such waivers. Any future delays
in filing our periodic reports could cause us to breach our
public debt indentures and our obligations under our credit and
support facilities. In such circumstances, it is possible that
the holders of our public debt or our lenders would seek to
accelerate the maturity of our debt or that EDC or the lenders
would not grant us further waivers.
As a result of the delayed filing of the 2005 Annual Reports
with the SEC, an event of default occurred under the 2006 Credit
Facility. As a result of this and certain other related
breaches, lenders holding greater than 50% of each tranche under
the 2006 Credit Facility have the right to accelerate such
tranche, and lenders holding greater than 50% of all of the
secured loans under the 2006 Credit Facility have the right to
exercise rights against certain collateral. The entire
$1.3 billion under the 2006 Credit Facility is currently
outstanding.
In addition, as a result of the delayed filing of this report
with the SEC and other related breaches, EDC has the right to
refuse to issue additional support and terminate its commitments
under the EDC Support Facility, or require that NNL cash
collateralize all existing support. As at December 31,2005, there was approximately $162 million of outstanding
support under the EDC Support Facility.
As a result of the delayed filing of this report with the SEC,
we and NNL were not in compliance with our obligations to
deliver our SEC filings to the trustees under our public debt
indentures. The delay in filing this report did not result, and
the anticipated delay in filing the 2006 First Quarter Reports
(which we are obligated to deliver to the trustees by
May 25, 2006) will not result, in an automatic default and
acceleration of such long-term debt. Neither the trustee under
any such public debt indenture nor the holders of at least 25%
of the outstanding principal amount of any series of debt
securities issued under the indentures have the right to
accelerate the maturity of such debt securities unless we or
NNL, as the case may be, fail to file and deliver our required
SEC filings within 90 days after the above mentioned
holders have given notice of such default to us or NNL. While
such notice could have been given at any time after
March 30, 2006 as a result of the delayed filing of this
report, neither we nor NNL has received such a notice to the
date of this report. In addition, any acceleration of the loans
under the 2006 Credit Facility would result in a cross-default
under the public debt indentures that would give the trustee
under any such public debt indenture or the holders of at least
25% of the outstanding principal amount of any series of debt
securities issued under the indentures the right to accelerate
such series of debt securities. Approximately $500 million
of debt securities of NNL (or its subsidiaries) and
$1.8 billion of convertible debt securities of us
(guaranteed by NNL) are currently outstanding under the
indentures.
The delay in the filing of our 2006 First Quarter Report with
the SEC will result in a breach of our public debt indentures
and our obligations under the 2006 Credit Facility and the EDC
Support Facility and will require us to seek waivers for this
breach from EDC under the EDC Support Facility and our lenders
under the 2006 Credit Facility, which could reduce our access to
the EDC Support Facility and may adversely affect our liquidity.
In such circumstances, it is possible that the holders of our
public debt or the lenders under the 2006 Credit Facility would
seek to accelerate the maturity of that debt and that EDC our
lenders would not grant a waiver or that the terms of such a
waiver would be unfavorable.
We and NNL are currently in discussions with the lenders and EDC
to negotiate waivers under the 2006 Credit Facility and the EDC
Support Facility related to the Third Restatement and the delay
in filing the 2005 Annual Reports and the
27
anticipated delay in filing the 2006 First Quarter Reports. We
expect we will reach agreement with the lenders and EDC with
respect to the terms of an acceptable waiver, but there can be
no assurance we will obtain such waivers.
If an acceleration of our and NNL’s obligations were to
occur, we and NNL may be unable to meet our respective payment
obligations with respect to the related indebtedness. Any such
acceleration could also adversely affect our business, results
of operations, financial condition and liquidity and the market
price of our publicly traded securities.
The anticipated delay in filing the 2006 First Quarter
Reports or any other future breach of the continued listing
requirements of the NYSE and TSX could cause the NYSE and/or the
TSX to commence suspension or delisting procedures.
We have breached the continued listing requirements of the NYSE
and TSX by the delayed filing of this report and certain prior
periodic reports due to our multiple restatements. Any future
breach of the continued listing requirements, including related
to our anticipated delay in filing our 2006 First Quarter
Report, could cause the NYSE or TSX to commence suspension or
delisting procedures in respect of Nortel Networks Corporation
common shares or other of our or NNL’s listed securities.
The commencement of any suspension or delisting procedures by
either exchange remains, at all times, at the discretion of such
exchange and would be publicly announced by the exchange.
If a suspension or delisting were to occur, there would be
significantly less liquidity in the suspended or delisted
securities. In addition, our ability to raise additional
necessary capital through equity or debt financing, and attract
and retain personnel by means of equity compensation, would be
greatly impaired. Furthermore, with respect to any suspended or
delisted securities, we would expect decreases in institutional
and other investor demand, analyst coverage, market making
activity and information available concerning trading prices and
volume, and fewer broker-dealers would be willing to execute
trades with respect to such securities. A suspension or
delisting would likely decrease the attractiveness of Nortel
Networks Corporation common shares or other listed securities of
Nortel Networks Corporation and NNL to investors and cause the
trading volume of Nortel Networks Corporation common shares or
other listed securities of Nortel Networks Corporation and NNL
to decline, which could result in a decline in the market price
of such securities.
Risks Relating to Our Business
Our operating results have historically been subject to
yearly and quarterly fluctuations and are expected to continue
to fluctuate, which may adversely affect the market price of our
publicly traded securities. Factors contributing to these
fluctuations could have a material adverse effect on our
business, results of operations and financial condition.
Our operating results have historically been, and are expected
to continue to be, subject to quarterly and yearly fluctuations
as a result of a number of factors. These factors include:
•
our ability to stimulate customer spending by anticipating and
offering products and services that customers will require in
the future to increase the efficiency and profitability of their
networks;
•
our ability to focus our business on what we believe to be
potentially higher growth and higher margin businesses while
balancing the higher operational and financial risks associated
with these higher growth and higher margin businesses;
•
our ability to enter into strategic alliances and make
investments, including acquisitions, to strengthen our business
and to dispose of or exit non-core businesses;
•
the impact of acquired businesses and technologies on our
revenues and cost structure;
•
the size and timing of customer orders and shipments;
•
the recognition and deferral of revenues in accordance with
GAAP, which can vary significantly depending on contractual
practices and associated selling processes;
•
our ability to fund and sustain our research and development
activities and their impact on the development of future
products;
•
the ability of our customers and suppliers to obtain financing
to fund capital expenditures;
•
the impact of global economic conditions and other trends and
factors affecting the telecommunications industry that are
beyond our control, which may result in reduced demand and
pricing pressure on our products, as discussed below;
•
fluctuations in our gross margins, as discussed below;
•
our ability to execute our strategic plan and to successfully
complete programs on a timely basis to reduce our cost
structure, including fixed costs, without negatively impacting
our relationships with our customers, to streamline our
operations and to reduce product costs;
28
•
the impact of our product development schedules, product quality
variances, manufacturing capacity and lead times required to
produce our products and ability to successfully manage our
supply-chain and contract manufacturers;
•
our ability to maintain appropriate inventory levels;
•
our ability to focus on the
day-to-day operation of
our business while effecting our multiple restatements,
implementing improvements to our internal controls and
procedures, including our accounting systems, internal processes
and organizations, finalizing and implementing the Proposed
Class Action Settlement and addressing the other civil
litigation actions and investigations related to our
restatements;
•
the retention of qualified personnel and our ability to
stabilize and develop our senior management team;
•
the litigation reserve recorded in connection with the Proposed
Class Action Settlement, the equity component of which will
be adjusted in future quarters until the finalization of the
settlement;
•
our ability to obtain payment from customers on a timely basis
and the related impact on provisions;
•
the inherent uncertainties of using forecasts, estimates and
assumptions for asset valuations and in determining the amounts
of accrued liabilities, provisions, including with respect to
customer payments, and other items in our consolidated financial
statements;
•
the impact of changes in global capital markets and interest
rates, including on our pension plan assets and obligations;
•
the impact of fair value accounting for employee stock options
which requires us to record an expense over the stock option
vesting period, based on the fair value at the date the options
are granted;
•
the requirement to perform goodwill impairment tests on an
annual basis and between annual tests in certain circumstances,
to value our deferred tax assets and to partially accrue
unfunded pension liabilities;
•
the impact of agreements we have entered into that may require
us to make certain indemnification payments to third parties in
the event of certain changes in an underlying economic
characteristic related to assets, liabilities or equity
securities of such third parties. The occurrence of events that
may cause us to become liable to make an indemnification payment
may be beyond our control and an obligation to make a
significant indemnification payment under such agreements could
have a negative effect on our reported results;
•
our ability to successfully comply with increased and complex
regulations;
•
accruals for employee incentive bonuses;
•
further restructuring costs; and
•
the impact of higher insurance premiums and deductibles and
greater limitations on insurance coverage.
As a consequence, operating results for a particular future
period are difficult to predict, and therefore, prior results
are not necessarily indicative of results in future periods. In
addition, our results for any particular period may be adversely
affected by developments in the ongoing litigation and
investigations relating to our restatements. Any of the
foregoing factors, or any other factors described herein, could
have a material adverse effect on our business, results of
operations and financial condition that could adversely affect
the market price of our publicly traded securities.
Global economic conditions and other trends and factors
affecting the telecommunications industry are beyond our control
and may result in reduced demand and pricing pressure on our
products.
Certain trends and factors which may affect the industry are
beyond our control and may adversely affect our business and
results of operations. These trends and factors include:
•
adverse changes in the public and private equity and debt
markets and our ability, as well as the ability of our customers
and suppliers, to obtain financing or to fund working capital
and capital expenditures;
•
adverse changes in the credit quality of our customers and
suppliers;
•
adverse changes in the market conditions in our industry and the
specific markets for our products;
•
the trend towards the sale of converged networking solutions,
which could lead to reduced capital spending on multiple
networks by our customers, and other significant technology
shifts which could result in rapidly declining markets,
including for our legacy products, and disproportionate growth
in new technologies;
•
visibility to, and the actual size and timing of, capital
expenditures by our customers;
•
inventory practices, including the timing of product and service
deployment, of our customers;
•
the amount of network capacity and the network capacity
utilization rates of our customers, and the amount of sharing
and/or acquisition of new and/or existing network capacity by
our customers;
•
policies of our customers regarding utilization of single or
multiple vendors for the products they purchase;
•
the overall trend toward industry consolidation and
rationalization among our customers, competitors and suppliers;
29
•
conditions in the broader market for communications products,
including data networking products and computerized information
access equipment and services;
•
increased price competition, particularly from low cost
competitors;
•
changes in legislation or accounting rules and governmental and
environmental regulation or intervention affecting
communications or data networking;
•
computer viruses, break-ins and similar disruptions from
unauthorized tampering with our computer systems;
•
acts of war, terrorism or natural disasters that could lead to
disruptions in general global economic activity, changes in
logistics and security arrangements and reduced customer demand
for our products and services; and
•
cautious capital spending in our industry, which has affected,
and could affect, demand for, or pricing pressures on, our
products.
We face significant competition, may not be able to
maintain our market share and may suffer from competitive
pricing practices.
We operate in a highly volatile industry that is characterized
by industry rationalization and consolidation, vigorous
competition for market share and rapid technological
development. Competition is heightened in periods of slow
overall market growth. These factors could result in aggressive
pricing practices and growing competition from smaller niche
companies and established competitors, as well as
well-capitalized computer systems and communications companies,
which, in turn, could separately or together with consolidation
in the industry have a material adverse effect on our gross
margins.
Since some of the markets in which we compete are characterized
by the potential for rapid growth and, in certain cases, low
barriers to entry and rapid technological changes, smaller,
specialized companies and
start-up ventures are
now, or may in the future become, principal competitors. We may
also face competition from the resale of used telecommunications
equipment, including our own, by failed, downsized or
consolidated high technology enterprises and telecommunications
service providers. In addition, we face the risk that certain of
our competitors may enter into additional business combinations,
accelerate product development, or engage in aggressive price
reductions or other competitive practices, which could make them
larger, more diversified, lower cost, better capitalized, more
powerful or more aggressive competitors.
We expect that we will face additional competition from existing
competitors and from a number of companies that have entered or
may enter our existing and future markets. In particular, we
currently, and may in the future, face increased competition
from low cost competitors such as Huawei, ZTE Corporation and
other aggressive entrants in the market seeking to grow market
share. Some of our current and potential competitors have
substantially greater marketing, technical and financial
resources, including access to capital markets and/or the
ability to provide customer financing in connection with the
sale of products. Many of our current and potential competitors
have also established, or may in the future establish,
relationships with our current and potential customers. Other
competitive factors include the ability to provide new
technologies and products,
end-to-end networking
solutions, and new product features, such as security, as well
as conformance to industry standards. Increased competition
could result in price reductions, negatively affecting our
operating results and reducing profit margins, and could
potentially lead to a loss of market share.
We may be materially and adversely affected by cautious
capital spending by our customers. Increased consolidation among
our customers and the loss of customers in certain markets could
have a material adverse effect on our business, results of
operations and financial condition.
Continued cautiousness in capital spending by service providers
and other customers may affect our revenues more than we
currently expect and may require us to adjust our current
business model. Our revenues and operating results have been and
may continue to be materially and adversely affected by the
continued cautiousness in capital spending by our customers. We
have focused on the larger customers in certain markets, which
provide a substantial portion of our revenues. Increased
industry consolidation among our customers may lead to downward
pressure on the prices of our products, reduced spending, or a
loss, reduction or delay in business from one or more of these
customers. Such increased industry consolidation among our
customers, reduced spending, a loss, reduction or delay in
business from one or more of these customers, or a failure to
achieve a significant market share with these customers, could
have a material adverse effect on our business, results of
operations, financial condition and liquidity. As a result, our
revenues and cash flows may be materially lower than we expect
and we may be required to further reduce our capital
expenditures and investments or take other measures in order to
meet our cash requirements.
30
Rationalization and consolidation in the industry may lead
to increased competition and harm our business.
The industry has experienced consolidation and rationalization
and we expect this trend to continue. There have been adverse
changes in the public and private equity and debt markets for
industry participants, which have affected their ability to
obtain financing or to fund capital expenditures. Some industry
participants have experienced financial difficulty and have
filed, or may file, for bankruptcy protection or may be acquired
by other industry participants. Other industry participants may
merge and we and one or more of our competitors may each supply
products to the companies that have merged or will merge. This
rationalization and/or consolidation could result in our
dependence on a smaller number of customers, purchasing decision
delays by the merged companies and/or our playing a lesser role,
or no longer playing a role, in the supply of communications
products to the merged companies and downward pressure on
pricing of our products. This rationalization and/or
consolidation could also cause increased competition among our
customers and pressure on the pricing of their products and
services, which could cause further financial difficulties for
our customers and result in reduced spending. A rationalization
of industry participants could also increase the supply of used
communications products for resale, resulting in increased
competition and pressure on the pricing for our new products. In
addition, telecommunications equipment suppliers may enter into
business combinations, including the proposed merger of Lucent
and Alcatel, or may be acquired by or sell a substantial portion
of their assets to other competitors, resulting in accelerated
product development, increased financial strength, or a broader
base of customers, creating even more powerful or aggressive
competitors. We may also see rationalization among
equipment/component suppliers. The business failures of
operators, competitors or suppliers may cause uncertainty among
investors and in the industry generally and harm our business.
We operate in highly dynamic and volatile industries
characterized by rapidly changing technologies, evolving
industry standards, frequent new product introductions and short
product life cycles.
The markets for our products are characterized by rapidly
changing technologies, evolving industry standards, frequent new
product introductions and short product life cycles. Our success
depends, in substantial part, on the timely and successful
introduction of high quality new products and upgrades to
replace our legacy products with declining market demand, as
well as cost reductions on current products to address the
operational speed, bandwidth, efficiency and cost requirements
of our customers. Our success will also depend on our ability to
comply with emerging industry standards, to operate with
products of other suppliers, to integrate, simplify and reduce
the number of software programs used in our portfolio of
products, to address emerging market trends, to provide our
customers with new revenue-generating opportunities and to
compete with technological and product developments carried out
by others. The development of new, technologically advanced
products, including
IP-optimized networking
solutions, software products and 3G wireless networks, is a
complex and uncertain process resulting in the increasing
importance of maintaining financial flexibility to react to
changing market conditions and requiring significant R&D
commitments and high levels of innovation, as well as the
accurate anticipation of technological and market trends.
Investments in this environment may result in our R&D and
other expenses growing at a faster rate than our revenues,
particularly since the initial investment to bring a product to
market may be high or market trends could change unexpectedly.
We may not be successful in targeting new market opportunities,
in developing and commercializing new products in a timely
manner or in achieving market acceptance for our new products.
The success of new or enhanced products, including
IP-optimized networking
solutions and 3G wireless networks, depends on a number of
other factors, including the timely introduction of those
products, market acceptance of new technologies and industry
standards, the quality and robustness of new or enhanced
products, competing product offerings, the pricing and marketing
of those products and the availability of funding for those
networks. Products and technologies developed by our competitors
may render our products obsolete. Hackers may attempt to disrupt
or exploit our customers’ use of our technologies. If we
fail to respond in a timely and effective manner to
unanticipated changes in one or more of the technologies
affecting telecommunications and data networking or our new
products or product enhancements fail to achieve market
acceptance, our ability to compete effectively in our industry,
and our sales, market share and customer relationships could be
materially and adversely affected.
In addition, unanticipated changes in market demand for products
based on a specific technology, particularly lower than
anticipated, or delays in, demand for
IP-optimized networking
solutions, particularly long-haul and metro optical networking
solutions, or 3G wireless networks, could have a material
adverse effect on our business, results of operations and
financial condition if we fail to respond to those changes in a
timely and effective manner.
31
Our performance may be materially and adversely affected
if our expectations regarding market demand for particular
products prove to be wrong.
We expect that data communications traffic will grow at a faster
rate than the growth expected for voice traffic and that the use
of the Internet will continue to increase. We expect the growth
of data traffic and the use of the Internet will significantly
impact traditional voice networks, both wireline and wireless.
We believe that this will create market discontinuities, which
will make traditional voice network products and services less
effective as they were not designed for data traffic. We believe
that these market discontinuities in turn will lead to the
convergence of data and voice through upgrades of traditional
voice networks to transport large volumes of data traffic or
through the construction of new networks designed to transport
both voice and data traffic. Either approach would require
significant capital expenditures by service providers. We also
believe that such developments will increase the demand for
IP-optimized networking
solutions, and 3G wireless networks.
We cannot be sure what the rate of this convergence of voice and
data networks will be, due to the dynamic and rapidly evolving
nature of the communications business, the technology involved
and the availability of capital. Consequently, market
discontinuities may occur and the demand for
IP-optimized networking
solutions or 3G wireless networks may be lower than
expected. Alternatively, the pace of that development may be
slower than currently anticipated. On a regional basis, growth
of our revenues from sales of our networking solutions in
developing countries, such as China and India, may be less than
we anticipate if current customer orders are not indicative of
future sales, strong growth in our UMTS technology does not
occur, we are unable to establish strategic alliances in key
markets or developing countries experience slower growth or
fewer deployments of VoIP and wireless data networks than we
anticipate.
The market may also develop in an unforeseen direction. Certain
events, including the commercial availability and actual
implementation of new technologies, including 3G wireless
networks, or the evolution of other technologies, may occur,
which would affect the extent or timing of anticipated market
demand, or increase demand for products based on other
technologies, or reduce the demand for
IP-optimized networking
solutions or 3G wireless networks. Any such change in
demand may reduce purchases of our networking solutions by our
customers, require increased expenditures to develop and market
different technologies, or provide market opportunities for our
competitors. Our performance may also be materially and
adversely affected by a lack of growth in the rate of data
traffic, a reduction in the use of the Internet or a reduction
in the demand for
IP-optimized networking
solutions or 3G wireless networks in the future, and slower
than anticipated revenue growth from our network solutions such
as Wireless Local Area Networks and carrier routing.
We also cannot be sure that the metro optical portion of our
Carrier Packet Networks business will continue to represent as
large of a percentage of our overall Carrier Packet Networks
revenues as we expect, or that our current growth in carrier
VoIP will continue, or that sales of our traditional circuit
switching solutions will not decline more rapidly than we
anticipate, or that the rate of decline will not continue to
exceed the rate of growth of our next generation solutions, any
of which could materially and adversely affect our business,
results of operations and financial condition.
We face certain barriers in our efforts to expand
internationally.
We intend to continue to pursue international and emerging
market growth opportunities. In many international markets,
long-standing relationships between potential customers and
their local suppliers and protective regulations, including
local content requirements and type approvals, create barriers
to entry. In addition, pursuing international opportunities may
require significant investments for an extended period before
returns on such investments, if any, are realized and such
investments may result in expenses growing at a faster rate than
revenues. Furthermore, those projects and investments could be
adversely affected by:
•
reversals or delays in the opening of foreign markets to new
competitors;
•
trade protection measures;
•
exchange controls;
•
currency fluctuations;
•
investment policies;
•
restrictions on repatriation of cash;
•
nationalization or regulation of local industry;
•
economic, social and political risks;
•
taxation;
•
interest rates;
•
challenges in staffing and managing international opportunities;
•
acts of war or terrorism;
32
•
natural disasters; and
•
other factors, depending on the country involved.
Difficulties in foreign financial markets and economies and of
foreign financial institutions, particularly in emerging
markets, could adversely affect demand from customers in the
affected countries. An inability to maintain or expand our
business in international and emerging markets while balancing
the higher operational and financial risks associated with these
markets could have a material adverse effect on our business,
results of operations and financial condition.
Our gross margins may decline, which would reduce our
operating results and could contribute to volatility in the
market price of our publicly traded securities.
Our gross margins may be negatively affected as a result of a
number of factors, including:
•
increased price competition in the networking industry,
particularly from low cost competitors;
•
increased industry consolidation and rationalization among our
customers, which may lead to decreased demand for, and downward
pricing pressure on the prices of, our products;
increased inventory provisions, obsolescence charges or contract
and customer settlement costs;
•
loss of cost savings on future inventory purchases as a result
of higher inventory levels;
•
increased warranty costs;
•
introduction of new products and costs of entering new markets;
•
customer requirements for increased level of service;
•
changes in distribution channels;
•
excess capacity or excess fixed assets;
•
accruals for employee incentive bonuses;
•
costs relating to our restatements, including the possibility of
substantial fines, settlements and/or damages or other penalties
and/or remedial actions; and
•
further restructuring costs.
Lower than expected gross margins would negatively affect our
operating results and could contribute to volatility in the
market price of our publicly traded securities.
Negative developments associated with our supply contracts
and contract manufacturing agreements including as a result of
using a sole supplier for key optical networking solutions
components may materially and adversely affect our business,
results of operations, financial condition and supply
relationships.
Some of our contracts with customers involve new technologies
currently being developed or that we have not yet commercially
deployed or that require us to build networks. Some of these
contracts contain delivery and installation timetables,
performance criteria and other contractual obligations which, if
not met, could result in our having to pay substantial penalties
or liquidated damages and/or the termination of the contract.
Our ability to meet these contractual obligations is, in part,
dependent on us obtaining timely and adequate component parts
and products from supply contracts and contract manufacturers.
Unexpected developments in these supply contracts could have a
material adverse effect on our revenues, cash flows and
relationships with our customers.
In particular, we currently rely on a sole supplier, Bookham,
Inc. or Bookham, for key optical networking solutions
components, and our supply of such components used in our
solutions could be materially adversely affected by adverse
developments in that supply arrangement with that supplier. In
December 2004, we entered into a restructuring agreement
with Bookham. In February 2005, we agreed to waive for a
period of time Bookham’s obligation to maintain a minimum
cash balance under certain secured and unsecured notes and in
May 2005 we agreed to adjust the prepayment provisions
under these notes, received additional collateral for these
notes and amended our supply agreement with Bookham to provide
Bookham with financial flexibility to continue the supply of
optical networking solutions components. In January 2006,
we amended the supply agreement to extend certain purchase
commitments and agreed to purchase a minimum of $72 million
in products from Bookham in 2006. The inability of this supplier
to meet its contractual obligations under our supply
arrangements and our inability to make alternative arrangements
could have a material adverse effect on our revenues, cash flows
and relationships with our customers. For more information, see
“Developments in 2005 and 2006 — Optical
Components Operations” in the “MD&A” section
of this report.
As part of the transformation of our supply chain from a
vertically integrated manufacturing model to a virtually
integrated model, we are in the process of finalizing the
outsourcing of substantially all of our manufacturing capacity to
33
contract manufacturers, including an agreement with Flextronics.
Commencing in the fourth quarter of 2004 and throughout 2005, we
completed the transfer to Flextronics of certain of our optical
design activities in Ottawa, Canada and Monkstown, Northern
Ireland and our manufacturing activities in Montreal, Canada and
Chateaudun, France. In order to allow completion of several
major information systems changes that are expected to simplify
and improve the quality of operations during the transaction, we
now expect to transfer the remaining manufacturing operations in
Calgary, Canada to Flextronics by the end of the second quarter
of 2006. We and Flextronics have agreed that we will retain our
Monkstown manufacturing operations and establish a regional
supply chain center to lead our EMEA supply chain operations.
Flextronics also has the ability in certain cases to exercise
rights to sell back to us certain inventory and equipment after
the expiration of a specified period (of up to fifteen months)
following each respective closing date. We do not expect such
rights to be exercised with respect to any material amount of
inventory and/or equipment. Upon the completion of the
divestiture, a significant portion of our supply chain will be
concentrated with Flextronics. There is no assurance that we
will be able to complete, on a timely basis or otherwise, the
remaining portion of the transaction with Flextronics, which
could materially and negatively impact our cash flows and
operating results. For more information, see “Developments
in 2005 and 2006 — Evolution of Our Supply Chain
Strategy” in the “MD&A” section of this
report.
We work closely with our suppliers and contract manufacturers to
address quality issues and to meet increases in customer demand,
when needed, and we also manage our internal manufacturing
capacity, quality, and inventory levels as required. However, we
may encounter shortages or interruptions in the supply of
quality components and/or products in the future. In addition,
our component suppliers and contract manufacturers have
experienced, and may continue to experience, a consolidation in
the industry and financial difficulties, both of which may
result in fewer sources of components or products and greater
exposure to the financial stability of our suppliers. A
reduction or interruption in component supply or external
manufacturing capacity, a significant increase in the price of
one or more components, or excessive inventory levels could
materially and negatively affect our gross margins and our
operating results and could materially damage customer
relationships.
Many of our current and planned products are highly
complex and may contain defects or errors that are detected only
after deployment in telecommunications networks, which could
harm our reputation and adversely affect our business, results
of operations and financial condition.
Our products are highly complex, and some of them can be fully
tested only when deployed in telecommunications networks or with
other equipment. From time to time, our products have contained
undetected defects, errors or failures. The occurrence of any
defects, errors or failures could result in cancellation of
orders, product returns, diversion of our resources, legal
actions by our customers or our customers’ end users and
other losses to us or to our customers or end users. We record
provisions for estimated costs related to warranties given to
customers on our products to cover defects. Our estimated
warranty obligation is based upon warranty terms, ongoing
product failure rates, historical material replacement costs and
the associated labor to correct the product defect. If actual
product failure rates, material replacement costs, service or
labor costs differ from our estimates, revisions to the
estimated warranty provision would be required. If we experience
an increase in warranty claims compared with our historical
experience, or if the costs of servicing warranty claims is
greater than the expectations on which the accrual is based, our
gross margin could be negatively affected. Any of these
occurrences could also result in the loss of or delay in market
acceptance of our products and loss of sales, which would harm
our business and adversely affect our business, results of
operations and financial condition. For more information on our
provisions for product warranties, see “Application of
Critical Accounting Policies and Estimates —
Provisions for Product Warranties” in the
“MD&A” section of this report.
Fluctuations in foreign currency exchange rates could
negatively impact our business, results of operations and
financial condition.
As an increasing proportion of our business may be denominated
in currencies other than U.S. dollars, fluctuations in
foreign currency exchange rates may have an adverse impact on
our business, results of operations and financial condition. Our
primary currency exposures are to Canadian dollars, British
pounds and the euro. These exposures may change over time as we
change the geographic mix of our global business and as our
business practices evolve. For instance, if we increase our
presence in emerging markets, we may see an increase in our
exposure to emerging market currencies, for example, the Indian
rupee. These currencies may be affected by internal factors and
external developments in other countries. Also, our ability to
enter into normal course derivative or hedging transactions in
the future may be impacted by our current credit condition. We
cannot predict whether foreign exchange losses will be incurred
in the future, and significant foreign exchange rate
fluctuations may have a material adverse effect on our business,
results of operations and financial condition.
34
We continue to restructure and transform our business to
respond to industry and market conditions and to address our
biggest operational and strategic challenges. The assumptions
underlying these efforts may prove to be inaccurate, or we may
fail to achieve the expected benefits from these efforts, and we
may have to restructure or transform our business again in the
future.
We continue to restructure and transform our business to realign
resources and achieve desired cost savings in an increasingly
competitive market. We have based our restructuring efforts on
certain assumptions regarding the cost structure of our
business. Our current assumptions may or may not be correct and
as a result, we may determine that further restructuring or
business transformation in the future will be needed. Our
restructuring efforts and business transformation may not be
sufficient for us to achieve improved results and meet the
changes in industry and market conditions, including increased
competition. In particular, we face increased competition from
low cost competitors such as Huawei and ZTE Corporation. We
must manage the potentially higher growth areas of our business,
which encompass higher operational and financial risks, as well
as the non-core areas, in order for us to achieve improved
results.
We have made, and will continue to make, judgments as to whether
we should further reduce our workforce or exit, or dispose of,
certain businesses. These workforce reductions may impair our
ability to achieve our current or future business objectives.
Costs incurred in connection with restructuring efforts may be
higher than estimated. Any decision by management to further
limit investment or exit, or dispose of, businesses may result
in the recording of additional charges. As a result, the costs
actually incurred in connection with the restructuring efforts
may be higher than originally planned and may not lead to the
anticipated cost savings and/or improved results.
As part of our review of restructured businesses, we look at the
recoverability of their tangible and intangible assets. Future
market conditions may trigger further write-downs of these
assets due to uncertainties in:
•
the estimates and assumptions used in asset valuations, which
are based on our forecasts of future business
performance; and
•
accounting estimates related to the useful life and
recoverability of the net book value of these assets, including
inventory, goodwill, net deferred taxes and other intangible
assets.
We will continue to review our restructuring work plan based on
our ongoing assessment of the industry and the business
environment.
We have also begun to focus on recent business transformation
objectives of business simplification (including pursuing market
opportunities where we can achieve a leadership position and at
least a 20 percent market share), quality improvement
(including implementation of a Six Sigma quality program),
reduced direct and indirect costs (including improved R&D
prioritization), and new revenue growth (including increased
sales and improved pricing effectiveness). There is no guarantee
that these strategic initiatives will improve our overall market
competitiveness and profitability or that they can be achieved
with our existing financial and managerial resources.
If market conditions deteriorate or future results of
operations are less than expected, an additional valuation
allowance may be required for all or a portion of our deferred
tax assets.
We currently have deferred tax assets, which may be used to
reduce taxable income in the future. We assess the realization
of these deferred tax assets quarterly, and if we determine that
it is more likely than not that some portion of these assets
will not be realized, an income tax valuation allowance is
recorded. If market conditions deteriorate or future results of
operations are less than expected, future assessments may result
in a determination that it is more likely than not that some or
all of our net deferred tax assets are not realizable. As a
result, we may need to establish an additional valuation
allowance for all or a portion of our net deferred tax assets,
which may have a material adverse effect on our business,
results of operations and financial condition.
If we fail to protect our intellectual property rights, or
if we are subject to adverse judgments or settlements arising
out of disputes regarding intellectual property rights, our
business, results of operations and financial condition could be
materially and adversely affected.
Our industry is subject to uncertainty over adoption of industry
standards and protection of intellectual property rights. Our
success is dependent on our proprietary technology, for the
protection of which we rely on patent, copyright, trademark and
trade secret laws. Our business is global and the level of
protection of our proprietary technology provided by those laws
varies by jurisdiction. Our issued patents may be challenged,
invalidated or circumvented, and our rights under issued patents
may not provide us with competitive advantages. Patents may not
be issued from pending applications, and claims in patents
issued in the future may not be sufficiently broad to protect
our proprietary technology. In addition, claims of intellectual
property infringement or trade secret misappropriation may be
asserted against us or our customers in connection with their
use of our products and the outcome of any of those claims may be
35
uncertain. An unfavorable outcome in such a claim could require
us to cease offering for sale the products that are the subject
of such a claim, pay substantial monetary damages to a third
party and/or make ongoing royalty payments to a third party. In
addition, any defense of claims of intellectual property
infringement or trade secret misappropriation may require
extensive participation by senior management and/or other key
employees and may reduce their time and ability to focus on
other aspects of our business. A failure by us to react to
changing industry standards, the lack of broadly-accepted
industry standards, successful claims of intellectual property
infringement or other intellectual property claims against us or
our customers, or a failure by us to protect our proprietary
technology could have a material adverse effect on our business,
results of operations and financial condition. In addition, if
others infringe on our intellectual property rights, we may not
be able to successfully contest such challenges.
Changes in regulation of the Internet and/or other aspects
of the industry may affect the manner in which we conduct our
business and may materially and adversely affect our business,
results of operations and financial condition.
Investment decisions of our customers could be affected by
regulation of the Internet or other aspects of the industry in
any country where we operate. We could also be materially and
adversely affected by an increase in competition among equipment
suppliers or by reduced capital spending by our customers, as a
result of a change in the regulation of the industry. If a
jurisdiction in which we operate adopts measures which affect
the regulation of the Internet and/or other aspects of the
industry, we could experience both decreased demand for our
products and increased costs of selling such products. Changes
in laws or regulations governing the Internet, Internet commerce
and/or other aspects of the industry could have a material
adverse effect on our business, results of operations and
financial condition.
In the U.S., on February 20, 2003, the FCC announced a
decision in its triennial review proceeding of the agency’s
rules regarding unbundled network elements, or UNE. The text of
the FCC’s order and reasons for the decision were released
on August 21, 2003. The uncertainty surrounding the impact
of the FCC’s decision, judicial review of the decision, the
adoption of interim rules, and the subsequent adoption of new
unbundling rules with an effective date of March 11, 2005
is affecting, and may continue to affect, the decisions of
certain of our
U.S.-based service
provider customers regarding investment in their
telecommunications infrastructure. These UNE rules and/or
material changes in other country-specific telecommunications or
other regulations may affect capital spending by certain of our
service provider customers, which could have a material adverse
effect on our business, results of operations and financial
condition.
In Europe, we are subject to new product content laws and
product takeback and recycling requirements that will require
full compliance commencing in July 2006. As a result of
these laws and requirements, we will incur additional compliance
costs. Although compliance costs relating to environmental
matters have not resulted in a material adverse effect on our
business, results of operations and financial condition in the
past, they may result in a material adverse effect in the
future. We are actively working on compliance plans and risk
mitigation strategies relating to the new laws and requirements.
We intend to manufacture products that are compliant with all
applicable legislation and meet our quality and reliability
requirements. Although we are working with our strategic
suppliers in this regard, it is possible that some of our
products may not be compliant by the legislated compliance date.
In such event, we expect that we will have the ability to rely
on available exemptions under the new legislation for most of
such products and currently do not expect significant disruption
to the distribution of such products.
We have made, and may continue to make, strategic
acquisitions. If we are not successful in operating or
integrating these acquisitions, our business, results of
operations and financial condition may be materially and
adversely affected.
From time to time, we acquire companies that we believe would
enhance the expansion of our business and products. We may make
selective opportunistic acquisitions of companies or businesses
with resources and product or service offerings capable of
providing us with additional product and/or market strengths.
For example, in June 2005, we acquired PEC and in
February 2006, we acquired Tasman Networks. Acquisitions
involve significant risks and uncertainties, including:
•
the industry may develop in a different direction than
anticipated and the technologies we acquire may not prove to be
those we need or the business model of acquired companies may
become obsolete;
•
the future valuations of acquired businesses may decrease from
the market price we paid for these acquisitions;
•
the revenues of acquired businesses may not offset increased
operating expenses associated with these acquisitions;
•
potential difficulties in completing in-process research and
development projects and delivering high quality products to our
customers;
36
•
potential difficulties in integrating new products, software,
internal controls, businesses and operations in an effective and
timely manner or at all;
•
our customers or customers of the acquired businesses may defer
purchase decisions as they evaluate the impact of the
acquisitions on our future product strategy;
•
potential loss of key employees of the acquired businesses;
•
diversion of the attention of our senior management from the
operation of our daily business;
•
entering new markets in which we have limited experience and
where competitors may have a stronger market presence;
•
the potential adverse effect on our cash position as a result of
all or a portion of an acquisition purchase price being paid in
cash;
•
potential issuance of equity or equity related securities as a
result of all or a portion of an acquisition purchase price
being paid with such equity or equity related securities, which
could result in the significant dilution of existing equity
positions; and
•
potential assumption of liabilities.
Our inability to successfully operate and integrate newly
acquired businesses appropriately, effectively and in a timely
manner could have a material adverse effect on our ability to
take advantage of further growth in demand for
IP-optimized network
solutions and other advances in technology, as well as on our
revenues, gross margins and expenses.
Acquisitions are inherently risky, and no assurance can be given
that our previous or future acquisitions will be successful and
will not materially adversely affect our business, operating
results or financial condition. Failure to manage and
successfully integrate acquisitions could materially harm our
business and operating results.
Our business may suffer if our strategic alliances are not
consummated or are not successful.
We have announced a number of strategic alliances with
suppliers, developers and members in our industry to facilitate
product compatibility, encourage adoption of industry standards
or to offer complementary product or service offerings to meet
customer needs, including our joint venture with LG Electronics
and our proposed joint venture with Huawei. Our business may be
adversely affected if we are not able to reach definite
agreements with respect to previously announced strategic
alliances in a timely manner or at all. Furthermore, we believe
that cooperation between multiple vendors is critical to the
success of our communications solutions for both service
providers and enterprises. In some cases, the companies with
which we have strategic alliances also compete against us in
some of our business areas. If a member of a strategic alliance
fails to perform its obligations, if the relationship fails to
develop as expected or if the relationship is terminated, we
could experience delays in product availability or impairment of
our relationships with our customers. Our business may also be
adversely affected if our choice of strategic alliance
collaborators does not enable us to leverage our existing and
future product and service offerings in order to capitalize on
expected future market trends (such as convergence in the
enterprise market).
If we fail to adequately evolve our financial and
managerial control and reporting systems and processes, our
ability to manage and grow our business will be negatively
affected.
Our ability to successfully offer our products and implement our
business plan in a rapidly evolving market depends upon an
effective planning and management process. We will need to
continue to improve our financial and managerial control and our
reporting systems and procedures through initiatives such as our
global finance transformation project, which includes the global
implementation of SAP, in order to manage our business more
effectively in the future. If we fail to continue to implement
improved systems and processes, our ability to manage our
business and results of operation could be adversely affected.
Our risk management strategy may be not effective or not
commensurate to the risks we are facing.
We maintain global blanket policies of insurance of the types
and in the amounts of comparable companies of the same size and
in the same industry. We limit our exposure to risk through a
combination of levels of self-insurance and the purchase of
various insurance coverages. We have retained certain
self-insurance risks with respect to certain employee benefit
programs such as worker’s compensation, group health
insurance, life insurance and other types of insurance. Our
insurance program is based on various lines and limits of
coverage that provides what we think are appropriate levels of
retained and insured risks. Insurance is arranged with reliable,
financially stable insurance companies as rated by A. M. Best
Company, Inc. We combine comprehensive risk management programs
and the active management of claims handling and litigation
processes by using internal professionals and external technical
expertise to manage the risk we retain.
37
If this risk management strategy is not effective or is not
commensurate to the risks we are facing, these risks could have
a material adverse effect on our business, results of
operations, financial condition and liquidity.
Risks Relating to Our Liquidity, Financing Arrangements and
Capital
Cash flow fluctuations may affect our ability to fund our
working capital requirements or achieve our business objectives
in a timely manner. Additional sources of funds may not be
available on acceptable terms or at all.
Our working capital requirements and cash flows historically
have been, and are expected to continue to be, subject to
quarterly and yearly fluctuations, depending on such factors as
timing and size of capital expenditures, levels of sales, timing
of deliveries and collection of receivables, inventory levels,
customer payment terms, customer financing obligations and
supplier terms and conditions. As of December 31, 2005, our
primary source of liquidity was cash and we expect this to
continue throughout 2006. Based on past performance and current
expectations we do not expect our operations to generate
significant cash flow in 2006. In addition, in 2006, we expect
our continued transfer of certain manufacturing assets to
Flextronics, and the sale of other non-core assets to continue
to be a source of cash at similar levels as 2005 amounts. We
estimate that as our cash will be sufficient to fund the changes
to our business model in accordance with our strategic plan (see
“Business Overview — Our Strategy and
Outlook” in the MD&A section of this report), fund our
investments and meet our customer commitments for at least the
next twelve month period commencing December 31, 2005,
including cash expenditures outlined under “Liquidity and
Capital Resources — Future Uses of Liquidity” in
the “MD&A” section of this report. In making this
estimate, we have not assumed the need to make any payments in
respect of fines or other penalties or judgments or settlements
in connection with our pending civil litigation not encompassed
by the Proposed Class Action Settlement or regulatory or
criminal investigations related to the restatements, which could
have a material adverse effect on our business, results of
operations, financial condition and liquidity, other than
anticipated professional fees and expenses. As more fully
discussed under “Material adverse legal judgments, fines,
penalties or settlements, including the Proposed
Class Action Settlement, could have a material adverse
effect on our business, results of operations, financial
condition and liquidity, which could be very significant,”
these payments could materially and adversely affect our cash
position, our available cash and cash flow from operations may
not be sufficient to pay them, and additional sources of funding
may not be available to us on commercially reasonable terms or
at all.
We and NNI agreed to a demand right exercisable at any time
after May 31, 2006 pursuant to which we will be required to
take all reasonable actions to issue senior unsecured debt
securities in the capital markets to repay the 2006 Credit
Facility. There can be no assurance that we will be able to
refinance the 2006 Credit Facility by issuing unsecured debt
securities. Any inability to refinance the 2006 Credit Facility
would materially adversely affect our liquidity. In addition, we
continue to monitor the capital markets for opportunities to
refinance upcoming debt maturities, as more fully discussed
under “Our high level of debt could materially and
adversely affect our business, results of operations, financial
condition and liquidity.” If we are unable to refinance our
existing debt that is coming due in 2007, should we decide to do
so, the amount of cash available to finance our operations and
other business activities and our ability to pay any judgments,
fines, penalties or settlements, if any, would be significantly
reduced, which could have a material adverse effect on our
business, results of operations, financial condition and
liquidity.
Other factors, discussed more fully elsewhere in this section,
may also result in our net cash requirements exceeding our
current expectations and negatively affect the amount of cash
available to finance our operations and other business
activities, including:
•
a greater than expected slowdown in capital spending by service
providers and other customers or other changes to our business
model could result in materially lower revenues and cash flows;
•
costs incurred in connection with restructuring efforts may be
higher than originally planned and may not lead to the
anticipated cost savings;
•
changes in market demand for networking products, which may
require increased expenditures to develop and market different
technologies;
•
we may need to make larger contributions to our defined benefit
plans in North America and the United Kingdom, or U.K., and
retirement plans in other countries;
•
an increased portion of our cash and cash equivalents may be
restricted as cash collateral for customer performance bonds and
contracts if the industry or our current condition
deteriorates; and
•
an inability of our subsidiaries to provide us with funding in
sufficient amounts could adversely affect our ability to meet
our obligations.
We may seek additional funds from liquidity-generating
transactions and other sources of external financing (which may
include a variety of debt, convertible debt and/or equity
financings), but these financings may not be available to us on
38
acceptable terms or at all. In addition, we may not continue to
have access to the EDC Support Facility when and as needed. Our
inability to manage cash flow fluctuations resulting from the
above factors and the potential reduction, expiry or termination
of the EDC Support Facility could have a material adverse effect
on our ability to fund our working capital requirements from
operating cash flows and other sources of liquidity or to
achieve our business objectives in a timely manner. These
circumstances could, for example:
•
make it more difficult for us to satisfy our obligations under
our outstanding debt and other obligations and to pay any
judgments, fines, penalties or settlements in connection with
our pending civil litigation and investigations;
•
require us to delay or reduce capital expenditures or the
introduction of new products, sell assets and/or forego business
opportunities such as acquisitions, R&D projects or product
design enhancements;
•
increase our vulnerability to economic downturns, adverse
industry conditions and adverse developments in our business,
and limit our flexibility in planning for or reacting to such
changes; and
•
place us at a competitive disadvantage compared to competitors
that have greater liquidity.
Our high level of debt could materially and adversely
affect our business, results of operations, financial condition
and liquidity.
In order to finance our business, we have incurred significant
levels of debt. As of December 31, 2005, we had
approximately $3.9 billion of debt reflected on our
consolidated balance sheet, of which $3.6 billion was notes
outstanding under our public debt indentures and
$162 million was outstanding under the EDC Support
Facility. In February 2006, we borrowed $1.3 billion
under the 2006 Credit Facility and repaid $1.275 billion of
notes issued under our public debt indentures. In the future, we
may need to obtain additional sources of funding, which may
include debt or convertible debt financing. A high level of
debt, arduous or restrictive terms and conditions related to
accessing certain sources of funding, or any significant
reduction in, or access to, the EDC Support Facility, could
materially and adversely affect our ability to fund the
operations of our business.
Other effects of our high degree of leverage include the
following:
•
it could be more difficult for us to satisfy our obligations
under our outstanding debt and other obligations;
•
we may have difficulty borrowing money in the future or
accessing other sources of funding;
•
we may have difficulty refinancing our existing debt, should we
decide to do so, including the $150 million of outstanding
7.40% Notes due June 15, 2006 issued by an indirect
wholly owned finance subsidiary of NNL and the $1.3 billion
outstanding under the 2006 Credit Facility due in February 2007;
•
we may need to dedicate a substantial portion of our cash and
cash flow from operations to debt payments, thereby
significantly reducing the availability of our cash and cash
flow from operations for other purposes, including payments of
judgments, settlements, fines or other penalties and our
operational needs (for example, in order to meet our debt
service obligations, we may be required to delay or reduce
capital expenditures or the introduction of new products, sell
assets and/or forego business opportunities such as
acquisitions, R&D projects or product design enhancements);
•
increase our vulnerability to economic downturns, adverse
industry conditions and adverse developments in our business,
and limit our flexibility in planning for or reacting to such
changes; and
•
place us at a competitive disadvantage compared to competitors
that have less debt.
Covenants under the 2006 Credit Facility and the
EDC Support Facility impose operating and financial
restrictions on us, which may prevent us from capitalizing on
business opportunities.
The agreements governing our credit facilities contain covenants
that:
•
limit our ability to create liens on our assets and the assets
of substantially all of our subsidiaries in excess of certain
baskets and permitted amounts;
•
limit our ability and the ability of substantially all of our
subsidiaries to merge, consolidate, amalgamate with another
person;
•
require us to maintain a minimum level of Adjusted EBITDA
beginning with the twelve-month period ending March 31,2006 (for more information on Adjusted EBITDA, see
“Liquidity an Capital Resources — Future Sources
of Liquidity — Credit facilities” in the
“MD&A” section of this report);
•
require us to maintain at least $1 billion of unrestricted
cash at all times; and
•
restrict the ability of our subsidiaries to incur funded debt in
excess of certain amounts without guaranteeing NNL’s
obligations under the EDC Support Facility.
39
In addition, we may in the future incur and guarantee debt with
more restrictive covenants (including maintenance financial
tests) that impose significant operating and financial
restrictions, including restrictions on our ability to engage in
other business activities that may be in our best long-term
interests.
Failure to comply with the covenants under the credit facilities
could materially and adversely affect our business, results of
operations, financial condition and liquidity.
Certain provisions in the indentures governing certain of
our public debt issues, together with the provisions of the 2006
Credit Facility, severely limit our ability to incur certain
types of additional secured debt while the secured loans under
the 2006 Credit Facility are outstanding.
Provisions in the indentures governing certain of our public
debt issues require us to grant security to the holders of such
debt on an equal and ratable basis with any new secured debt in
excess of certain amounts. Because we have granted security to
secure a portion of the 2006 Credit Facility without equally and
ratably securing all of our outstanding public debt securities,
we are currently severely limited in our ability to incur
certain types of additional secured debt. Our failure to provide
security in accordance with the terms of these indentures upon
our incurrence of certain types of additional secured debt would
constitute events of default under such indentures, the 2006
Credit Facility and the EDC Support Facility, which could have a
significant impact on our liquidity and could adversely affect
our ability to conduct business or access the capital markets
and could adversely impact our credit ratings.
An increased portion of our cash and cash equivalents may
be restricted as cash collateral if we are unable to secure
alternative support for certain obligations arising out of our
normal course business activities.
The EDC Support Facility may not provide all the support we
require for certain of our obligations arising out of our normal
course of business activities. As of December 31, 2005,
there was approximately $162 million of outstanding support
utilized under the EDC Support Facility, approximately
$142 million of which was outstanding under the small bond
sub-facility. In addition, bid and performance related bonds
with terms that extend beyond December 31, 2007, which,
absent any early termination of the EDC Support Facility, is the
expiry date of this facility, are currently not eligible for the
support provided by the EDC Support Facility. Given that the EDC
Support Facility is used to support bid and performance bonds
with varying terms, including those with at least 365 days,
we may need to increase our use of cash collateral to support
these obligations beginning on January 1, 2007 absent a
further extension of the facility. Unless EDC agrees to extend
the facility or agrees to provide support outside the scope of
the facility, we may be required to provide cash collateral to
support these obligations. We cannot provide any assurance that
we will reach an agreement with EDC on these matters. EDC may
also suspend its obligation to issue NNL any additional support
if events occur that have a material adverse effect on
NNL’s business, financial position or results of
operations. If we do not have access to sufficient support under
the EDC Support Facility, and if we are unable to secure
alternative support, an increased portion of our cash and cash
equivalents may be restricted as cash collateral, which could
adversely affect our ability to fund some of our normal course
business activities, capital expenditures, R&D projects and
our ability to borrow in the future.
An inability of our subsidiaries to provide us with
funding in sufficient amounts could adversely affect our ability
to meet our obligations.
We may at times depend primarily on loans, dividends or other
forms of financing from our subsidiaries to meet our obligations
to pay interest and principal on outstanding public debt and to
pay corporate expenses. If our subsidiaries are unable to pay
dividends or provide us with loans or other forms of financing
in sufficient amounts, or if there are any restrictions on the
transfer of cash between us and our subsidiaries, including
commercial limitations on transfers of cash pursuant to our
joint ventures commitments, our liquidity and our ability to
meet our obligations could be adversely affected.
We may need to make larger contributions to our defined
benefit plans in the future.
We currently maintain various defined benefit plans in North
America and the U.K. which cover various categories of employees
and retirees, which represent our major retirement plans. In
addition, we have smaller retirement plans in other countries.
Our obligations to make contributions to fund benefit
obligations under these plans are based on actuarial valuations,
which themselves are based on certain assumptions about the
long-term operation of the plans, including employee turnover
and retirement rates, the performance of the financial markets
and interest rates. If experience differs from the assumptions,
the amounts we are obligated to contribute to the plans may
increase. In particular, the
40
performance of the financial markets is difficult to predict,
particularly in periods of high volatility in the equity
markets. If the financial markets perform lower than the
assumptions, we may have to make larger contributions in the
future than we would otherwise have to make and expenses related
to defined benefit plans could increase. Similarly, changes in
interest rates can impact our contribution requirements. In a
low interest rate environment, the likelihood of required
contributions in the future increases. If interest rates are
lower in the future than we assume they will be, then we would
probably be required to make larger contributions than we would
otherwise have to make. In addition, we are currently in
discussions with the Trustee of our pension plan in the U.K. to
establish a long-term funding agreement, which would increase
the level of contributions in 2006 and in subsequent years.
Industry concerns could continue and increase our exposure
to our customers’ credit risk and the risk that our
customers will not be able to fulfill their payment obligations
to us under customer financing arrangements.
The competitive environment in which we operate has required us
in the past to provide significant amounts of medium-term and
long-term customer financing. Customer financing arrangements
may include financing in connection with the sale of our
products and services, funding for certain non-product and
service costs associated with network installation and
integration of our products and services, financing for working
capital and equity financing. While we have significantly
reduced our customer financing exposure, we expect we may
continue in the future to provide customer financing to
customers in areas that are strategic to our core business
activity.
We expect to continue to hold most current and future customer
financing obligations for longer periods prior to any possible
placement with third-party lenders, due to, among other factors,
recent economic uncertainty in various countries, adverse
capital market conditions, our current credit condition, adverse
changes in the credit quality of our customers and reduced
demand for telecommunications financing in capital and bank
markets. In addition, risks generally associated with customer
financing, including the risks associated with new technologies,
new network construction, market demand and competition,
customer business plan viability and funding risks, may require
us to hold certain customer financing obligations over a longer
term. We may not be able to place any of our current or future
customer financing obligations with third-party lenders on
acceptable terms.
From time to time, certain of our customers may experience
financial difficulties and fail to meet their financial
obligations. When this occurs, we may incur charges for
provisions related to certain trade and customer financing
receivables. Any future financial difficulties experienced by
any of our customers could have a material adverse effect on our
cash flow and operating results.
Our stock price has historically been volatile and further
declines in the market price of our publicly traded securities
may negatively impact our ability to make future acquisitions,
raise capital, issue debt and retain employees.
Our publicly traded securities have experienced, and may
continue to experience, substantial price volatility, including
considerable decreases, particularly as a result of variations
between our actual or anticipated financial results and the
published expectations of analysts and as a result of
announcements by our competitors and us, including our
announcements related to our multiple restatements, the
Independent Review, the Revenue Independent Review, our
management changes, the regulatory and criminal investigations,
the Proposed Class Action Settlement, the other civil
litigation proceedings and related matters. The proposed
issuance of 628,667,750 Nortel Networks Corporation common
shares (representing 14.5% of our equity as of February 7,2006) under the Proposed Class Action Settlement, if
finalized and approved, will result in dilution of existing
equity positions and may increase volatility in the market price
of Nortel Networks Corporation common shares or our other
publicly traded securities. Our credit quality, any equity or
equity related offerings, operating results and prospects,
restatements of previously issued financial statements, any
exclusion of our publicly traded securities from any widely
followed stock market indices, among other factors, will also
affect the market price of our publicly traded securities.
The stock markets have experienced extreme price fluctuations
that have affected the market price and trading volumes of many
technology and telecommunications companies in particular, with
potential consequential negative effects on the trading of
securities of those companies. A major decline in the capital
markets generally, or an adjustment in the market price or
trading volumes of our publicly traded securities, may
negatively impact our ability to raise capital, issue debt,
secure customer business, retain employees or make future
acquisitions. These factors, as well as general economic and
geopolitical conditions, and continued negative events within
the technology sector, may in turn have a material adverse
effect on the market price of our publicly traded securities.
41
The proposed share consolidation could result in a lower
total market capitalization or adversely affect the liquidity of
our common shares. A consolidation could make it more difficult
or more expensive for shareholders to sell their shares.
Numerous factors and contingencies could affect our share price
following a share consolidation, including the status of the
market for the common shares at the time, our reported results
of operations in future periods, and general economic,
geopolitical, stock market and industry conditions. Accordingly,
the market price of our common shares may not be sustainable at
the direct arithmetic result of the consolidation, and may be
lower. If the market price of our common shares is lower than it
was before the consolidation, our total market capitalization
(the aggregate value of all common shares at the then market
price) after the consolidation may be lower than before the
consolidation.
While a higher share price may help generate investor interest
in Nortel Networks Corporation common shares, the proposed
consolidation may not result in a per share market price that
will attract institutional investors or investment funds and
such share price may not satisfy the investing guidelines of
institutional investors or investment funds. As a result, the
trading liquidity of NNC’s common shares may not
necessarily improve. If the consolidation is implemented and the
market price of NNC’s common shares declines, the
percentage decline may be greater than would occur in the
absence of the consolidation. The market price of NNC’s
common shares will, however, also be based on our performance
and other factors, which are unrelated to the number of common
shares outstanding. Furthermore, the liquidity of NNC’s
common shares could be adversely affected by the reduced number
of common shares that would be outstanding after the
consolidation.
A consolidation may result in some shareholders owning “odd
lots” of less than 100 common shares of NNC on a
post-consolidation basis. Odd lots may be more difficult to
sell, or require greater transaction costs per share to sell,
than shares in “board lots” of even multiples of
100 shares.
ITEM 1B. Unresolved Staff
Comments
None.
ITEM 2.
Properties
At December 31, 2005, we operated 189 sites around the
world occupying approximately 12.3 million square feet. The
following table sets forth additional information regarding
these sites:
Number of Sites
Type of Site*
Owned
Leased
Geographic Locations
Manufacturing and repair
5
—
Canada, EMEA, CALA and the Asia Pacific region
Distribution centers
—
8
United States, EMEA, CALA and the Asia Pacific region
Offices (administration, sales and field service)
4
161
All geographic regions
Research and development
4
7
United States, Canada, EMEA and the Asia Pacific region
TOTAL**
13
176
*
Indicates the primary use of the site. A number of our sites are
mixed-use facilities.
**
Excludes approximately 6.1 million square feet, consisting
primarily of leased and/or vacant property designated as part of
a planned square footage reduction in connection with our
restructuring activities commenced in 2001. At December 31,2005 approximately 3.6 million square feet of such property
was sub-leased.
At December 31, 2005, our facilities were primarily used,
on a consolidated basis, approximately as follows:
•
31% by Global Operations;
•
14% by Carrier Packet Networks;
•
11% by Enterprise Networks;
•
6% by CDMA Networks;
•
8% by GSM and UMTS Networks; and
•
30% by one or more of our reporting segments and/or corporate
facilities.
In 2005, we continued to reduce the square footage of our global
facilities to better align ourselves with current market
conditions. We believe our facilities are suitable and adequate,
and have sufficient capacity to meet our current needs. We
continue to evaluate our future real estate needs based on the
current industry environment and taking into account our
business requirements. In 2005, we entered into an agreement to
sell our facility in Brampton, Ontario to Rogers
42
Communications Inc. The sale, completed on January 4, 2006,
includes approximately one million square feet, fixtures and
certain personal property located at the facility and
63 acres of land.
ITEM 3.
Legal Proceedings
Subsequent to the February 15, 2001 announcement in which
Nortel provided revised guidance for financial performance for
the 2001 fiscal year and the first quarter of 2001, Nortel and
certain of its then current officers and directors were named as
defendants in more than twenty-five purported class action
lawsuits. These lawsuits in the U.S. District Courts for
the Eastern District of New York, the Southern District of New
York and the District of New Jersey and in courts in the
provinces of Ontario, Québec and British Columbia in
Canada, on behalf of shareholders who acquired Nortel Networks
Corporation securities as early as October 24, 2000 and as
late as February 15, 2001, allege, among other things,
violations of U.S. federal and Canadian provincial
securities laws. These matters also have been the subject of
review by Canadian and U.S. securities regulatory
authorities. On May 11, 2001, the defendants filed motions
to dismiss and/or stay in connection with the three proceedings
in Québec primarily based on the factual allegations
lacking substantial connection to Québec and the inclusion
of shareholders resident in Québec in the class claimed in
the Ontario lawsuit. The plaintiffs in two of these proceedings
in Québec obtained court approval for discontinuances of
their proceedings on January 17, 2002. The motion to
dismiss and/or stay the third proceeding (the “Québec
I Action”) was heard on November 6, 2001 and the court
deferred any determination on the motion to the judge who will
hear the application for authorization to commence a class
proceeding. On December 6, 2001, the defendants filed a
motion seeking leave to appeal that decision. The motion for
leave to appeal was dismissed on March 11, 2002. On
October 16, 2001, an order in the U.S. District Court
for the Southern District of New York was filed consolidating
twenty-five of the related U.S. class action lawsuits into
a single case, appointing class plaintiffs and counsel for such
plaintiffs (the “Nortel I Class Action”). The
plaintiffs served a consolidated amended complaint on
January 18, 2002. On December 17, 2001, the defendants
in the British Columbia action (the “British Columbia
Action”) served notice of a motion requesting the court to
decline jurisdiction and to stay all proceedings on the grounds
that British Columbia is an inappropriate forum. The motion has
been adjourned at the plaintiffs’ request to a future date
to be set by the parties.
On April 1, 2002, Nortel filed a motion to dismiss the
Nortel I Class Action on the ground that it failed to state
a cause of action under U.S. federal securities laws. On
January 3, 2003, the District Court denied the motion to
dismiss the consolidated amended complaint for the Nortel I
Class Action. The plaintiffs served a motion for class
certification on March 21, 2003. On May 30, 2003, the
defendants served an opposition to the motion for class
certification. Plaintiffs’ reply was served on
August 1, 2003. The District Court held oral arguments on
September 3, 2003 and issued an order granting class
certification on September 5, 2003. On September 23,2003, the defendants filed a motion in the U.S. Court of
Appeals for the Second Circuit for permission to appeal the
class certification decision. The plaintiffs’ opposition to
the motion was filed on October 2, 2003. On
November 24, 2003, the U.S. Court of Appeals for the
Second Circuit denied the motion. On March 10, 2004, the
District Court approved the form of notice to the class, which
was published and mailed.
On July 17, 2002, a purported class action lawsuit (the
“Ontario Claim”) was filed in the Ontario Superior
Court of Justice, Commercial List, naming Nortel, certain of its
current and former officers and directors and its auditors as
defendants. The factual allegations in the Ontario Claim are
substantially similar to the allegations in the Nortel I
Class Action. The Ontario Claim is on behalf of all
Canadian residents who purchased Nortel Networks Corporation
securities (including options on Nortel Networks Corporation
securities) between October 24, 2000 and February 15,2001. The plaintiffs claim damages of Canadian $5 billion,
plus punitive damages in the amount of Canadian $1 billion,
prejudgment and postjudgment interest and costs of the action.
On September 23, 2003, the Court issued an order allowing
the plaintiffs to proceed to amend the Ontario Claim and
requiring that the plaintiffs serve class certification
materials by December 15, 2003. On September 24, 2003,
the plaintiffs filed a notice of discontinuance of the original
action filed in Ontario. On December 12, 2003,
plaintiffs’ counsel requested an extension of time to
January 21, 2004 to deliver class certification materials.
On January 21, 2004, plaintiffs’ counsel advised the
Court that the two representative plaintiffs in the action no
longer wished to proceed, but counsel was prepared to deliver
draft certification materials pending the replacement of the
representative plaintiffs. On February 19, 2004, the
plaintiffs’ counsel advised the Court of a potential new
representative plaintiff. On February 26, 2004, the
defendants requested the Court to direct the plaintiffs’
counsel to bring a motion to permit the withdrawal of the
current representative plaintiffs and to substitute the proposed
representative plaintiff. On June 8, 2004, the Court signed
an order allowing a Second Fresh as Amended Statement of Claim
that substituted one new representative plaintiff, but did not
change the substance of the prior claim.
Subsequent to the March 10, 2004 announcement in which
Nortel indicated it was likely that it would need to revise its
previously announced unaudited results for the year ended
December 31, 2003, and the results reported in certain of
its
43
quarterly reports for 2003, and to restate its previously filed
financial results for one or more earlier periods, Nortel and
certain of its then current and former officers and directors
were named as defendants in 27 purported class action lawsuits.
These lawsuits in the U.S. District Court for the Southern
District of New York on behalf of shareholders who acquired
Nortel Networks Corporation securities as early as
February 16, 2001 and as late as May 15, 2004, allege,
among other things, violations of U.S. federal securities
laws. These matters are also the subject of investigations by
Canadian and U.S. securities regulatory and criminal
investigative authorities. On June 30, 2004, the Court
signed Orders consolidating the 27 class actions (the
“Nortel II Class Action”) and appointing
lead plaintiffs and lead counsel. The plaintiffs filed a
consolidated class action complaint on September 10, 2004,
alleging a class period of April 24, 2003 through and
including April 27, 2004. On November 5, 2004, Nortel
and the Audit Committee Defendants filed a motion to dismiss the
consolidated class action complaint. On January 18, 2005,
the lead plaintiffs, Nortel and the Audit Committee Defendants
reached an agreement in which Nortel would withdraw its motion
to dismiss and plaintiffs would dismiss Count II of the
complaint, which asserts a claim against the Audit Committee
Defendants. On May 13, 2005, the plaintiffs filed a motion
for class certification. On September 16, 2005, lead
plaintiffs filed an amended consolidated class action complaint
that rejoined the previously dismissed Audit Committee
Defendants as parties to the action. On March 16, 2006, the
plaintiffs withdrew their motion for class certification.
On July 28, 2004, Nortel and certain of their current and
former officers and directors, were named as defendants in a
purported class proceeding in the Ontario Superior Court of
Justice on behalf of shareholders who acquired Nortel Networks
Corporation securities as early as November 12, 2002 and as
late as July 28, 2004 (the “Ontario I Action”).
This lawsuit alleges, among other things, breaches of trust and
fiduciary duty, oppressive conduct and misappropriation of
corporate assets and trust property in respect of the payment of
cash bonuses to executives, officers and employees in 2003 and
2004 under the Nortel Return to Profitability bonus program and
seeks damages of Canadian $250 million and an order under
the Canada Business Corporations Act directing that an
investigation be made respecting these bonus payments.
On February 16, 2005, a motion for authorization to
institute a class action on behalf of residents of Québec,
who purchased Nortel securities between January 29, 2004
and March 15, 2004, was filed in the Québec Superior
Court naming Nortel as a defendant (the
“Québec II Action”). The motion alleges that
Nortel made misrepresentations about 2003 financial results.
On March 9, 2005, Nortel and certain of its current and
former officers and directors and its auditors were named as
defendants in a purported class action proceeding filed in the
Ontario Superior Court of Justice, Commercial List, on behalf of
all Canadian residents who purchased Nortel Networks Corporation
securities from April 24, 2003 to April 27, 2004 (the
“Ontario II Action”). This lawsuit alleges, among
other things, negligence, misrepresentations, oppressive
conduct, insider trading and violations of Canadian corporation
and competition laws in connection with Nortel’s 2003
financial results and seeks damages of Canadian $3 billion,
plus punitive damages in the amount of Canadian $1 billion,
prejudgment and postjudgment interest and costs of the action.
On September 30, 2005, Nortel announced that a mediator had
been jointly appointed by the two U.S. District Court
Judges presiding over the Nortel I Class Action and the
Nortel II Class Action to oversee settlement
negotiations between Nortel and the lead plaintiffs in these two
actions. The appointment of the mediator was pursuant to a
request by Nortel and the lead plaintiffs for the Courts’
assistance to facilitate the possibility of achieving a global
settlement regarding these actions. The settlement discussions
before the mediator are confidential and non-binding on the
parties without prejudice to their respective positions in the
litigation. The mediator, United States District Court Judge the
Honorable Robert W. Sweet, is not presiding over either of these
actions. On February 8, 2006, Nortel announced that, as a
result of this mediation process, Nortel and the lead plaintiffs
in the Nortel I Class Action and the Nortel II
Class Action have reached an agreement in principle to
settle these lawsuits (the “Proposed Class Action
Settlement”).
The Proposed Class Action Settlement would be part of, and
is conditioned on, Nortel reaching a global settlement
encompassing all pending shareholder class actions and proposed
shareholder class actions commenced against Nortel and certain
other defendants following Nortel’s announcement of revised
financial guidance during 2001, and Nortel’s revision of
its 2003 financial results and restatement of other prior
periods, including, without limitation, the Nortel I
Class Action, the Nortel II Class Action, the
Ontario Claim, the Québec I Action, the British Columbia
Action, the Ontario I Action, the Québec II Action and
the Ontario II Action. The Proposed Class Action
Settlement is also conditioned on Nortel and the lead plaintiffs
reaching agreement on corporate governance related matters and
the resolution of insurance related issues. On March 17,2006 Nortel announced that it and the lead plaintiff had reached
such an agreement with Nortel’s insurers to certain
indemnification obligations. Nortel believes that these
indemnification obligations would be unlikely to materially
increase its total cash payment obligations under the Proposed
Class Action
44
Settlement. The insurance payments would not reduce the amounts
payable by Nortel as noted below. Nortel also agreed to certain
corporate governance enhancements, including the codification of
certain of its current governance practices in its Board of
Directors written mandate and the inclusion in its annual proxy
circular and proxy statement of a report on certain of its
governance practices.
Under the terms of the proposed global settlement contemplated
by the Proposed Class Action Settlement, Nortel would make
a payment of $575 million in cash, issue 628,667,750 of
Nortel Networks Corporation common shares (representing 14.5% of
Nortel’s equity as of February 7, 2006), and
contribute one-half of any recovery in Nortel’s existing
litigation against Messrs. Frank Dunn, Douglas Beatty and
Michael Gollogly, Nortel’s former senior officers who were
terminated for cause in April 2004, seeking the return of
payments made to them under Nortel’s bonus plan in 2003. In
the event of a share consolidation of Nortel Networks
Corporation common shares, the number of Nortel Networks
Corporation common shares to be issued pursuant to the Proposed
Class Action Settlement would be adjusted accordingly. The
total settlement amount would include all plaintiffs’
court-approved attorneys’ fees. As a result of the Proposed
Class Action Settlement, Nortel has established a
litigation reserve and recorded a charge to its full-year 2005
financial results of $2,474 million, $575 million of
which relates to the proposed cash portion of the Proposed
Class Action Settlement, while $1,899 million relates
to the proposed equity component and will be adjusted in future
quarters based on the fair value of the Nortel Networks
Corporation common shares issuable until the finalization of the
settlement. Any change to the terms of the Proposed
Class Action Settlement would likely result in an
adjustment to the litigation reserve. Nortel expects to fund its
cash contribution to the settlement, if finalized, out of its
then available cash balances.
Nortel and the lead plaintiffs in the Nortel I Class Action
and the Nortel II Class Action are continuing
discussions towards a definitive settlement agreement based on
the Proposed Class Action Settlement. At this time, it is
not certain that such an agreement can be reached, that each of
the actions noted above can be brought into, or otherwise bound
by, the proposed settlement, if finalized, that any such
definitive settlement agreement would receive the required court
and other approvals in all applicable jurisdictions, and the
timing of any developments related to these matters is not
certain.
In addition to the shareholder class actions encompassed by the
Proposed Class Action Settlement, Nortel is also subject to
ongoing regulatory and criminal investigations and related
matters relating to its accounting restatements, and to certain
other class actions, securities litigation and other actions
described below. The Proposed Class Action Settlement and
the litigation reserve charge taken in connection with the
Proposed Class Action Settlement do not relate to these
matters. Nortel has not taken any additional reserves at this
time for any potential judgments, fines, penalties or
settlements that may arise from these other pending
investigations or actions (other than for anticipated
professional fees and expenses).
On April 5, 2004, Nortel announced that the Securities
Exchange Commission (the “SEC”) had issued a formal
order of investigation in connection with Nortel’s previous
restatement of its financial results for certain periods, as
announced in October 2003, and Nortel’s announcements in
March 2004 regarding the likely need to revise certain
previously announced results and restate previously filed
financial results for one or more periods. The matter had been
the subject of an informal SEC inquiry. On April 13, 2004,
Nortel announced that it had received a letter from the staff of
the Ontario Securities Commission (the “OSC”) advising
that there is an OSC Enforcement Staff investigation into the
same matters that are the subject of the SEC investigation.
On May 14, 2004, Nortel announced that it had received a
federal grand jury subpoena for the production of certain
documents, including financial statements and corporate,
personnel and accounting records, in connection with an ongoing
criminal investigation being conducted by the
U.S. Attorney’s Office for the Northern District of
Texas, Dallas Division. On August 23, 2005, Nortel received
an additional federal grand jury subpoena in this investigation
seeking production of additional documents, including documents
relating to the Nortel Retirement Income Plan and the Nortel
Long-Term Investment Plan.
On August 16, 2004, Nortel received a letter from the
Integrated Market Enforcement Team of the Royal Canadian Mounted
Police (the “RCMP”) advising Nortel that the RCMP
would be commencing a criminal investigation into Nortel’s
financial accounting situation.
A purported class action lawsuit was filed in the
U.S. District Court for the Middle District of Tennessee on
December 21, 2001, on behalf of participants and
beneficiaries of the Nortel Long-Term Investment Plan (the
“Plan”) at any time during the period of March 7,2000 through the filing date and who made or maintained Plan
investments in Nortel Networks Corporation common shares, under
the Employee Retirement Income Security Act (“ERISA”)
for Plan-wide relief and alleging, among other things, material
misrepresentations and omissions to induce Plan participants to
45
continue to invest in and maintain investments in Nortel
Networks Corporation common shares in the Plan. A second
purported class action lawsuit, on behalf of the Plan and Plan
participants for whose individual accounts the Plan purchased
Nortel Networks Corporation common shares during the period from
October 27, 2000 to February 15, 2001 and making
similar allegations, was filed in the same court on
March 12, 2002. A third purported class action lawsuit, on
behalf of persons who are or were Plan participants or
beneficiaries at any time since March 1, 1999 to the filing
date and making similar allegations, was filed in the same court
on March 21, 2002. The first and second purported class
action lawsuits were consolidated by a new purported class
action complaint, filed on May 15, 2002 in the same court
and making similar allegations, on behalf of Plan participants
and beneficiaries who directed the Plan to purchase or hold
shares of certain funds, which held primarily Nortel Networks
Corporation common shares, during the period from March 7,2000 through December 21, 2001. On September 24, 2002,
plaintiffs in the consolidated action filed a motion to
consolidate all the actions and to transfer them to the
U.S. District Court for the Southern District of New York.
The plaintiffs then filed a motion to withdraw the pending
motion to consolidate and transfer. The withdrawal was granted
by the District Court on December 30, 2002. A fourth
purported class action lawsuit, on behalf of the Plan and Plan
participants for whose individual accounts the Plan held Nortel
Networks Corporation common shares during the period from
March 7, 2000 through March 31, 2001 and making
similar allegations, was filed in the U.S. District Court
for the Southern District of New York on March 12, 2003. On
March 18, 2003, plaintiffs in the fourth purported class
action filed a motion with the Judicial Panel on Multidistrict
Litigation to transfer all the actions to the U.S. District
Court for the Southern District of New York for coordinated or
consolidated proceedings pursuant to 28 U.S.C.
section 1407. On June 24, 2003, the Judicial Panel on
Multidistrict Litigation issued a transfer order transferring
the Southern District of New York action to the
U.S. District Court for the Middle District of Tennessee
(the “Consolidated ERISA Action”). On
September 12, 2003, the plaintiffs in all the actions filed
a consolidated class action complaint. On October 28, 2003,
the defendants filed a motion to dismiss the complaint and a
motion to stay discovery pending disposition of the motion to
dismiss. On March 30, 2004, the plaintiffs filed a motion
for certification of a class consisting of participants in, or
beneficiaries of, the Plan who held shares of the Nortel Stock
Fund during the period from March 7, 2000 through
March 31, 2001. On April 27, 2004, the Court granted
the defendants’ motion to stay discovery pending resolution
of defendants’ motion to dismiss. On June 15, 2004,
the plaintiffs filed a First Amended Consolidated
Class Action Complaint that added additional current and
former officers and employees as defendants and expanded the
purported class period to extend from March 7, 2000 through
to June 15, 2004. On June 17, 2005, the plaintiffs
filed a Second Amended Consolidated Class Action Complaint
that added additional current and former directors, officers and
employees as defendants and alleged breach of fiduciary duty on
behalf of the Plan and as a purported class action on behalf of
participants and beneficiaries of the Plan who held shares of
the Nortel Networks Stock Fund during the period from
March 7, 2000 through June 17, 2005. On July 8,2005, the defendants filed a Renewed Motion to Dismiss
Plaintiffs’ Second Amended Class Action Complaint. On
July 29, 2005, plaintiffs filed an opposition to the
motion, and defendants filed a reply memorandum on
August 12, 2005. On March 30, 2006, the defendants
filed an additional motion to dismiss raising the jurisdictional
challenge that all former Plan participants, including one of
the named plaintiffs, lack standing to assert a claim under
ERISA. On April 17, 2006, plaintiffs filed a motion to
strike this motion to dismiss.
On May 18, 2004, a purported class action lawsuit was filed
in the U.S. District Court for the Middle District of
Tennessee on behalf of individuals who were participants and
beneficiaries of the Plan at any time during the period of
December 23, 2003 through the filing date and who made or
maintained Plan investments in Nortel Networks Corporation
common shares, under the ERISA for Plan-wide relief and
alleging, among other things, breaches of fiduciary duty. On
September 3, 2004, the Court signed a stipulated order
consolidating this action with the Consolidated ERISA Action
described above. On June 16, 2004, a second purported class
action lawsuit, on behalf of the Plan and Plan participants for
whose individual accounts the Plan purchased Nortel Networks
Corporation common shares during the period from
October 24, 2000 to June 16, 2004, and making similar
allegations, was filed in the U.S. District Court for the
Southern District of New York. On August 6, 2004, the
Judicial Panel on Multidistrict Litigation issued a conditional
transfer order to transfer this action to the U.S. District
Court for the Middle District of Tennessee for coordinated or
consolidated proceedings pursuant to 28 U.S.C.
section 1407 with the Consolidated ERISA Action described
above. On August 20, 2004, plaintiffs filed a notice of
opposition to the conditional transfer order with the Judicial
Panel. On December 6, 2004, the Judicial Panel denied the
opposition and ordered the action transferred to the
U.S. District Court for the Middle District of Tennessee
for coordinated or consolidated proceedings with the
Consolidated ERISA Action described above. On January 3,2005, this action was received in the U.S. District Court
for the Middle District of Tennessee and consolidated with the
Consolidated ERISA Action described above.
On July 30, 2004, a shareholders’ derivative complaint
was filed in the U.S. District Court for the Southern
District of New York against certain current and former officers
and directors, of Nortel alleging, among other things, breach of
46
fiduciary duties owed to Nortel during the period from 2000 to
2003 including by causing Nortel to engage in unlawful conduct
or failing to prevent such conduct; causing Nortel to issue
false statements; and violating the law (the
“U.S. Derivative Action”). On February 14,2005, the defendants filed motions to dismiss the derivative
complaint. On April 29, 2005, the plaintiffs filed an
opposition to the motions to dismiss. On May 26, 2005, the
defendants filed a reply memorandum in support of the motions to
dismiss. On August 24, 2005, the Court issued an opinion
and order granting the defendants’ motions to dismiss the
derivative complaint. Since the plaintiffs did not appeal the
dismissal and the time to file an appeal has passed, this action
is concluded.
On December 21, 2005, an application was filed in the
Ontario Superior Court of Justice for leave to commence a
shareholders’ derivative action on Nortel’s behalf
against certain current and former officers and directors, of
Nortel alleging, among other things, breach of fiduciary duties,
breach of duty of care and negligence, and unjust enrichment in
respect of various alleged acts and omissions including causing
or permitting Nortel to issue alleged materially false and
misleading statements regarding expected growth in revenues and
earnings for 2000 and 2001 and endorsing or permitting
accounting practices relating to provisions not in compliance
with GAAP. The proposed derivative action would seek on
Nortel’s behalf, among other things, compensatory damages
of Canadian $1 billion and punitive damages of Canadian
$10 million from the individual defendants (the
“Proposed Ontario Derivative Action”). In the Proposed
Ontario Derivative Action, the defendants are the same and the
allegations are substantially similar to the derivative
complaint in the U.S. Derivative Action. The Proposed
Ontario Derivative Action would also seek an order directing
Nortel’s Board of Directors to reform and improve
Nortel’s corporate governance and internal control
procedures as the Court may deem necessary or desirable and an
order that Nortel pay the legal fees and other costs in
connection with the Proposed Ontario Derivative Action. The
application for leave to commence the Proposed Ontario
Derivative Action has not yet been heard. However, in response
to a motion brought by the applicants to preserve potential
claims against the possible expiration of potential limitation
periods, Nortel consented to an order, entered February 14,2006, permitting the applicants to file and have issued by the
Court, on an interim basis and pending final determination of
the application, the Proposed Ontario Derivative Action without
prejudice to Nortel’s position on the merits of the
application itself. The order provides that no further steps
shall be taken against the individual defendants in the Proposed
Ontario Derivative Action unless the application is granted and
if the application is denied the Proposed Ontario Derivative
Action is to be discontinued.
On January 31, 2005, a Statement of Claim was filed in the
Ontario Superior Court of Justice by Nortel and NNL against
Messrs. Frank Dunn, Douglas Beatty and Michael Gollogly,
Nortel’s former senior officers who were terminated for
cause in April 2004, seeking the return of payments made to them
under Nortel’s bonus plan in 2003.
On April 20, 2006, Mr. Frank Dunn filed a Notice of
Action in the Ontario Superior Court of Justice against Nortel
and NNL asserting claims for wrongful dismissal, defamation and
mental distress, and seeking punitive, exemplary and aggravated
damages, out-of-pocket
expenses and special damages, indemnity for legal expenses
incurred as a result of civil and administrative proceedings
brought against him by reason of his having been an officer or
director of the defendants, pre-judgement interest and costs. On
April 24, 2006, the court granted Mr. Dunn’s
request for interim relief to seal the file pending return of
his motion to stay his action and seal the file. The
court’s order was without prejudice to defendant’s
disclosure obligations under applicable securities laws.
Except as otherwise described herein, in each of the matters
described above, the plaintiffs are seeking an unspecified
amount of monetary damages. Nortel is unable to ascertain the
ultimate aggregate amount of monetary liability or financial
impact to Nortel of the above matters, which, unless otherwise
specified, seek damages from the defendants of material or
indeterminate amounts or could result in fines and penalties.
With the exception of $2,474 million Nortel has taken as a
charge in its 2005 financial results as a result of the Proposed
Class Action Settlement, Nortel has not taken any reserves
for any potential judgments, fines, penalties or settlements
that may result from these actions, suits, claims, proceedings
and investigations. Nortel cannot determine whether these
actions, suits, claims, proceedings and investigations will,
individually or collectively, have a material adverse effect on
the business, results of operations, financial condition or
liquidity of Nortel. Except for matters encompassed by the
Proposed Class Action Settlement, as to which Nortel and
the lead plaintiffs are continuing discussions towards a
definitive settlement agreement, Nortel intends to defend these
actions, suits, claims and proceedings, litigating or settling
cases where in management’s judgment it would be in the
best interest of shareholders to do so. Nortel will continue to
cooperate fully with all authorities in connection with the
regulatory and criminal investigations. For information on the
risks relating to the legal proceedings, see the “Risk
Factors” section of this report.
Nortel is also a defendant in various other suits, claims,
proceedings and investigations which arise in the normal course
of business.
47
Environmental matters
Nortel’s operations are subject to a wide range of
environmental laws in various jurisdictions around the world.
Nortel seeks to operate its business in compliance with such
laws. Nortel is subject to new European product content laws and
product takeback and recycling requirements that will require
full compliance commencing in July 2006. As a result of these
laws and requirements Nortel will incur additional compliance
costs. Although costs relating to environmental matters have not
resulted in a material adverse effect on the business, results
of operations, financial condition or liquidity in the past,
there can be no assurance that Nortel will not be required to
incur such costs in the future. Nortel is actively working on
compliance plans and risk mitigation strategies relating to the
new laws and requirements. Although Nortel is working with its
strategic suppliers in this regard, it is possible that some of
Nortel’s products may not be compliant by the legislated
compliance date. In such event, Nortel expects that it will have
the ability to rely on available exemptions under the new
legislation for most of such products and currently does not
expects disruption to the distribution of such products to be
significant. Nortel intends to manufacture products that are
compliant with all applicable legislation and meet its quality
and reliability requirements.
Nortel has a corporate environmental management system standard
and an environmental program to promote such compliance.
Moreover, Nortel has a periodic, risk-based, integrated
environment, health and safety audit program. Nortel’s
environmental program focuses its activities on design for the
environment, supply chain and packaging reduction issues. Nortel
works with its suppliers and other external groups to encourage
the sharing of non-proprietary information on environmental
research.
Nortel is exposed to liabilities and compliance costs arising
from its past and current generation, management and disposal of
hazardous substances and wastes. As of December 31, 2005,
the accruals on the consolidated balance sheet for environmental
matters were $27 million. Based on information available as
of December 31, 2005, management believes that the existing
accruals are sufficient to satisfy probable and reasonably
estimable environmental liabilities related to known
environmental matters. Any additional liabilities that may
result from these matters, and any additional liabilities that
may result in connection with other locations currently under
investigation, are not expected to have a material adverse
effect on the business, results of operations, financial
condition and liquidity of Nortel.
Nortel has remedial activities under way at 14 sites which are
either currently or previously owned or occupied facilities. An
estimate of Nortel’s anticipated remediation costs
associated with all such sites, to the extent probable and
reasonably estimable, is included in the environmental accruals
referred to above in an approximate amount of $27 million.
Nortel is also listed as a potentially responsible party under
the U.S. Comprehensive Environmental Response, Compensation
and Liability Act (“CERCLA”) at four Superfund sites
in the U.S. (at two of the Superfund sites, Nortel is
considered a de minimis potentially responsible party). A
potentially responsible party within the meaning of CERCLA is
generally considered to be a major contributor to the total
hazardous waste at a Superfund site (typically 10% or more,
depending on the circumstances). A de minimis potentially
responsible party is generally considered to have contributed
less than 10% (depending on the circumstances) of the total
hazardous waste at a Superfund site. An estimate of
Nortel’s share of the anticipated remediation costs
associated with such Superfund sites is expected to be de
minimis and is included in the environmental accruals of
$27 million referred to above.
Liability under CERCLA may be imposed on a joint and several
basis, without regard to the extent of Nortel’s
involvement. In addition, the accuracy of Nortel’s estimate
of environmental liability is affected by several uncertainties
such as additional requirements which may be identified in
connection with remedial activities, the complexity and
evolution of environmental laws and regulations, and the
identification of presently unknown remediation requirements.
Consequently, Nortel’s liability could be greater than its
current estimate.
ITEM 4.
Submission of Matters to a Vote of Security Holders
Not applicable.
48
PART II
ITEM 5.
Market for Registrant’s Common Equity, Related
Stockholder Matters and Issuer Purchases of Equity Securities
The common shares of Nortel Networks Corporation are listed and
posted for trading on the New York Stock Exchange in the United
States and on the Toronto Stock Exchange in Canada. The
following table sets forth the high and low sale prices of the
common shares as reported on the New York Stock Exchange
composite tape and on the Toronto Stock Exchange.
New York Stock
Toronto Stock
Exchange
Exchange
Composite Tape
(Canadian $)
High
Low
High
Low
2006
First Quarter
$
3.43
$
2.73
$
4.02
$
3.13
2005
Fourth Quarter
3.57
2.75
4.22
3.21
Third Quarter
3.38
2.51
4.06
3.07
Second Quarter
2.91
2.26
3.63
2.85
First Quarter
3.62
2.62
4.40
3.23
2004
Fourth Quarter
3.91
2.92
4.80
3.49
Third Quarter
5.05
3.16
6.40
4.11
Second Quarter
6.33
3.01
8.35
4.16
First Quarter
8.50
4.30
11.94
5.53
On April 17, 2006, the last sale price on the New York
Stock Exchange was $2.77 and on the Toronto Stock Exchange was
Canadian $3.17.
On April 17, 2006, approximately 189,245 registered
shareholders held 100% of the outstanding common shares of
Nortel Networks Corporation. This included the Canadian
Depository for Securities and the Depository Trust Company, two
clearing corporations, which held a total of approximately
97.23% of the common shares of Nortel Networks Corporation on
behalf of other shareholders.
Securities authorized for issuance under equity compensation
plans
For a discussion of Nortel’s equity compensation plans,
please see “Equity compensation plan information” in
Item 12, “Security Ownership of Certain Beneficial
Owners and Management and Related Stockholder Matters”.
Dividends
On June 15, 2001, Nortel announced that its Board of
Directors decided to discontinue the declaration and payment of
common share dividends. As a result, dividends have not been
declared and paid on Nortel Networks Corporation common shares
since June 29, 2001, and future dividends will not be
declared unless and until the Board of Directors decides
otherwise. On July 26, 2001, the Board of Directors of
Nortel suspended the operation of the Nortel Networks
Corporation Dividend Reinvestment and Stock Purchase Plan.
Canadian tax matters
Dividends
Under the United States-Canada Income Tax Convention (1980), or
the Convention, Canadian withholding tax of 15% generally
applies to the gross amount of dividends (including stock
dividends) paid or credited to beneficial owners of Nortel
Networks Corporation common shares:
•
who are resident in the United States for the purposes of the
Convention; and
•
who do not hold the shares in connection with a business carried
on through a permanent establishment or a fixed base in Canada.
The Convention provides an exemption from withholding tax on
dividends paid or credited to certain tax-exempt organizations
that are resident in the United States for purposes of the
Convention. Persons who are subject to the United States federal
income tax on dividends may be entitled, subject to certain
limitations, to either a credit or deduction with respect to
Canadian income taxes withheld with respect to dividends paid or
credited on Nortel Networks Corporation common shares.
49
Sales or other dispositions of shares
Gains on sales or other dispositions of Nortel Networks
Corporation common shares by a non-resident of Canada are
generally not subject to Canadian income tax, unless the holder
realizes the gains in connection with a business carried on in
Canada. A gain realized upon the disposition of Nortel Networks
Corporation common shares by a resident of the United States
that is otherwise subject to Canadian tax may be exempt from
Canadian tax under the Convention. Where Nortel Networks
Corporation common shares are disposed of by way of an
acquisition of such common shares by Nortel, other than a
purchase in the open market in the manner in which common shares
would normally be purchased by any member of the public in the
open market, the amount paid by Nortel in excess of the
paid-up capital of such
common shares will be treated as a dividend, and will be subject
to non-resident withholding tax.
Sales of unregistered securities
During 2005, Nortel did not issue any common shares under the
Nortel Networks/ BCE 1985 Stock Option Plan or the Nortel
Networks/ BCE 1999 Stock Option Plan. Any common shares issued
under these plans are deemed to be exempt from registration
under the United States Securities Act of 1933, as amended,
pursuant to Regulation S. All funds received by Nortel in
connection with the exercise of stock options granted under the
two Nortel Networks/ BCE stock option plans are transferred in
full to BCE pursuant to the terms of the May 1, 2000 plan
of arrangement, except for nominal amounts paid to Nortel to
round up fractional entitlements into whole shares. Nortel keeps
these nominal amounts and uses them for general corporate
purposes.
50
ITEM 6.
Selected Financial Data (Unaudited)
The selected financial data presented below was derived from
Nortel Networks Corporation’s (“Nortel”) audited
consolidated financial statements and related notes thereto
included elsewhere in this Annual Report on
Form 10-K except
for the summarized balance sheet data as of December 31,2003, 2002 and 2001 and summarized results of operations data
for the years ended December 31, 2002 and 2001. Readers
should note the following information regarding the selected
financial data presented below.
As more fully described in note 4 of the audited
consolidated financial statements, Nortel has restated its
consolidated financial statements (the “Third
Restatement”).
Nortel has restated its previously reported consolidated
financial statements for the fiscal years 2004 and 2003 and the
quarters ended March 31, June 30 and
September 30, 2005 and 2004. The selected data below
includes all such restatement adjustments and covers the years
ended December 31, 2005, 2004, 2003, 2002 and 2001. The
audited restated consolidated balance sheet as of
December 31, 2004 and audited restated consolidated
statements of operations, statements of changes in equity and
comprehensive income (loss) and statements of cash flows for the
2004 and 2003 fiscal years ended December 31, are included
elsewhere in this Annual Report on
Form 10-K. Nortel
has not issued restated financial statements for the 2002 and
2001 fiscal years or a restated consolidated balance sheet as of
December 31, 2003 but selected unaudited information about
the Third Restatement adjustments for those periods is presented
below. The impact to periods prior to 2001 was de minimus.
2005
2004
2003
2002
2001
As restated*
As restated*
As restated
As restated
(Millions of U.S. dollars, except per share amounts)
Results of Operations
Revenues
$
10,523
$
9,516
$
9,932
$
10,738
$
18,833
Research and development expense
1,856
1,960
1,968
2,084
3,117
Special charges
Goodwill impairment
—
—
—
595
11,426
Other special charges
170
181
288
1,500
3,397
Shareholder litigation settlement expense
2,474
—
—
—
—
Operating earnings (loss)
(2,671
)
(250
)
(126
)
(3,133
)
(25,039
)
Other income (expense) — net
303
212
466
(6
)
(488
)
Income tax benefit (expense)
56
30
83
465
2,752
Net earnings (loss) from continuing operations
(2,576
)
(256
)
122
(2,958
)
(23,270
)
Net earnings (loss) from discontinued operations — net
of tax
1
49
183
(103
)
(2,465
)
Cumulative effect of accounting changes — net of tax
—
—
(12
)
—
15
Net earnings (loss)
(2,575
)
(207
)
293
(3,061
)
(25,720
)
Basic earnings (loss) per common share
— from continuing operations
$
(0.59
)
$
(0.06
)
$
0.03
$
(0.77
)
$
(7.30
)
— from discontinued operations
0.00
0.01
0.04
(0.03
)
(0.78
)
Basic earnings (loss) per common share
$
(0.59
)
$
(0.05
)
$
0.07
$
(0.80
)
$
(8.08
)
Diluted earnings (loss) per common share
— from continuing operations
$
(0.59
)
$
(0.06
)
$
0.03
$
(0.77
)
$
(7.30
)
— from discontinued operations
0.00
0.01
0.04
(0.03
)
(0.78
)
Diluted earnings (loss) per common share
$
(0.59
)
$
(0.05
)
$
0.07
$
(0.80
)
$
(8.08
)
Dividends declared per common share
—
—
—
—
$
0.0375
51
2005
2004
2003
2002
2001
As restated*
As restated
As restated
As restated
(Millions of U.S. dollars)
Financial Position as of December 31
Total assets
$
18,112
$
17,775
$
17,189
$
17,330
$
22,126
Total
debt(a)
3,896
3,891
4,017
4,225
5,079
Minority interests in subsidiary companies
780
626
613
631
654
Total shareholders’ equity
786
3,640
3,719
2,974
4,791
(a)
Total debt includes long-term debt, long-term debt due within
one year and notes payable.
See notes 3, 7, 10, 22 and 23 to the accompanying
audited consolidated financial statements for the impact of
accounting changes, special charges, acquisitions, divestitures
and closures and the shareholder litigation settlement expense
related to the proposed class action litigation settlement,
respectively, that affect the comparability of the above
selected financial data.
*
See note 4 to the accompanying consolidated financial
statements.
52
The following information presents the financial impact of the
Third Restatement adjustments on Nortel’s previously
reported Consolidated Statement of Operations data for the years
ended December 31, 2002 and 2001:
Consolidated Statement of Operations data for the year ended
December 31, 2002
As Previously
Reported
Adjustments
As Restated
(Millions of U.S. dollars,
except per share amounts)
Revenues
$
11,008
$
(270
)
$
10,738
Cost of revenues
7,103
(217
)
6,886
Gross profit
$
3,905
$
(53
)
$
3,852
Net earnings (loss) from continuing operations
(2,893
)
(65
)
(2,958
)
Net earnings (loss)
(2,994
)
(67
)
(3,061
)
Basic and diluted earnings (loss) per common share
— from continuing operations
$
(0.75
)
$
(0.02
)
$
(0.77
)
— from discontinued operations
(0.03
)
0.00
(0.03
)
Basic and diluted earnings (loss) per common share
$
(0.78
)
$
(0.02
)
$
(0.80
)
Consolidated Statement of Operations data for the year ended
December 31, 2001
As Previously
Reported
Adjustments
As Restated
(Millions of U.S. dollars,
except per share amounts)
Revenues
$
18,900
$
(67
)
$
18,833
Cost of revenues
14,612
(63
)
14,549
Gross profit
$
4,288
$
(4
)
$
4,284
Net earnings (loss) from continuing operations
(23,270
)
—
(23,270
)
Net earnings (loss)
(25,722
)
2
(25,720
)
Basic and diluted earnings (loss) per common share
— from continuing operations
$
(7.30
)
0.00
$
(7.30
)
— from discontinued operations
(0.78
)
0.00
(0.78
)
Basic and diluted earnings (loss) per common share
$
(8.08
)
0.00
$
(8.08
)
Revenues and cost of revenues adjustments
The following table summarizes the revenue recognition
adjustments to revenue and cost of revenues (refer to
note 4 of the accompanying consolidated financial
statements for a description of the nature of the adjustments).
Revenues
Cost of Revenues
2002
2001
2002
2001
(Millions of U.S. dollars)
As previously reported:
$
11,008
$
18,900
$
7,103
$
14,612
Adjustments:
Application of SOP 81-1
$
(157
)
$
(44
)
$
(148
)
$
(42
)
Application of SAB 104 and SOP 97-2
(111
)
(34
)
(66
)
(24
)
Other revenue recognition adjustments
(2
)
11
(3
)
3
As restated:
$
10,738
$
18,833
$
6,886
$
14,549
53
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND
Other long-term liabilities reflected on the balance
sheets
100
Customer financing
100
Acquisitions
101
Future Sources of Liquidity
101
Credit facilities
102
Available support facility
103
Shelf registration statement and base shelf prospectus
104
Credit Ratings
104
Off-Balance Sheet Arrangements
105
Bid, Performance Related and Other Bonds
105
Receivables Securitization and Certain Variable Interest
Transactions
105
Other Indemnifications or Guarantees
107
Application of Critical Accounting Policies and Estimates
107
Revenue Recognition
107
Provisions for Doubtful Accounts
109
Provisions for Inventory
110
Provisions for Product Warranties
110
Income Taxes
111
Tax asset valuation
111
Tax contingencies
112
Goodwill Valuation
113
Pension and Post-retirement Benefits
114
Special Charges
115
Other Contingencies
115
Accounting Changes and Recent Accounting Pronouncements
116
Accounting Changes
116
Recent Accounting Pronouncements
116
Canadian Supplement
118
Accounting Changes
118
Outstanding Share Data
120
Market Risk
120
Equity Price Risk
121
Environmental Matters
121
Legal Proceedings
121
55
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read this Management’s Discussion and
Analysis of Financial Condition and Results of Operation, or
MD&A, in combination with the accompanying audited
consolidated financial statements prepared in accordance with
accounting principles generally accepted in the United States,
or U.S. GAAP.
As discussed herein, this MD&A gives effect to the Third
Restatement as described below in “Restatements; Nortel
Networks Audit Committee Independent Review; Material
Weaknesses; Related Matters” and in note 4 of the
accompanying audited consolidated financial statements. The
Third Restatement involved the restatement of our consolidated
financial statements for 2004, 2003, 2002, 2001 and the first,
second and third quarters of 2005 and 2004. Amendments to our
prior filings with the United States Securities and Exchange
Commission, or SEC, would be required in order for us to be in
full compliance with our reporting obligations under the
Exchange Act. We believe that we have included in this report
all information needed for current investor understanding.
Disclosure in the Annual Report on
Form 10-K for the
year ended December 31, 2004, or the 2004
Form 10-K, and the
Quarterly Reports on
Form 10-Q, for the
quarterly periods ended March 31, June 30, and
September 30, 2005, or the 2005
Form 10-Qs, would
in large part repeat the disclosure contained in this report.
Accordingly, we do not plan to amend our 2005
Form 10-Qs, 2004
Form 10-K or any
other prior filings. SEC review may require us to amend this
report or our other public filings.
Certain statements in this MD&A contain words such as
“could”, “expects”, “may”,
“anticipates”, “believes”,
“intends”, “estimates”, “plans”,
“envisions”, “seeks” and other similar
language and are considered forward-looking statements or
information under applicable securities laws. These statements
are based on our current expectations, estimates, forecasts and
projections about the operating environment, economies and
markets in which we operate. These statements are subject to
important assumptions, risks and uncertainties, which are
difficult to predict and the actual outcome may be materially
different. Although we believe expectations reflected in such
forward-looking statements are reasonable based upon the
assumptions in this MD&A, they may prove to be inaccurate
and consequently our actual results could differ materially from
our expectations set out in this MD&A. In particular, the
risk factors described in the “Risk Factors” section
of this report could cause actual results or events to differ
materially from those contemplated in forward-looking
statements. Unless required by applicable securities laws, we
disclaim any intention or obligation to publicly update or
revise any forward-looking statements, whether as a result of
new information, future events or otherwise.
Where we say “we”, “us”, “our”,
“NNC”, or “Nortel”, we mean Nortel Networks
Corporation or Nortel Networks Corporation and its subsidiaries,
as applicable, and where we refer to the “industry”,
we mean the telecommunications industry. All dollar amounts in
this MD&A are in millions of United States, or U.S., dollars
unless otherwise stated. All amounts for prior periods and prior
period comparisons are presented on a restated basis unless
otherwise stated.
The common shares of Nortel Networks Corporation are publicly
traded on the New York Stock Exchange, or NYSE, and Toronto
Stock Exchange, or TSX, under the symbol “NT”. Nortel
Networks Limited, or NNL, is our principal direct operating
subsidiary and its results are consolidated into our results.
Nortel holds all of NNL’s outstanding common shares but
none of its outstanding preferred shares. NNL’s preferred
shares are reported in minority interests in subsidiary
companies in the audited consolidated balance sheets and
dividends and the related taxes are reported in minority
interests — net of tax in the audited consolidated
statements of operations.
Business Overview
Our Business
Nortel is a global supplier of communication equipment serving
both service provider and enterprise customers. We deliver
products and solutions that help simplify networks, improve
productivity as well as drive value creation and efficiency for
consumers. Our next-generation technologies span access and core
networks, support multimedia and business-critical applications,
and help eliminate today’s barriers to efficiency, speed
and performance by simplifying networks and connecting people
with information. Our networking solutions consist of hardware,
software and services. Our business activities include the
design, development, assembly, marketing, sale, licensing,
installation, servicing and support of these networking
solutions. As a substantial portion of our business has a
technology focus, we are dedicated to making strategic
investments in research and development, or R&D. We believe
one of our core strengths is strong
56
customer loyalty from providing value to our customers through
high reliability networks, a commitment to ongoing support, and
evolving solutions to address product technology trends.
Our Segments
During 2005, our operations were organized into four reportable
segments as follows:
•
Carrier Packet Networks provides: (i) circuit and packet
voice solutions, (ii) data networking and security
solutions and (iii) optical networking solutions. Together,
these solutions provide data, voice and multimedia
communications solutions to our service provider customers that
operate wireline networks. These service provider customers
include local and long distance telephone companies, wireless
service providers, cable operators and other communication
service providers.
•
CDMA Networks provides communication network solutions to our
wireless service provider customers based on Code Division
Multiple Access, or CDMA, and Time Division Multiple Access, or
TDMA, technologies to enable those service providers to offer
their customers, the subscribers for wireless communication
services, the ability to be mobile while they send and receive
voice and data communications using wireless devices, such as
cellular telephones, personal digital assistants and other
computing and communications devices.
•
GSM and UMTS Networks also provides communication network
solutions to our wireless service provider customers; however,
these solutions are based on Global System for Mobile
Communications, or GSM, and Universal Mobile Telecommunications
System, or UMTS, technologies.
•
Enterprise Networks provides: (i) circuit and packet voice
solutions and (ii) data networking and security solutions
which provide data, voice and multimedia communications
solutions to our enterprise customers. Our Enterprise Networks
customers consist of a broad range of enterprise customers
around the world, including large businesses and their branch
offices, small businesses and home offices, as well as
government agencies, educational and other institutions and
utility organizations.
On September 30, 2005, we announced a new organizational
structure that we expect will strengthen our enterprise focus,
drive product efficiencies, and enhance our delivery of global
services. The new alignment includes two product groups:
(i) Enterprise Solutions and Packet Networks, which
combines optical networking solutions (included in our Carrier
Packet Networks segment in 2005), data networking and security
solutions and portions of circuit and packet voice solutions
(included in both our Carrier Packet Networks segment and
Enterprise Networks segment in 2005) into a unified product
group; and (ii) Mobility and Converged Core Networks, which
combines our CDMA solutions and GSM and UMTS solutions (each a
separate segment in 2005) and other circuit and packet voice
solutions (included in our Carrier Packet Networks segment in
2005). By creating two product groups, we expect to simplify our
business model and create new cost efficiencies by leveraging
common hardware and software platforms. We expect these two
product groups to form our reportable segments commencing in the
first quarter of 2006.
We are also in the process of establishing an operating segment
that focuses on providing professional services in five key
areas: integration services, security services, managed
services, optimization services, and maintenance services, which
are currently a component of all of our networking solutions. We
expect this operating segment to become a third reportable
segment in the second half of 2006.
How We Measure Performance
Our president and chief executive officer, or CEO, has been
identified as our chief operating decision maker, or CODM, in
assessing the performance and allocating resources to our
operating segments. The primary financial measure used by the
CODM is management earnings (loss) before income taxes, or
Management EBT. This measure includes the cost of revenues,
selling, general and administrative, or SG&A, expense,
R&D expense, interest expense, other income
(expense) — net, minority interests — net of
tax and equity in net earnings (loss) of associated
companies — net of tax. Interest attributable to
long-term debt is not allocated to a reportable segment and is
included in “Other”. The CODM does not review asset
information on a segmented basis in order to assess performance
and allocate resources. See “Segment
information — General description” in note 6
of the accompanying audited consolidated financial statements.
In addition, from time to time, we monitor performance in the
following areas: status with our key customers on a global
basis; the achievement of expected milestones of our key R&D
projects; and the achievement of our key strategic initiatives.
In an effort to ensure we are creating value for our customers
and maintaining strong relationships with those customers, we
monitor our project implementation, customer service levels and
the status of key customer contracts. We also conduct regular
customer satisfaction and loyalty surveys to monitor customer
relationships. With respect to our R&D projects, we measure
content, quality and timeliness versus project plans.
57
Our Business Environment
With the growth of data, voice and multimedia communications
over the public telephone network, the public Internet and
private voice and data communications networks, disparate
networks are migrating to converged high performance packet
networks that can support most types of communications traffic
and applications. Converged voice and data networks
incorporating packet-based technologies provide an opportunity
for service providers to offer new revenue generating services
while reducing annual operating costs and an opportunity for
enterprises to become more cost effective and productive. We
believe our key advantage lies in our ability to transition and
upgrade our enterprise and service provider customers’
voice and data networks to a multimedia-enabled Internet
Protocol, or IP, networks with carrier grade reliability.
The demand for voice over IP, or VoIP, and broadband access to
IP based networks and third generation, or 3G, wireless networks
were a source of industry growth in 2005, and we expect spending
in these areas will continue to expand the market for services
and solutions provided by communications equipment vendors. We
anticipate this demand to lead to further investment in network
infrastructure, including optical technologies, and application
convergence. Regulatory developments, including the anticipated
grant of new national licenses for 3G wireless services in
China, are also expected to have a positive impact on industry
demand for next generation wireless services.
At the same time, the market for traditional voice and second
generation wireless technologies is expected to continue to
decline. These significant technology shifts have resulted in
service providers and enterprises limiting their investment in
mature technologies as they focus on maximizing return on
invested capital, requiring communications equipment vendors to
leverage their installed base in legacy markets. Furthermore,
pricing pressures continue to increase as a result of global
competition, particularly from suppliers situated in emerging
markets with low cost structures like China. Consolidation among
customers, leading to fewer and larger customers, many of whom
are focusing on improving the efficiency of their combined
networks rather than network expansion, is also increasing
pricing pressure. In addition, significant consolidation among
communications equipment vendors is commencing and is expected
to continue.
While we have seen encouraging indicators in certain parts of
the market, we can provide no assurance the growth areas that
have begun to emerge will continue in the future. See the
“Risk Factors” section of this report for factors that
may negatively impact our results.
Our Strategy
We continue to drive our business forward with a renewed focus
on execution and operational excellence through (i) the
transformation of our businesses and processes;
(ii) integrity renewal and (iii) growth imperatives.
Our plan for business transformation is expected to address our
biggest operational challenges and is focused on simplifying our
organizational structure, reflecting the alignment of carrier
and enterprise networks, and maintains a strong focus on revenue
generation as well as quality improvements and cost reduction
through a program known as Six Sigma. This program contemplates
the transformation of our business in six key areas: services,
procurement effectiveness, revenue stimulation (including sales
and pricing), R&D effectiveness, general and administrative
effectiveness, and organizational and workforce effectiveness.
Employees throughout our organization are engaged in supporting
various objectives in each of these areas.
We remain focused on integrity renewal through a commitment to
effective corporate governance practices, remediation of our
material weaknesses in our internal controls and ethical
conduct. We have enhanced our compliance function to increase
compliance with applicable laws, regulations and company
policies and to increase employee awareness of our code of
ethical business conduct.
Our growth imperatives are motivated by a desire to increase
profitable growth and focus on areas where we can attain a
leadership position and a minimum market share of twenty percent
in key technologies. Some areas in which we plan to increase our
investment include products compliant with the Worldwide
Interoperability for Microwave Access, or WiMAX, standard, the
IP Multimedia Subsystem, or IMS, architecture, and IPTV. As part
of this strategy, we have decided to redirect funding from our
services edge router business and to sell certain assets of our
blade server switch business unit.
We have developed our strategy with a view to maximizing the
effectiveness of our strategic alliances and capturing the
benefits of growing technology convergence in the marketplace.
We believe our strategy will position us to respond to evolving
technology and industry trends and enable us to provide
end-to-end solutions
that are developed internally and through our strategic
alliances. We expect to continue to play an active role in
influencing emerging broadband and
58
wireless standards. Furthermore, we believe cooperation of
multiple vendors is critical to the success of our
communications solutions for both service providers and
enterprises.
Recent key strategic and business initiatives include our
finance transformation project, which will implement, among
other things, a new information technology platform
(SAP) to provide an integrated global financial system;
growing our business with U.S. government clients through
PEC Solutions, Inc. (now Nortel Government Solutions,
Incorporated), or PEC, which we acquired in June 2005;
establishing a greater presence in Asia Pacific through our
recently established joint venture with LG Electronics, Inc., or
LG; our proposed joint venture with Huawei Technologies Co.,
Ltd, or Huawei, to develop ultra broadband access solutions;
strengthening our
end-to-end convergence
solutions and focus on the enterprise market, including the
acquisition of Tasman Networks Inc., or Tasman Networks; and
evolving our supply chain strategy.
Developments in 2005 and 2006
2005 Consolidated Results Summary
Summary of selected financial data:
% of
% of
% of
2005
Revenues
2004
Revenues
2003
Revenues
(Millions of U.S. dollars)
Revenues
$
10,523
$
9,516
$
9,932
Gross profit
4,306
40.9
3,942
41.4
4,209
42.4
Operating expenses
Selling, general and administrative expense
2,413
22.9
2,133
22.4
1,966
19.8
Research and development expense
1,856
17.6
1,960
20.6
1,968
19.8
Special charges
170
1.6
181
1.9
288
2.9
Gain (loss) on sale of businesses and assets
(47
)
(0.4
)
91
1.0
4
0.0
Shareholder litigation settlement expense
(a)
2,474
23.5
—
—
Operating earnings (loss)
(2,671
)
(25.4
)
(250
)
(2.6
)
(126
)
(1.3
)
Other income — net
303
2.9
212
2.2
466
4.7
Interest expense
218
2.1
202
2.1
206
2.1
Income tax benefit
56
0.5
30
0.3
83
0.8
Net earnings (loss) from continuing operations
(2,576
)
(24.5
)
(256
)
(2.7
)
122
1.2
Net earnings (loss) from discontinued operations — net
of tax
1
0.0
49
0.5
183
1.8
Net earnings (loss)
$
(2,575
)
(24.5
)
$
(207
)
(2.2
)
$
293
3.0
(a)
Relates to proposed settlement of certain shareholder class
action litigation first announced on February 8, 2006.
As discussed under “Restatements; Nortel Networks Audit
Committee Independent Review; Material Weaknesses; Related
Matters”, we have restated our consolidated financial
statements for 2004, 2003, 2002, 2001 and the first, second and
third quarters of 2005 and 2004. See also note 4 to the
accompanying audited consolidated financial statements.
Our revenues increased by approximately 11 percent in 2005
compared to 2004. The increase in revenues was across all of our
geographic regions and particularly in the U.S., Asia Pacific,
EMEA and CALA regions. In 2005, Carrier Packet Networks revenues
were $2,828, an increase of 9 percent compared to 2004;
CDMA Networks revenues were $2,321, an increase of
5 percent compared to 2004; GSM and UMTS Networks revenues
were $2,799, an increase of 16 percent compared to 2004;
Enterprise Networks revenues were $2,570, an increase of
12 percent compared to 2004. For further information
related to the changes in revenue by segment, see “Results
of Operations — Continuing Operations —
Segment Information”.
Our gross margin remained essentially flat in 2005 compared to
2004 primarily due to gross margin decreases in
CDMA Networks and Enterprise Networks offset by increases
in Carrier Packet Networks. Overall, we continue to see
improvements in our cost structure as a result of lower material
pricing and significant recoveries in our inventory provisions
related to the sale of certain optical inventory that was
previously provided for, partially offset by unfavorable product
mix, negative gross margin impact from our contract with Bharat
Sanchar Nigam Limited, or BSNL, and competitive pricing
pressures.
59
During 2005, SG&A expense as a percentage of revenues
remained essentially flat compared to 2004. During 2005,
SG&A expense included higher costs related to our internal
control remedial measures, investment in our finance processes
and restatement related activities, unfavorable foreign exchange
rate fluctuation, lower bad debt recoveries, increase in sales
and marketing expense arising from the consolidation of the
results of PEC and LG-Nortel, increased expense related to the
Mike Zafirovski settlement with Motorola and costs associated
with executive departures; partially offset by cost savings
associated with the restructuring plan announced in 2004, or
2004 Restructuring Plan and a reduction in our stock-based
compensation related to the Restricted Stock Unit, or RSU,
program.
R&D expense as a percentage of revenues decreased by
approximately 3 percentage points to 17.6% in 2005 compared
to 2004 primarily due to the continued favorable impact of the
savings associated with our 2004 Restructuring Plan partially
offset by increased investments in targeted product areas,
primarily in our Enterprise Networks segment, and unfavorable
foreign exchange impacts.
Special charges as a percentage of revenue remained essentially
flat in 2005 compared to 2004 primarily due to activities
associated with the implementation of our 2004 Restructuring
Plan that were substantially completed in the first half of 2005.
For further information related to the changes in operating
expenses, see “Results of Operations — Continuing
Operations — Operating Expenses”.
Shareholder litigation settlement expense of $2,474 was recorded
during the year ended December 31, 2005, as a result of an
agreement in principle reached for the settlement of certain
shareholder class action litigation. For additional information
see, “Developments in 2005 and 2006 — Significant
Business Developments — Proposed Class Action
Settlement”.
Significant Business Developments
Management
Mr. Mike S. Zafirovski was appointed president and
CEO, effective November 15, 2005. Mr. Zafirovski
succeeded Mr. William A. Owens as chief executive officer.
A lawsuit filed on October 18, 2005 by Motorola, Inc.,
Mr. Zafirovski’s former employer, was subsequently
settled on October 31, 2005 and provides that
Mr. Zafirovski cannot disclose Motorola trade secrets or
confidential information, and Mr. Zafirovski and we have
agreed for a specified period to refrain from hiring or
recruiting Motorola employees under certain circumstances. The
settlement also includes restrictions, until July 1, 2006,
on Mr. Zafirovski’s communications with certain
specified companies, some of which are our customers, and
limitations on his ability to advise us on competitive strategy
or analysis relative to Motorola for a defined period.
Mr. Zafirovski has paid Motorola $11.5, which is part of
his separation payment from Motorola, and we have reimbursed
Mr. Zafirovski for his repayment and selected legal costs
and $12 for expenses, including income taxes, that relate to
this repayment.
Proposed Class Action Settlement
On February 8, 2006, we announced that, as a result of the
previously announced mediation process we entered into with the
lead plaintiffs in two significant class action lawsuits pending
in the U.S. District Court for the Southern District of New
York and based on the recommendation of a senior Federal Judge,
we and the lead plaintiffs have reached an agreement in
principle to settle these lawsuits, or the Proposed
Class Action Settlement. This settlement would be part of,
and is conditioned on, our reaching a global settlement
encompassing all pending shareholder class actions and proposed
shareholder class actions commenced against us and certain other
defendants following our announcement of revised financial
guidance during 2001 and our revision of certain of our 2003
financial results and restatement of other prior periods. The
Proposed Class Action Settlement is also conditioned upon
the receipt of all required court, securities regulatory and
stock exchange approvals. On March 17, 2006, we announced
that we and the lead plaintiffs reached an agreement on the
related insurance and corporate governance matters including our
insurers agreeing to pay $228.5 in cash towards the settlement
and us agreeing with our insurers to certain indemnification
obligations. On April 3, 2006, the insurance proceeds were
placed into escrow by the insurers. We believe that these
indemnification obligations would be unlikely to materially
increase our total cash payment obligations under the Proposed
Class Action Settlement. The insurance payments would not
reduce the amounts payable by us as noted below. We also agreed
to certain corporate governance enhancements, including the
codification or certain of our current governance practices
(such as the annual election by our directors of a non-executive
Board chair) in our Board of Directors written mandate and the
inclusion in our annual proxy circular and proxy statement of a
report on certain of our other governance practices (such as the
60
process followed for the annual evaluation of the Board,
committees of the Board and individual directors). The Proposed
Class Action Settlement would contain no admission of
wrongdoing by us or any of the other defendants.
Under the terms of the proposed global settlement contemplated
by the Proposed Class Action Settlement, we would make a
payment of $575 in cash, issue 628,667,750 of Nortel Networks
Corporation common shares (representing 14.5% of our equity as
of February 7, 2006), and contribute one-half of any
recovery in our existing litigation against our former president
and chief executive officer, former chief financial officer and
former controller, who were terminated for cause in April 2004,
seeking the return of payments made to them under our bonus plan
in 2003. In the event of a share consolidation of Nortel
Networks Corporation common shares, the number of Nortel
Networks Corporation common shares to be issued pursuant to the
Proposed Class Action Settlement would be adjusted
accordingly. As a result of the Proposed Class Action
Settlement, we have established a litigation provision and
recorded a charge to our full-year 2005 financial results of
$2,474, of which $575 relates to the proposed cash portion of
the Proposed Class Action Settlement, while $1,899 relates
to the proposed equity component and will be adjusted in future
quarters based on the fair value of the Nortel Networks
Corporation common shares issuable until the finalization of the
settlement. The cash amount bears interest commencing
March 23, 2006 at a prescribed rate and is to be held in
escrow on June 1, 2006 pending satisfactory completion of
all conditions to the Proposed Class Action Settlement. Any
change to the terms of the Proposed Class Action Settlement
as a result of ongoing discussions with the lead plaintiffs
would likely also result in an adjustment to the litigation
provision.
Discussions are ongoing regarding a process to resolve the
Canadian actions as part of the terms of the Proposed
Class Action Settlement and we and the lead plaintiffs are
continuing discussions towards a definitive settlement
agreement. At this time, it is not certain that such an
agreement can be reached, that each of the actions noted above
can be brought into, or otherwise bound by, the proposed
settlement, if finalized, or that such an agreement would
receive the required court and other approvals in all applicable
jurisdictions. The timing of any developments related to these
matters is also not certain. The Proposed Class Action
Settlement and the litigation provision charge taken in
connection with the Proposed Class Action Settlement do not
relate to ongoing regulatory and criminal investigations and do
not encompass a related Employment Retirement Income Security
Act, or ERISA, class action or the pending application in Canada
for leave to commence a derivative action against certain of our
current and former officers and directors.
For additional information, see “Legal Proceedings”,
“Liquidity and Capital Resources”, “Developments
in 2005 and 2006 — Restatements; Nortel Networks Audit
Committee Independent Review; Material Weaknesses; Related
Matters — Third Restatement”, the “Risk
Factors” section of this report and
“Contingencies” in note 22 of the accompanying
audited consolidated financial statements.
Credit and Support Facilities
On February 14, 2006, we entered into a new one-year credit
facility in the aggregate principal amount of $1,300, or the
2006 Credit Facility. This new facility consists of (i) a
senior secured one-year term loan facility in the amount of
$850, or Tranche A Term Loans, and (ii) a senior
unsecured one-year term loan facility in the amount of $450, or
Tranche B Term Loans, and was extended by JPMorganChase
Bank, N.A., Citigroup Corporate and Investment Banking, Royal
Bank of Canada and Export Development Canada, or EDC. The
Tranche A Term Loans are secured equally and ratably with
NNL’s obligations under the $750 support facility, or the
EDC Support Facility, with EDC and NNL’s 6.875% Bonds due
2023, or the 2023 Bonds, by a lien on substantially all of the
U.S. and Canadian assets of NNL and the U.S. assets of our
indirect subsidiary, Nortel Networks Inc., or NNI. The
Tranche A Term Loans are also secured equally and ratably
with NNL’s obligations under the EDC Support Facility by a
lien on substantially all of NNC’s U.S. and Canadian
assets. The Tranche A Term Loans and Tranche B Term
Loans are also guaranteed by NNC and NNL and NNL’s
obligations under the EDC Support Facility are also guaranteed
by NNC and NNI, in each case until the maturity or prepayment of
the 2006 Credit Facility. The 2006 Credit Facility, which will
mature in February 2007, was drawn down in the full amount on
February 14, 2006 and we used the net proceeds primarily to
repay the outstanding $1,275 aggregate principal amount of
NNL’s 6.125% Notes that matured on February 15,2006. The Tranche A Loans initially bear interest at 6.875%
while the Tranche B Loans initially bear interest at
7.625%. We and NNI agreed to a demand right exercisable at any
time after May 31, 2006 pursuant to which we will be
required to take all reasonable actions to issue senior
unsecured debt securities in the capital markets to repay the
2006 Credit Facility.
Effective October 24, 2005, NNL and EDC entered into an
amendment of the EDC Support Facility that maintained the total
EDC Support Facility at up to $750, including the existing $300
of committed support for performance bonds and similar
instruments, and the extension of the maturity date of the EDC
Support Facility for an additional year to December 31,2007.
61
As a result of the delayed filing of this report with the SEC,
an event of default occurred under the 2006 Credit Facility and
EDC has the right to refuse to issue additional support and
terminate its commitment under the EDC Support Facility. For
more information, see “Restatements; Nortel Networks Audit
Committee Independent Review; Material Weaknesses; Related
Matters — Third Restatement”.
For more information on the 2006 Credit Facility and the EDC
Support Facility, see “Liquidity and Capital
Resources — Future Sources of Liquidity” and the
“Risk Factors” section of this report.
Acquisitions
On February 24, 2006, we acquired Tasman Networks, an
established networking company that provides a portfolio of
secure enterprise routers for $99.5 in cash.
On June 3, 2005, we acquired PEC through a cash tender
offer at a price of $15.50 per common share of PEC. The
aggregate cash consideration (including $33 with respect to
stock options) was approximately $449, including estimated costs
of acquisition of $8. This acquisition was accounted for using
the purchase method. We recorded approximately $278 of
non-amortizable intangible assets associated with the
acquisition of PEC, which assets consist solely of goodwill. The
goodwill of PEC is not deductible for tax purposes, and has been
allocated to our Enterprise Networks segment and will be
allocated to our new Enterprise Solutions and Packet Networks
segment.
PEC is a professional network technologies integrator which
delivers services, systems and secure communication solutions to
governmental entities designed to help improve workforce
productivity, reduce operational costs and streamline
interagency communications. Its primary customers are executive
agencies and departments of the U.S. Federal Government,
the Federal Judiciary, and prime contractors to the
U.S. government. We expect the PEC acquisition to allow us
to pursue opportunities in areas that complement our existing
products and to increase our competitiveness in the government
market.
Our consolidated financial statements include PEC’s
operating results from the date of the acquisition. For
additional financial and other information related to the PEC
acquisition, including a proxy agreement related to our
ownership interest in PEC, see “Acquisitions, divestitures
and closures” in note 10 of the accompanying audited
consolidated financial statements.
Joint Ventures
On November 9, 2005, we and Huawei Technologies Co., Ltd.
entered into a non-binding Memorandum of Understanding to
establish a joint venture for developing ultra broadband access
solutions. Both sides continue to discuss and evaluate the most
effective method of consummating the proposed strategic
alliance, which is subject to negotiation, execution of
definitive agreements and customary regulatory approvals. See
the “Risk Factors” section of this report.
On November 3, 2005, we entered into a joint venture with
LG named LG-Nortel Co. Ltd, or LG-Nortel. The joint venture
combines the telecommunications infrastructure business of LG
with our Republic of Korea distribution and services business to
offer telecom and networking solutions to customers in Republic
of Korea and plans to offer to other markets globally. We
received 50 percent plus one share of the common shares of
the joint venture in exchange for consideration consisting of
principally cash and our Republic of Korea distribution and
services business totaling approximately $155, including
estimated costs of acquisition of $10. Separately, LG will be
entitled to payments from us over a two-year period up to a
maximum of $80 based on achievement by LG-Nortel of certain
business goals. The results of LG-Nortel are included in our
consolidated financial statements commencing November 3,2005. The aggregate purchase price based on management’s
best current estimate of the relative values of the assets
acquired and liabilities assumed in LG-Nortel is approximately
$155. For additional financial information related to LG-Nortel,
see “Acquisitions, divestitures and closures” in
note 10 of the accompanying audited consolidated financial
statements.
Evolution of Our Supply Chain Strategy
In 2004, we entered into an agreement with Flextronics
International Ltd., or Flextronics, regarding the divestiture of
substantially all of our remaining manufacturing operations and
related activities, including certain product integration,
testing, repair operations, supply chain management, third party
logistics operations and design assets. We and Flextronics also
entered into a four year supply agreement for manufacturing
services (whereby after completion of the transaction
Flextronics will manage approximately $2,500 of our annual cost
of revenues) and a three-year supply agreement for design
services.
62
Commencing in the fourth quarter of 2004, and throughout 2005,
we completed the transfer to Flextronics of certain of our
optical design activities in Ottawa, Canada and Monkstown,
Northern Ireland and our manufacturing activities in Montreal,
Canada and Chateaudun, France. In order to allow completion of
several major information systems changes that are expected to
simplify and improve the quality of operations during the
transition, we now expect to transfer the remaining
manufacturing operations in Calgary, Canada to Flextronics by
the end of the second quarter of 2006. We and Flextronics have
agreed that we will retain our Monkstown manufacturing
operations and establish a regional supply chain center to lead
our EMEA supply chain operations.
The successful completion of the agreement with Flextronics will
result in the transfer of approximately 2,100 employees to
Flextronics, of which approximately 1,450 were transferred as of
December 31, 2005. We expect gross cash proceeds ranging
between $575 and $625, of which approximately $380 has been
received as of December 31, 2005, partially offset by cash
outflows incurred to date and expected to be incurred in 2006
attributable to direct transaction costs and other costs
associated with the transaction. These proceeds will be subject
to a number of adjustments, including potential post-closing
date asset valuations and potential post-closing indemnity
payments. Any net gain on the sale of this business will be
recognized once substantially all of the risks and other
incidents of ownership have been transferred.
During the year ended December 31, 2005, we recorded a
charge through gain (loss) on sale of businesses and assets of
$40, related to this ongoing divestiture to Flextronics. The
charges relate to legal and professional fees, pension
adjustments and real estate impairments.
For additional information related to the Flextronics
divestiture, see “Liquidity and Capital Resources” and
“Divestitures” in note 10 of the accompanying
audited consolidated financial statements.
Optical Components Operations
On December 2, 2004, we entered into a restructuring
agreement with Bookham Technology plc, or Bookham, a sole
supplier of key optical components for our optical networks
solutions in our Carrier Packet Networks segment. In February
2005, we agreed to waive until November 6, 2006 minimum
cash balance requirements under certain Bookham notes and in May
2005, we adjusted the prepayment provisions of these notes and
received additional collateral for these notes. In May 2005, we
amended our supply agreement with Bookham to provide Bookham
with financial flexibility to continue the supply of optical
components for our optical networks solutions. See “Related
party transactions” in note 21 of the accompanying
audited consolidated financial statements.
On January 13, 2006, we received $20 in cash plus accrued
interest to retire our $20 aggregate principal amount Bookham
Series A secured note due November 2007. In addition, we
sold our $25.9 aggregate principal amount Bookham Series B
secured note due November 2006 for approximately $26 to a group
of unrelated investors.
On January 13, 2006, we and Bookham amended the current
supply agreement and extended certain purchase commitments,
which had been scheduled to expire on April 29, 2006. Under
the terms of the amended supply agreement, have agreed to
purchase a minimum of $72 in products from Bookham in 2006. In
addition, we entered into an agreement on the same date, under
which we agreed not to sell until after June 30, 2006 the
approximately 4 million shares of Bookham common stock that
we currently own.
In August 2004, we entered into a contract with BSNL to
establish a wireless network in India. We recognized revenues of
approximately $228 and $20 in 2005 and 2004, respectively, and
project losses of approximately $148 and $160, in the
corresponding years. We expect to recognize additional revenues
of approximately $92 and additional project losses of
approximately $19 in 2006. The losses are primarily driven by
the existing contractual terms negotiated in response to pricing
pressures as a result of the competitive nature of India’s
telecommunications market and an increase in project
implementation costs. The time limit within which BSNL could
exercise its 50% business expansion option under the contract
has passed and we will not supply BSNL with products or services
for this expansion.
Restatements; Nortel Audit Committee Independent Review;
Material Weaknesses; Related Matters
First and Second Restatements and Independent
Review
We have effected successive restatements of prior period
financial results. Following the restatement (effected in
December 2003) of our consolidated financial statements for the
years ended December 31, 2002, 2001 and 2000 and for the
quarters ended March 31, 2003 and June 30, 2003, or
the First Restatement, the Audit Committees of NNC’s and
63
NNL’s Board of Directors, or the Audit Committee, initiated
an independent review of the facts and circumstances leading to
the First Restatement, or the Independent Review, and engaged
Wilmer Cutler Pickering Hale & Dorr LLP, or WilmerHale,
to advise it in connection with the Independent Review. This
review and related work led to a variety of actions, including
the termination for cause of NNC’s and NNL’s former
CEO, chief financial officer and controller in April 2004 and
seven additional individuals with significant responsibilities
for financial reporting in August 2004, and ultimately to the
restatement of our financial statements for the years ended
December 31, 2002 and 2001 and the quarters ended
March 31, 2003 and 2002, June 30, 2003 and 2002 and
September 30, 2003 and 2002, or the Second Restatement. For
more information about the First and Second Restatement, see our
2003 Annual Report on
Form 10-K, or the
2003 Annual Report
In January 2005, the Audit Committee reported the findings of
the Independent Review, together with its recommendations for
governing principles for remedial measures, the summary of which
is included in the “Controls and Procedures” section
of the 2003 Annual Report. Each of our and NNL’s Board of
Directors adopted these recommendations in their entirety and
directed our management to implement those principles, through a
series of remedial measures, across the company, to prevent any
repetition of past misconduct and re-establish a finance
organization with values of transparency, integrity, and sound
financial reporting as its cornerstone. Management’s
ongoing implementation efforts are described below and will
continue following the filing of this report. The Board of
Directors has monitored the implementation efforts to date and
will continue to regularly monitor management’s
implementation efforts. See the “Controls and
Procedures” section of this report.
Material Weaknesses in Internal Control over Financial
Reporting
Over the course of the Second Restatement process, we identified
a number of reportable conditions, each constituting a material
weakness, in our internal control over financial reporting as of
December 31, 2003. Five of those material weaknesses
continued to exist as of December 31, 2004.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002,
or SOX 404, and the related SEC rules, management assessed the
effectiveness of our internal control over financial reporting
as of December 31, 2005, using the criteria issued by the
Committee of Sponsoring Organizations of the Treadway
Commission, or COSO, in Internal Control-Integrated Framework.
Based on that assessment, management determined that those
previously identified five material weaknesses continued to
exist as of December 31, 2005 and therefore concluded that,
as of December 31, 2005, we did not maintain effective
internal control over financial reporting based on the COSO
criteria. Deloitte issued an attestation report with respect to
that assessment and conclusion, which is included in
Item 9-A of this report, and concluded that our internal
control over financial reporting was not effective as of
December 31, 2005. The material weaknesses in our internal
control over financial reporting as of December 31, 2005,
which remain unremedied, are:
•
lack of compliance with written Nortel procedures for monitoring
and adjusting balances related to certain accruals and
provisions, including restructuring charges and contract and
customer accruals;
•
lack of compliance with Nortel procedures for appropriately
applying applicable GAAP to the initial recording of certain
liabilities including those described in Statement of Financial
Accounting Standards, or SFAS, No. 5, “Accounting for
Contingencies”, or SFAS No. 5, and to foreign
currency translation as described in SFAS No. 52,
“Foreign Currency Translation”, or
SFAS No. 52;
•
lack of sufficient personnel with appropriate knowledge,
experience and training in U.S. GAAP and lack of sufficient
analysis and documentation of the application of U.S. GAAP
to transactions, including but not limited to revenue
transactions;
•
lack of a clear organization and accountability structure within
the accounting function, including insufficient review and
supervision, combined with financial reporting systems that are
not integrated and which require extensive manual
interventions; and
•
lack of sufficient awareness of, and timely and appropriate
remediation of, internal control issues by Nortel personnel.
As used above, the term “material weakness” means a
significant deficiency (within the meaning of Public Company
Accounting Oversight Board Auditing Standard No. 2), or a
combination of significant deficiencies, that results in more
than a remote likelihood that a material misstatement of our
annual or interim financial statements will not be prevented or
detected.
We continue to identify, develop and implement remedial measures
to address these material weaknesses in our internal control
over financial reporting. For more information see the
“Controls and Procedures” section of this report and
“Risks Related to Our Restatements and Related
Matters” in the “Risk Factors” section of this
report.
64
Third Restatement
Over the course of the Second Restatement process, Nortel,
together with its external independent registered chartered
accountants, identified a number of material weaknesses in our
internal control over financial reporting as at
December 31, 2003. Five of those material weaknesses
continued to exist as at December 31, 2004 and 2005. In
addition, in January 2005, our and NNL’s Boards of
Directors adopted in their entirety the governing principles for
remedial measures identified through the Independent Review. We
continue to develop and implement these remedial measures.
As part of these remedial measures and to compensate for the
unremedied material weaknesses in our internal control over
financial reporting, we undertook intensive efforts in 2005 to
enhance our controls and procedures relating to the recognition
of revenue. These efforts included, among other measures,
extensive documentation and review of customer contracts for
revenue recognized in 2005 and earlier periods. As a result of
the contract review, it became apparent that certain of the
contracts had not been accounted for properly under
U.S. GAAP. Most of these errors related to contractual
arrangements involving multiple deliverables, for which revenue
recognized in prior periods should have been deferred to later
periods, under American Institute of Certified Public
Accountants Statement of Position, or SOP, 97-2 “Software
Revenue Recognition”, and SEC Staff Accounting Bulletin, or
SAB, 104 “Revenue Recognition”, or SAB 104.
In addition, based on our review of our revenue recognition
policies and discussions with our independent registered
chartered accountants as part of the 2005 audit, we determined
that in our previous application of these policies, we
misinterpreted certain of these policies principally related to
complex contractual arrangements with customers where multiple
deliverables were accounted for using the
percentage-of-completion method of accounting under
SOP 81-1, as described in more detail below:
•
Certain complex arrangements with multiple deliverables were
previously fully accounted for under the percentage of
completion method of SOP 81-1, but elements outside of the
scope of SOP 81-1 should have been examined for separation
under the guidance in
EITF 00-21; and
•
Certain complex arrangements accounted for under the
percentage-of-completion
method did not meet the criteria for this treatment in
SOP 81-1 and
should instead have been accounted for using completed contract
accounting under
SOP 81-1.
In correcting for both application errors, the timing of revenue
recognition was frequently determined to be incorrect, with
revenue having generally been recognized prematurely when it
should have been deferred and recognized in later periods.
Management’s determination that these errors required
correction led to the Audit Committee’s decision on
March 9, 2006 to effect a further restatement of our
consolidated financial statements (the “Third
Restatement”). We have restated our consolidated balance
sheet as of December 31, 2004 and consolidated statements
of operations, changes in equity and comprehensive income (loss)
and cash flows for each of the years ended December 31,2004 and 2003. The Third Restatement also corrected other
miscellaneous accounting errors, as well as the classification
of certain items within the consolidated statements of
operations and cash flows, as described below. The impact of the
Third Restatement to periods prior to 2003 was a net increase of
$70 to opening accumulated deficit as of January 1, 2003.
65
The following tables present the impact of the Third Restatement
on our previously reported consolidated statements of operations
data for the years ended December 31, 2004 and 2003.
Consolidated Statement of Operations data for the year
ended December 31, 2004
Revenue and
As Previously
Cost of Revenue
Other
Reported
Adjustments
Adjustments
As Restated
Revenues
$
9,828
$
(312
)
$
—
$
9,516
Gross profit
4,078
(132
)
(4
)
3,942
Operating earnings (loss)
(111
)
(132
)
(7
)
(250
)
Earnings (loss) from continuing operations before income taxes,
minority interests and equity in net loss of associated companies
(83
)
(132
)
(25
)
(240
)
Net earnings (loss) from continuing operations
(100
)
(131
)
(25
)
(256
)
Net earnings (loss) from discontinued operations — net
of tax
49
—
—
49
Net earnings (loss)
(51
)
(131
)
(25
)
(207
)
Basic and diluted earnings (loss) per common share
— from continuing operations
$
(0.02
)
$
(0.03
)
$
(0.01
)
$
(0.06
)
— from discontinued operations
0.01
0.00
0.00
0.01
Basic and diluted earnings (loss) per common share
$
(0.01
)
$
(0.03
)
$
(0.01
)
$
(0.05
)
Consolidated Statement of Operations data for the year
ended December 31, 2003
Revenue and
As Previously
Cost of Revenue
Other
Reported
Adjustments
Adjustments
As Restated
Revenues
$
10,193
$
(261
)
$
—
$
9,932
Gross profit
4,341
(122
)
(10
)
4,209
Operating earnings (loss)
45
(122
)
(49
)
(126
)
Earnings (loss) from continuing operations before income taxes,
minority interests and equity in net loss of associated companies
281
(132
)
(15
)
134
Net earnings (loss) from continuing operations
262
(125
)
(15
)
122
Net earnings (loss) from discontinued operations — net
of tax
184
—
(1
)
183
Net earnings (loss)
434
(125
)
(16
)
293
Basic and diluted earnings (loss) per common share
— from continuing operations
$
0.06
$
(0.03
)
$
0.00
$
0.03
— from discontinued operations
0.04
0.00
0.00
0.04
Basic and diluted earnings (loss) per common share
$
0.10
$
(0.03
)
$
0.00
$
0.07
Revenues and cost of revenues adjustments
The Third Restatement adjustments that related to revenue
recognition errors resulted in a net decrease to revenues of
$312 and $261 for the years ended December 31, 2004 and
2003, respectively. These errors related to revenue previously
recognized that should have been deferred to subsequent periods.
Corresponding adjustments to cost of revenues were made,
resulting in a net decrease to cost of revenues of $180 and $139
related to the revenue recognition adjustments,
66
and a total net decrease of $176 and $129 including other
adjustments, for the years ended December 31, 2004 and 2003
respectively.
Revenues
Cost of Revenues
2004
2003
2004
2003
As previously reported
$
9,828
$
10,193
$
5,750
$
5,852
Adjustments:
Application of SOP 81-1
(84
)
(118
)
(55
)
(103
)
Interaction between multiple revenue recognition accounting
standards
(174
)
(49
)
(127
)
(26
)
Application of SAB 104 and SOP 97-2
(38
)
(84
)
14
(36
)
Other revenue recognition adjustments
(16
)
(10
)
(12
)
26
Other
adjustments(a)
—
—
4
10
As restated
$
9,516
$
9,932
$
5,574
$
5,723
(a)
For further details see explanations of ‘Other
adjustments’.
Application of SOP 81-1
We determined that in certain arrangements we had misinterpreted
the guidance in SOP 81-1 relating to the application of
percentage-of-completion
accounting. Under the
percentage-of-completion
method, revenues are generally recorded based on a measure of
the percentage of costs incurred to date relative to the total
expected costs of the contract. In certain circumstances where a
reasonable estimate of costs cannot be made, but it is assured
that no loss will be incurred, revenue is recognized to the
extent of direct costs incurred (“zero margin
accounting”). If a reasonable estimate of costs cannot be
made and we are not assured that no loss will be incurred,
revenue should be recognized using completed contract accounting.
For certain arrangements accounted for under the
percentage-of-completion
method which included rights to future software upgrades, we
have now determined that we did not have a sufficient basis to
estimate the total costs of the arrangements, due to the
inability to estimate the cost of providing these future
software upgrades. In addition, in one arrangement, we had
previously applied zero margin accounting on the basis that we
believed that no loss would be incurred. We have now determined
that assurance that no loss would be incurred exists only in
very limited circumstances, such as in cost recovery
arrangements. Accordingly, we have determined that
percentage-of-completion
accounting should not have been used to account for these
specific arrangements, and the completed contract method should
have been applied under
SOP 81-1. Under
the completed contract method, revenues and certain costs are
deferred until completion of the arrangement, which results in a
delay in the timing of revenue recognition as compared to
arrangements accounted for under
percentage-of-completion
accounting.
Interaction between multiple revenue recognition accounting
standards
We determined there were accounting errors related to the
application of SOP 81-1,
SOP 97-2 and
related interpretive guidance under
EITF 00-21.
Some of our customer arrangements have multiple deliverable
elements for which different accounting standards may govern the
appropriate accounting treatment. For those arrangements that
contained more-than-incidental software and involved significant
production, modification or customization of software or
software related elements (“customized elements”), we
had previously applied the
percentage-of-completion
method of accounting under SOP 81-1 to all the elements
under the arrangement, in accordance with our interpretation of
SOP 97-2. This
included certain future software, software-related or
non-software related deliverables.
We have now determined that we should have applied the
separation criteria set forth in
EITF 00-21 and
SOP 97-2 to
non-software and software/software-related elements,
respectively, to determine whether the various elements under
these arrangements should be treated as separate units of
accounting. Generally, the applicable separation criteria in
EITF 00-21 and
SOP 97-2 requires
sufficient objective and reliable evidence of fair value for
each element. If an undelivered non-SOP 81-1 element cannot
be separated from an SOP 81-1 element, depending on the
nature of the elements and the timing of their delivery, the
combined unit of accounting may be required to be accounted for
under SOP 97-2
rather than under SOP 81-1.
SOP 97-2 provides
that the entire revenue associated with the combined elements
should typically be deferred until the earlier of the point at
which (i) the undelivered element(s) meet the criteria for
67
separation or (ii) all elements within the combined unit of
accounting have been delivered. Once there is only one remaining
element to be delivered within the unit of accounting, the
deferred revenue is recognized based on the revenue recognition
guidance applicable to the last delivered element.
For certain of our multiple element arrangements involving
customized elements where elements such as PCS, specified
upgrade rights and/or non-essential hardware or software
products remained undelivered, we frequently determined that the
undelivered element could not be treated as a separate unit of
accounting because fair value could not be established for all
undelivered non-customized elements. Accordingly, we should not
have accounted for the revenue using
percentage-of-completion
accounting. Instead, the revenue should have been deferred in
accordance with
SOP 97-2 until
such time as the fair value of the undelivered element could be
established or all remaining elements have been delivered. Once
there is only one remaining element to be delivered within the
unit of accounting, the deferred revenue is recognized based on
the revenue recognition guidance applicable to that last element.
Application of SAB 104 and
SOP 97-2
Primarily as a result of our contract review, we determined that
in respect of certain contracts providing for multiple
deliverables, revenues had previously been recognized for which
the revenue recognition criteria under
SOP 97-2 or
SAB 104, as applicable, had not been met. These errors
related primarily to situations in which the fair value of an
undelivered element under the arrangement could not be
established.
In certain arrangements, we had treated commitments to make
available a specified quantity of upgrades during the contract
period as PCS. Under
SOP 97-2, where
fair value cannot be established for PCS, revenue is recognized
for the entire arrangement ratably over the PCS term. We have
now determined that commitments to make available a specified
quantity of upgrades do not qualify as PCS and should be
accounted for as a separate element of the arrangement from the
PCS. Fair value could not be established for these commitments
to make available a specified quantity of upgrades and as a
result, the revenue related to the entire arrangement should
have been deferred until the earlier of when (i) fair value
of the undelivered element could be established or (ii) the
undelivered element is delivered. Adjustments were made to defer
the revenue and related costs until the upgrades were delivered.
In certain multiple element arrangements, we had recognized
revenue upon delivery of products under the arrangement although
other elements under the arrangement, such as future contractual
or implicit PCS, had not been delivered. If sufficient evidence
of fair value cannot be established for an undelivered element,
revenue related to the delivered products should be deferred
until the earlier of when vendor specific objective evidence, or
fair value, or VSOE, for the undelivered element can be
established or all the remaining elements have been delivered.
Once there is only one remaining element, the deferred revenue
is recognized based on the revenue recognition guidance
applicable to that last undelivered element. For instance, where
PCS is the last undelivered element within the unit of
accounting, deferred revenue is recognized ratably over the PCS
term. As we identified a number of contracts where sufficient
evidence of fair value could not be established for the
undelivered elements, adjustments were made to defer the revenue
and related costs from the periods in which they were originally
recorded and until such time as the appropriate criteria
recognition were met.
In addition, we identified and corrected certain revenue
recognition errors that related to the application of
SAB 104 and SOP 97-2. The cumulative adjustments were
previously recorded in 2004, rather than restating prior
periods, because they were not material either to 2004, or the
prior period results as originally reported. As part of the
Third Restatement, these adjustments have now been recorded in
the appropriate periods as follows:
•
A cumulative correction previously recorded in the third quarter
of 2004 has now been recorded primarily in 2003, and prior
periods resulting in an increase to revenue of $89 in the third
quarter of 2004. The adjustment was to correct for previously
recognized revenue relating to past sales of Optical Networks
equipment which we determined should have been deferred and
recognized with the delivery of future contractual PCS and other
services over the term of the PCS.
•
A cumulative correction in the fourth quarter of 2004 has now
been recorded in the appropriate prior periods resulting in an
increase to revenue of $40 in the fourth quarter of 2004. The
adjustment was to correct for previously recognized revenue
related to an EMEA contract which should have been deferred
until the delivery of certain undelivered elements such as
services.
Other revenue recognition adjustments
In addition, errors related to application of the profit center
definition were identified and corrected. We made other revenue
corrections related to the treatment of non-cash incentives, and
certain errors related to the classification of
68
revenue. Other revenue recognition adjustments also reflect the
impact on cost of revenues of corrections to standard costing on
deferred costs (related to deferred revenue) included in
inventory, and other adjustments to inventory to correct
standard costing.
Other adjustments
Other miscellaneous adjustments were identified and recorded in
the Third Restatement, the more significant of which are
summarized below.
Health and Welfare Trust
In prior periods, we had incorrectly netted employee benefit
plan assets against the post-employment and post-retirement
liabilities and incorrectly recognized gains and losses through
the consolidated statement of operations related to certain
assets held in an employee benefit trust in Canada, or Health
and Welfare Trust. Historically, we had accounted for the assets
of the Health and Welfare Trust in accordance with
SFAS No. 106 “Employers’ Accounting for Post
Retirement Benefit Plans” (“SFAS 106”) and
SFAS No. 112, “Employers’ Accounting for
Post-Employment Benefit Plans” (“SFAS 112”)
which, among other things, permitted the netting of these plan
assets against the post-employment and post-retirement
liabilities if the assets are appropriately segregated and
restricted. Upon further review, we determined that these assets
should not have been netted against the liabilities because the
Health and Welfare Trust was not legally structured so as to
segregate and restrict its assets to meet the definition of plan
assets under SFAS 106 and SFAS 112. As a result, we
corrected prior periods to present plan assets and liabilities
on a gross basis, and to recognize gains and losses in OCI.
We further determined that Nortel was the primary beneficiary of
the Health and Welfare Trust, which met the definition of a
variable interest entity under FIN 46R “Consolidation
of Variable Interest Entities”. As a result, we corrected
prior periods to consolidate the Health and Welfare Trust into
our results as of July 1, 2003, the effective date of
FIN 46R. The combined impact of these adjustments in the
Third Restatement was an increase in cost of revenues of $2 and
$10, an increase in selling, general and administrative expense
of $3 and $12, an increase in R&D expense of $4 and $6 and
an increase in other income of $8 and $9 for the years ended
December 31, 2004 and 2003, respectively. As of
December 31, 2004, total assets increased by $138 and
liabilities increased by $144, including the related foreign
exchange impact, as a result of these adjustments.
Foreign exchange
We had previously recorded foreign exchange gains in our 2004
consolidated financial statements, to correct a cumulative error
from prior periods related to the functional currency
designation of an entity in Brazil. This adjustment was
previously recorded in 2004 rather than restating the prior
periods, because the adjustment was not material either to the
2004 or the prior period results as originally reported. As part
of the Third Restatement, the impact of this adjustment has now
been recorded in the appropriate prior periods, resulting in a
decrease to other income for the year ended December 31,2004 of $33 and an increase for the year ended December 31,2003 of $18.
We also identified and corrected additional foreign currency
translation errors related to a pension liability under the
Supplemental Executive Retirement Plan and historical balances
for certain long-term debt issue and discount costs. The impact
of the adjustments in the Third Restatement to correct these
errors resulted in a net decrease to other income of $3 for the
year ended December 31, 2004 and a decrease of $8 for the
year ended December 31, 2003.
In addition, the foreign exchange gains and losses, if any,
resulting from the Third Restatement adjustments were recorded
in other income-net, and are presented in ‘Other
adjustments’ in the consolidated statements of operations
data tables above.
Other
We had previously capitalized legal and professional fees and
real estate impairment costs relating to the transaction with
Flextronics for the divestiture of substantially all of our
remaining manufacturing operations and related activities,
accumulating those costs in the consolidated balance sheet as
deferred costs starting in 2004. We have determined that these
costs should instead have been recognized as incurred in prior
periods. Accordingly, we have made adjustments to record these
costs in the appropriate prior period, resulting in a decrease
to gain (loss) on sale of businesses and assets of $6 for the
year ended December 31, 2004.
69
In 2004, we corrected certain other accounting errors we had
identified that related to prior periods. These adjustments were
previously recorded in 2004 rather than restating prior periods
because they were not material to 2004 or to the financial
statements as originally reported. However, as part of the Third
Restatement, these adjustments have now been recorded in the
appropriate prior periods. These adjustments were as follows:
•
During 2004, we had recorded a cumulative correction to
reclassify an operating lease to a capital lease. These
adjustments have now been recorded to the appropriate prior
periods which resulted in a decrease in selling, general and
administrative expense in the year ended December 31, 2004
of $16 and an increase in the year ended December 31, 2003
of $5.
•
We had previously recorded the release of a customer financing
provision of $9 in 2004 that should have been recorded in 2003.
As a result, selling, general and administrative expense has
increased by $9 for the year ended December 31, 2004 and
decreased by $9 for the year ended December 31, 2003.
•
We have corrected the useful lives of various leasehold
improvement assets, included in plant and equipment —
net, which resulted in a decrease to depreciation expense for
the year ended December 31, 2004 of $6 and an increase for
the year ended December 31, 2003 of $3.
Reclassifications
We had previously classified changes in restricted cash and cash
equivalents as a component of net cash from (used in) operating
activities of continuing operations. We have now determined
that, under SFAS No. 95, “Statement of Cash
Flows”, changes in restricted cash and cash equivalents
should instead be recorded as a component of net cash from (used
in) investing activities of continuing operations. Accordingly,
we have made adjustments of $17 and $200 for the years ended
December 31, 2004 and 2003, respectively, to reclassify
changes in restricted cash and cash equivalents from net cash
from (used in) operating activities of continuing operations to
net cash from (used in) investing activities of continuing
operations in the consolidated statements of cash flows.
Certain sublease income has been reclassified in the
consolidated statement of operations. The impact of this
adjustment resulted in an increase of $10 and $2 in selling,
general and administrative expense and cost of revenues,
respectively and an increase in other income of $12 for the year
ended December 31, 2004. For the year ended
December 31, 2003, sublease income of $15 was reclassified
from selling, general and administrative expense to other income.
Earnings (loss) from continuing operations before income taxes,
minority interests and equity in net earnings (loss) of
associated companies
114
84
Net earnings (loss) from continuing operations
96
65
Net earnings from discontinued operations — net of tax
37
37
Net earnings (loss)
$
133
$
102
Basic and diluted earnings (loss) per common share
— from continuing operations
$
0.02
$
0.01
— from discontinued operations
0.01
0.01
Basic and diluted earnings (loss) per common share
$
0.03
$
0.02
Adjustments
The following table summarizes the revenue adjustments and other
adjustments to net earnings (loss). See above, and
“Quarterly Financial Data” in this Report for a
description of the nature of these adjustments.
2005
2004
Three
Three
Three
Three
Three
Three
Three
Months
Months
Months
Months
Months
Months
Months
Ended
Ended
Ended
Ended
Ended
Ended
Ended
March 31
June 30
September 30
March 31
June 30
September 30
December 31
Revenues — as previously reported
$
2,536
$
2,855
$
2,655
$
2,444
$
2,590
$
2,179
$
2,615
Adjustments:
Application of SOP 81-1
82
(23
)
(13
)
(22
)
(29
)
(17
)
(16
)
Interaction between multiple revenue recognition accounting
standards
(183
)
(155
)
(70
)
(19
)
(31
)
(49
)
(75
)
Application of SAB 104 and SOP 97-2
(53
)
(45
)
(62
)
(37
)
(54
)
42
11
Other revenue recognition adjustments
7
(13
)
8
—
2
4
(22
)
Revenues — as restated
$
2,389
$
2,619
$
2,518
$
2,366
$
2,478
$
2,159
$
2,513
Net earnings (loss) — as previously reported
$
(49
)
$
45
$
(105
)
$
59
$
16
$
(259
)
$
133
Adjustments:
Application of SOP 81-1
9
(12
)
(6
)
(3
)
(14
)
(3
)
(8
)
Interaction between multiple revenue recognition accounting
standards
(26
)
(12
)
(7
)
(6
)
(7
)
(10
)
(24
)
Application of SAB 104 and SOP 97-2
(26
)
(25
)
(22
)
(23
)
(26
)
2
(5
)
Other revenue recognition adjustments
(3
)
(50
)
6
(9
)
3
2
—
Gain on sale of businesses
(21
)
25
—
(1
)
—
—
(6
)
Health and WelfareTrust
—
—
—
—
—
—
(1
)
Foreign
exchange(i)
2
11
(5
)
—
6
(34
)
(10
)
Other
10
(15
)
3
(2
)
(1
)
1
23
Net earnings (loss) — as restated
$
(104
)
$
(33
)
$
(136
)
$
15
$
(23
)
$
(301
)
$
102
(i)
Includes the foreign exchange gains and losses resulting from
the Third Restatement adjustments, and the correction of certain
foreign exchange errors as described in note 4 of the
accompanying consolidated financial statements.
72
Credit and Support Facilities
As a result of the delayed filing of this report with the SEC,
an event of default occurred under the 2006 Credit Facility. As
a result of this and certain other related breaches, lenders
holding greater than 50% of each tranche under the 2006 Credit
Facility have the right to accelerate such tranche, and lenders
holding greater than 50% of all of the secured loans under the
2006 Credit Facility have the right to exercise rights against
certain collateral. The entire $1,300 under the 2006 Credit
Facility is currently outstanding.
In addition, as a result of the delayed filing of this report
with the SEC and other related breaches, EDC has the right to
refuse to issue additional support and terminate its commitments
under the $750 EDC Support Facility or require that NNL cash
collateralize all existing support. As of April 14, 2006,
there was approximately $162 of outstanding support under the
EDC Support Facility.
We are currently in discussions with our lenders under the 2006
Credit Facility and with EDC under the EDC Support Facility to
negotiate waivers related to the Third Restatement and the delay
in filing this report and the anticipated delay in filing our
Quarterly Report on
Form 10-Q for the
period ended March 31, 2006, or the 2006 First Quarter
Report. Although we expect to reach an agreement with the
lenders and EDC with respect to the terms of an acceptable
waiver, there can be no assurance that we will receive such
waivers.
Public debt securities
As a result of the delayed filing of this report with the SEC,
we and NNL were not in compliance with our obligations to
deliver our SEC filings to the trustees under our public debt
indentures. The delay in filing this report did not result, and
the anticipated delay in filing the 2006 First Quarter Reports
(which we are obligated to deliver to the trustees by
May 25, 2006) will not result, in an automatic default and
acceleration of such long-term debt. Neither the trustee under
any such public debt indenture nor the holders of at least 25%
of the outstanding principal amount of any series of debt
securities issued under the indentures have the right to
accelerate the maturity of such debt securities unless we or
NNL, as the case may be, fail to file and deliver our required
SEC filings within 90 days after the above mentioned
holders have given notice of such default to us or NNL. While
such notice could have been given at any time after
March 30, 2006 as a result of the delayed filing of this
report, neither we nor NNL has received such a notice to the
date of this report. In addition, any acceleration of the loans
under the 2006 Credit Facility would result in a cross-default
under the public debt indentures that would give the trustee
under any such public debt indenture or the holders of at least
25% of the outstanding principal amount of any series of debt
securities issued under the indentures the right to accelerate
such series of debt securities. Approximately $500 of debt
securities of NNL (or its subsidiaries) and $1,800 of our
convertible debt securities (guaranteed by NNL) are currently
outstanding under the indentures.
If an acceleration of our and NNL’s obligations were to
occur, we and NNL may be unable to meet our respective payment
obligations with respect to the related indebtedness. Any such
acceleration could also adversely affect our business, results
of operations, financial condition and liquidity and the market
price of our publicly traded securities. See the “Risk
Factors” section of this report.
Stock-based compensation plans
As a result of our March 10, 2006 announcement that we and
NNL would have to delay the filing of our 2005
Form 10-Ks, we
suspended, as of March 10, 2006, the grant of any new
equity and exercise or settlement of previously outstanding
awards under the Nortel 2005 Stock Incentive Plan, or SIP, the
purchase of Nortel Networks Corporation common shares under the
stock purchase plans for eligible employees in eligible
countries that facilitate the acquisition of Nortel Networks
Corporation common shares; the exercise of outstanding options
granted under the Nortel Networks Corporation 2000 Stock Option
Plan, or the 2000 Plan, and the Nortel Networks Corporation 1986
Stock Option Plan as amended and restated, or the 1986 Plan, or
the grant of any additional options under those plans, or the
exercise of outstanding options granted under employee stock
option plans previously assumed by us in connection with mergers
and acquisitions; and the purchase of units in a Nortel Networks
stock fund or purchase of Nortel Networks Corporation common
shares under our defined contribution and investment plans,
until such time as, at the earliest, we are in compliance with
U.S. and Canadian regulatory securities filing requirements.
Regulatory actions
On April 10, 2006, the Ontario Securities Commission, or
OSC issued a final order prohibiting all trading by our
directors, officers and certain current and former employees in
our and NNL’s securities. This order will remain in effect
73
until two full business days following the receipt by the OSC of
all filings required to be made by us and NNL pursuant to
Ontario securities laws.
Stock exchanges
As a result of the delay in filing this report and the
anticipated delay in filing the 2006 First Quarter Reports with
the SEC, we are in breach of the continued listing requirements
of the NYSE and the TSX. The TSX has granted us and NNL an
extension up to April 30, 2006 by which to file our 2005
Form 10-Ks. To
date, neither the NYSE nor the TSX has commenced any suspension
or delisting procedures in respect of Nortel Networks
Corporation common shares and other of our and NNL’s listed
securities. The commencement of any suspension or delisting
procedures by either exchange remains, at all times, at the
discretion of such exchange.
Annual Shareholders’ Meeting
On April 6, 2006, we announced the postponement of our
Annual Shareholders’ Meeting for 2005 to June 29, 2006
due to the delay in filing this report.
Revenue Independent Review
As described in our 2003 Annual Report, management identified
certain accounting practices and errors related to revenue
recognition that it determined required adjustment as part of
the Second Restatement. In light of the resulting corrections to
previously reported revenues totaling approximately
$3.4 billion, the Audit Committee determined to review the
facts and circumstances leading to the restatement of these
revenues for specific transactions identified in the Second
Restatement, with a particular emphasis on the underlying
conduct, or the Revenue Independent Review. The Audit Committee
sought a full understanding of the historic events that required
the revenues for these specific transactions to be restated and
intended to consider any appropriate additional remedial
measures, including those involving internal controls and
processes. The Audit Committee engaged WilmerHale to advise it
in connection with this review. Because of the significant
accounting issues involved in the inquiry, WilmerHale retained
Huron Consulting Services LLC, or Huron, to provide expert
accounting assistance, and Huron was involved in all phases of
WilmerHale’s work. The Audit Committee launched its
independent review after the Second Restatement was completed
and did not seek to have WilmerHale and Huron audit or otherwise
review the substantive accuracy of our restated financial
statements or review other aspects of our accounting practices
not adjusted in the Second Restatement.
The Revenue Independent Revenue focused principally on
transactions that accounted for approximately $3.0 billion
of the $3.4 billion in restated revenue, with a particular
emphasis on transactions that accounted for approximately
$2.6 billion in 2000. That emphasis was appropriate because
(1) the size of the revenue restatement for 2000
($2.8 billion of the total restated revenue of
$3.4 billion) and (2) the same types of errors made in
2000 reoccurred in subsequent years. As more fully described in
Item 9A of the 2003 Annual Report, the revenue adjustments
that were part of the Second Restatement primarily related to
certain categories of transactions, and the Revenue Independent
Review has examined transactions in each of these categories.
The Revenue Independent Review found that, in an effort to meet
internal and external targets, the senior corporate finance
management team, none of whom are current employees, changed our
accounting policies several times during 2000, either to defer
revenue out to a subsequent period or pull revenue into the
current period. After changing internal accounting policies,
senior corporate finance management did not understand the
relevant U.S. GAAP requirements, misapplied these
U.S. GAAP requirements, and in certain circumstances,
turned a blind eye to these U.S. GAAP requirements. As a
result, the Revenue Independent Review concluded that Nortel
recognized revenue for numerous transactions without regard for
the proper accounting and this conduct was driven by the need to
close revenue and earnings gaps.
The independent review of the facts leading to the initial
erroneous recognition of revenues that were restated as a result
of the Second Restatement is now complete. While the focus of
the Revenue Independent Review was on the underlying conduct
related to the transactions discussed above that were restated,
this review found no additional accounting errors that should be
investigated by management for possible restatement.
In the Independent Review Summary approved by the Board of
Directors and included in our 2003 Annual Report, the Board of
Directors adopted a framework of governing remedial principles
to prevent recurrence of the inappropriate accounting conduct,
to rebuild a finance environment based on transparency and
integrity, and to ensure sound financial reporting and
comprehensive disclosure. The Board of Directors directed
management to implement those principles,
74
through a series of remedial measures, across the company, to
prevent any repetition of past misconduct and re-establish a
finance organization with values of transparency, integrity, and
sound financial reporting as its cornerstone. Management’s
ongoing implementation efforts are described below and will
continue following the filing of this report. The Board of
Directors has monitored the implementation efforts to date and
will continue to regularly monitor management’s
implementation efforts.
Regulatory Actions and Pending Litigation
We are under investigation by the SEC and the OSC Enforcement
Staff. In addition, we have received U.S. federal grand
jury subpoenas for the production of certain documents sought in
connection with an ongoing criminal investigation being
conducted by the U.S. Attorney’s Office for the
Northern District of Texas, Dallas Division. Further, the
Integrated Market Enforcement Team of the Royal Canadian Mounted
Police, or RCMP, has advised us that it would be commencing a
criminal investigation into our financial accounting situation.
Regulatory sanctions may potentially require us to agree to
remedial undertakings that may involve the appointment of an
independent adviser to review, assess and monitor our accounting
practices, financial reporting and disclosure processes and
internal control systems. We will continue to cooperate fully
with all authorities in connection with these investigations and
reviews.
In addition, numerous class action complaints and other actions
have been filed against us and NNL, including class action
complaints under ERISA and an application in Canada for leave to
commence a derivative action against certain of our current and
former officers and directors.
As described above under “Significant Business
Developments — Proposed Class Action
Settlement,” on February 8, 2006, we announced the
Proposed Class Action Settlement of all pending and
proposed shareholder class actions. This settlement would be
part of, and is conditioned on our reaching a global settlement
encompassing all pending shareholder class actions and proposed
shareholder class actions commenced against us and certain other
defendants following our announcement of revised financial
guidance during 2001 and our revision of our 2003 financial
results and restatement of other prior periods. The Proposed
Class Action Settlement is also conditioned on the receipt
of all required court, securities regulatory and stock exchange
approvals. On March 17, 2006, we announced that we and the
lead plaintiffs reached an agreement on the related insurance
and corporate governance matters including our insurers agreeing
to pay $228.5 in cash towards the settlement and us
agreeing with our insurers to certain indemnification
obligations. We believe that these indemnification obligations
would be unlikely to materially increase our total cash payment
obligations under the Proposed Class Action Settlement. The
insurance payments would not reduce the amounts payable by us as
noted below. We also agreed to certain corporate governance
enhancements, including the codification of certain of our
current governance practices (such as the annual election by our
directors of a non-executive Board chair) in our Board of
Directors written mandate and the inclusion in our annual proxy
circular and proxy statement of a report on certain of our other
governance practices (such as the process followed for the
annual evaluation of the Board, committees of the Board and
individual directors). The Proposed Class Action Settlement
would contain no admission of wrongdoing by us or any of the
other defendants. The Proposed Class Action Settlement does
not relate to the ongoing regulatory and criminal investigations
and does not encompass the related ERISA class action or the
pending application in Canada for leave to commence a derivative
action against certain of our current and former officers and
directors. For more information, see “Developments in 2005
and 2006 — Significant Business
Developments — Proposed Class Action
Settlement”.
Our pending civil litigation and regulatory and criminal
investigations are significant and, if decided against us,
including if we are not able to reach a global definitive
settlement in the case of the civil litigation proposed to be
encompassed by the Proposed Class Action Settlement, could
materially adversely affect our business, results of operations,
financial condition or liquidity by requiring us to pay
substantial judgments, settlements, fines, sanctions or other
penalties, or requiring us to issue equity or equity related
securities which could potentially result in the significant
dilution of existing shareholders equity positions.
For additional information, see “Liquidity and Capital
Resources”, the “Legal Proceedings” and
“Risk Factors” sections of this report and
“Contingencies” in note 22 of the accompanying
audited consolidated financial statements. For more information
on the Proposed Class Action Settlement, see also
“Significant Business Developments — Proposed
Class Action Settlement”.
75
Results of Operations — Continuing Operations
Consolidated Information
Revenues
Demand Trends for Our Network Solutions
The following table sets forth our external revenues by category
of network solutions:
CDMA solutions include revenues from traditional TDMA solutions
(which were no longer significant in 2005).
(b)
Circuit and packet voice and data networking and security
solutions each aggregate revenues included in our Carrier Packet
Networks and Enterprise Networks segments, while optical
networking solutions are included in our Carrier Packet Networks
segment.
(c)
Other includes our revenues from PEC (included in our Enterprise
Networks segment), which we acquired in June 2005, and various
other network solutions.
(d)
In the first quarter of 2006, we expect the following two new
product groups to form our reportable segments:
(i) Enterprise Solutions and Packet Networks, which
combines optical networking solutions (included in our Carrier
Packet Networks segment in 2005), data networking and security
solutions and portions of circuit and packet voice solutions
(included in both our Carrier Packet Networks segment and
Enterprise Networks segment in 2005) into a unified product
group; and (ii) Mobility and Converged Core Networks, which
combines our CDMA solutions and GSM and UMTS solutions (each in
a separate segment in 2005) and other circuit and packet voice
solutions (included in our Carrier Packet Networks segment in
2005).
The following discusses significant demand trends in 2005 and
2004 for our various network solutions, which impacted our
consolidated revenues. We make reference to demand trends in
developing and developed countries. Other than the United States
and Canada, which we consider developed, each of our geographic
regions encompass both developed and developing countries. Other
factors also impacted our 2005 and 2004 revenues, and this
discussion should be read together with the “Geographic
Revenues” and “Segment Information” sections.
CDMA Solutions
•
In 2005, revenues from our CDMA solutions (which increased 5%
over 2004) were positively impacted by significant expansion to
meet increased subscriber demand, primarily in developed
countries, and the evolution of wireless networks to next
generation CDMA technologies, which facilitate mobile high speed
data services. Demand for new CDMA technologies was generally
greater in developed countries with an installed base of CDMA
solutions. In addition, network completions and industry
consolidation negatively impacted our revenues in certain
regions. Revenues from TDMA solutions were not significant.
In 2004, revenues from our CDMA solutions (which decreased 6%
over 2003) were negatively impacted by substantial declines in
TDMA solutions across all regions as customers continued to
migrate from the mature TDMA technology to GSM and CDMA wireless
technologies. Revenues from CDMA solutions were positively
impacted in developed countries by factors that positively
impacted revenues in 2005. Network completions during the first
half of 2003 negatively impacted our revenues in certain regions.
GSM and UMTS Solutions
•
In 2005, revenues from our GSM and UMTS solutions (which
increased 16% over 2004) reflected increases in both GSM
solutions and UMTS solutions. Revenues from our GSM solutions
were positively impacted by greater infrastructure sales,
particularly in developing countries, related to increasing
demand by subscribers. In addition, industry consolidation and a
mature installed base of GSM solutions negatively impacted our
revenues in certain regions. Revenues from our UMTS solutions
were positively impacted by higher subscriber demand to support
76
progressively more sophisticated communication services and
continued transition to this next generation technology
primarily in developed countries where demand for these services
is highest and to a lesser extent in developing countries. In
addition, industry consolidation negatively impacted our
revenues in the U.S.
In 2004, revenues from our GSM and UMTS solutions (which
increased 28% over 2003) reflected increases in both GSM
solutions and UMTS solutions. Revenues from these solutions were
impacted in all regions by the same factors that were present in
2005. In addition, new contracts were obtained in certain
regions.
Circuit and Packet Voice Solutions
•
In 2005, revenues from our circuit and packet voice solutions
(which increased 6% over 2004) were positively impacted by an
increase in packet voice solutions offset by declines in circuit
voice solutions. Revenues from packet voice solutions were
positively impacted by increased demand for next-generation
packetized communications, including VoIP, which resulted in
reduced expenditures, primarily by service providers, for
circuit voice solutions that do not readily accommodate these
forms of communication. Demand for circuit and packet voice
solutions varied across developed and developing countries.
In 2004, revenues from our circuit and packet voice solutions
(which decreased 14% over 2003) were negatively impacted by a
substantial decrease in circuit voice solutions partially offset
by an increase in packet voice solutions. Revenues from circuit
voice solutions were negatively impacted due to continued
reductions in capital expenditures by our service provider
customers and a reduction in spending on our mature products in
all regions where these solutions are marketed. Packet voice
solutions were impacted in all regions by the same factors that
positively impacted revenues in 2005. In addition, revenues from
packet voice solutions were negatively impacted by enterprise
customers in certain regions reducing their spending on certain
of our products.
Data Networking and Security Solutions
•
In 2005, revenues from our data networking and security
solutions (which remained essentially flat over 2004) were
negatively impacted by reduced demand for our legacy routing
solutions and a mature router access market. Revenues were
positively impacted by demand for IP based services and related
next generation routing solutions, which include features such
as power over Ethernet. This demand varied across developed and
developing countries depending on the rate of network upgrade
and expansion.
In 2004, revenues from our data networking and security
solutions (which decreased 11% over 2003) were impacted by
factors that negatively impacted revenues in 2005, particularly
in developed countries and in relation to our mature products
due to the ongoing shift toward IP based services.
Optical Networking Solutions
•
In 2005, revenues from our optical networking solutions (which
increased 24% over 2004) were positively impacted by increased
demand for multimedia and other communications at broadband
network speeds. Revenues from our metro networking solutions
were positively impacted by the delivery of triple play services
(data, voice and multimedia) by a range of service providers,
particularly in developed countries where these services are
readily available. Revenues from our long-haul solutions were
positively impacted by network expansion by wireless and other
service providers in developed countries where the focus is on
maximizing return on invested capital by increasing the capacity
utilization rates and efficiency of existing networks to meet
fluctuations in subscriber demand.
In 2004, revenues from our optical networking solutions (which
decreased 18% over 2003) were negatively impacted by reduced
spending by service providers in developed countries on
long-haul solutions as they continued to focus on maximizing
return on invested capital by increasing their capacity
utilization rates and efficiency of existing networks to meet
fluctuations in subscriber demand partially offset by increases
in metro networking solutions, particularly in developed
countries, for the same reasons that positively impacted these
revenues in 2005. Significant excess inventories and capacity
related to optical networking solutions continued to exist in a
number of regions which also resulted in ongoing pricing
pressures.
77
Geographic Revenues
The following table summarizes our geographic revenues based on
the location of the customer:
From a geographic perspective, the 11% increase in revenues in
2005 compared to 2004 was primarily due to a:
•
12% increase in revenues in the U.S. primarily due to a
substantial increase in packet voice and optical networking
solutions, a significant increase in CDMA solutions and an
improvement in data networking and security solutions. The
increase in optical networking solutions was negatively impacted
by a decrease in optical networking solutions in the first
quarter of 2005 due to shipping delays to our customers as a
result of the completion of a portion of the Flextronics
transaction relating to manufacturing facilities in Montreal.
The increase in revenues in the U.S. was also significantly
impacted by our acquisition of PEC in the second quarter of 2005
and the recognition of previously deferred revenues upon
deployment of a software upgrade related to packet voice
solutions. These increases in revenue were partially offset by a
substantial decrease in circuit voice solutions and lower
revenues from GSM and UMTS solutions;
•
9% increase in revenues in EMEA primarily due to a substantial
increase in GSM and UMTS solutions and packet voice solutions
and a significant increase in optical networking solutions.
These increases in revenue were partially offset by a
substantial decrease in CDMA solutions due to network
completions and industry consolidation, a significant decrease
in circuit voice solutions and a decline in data networking and
security solutions;
•
4% increase in revenues in Canada primarily due to a substantial
increase in CDMA solutions, packet voice solutions and data
networking and security solutions, a significant increase in
optical networking solutions and favorable foreign exchange rate
fluctuation impact associated with the strengthening of the
Canadian dollar against the U.S. dollar; partially offset
by a substantial decrease in circuit voice solutions and a
substantial decrease in GSM solutions primarily due to industry
consolidation. The increase in optical networking solutions was
negatively impacted by a decrease in optical networking
solutions in the first quarter of 2005 due to shipping delays to
our customers as a result of the completion of a portion of the
Flextronics transaction relating to manufacturing facilities in
Montreal;
•
11% increase in revenues in Asia Pacific primarily due to a
substantial increase in GSM and UMTS solutions (due primarily to
the BSNL contract described under “Developments in 2005 and
2006 — Significant Business Developments —
Bharat Sanchar Nigam Limited Contract”). This increase was
partially offset by a substantial decrease in CDMA solutions due
to the impact of network completions during the first half of
2004; and
•
9% increase in revenues in CALA due primarily to a substantial
increase in GSM solutions and optical networking solutions and
significant increase in circuit and packet voice solutions
partially offset by a substantial decrease in data networking
and security solutions and significant decrease in CDMA
solutions in the first half of 2005.
2004 vs. 2003
From a geographic perspective, the 4% decrease in revenues in
2004 compared to 2003 was primarily due to a:
•
13% decrease in revenues in the U.S. primarily due to a
substantial decrease in circuit voice solutions, optical
networking solutions and data networking and security solutions.
The decrease is also due in part to a substantial decrease in
revenues due to the recognition of revenues in 2003 deferred
from prior periods that did not occur to the same extent in 2004
as described under “Segment Information —
Enterprise Networks”. These declines were partially offset
by an increase in GSM and UMTS solutions;
78
•
8% decrease in revenues in Canada primarily due to a substantial
decrease in circuit voice solutions, CDMA solutions and
significant decrease in optical networking solutions due to
network completions during the first half of 2003. These
decreases were partially offset by a substantial increase in GSM
and UMTS solutions;
•
revenues in Asia Pacific were essentially flat. CDMA solutions
and optical networking solutions revenues decreased
substantially primarily due to network completions during the
first half of 2003. These declines were offset by a substantial
increase in GSM and UMTS solutions and an improvement in data
networking and security solutions; partially offset by:
•
11% increase in revenues in EMEA primarily due to a substantial
increase in GSM and UMTS solutions and CDMA solutions partially
offset by decrease in circuit voice solutions related to reduced
spending by service provider customers and significant decrease
in optical networking solutions; and
•
14% increase in revenues in CALA primarily from a substantial
increase in GSM solutions, packet voice solutions and data
networking and security solutions. These increases were
partially offset by significant decrease in CDMA solutions and a
slight decrease in optical networking solutions.
Gross profit increased $364 (while gross margin decreased by
approximately 0.5 percentage points) in 2005 compared to
2004 primarily due to:
•
an increase of approximately $570 due to overall higher sales
volumes;
•
an increase of approximately $240 due to continued improvements
in our cost structure primarily as a result of lower material
pricing;
•
an increase of $45 primarily due to recoveries in our inventory
provisions related to the sale of certain optical inventory that
was previously provided for and lower warranty costs as a result
of improved product quality in the first half of 2005; and
•
an estimated project loss of approximately $148 in 2005 compared
to a project loss of $160 in 2004 related to the BSNL contract
in India. For further information related to the BSNL contract,
see “Developments in 2005 and 2006 — Significant
Business Developments — Bharat Sanchar Nigam Limited
Contract”; partially offset by
•
a decrease of $482 primarily as a result of (i) pricing
pressures on certain of our products due to increased
competition for service provider and enterprise customers; and
(ii) unfavorable product mix associated with increased
sales of our next generation products which typically have lower
gross margins in the early stages of product evolution than our
traditional network expansion products and circuit switching
technologies; and
•
a decrease of $21 related to our employee bonus plans primarily
in the first half of 2005.
Gross profit decreased $267 and gross margin decreased by
approximately 1.0 percentage points in 2004 compared to
2003 primarily due to:
•
a decrease of approximately $534 primarily as a result of
(i) pricing pressures on certain of our products due to
increased competition for service provider and enterprise
customers; (ii) unfavorable product mix associated with
increased sales of our next generation products which typically
have lower gross margins in the early stages of product
evolution; and (iii) lower sales volumes of network
expansion products and software upgrades that typically have
higher margins;
•
an estimated project loss of approximately $160 related to a
contract with BSNL in India recognized in 2004. For further
information related to the BSNL contract, see “Developments
in 2005 and 2006 — Significant Business
Developments — Bharat Sanchar Nigam Limited
Contract”;
•
a decrease of approximately $235 due to overall lower sales
volumes; and
•
a one-time reduction in accruals of $53 associated with a
certain customer bankruptcy settlement in the third quarter of
2003 not repeated in 2004; partially offset by
•
an estimated increase of approximately $425 due to continued
improvements in our cost structure primarily as a result of
lower material pricing;
•
an increase of approximately $205 primarily due to (i) an
absence of significant inventory provision costs that were
incurred in prior years as a result of excess inventories due to
a decline in revenues in the Carrier Packet Networks segment of
our business; and (ii) lower warranty costs as a result of
improved product quality; and
79
•
an approximate $85 decrease in expenses related to our employee
return to profitability, or RTP, and regular bonus plans which
were not incurred in 2004.
SG&A expense increased $280 (and remained essentially flat
as a percentage of revenues) in 2005 compared to 2004 primarily
due to:
•
net trade and customer financing receivable recoveries of
approximately $9 in 2005 compared with recoveries of $118
realized primarily in the second half of 2004;
•
costs related to our internal control remedial measures and
investments in our finance processes and restatement related
activities of approximately $211 in 2005 compared to
approximately $136 in 2004;
•
an increase in sales and marketing expense in the second half of
2005 of approximately $53 arising from the consolidation of the
results of PEC and LG-Nortel;
•
increased expenses of $26 related to our employee bonus plans;
•
unfavorable foreign exchange rate fluctuation impacts associated
with the strengthening of the Canadian dollar against the
U.S. dollar;
•
expenses of approximately $39 incurred in the fourth quarter of
2005 related to our agreement to reimburse Mr. Zafirovski
for his settlement with Motorola and increased costs associated
with the departure of senior executives; partially offset by
•
cost savings associated with our 2004 Restructuring Plan and
cost containment initiatives; and
•
a decrease of approximately $25 in our stock-based compensation
primarily due to costs incurred for our RSU program in the first
quarter of 2004 that was not repeated in 2005.
SG&A expense increased $167 and increased from 19.8% to
22.4% as a percentage of revenues in 2004 compared to 2003
primarily due to:
•
costs related to our restatement activities of approximately
$115 in 2004;
•
significant unfavorable foreign exchange impacts associated with
the strengthening of the Canadian dollar, euro and British pound
against the U.S. dollar;
•
an increase in expense related to our stock-based compensation
plans, including restricted stock unit and stock option
programs; and
•
net trade and customer financing receivable recoveries totaling
$118 in 2004 compared to a recovery of $189 in 2003. Recoveries
were higher in 2003 as a result of favorable settlements related
to the sale or restructuring of various receivables and net
recoveries on other trade and customer financing receivables due
to subsequent collections for amounts exceeding our original
estimates of net recovery; partially offset by
•
a decrease of approximately $120 related to our RTP and regular
bonus plans in 2004 compared to 2003.
For a discussion of our SG&A expense by segment, see
“Management EBT” under “Segment Information”.
R&D expense as a percentage of revenues decreased by
approximately 3.0 percentage points to 17.6% in 2005
compared to 2004 and remained essentially flat in 2004 compared
to 2003. R&D expense in 2005 decreased primarily due to:
•
cost savings associated with our 2004 Restructuring Plan;
partially offset by
80
•
increased investments in targeted product areas, primarily in
Enterprise Networks;
•
increased expense of approximately $24 related to our employee
bonus plans; and
•
unfavorable foreign exchange impacts associated with the
strengthening of the Canadian dollar against the
U.S. dollar.
Our continued strategic investments in R&D are aligned with
targeting technology leadership in anticipated growth areas. In
2005, we maintained a technology focus and commitment to invest
in new innovative solutions where we believed we would achieve
the greatest future benefit from this investment and we intend
to continue this practice in 2006.
We expect to continue to manage R&D expense according to the
requirements of our business, allocating resources and
investment where customer demand dictates, and reducing
resources and investment where opportunities for improved
efficiencies present themselves. Our R&D efforts are
currently focused on secure and reliable converged networks
including:
•
network applications (VoIP and multimedia solutions) for
enterprise and service provider customers;
•
services edge capability to realize simplification of customer
network operations and broadband access technologies, including
wireless and wireline; and
•
next-generation packet transport for converged networks.
Special Charges
In 2005, our focus has been on managing each of our businesses
based on financial performance, the market conditions and
customer priorities. In the third quarter of 2004, we announced
the 2004 Restructuring Plan that includes a work plan involving
focused workforce reductions, including a voluntary retirement
program, of approximately 3,250 employees, real estate
optimization and other cost containment actions such as
reductions in information services costs, outsourced services
and other discretionary spending across all segments, but
primarily in Carrier Packet Networks. Substantially all of the
employee actions related to the focused workforce reduction were
completed by the end of 2005. This workforce reduction is in
addition to the workforce reduction resulting from our agreement
with Flextronics. For more information on our agreement with
Flextronics, see “Developments in 2005 and 2006 —
Evolution of Our Supply Chain Strategy”. We expect the real
estate actions relating to the 2004 Restructuring Plan to be
substantially complete by the end of 2006.
We estimate total charges to earnings associated with the 2004
Restructuring Plan in the aggregate of approximately $410
comprised of approximately $240 with respect to the workforce
reductions and approximately $170 with respect to the real
estate actions. No additional special charges are expected to be
recorded with respect to the other cost containment actions. We
incurred aggregate charges of $165 in 2004 and $177 in 2005,
with the remainder expected to be substantially incurred during
2006.
The associated total cash costs of the 2004 Restructuring Plan
of approximately $360 are expected to be split equally between
the workforce reductions and real estate actions. Approximately
10% and 50% of these cash costs were incurred in 2004 and 2005,
respectively, and approximately 15% are expected to be incurred
in 2006. The remaining 25% of the cash costs relate to the real
estate actions and are expected to be incurred in 2007 through
2022 for ongoing lease costs related to impacted real estate
facilities. In addition to the above, we also incurred cash
costs of approximately $17 in 2005 for facility improvements
related to the real estate actions.
In 2005, we realized cost savings of approximately $340 related
to the 2004 Restructuring Plan, which were lower than our
previously estimated cost savings of $360 primarily due to
additional costs associated with new hires added throughout 2005
and delay in real estate actions. Reductions to cost of
revenues, SG&A expense and R&D expense contributed to
our total cost savings by approximately 10%, 35% and 55% as a
percentage of the realized cost savings, respectively, across
all segments but primarily in Carrier Packet Networks. Once the
2004 Restructuring Plan is completed, we anticipate future
annualized cost savings of approximately $425 primarily due to
reductions to the cost of revenues, SG&A expense and R&D
expense at a similar percentage of the realized cost savings
across all segments as in 2005. Our estimate of annualized cost
savings has been reduced from the previously reported estimate
of $450 to approximately $425 primarily due to the costs
associated with new hires and certain delays in real estate
actions. We expect that this work plan will primarily be funded
with cash from operations.
In 2003, we initiated activities to exit certain leased
facilities and leases for assets no longer used across all
segments.
81
During 2001, we implemented a work plan to streamline operations
and activities around core markets and leadership strategies in
light of the significant downturn in both the telecommunications
industry and the economic environment, and capital market trends
impacting operations and expected future growth rates, or the
2001 Restructuring Plan.
As of December 31, 2005 and 2004, the short-term provision
balance was $95 and $254, respectively, and the long-term
provision balance was $203 and $209, respectively.
Under the 2004 Restructuring Plan, we recorded special charges
of $177 (including revisions to prior accruals of $7) and $165
for the years ended December 31, 2005 and 2004,
respectively. Under the 2001 Restructuring Plan, we recorded
special charges of $(7), $16 and $288 (including revisions to
prior accruals of $(7), $9 and $(53)) for the years ended
December 31, 2005, 2004 and 2003, respectively.
82
The following table outlines special charges incurred by segment
for each of the three years ended December 31:
2004
Restructuring
2001 Restructuring
Plan
Plan
Total Special Charges
2005
2004
2005
2004
2003
2005
2004
2003
Special charges by segment:
Carrier Packet Networks
$
106
$
83
$
(3
)
$
9
$
121
$
103
$
92
$
121
CDMA Networks
11
14
—
2
11
11
16
11
GSM and UMTS Networks
32
21
(3
)
2
74
29
23
74
Enterprise Networks
28
26
(1
)
2
55
27
28
55
Other
—
21
—
1
27
—
22
27
Total special charges
$
177
$
165
$
(7
)
$
16
$
288
$
170
$
181
$
288
For additional information related to our restructuring
activities, see “Special charges” in note 7 of
the accompanying audited consolidated financial statements.
(Gain) Loss on Sale of Businesses and Assets
In 2005, loss on sale of businesses and assets of $47 was
primarily due to charges related to the ongoing divestiture of
our remaining manufacturing operations to Flextronics.
In 2004, gain on sale of businesses and assets of $91 was
primarily due to a gain of $78 related to the sale of certain
assets in CALA for which we received $80 in proceeds and a gain
of approximately $30 related to the sale of our directory
operator service business to VoltDelta, Resources LLC, or
VoltDelta.
In 2003, gain on sale of businesses and assets of $4 was
primarily due to the recognition of the remaining unamortized
deferred gain related to the sale of substantially all of the
assets of our Cogent Defence Systems business in 2001. The
remaining unamortized deferred gain of $23 was recognized as a
result of the sale of our 41% interest in EADS Telecom S.A.S.
(formerly EADS Defence and Security Networks S.A.S.). This gain
was partially offset by a loss due to retirement of fixed assets.
For additional information relating to these asset sales, see
“Acquisitions, divestitures and closures” in
note 10 of the accompanying audited consolidated financial
statements.
Shareholder Litigation Settlement Expense
Shareholder litigation settlement expense of $2,474 was recorded
during the year ended December 31, 2005 as a result of an
agreement in principle for the proposed settlement of
shareholder class action litigation. For additional information,
see “Developments in 2005 and 2006 — Significant
Business Developments — Proposed Class Action
Settlement”.
Other Income — Net
The components of other income — net were as follows:
Currency exchange gains were primarily related to
day-to-day
transactional activities.
83
In 2005, other income — net was $303, which (other
than interest income and currency exchange gains detailed above)
primarily included a:
•
dividend income inclusion of $43 on our short-term investments;
•
gain of $21 related to the sale of our remaining Arris Group
Inc. shares, $45 related to the sale of Axtel S.A. de CV, or
Axtel, shares and $7 related to the sale of shares of VoltDelta;
•
gain of $17 related to a customer exclusivity clause settlement;
•
income of $22 related to sub-leases of facilities; and
•
gain of $10 on customer financing arrangements; partially offset
by
•
loss of $20 from the sale of certain account
receivables; and
•
loss of $7 related to changes in fair value of derivative
financial instruments that did not meet the criteria for hedge
accounting.
In 2004, other income — net was $212, which (other
than interest income and currency exchange gains detailed above)
primarily included a:
•
dividend income of $22 on our short-term investments;
•
gain of $52 resulting from a restructured customer financing
arrangement;
•
gain of $18 related to the sale of our remaining 7 million
common shares of Entrust, Inc. for cash consideration of $33. As
a result of this transaction, we no longer hold any equity
interest in Entrust;
•
income of $12 related to sub-leases of facilities;
•
gain of $13 related to the sale of Arris Group shares. For
additional information on our investment in Arris Group, see
“Results of Operations — Discontinued
Operations”; and
•
gain of $7 related to a certain customer bankruptcy settlement;
partially offset by
•
loss of $24 related to changes in fair value of derivative
financial instruments that did not meet the criteria for hedge
accounting;
•
loss of $14 related to a write down of our Bookham
investment; and
•
loss of $7 related to prepaid equity forward purchase contracts
that were entered into in connection with the issuance of
restricted stock units.
In 2003, other income — net was $466, which (other
than interest income and currency exchange gains detailed above)
primarily included a:
•
gain of $96 related to the sale of our interest in EADS Telecom
in conjunction with the changes in ownership of our French and
German operations;
•
dividend income inclusion of $20 on our short-term investments;
•
gain of $31 related to the sale of Arris Group shares. For
additional information on our investment in Arris Group see
“Results of Operations — Discontinued
Operations”;
•
gain of $30 related to a certain customer bankruptcy settlement;
•
gain of $25 resulting from a settlement related to intellectual
property use;
•
gain of $22 related to changes in fair value of derivative
financial instruments that did not meet the criteria for hedge
accounting;
•
income of $15 related to sub-leases of facilities;
•
royalty income inclusion of $15 from patented technology;
•
gain of $11 related to sale of certain minority
investments; and
•
gain of $6 related to sale of a portion of our interest in
Bookham.
Interest Expense
Interest expense increased $16 in 2005 compared to 2004 and
decreased $4 in 2004 compared to 2003. The increase in interest
expense in 2005 was primarily due to increases in short-term
rates which negatively impacted our floating rate swap exposure
compared to 2004. In 2004, we reduced our long-term debt by
$134, from $4,000 as of December 31, 2003 to $3,866 as of
December 31, 2004, primarily due to the purchase of land
and two buildings for $87 that were previously leased by us and
a decrease of $30 in the fair value adjustment attributable to
hedged debt obligations. For additional information, see
“Long-term debt” in note 11 of the accompanying
audited consolidated financial statements.
Interest rates on our outstanding notes payable and long-term
debt remained essentially flat during these periods.
84
We expect an increase in the quarterly interest expense in 2006
primarily due to higher borrowing costs associated with our 2006
Credit Facility that replaced lower cost debt. For further
details relating to the repayment of long-term debt, see
“Developments in 2005 and 2006 — Significant
Business Developments — Credit and Support
Facilities”.
Income Tax Benefit (Expense)
In 2005, we recorded a tax benefit of $56 on a pre-tax loss of
$2,586 from continuing operations before minority interests and
equity in net earnings (loss) of associated companies. The tax
benefit of $56 is primarily related to the release of a
liability related to the retroactive application of our advance
pricing arrangements, or APA, and various R&D related
incentives partially offset by the drawdown of our deferred tax
assets and current tax provisions in certain taxable
jurisdictions, and various corporate minimum and other taxes. In
addition, we recorded additional valuation allowances against
the tax benefit of losses realized in some jurisdictions.
In 2004, we recorded a tax benefit of $30 on a pre-tax loss of
$240 from continuing operations before minority interests and
equity in net loss of associated companies. We recorded a tax
expense against the earnings of certain taxable entities and
recorded additional valuation allowances against the tax benefit
of current period losses of other entities. The tax benefit is
primarily a result of R&D related incentives, favorable
audit settlements, and a release of valuation allowances in
certain jurisdictions, partially offset by tax expense recorded
against the earnings of certain taxable entities and corporate
minimum and other taxes.
As of December 31, 2005, we have substantial loss
carryforwards and valuation allowances in our significant tax
jurisdictions. These loss carryforwards will serve to minimize
our future cash income related taxes. We will continue to assess
the valuation allowance recorded against our deferred tax assets
on a quarterly basis. The valuation allowance is in accordance
with SFAS No. 109, “Accounting for Income
Taxes”, which requires that a tax valuation allowance be
established when it is more likely than not that some portion or
all of a company’s deferred tax assets will not be
realized. Given the magnitude of our valuation allowance, future
adjustments to this valuation allowance based on actual results
could result in a significant adjustment to our effective tax
rate. For additional information, see “Application of
Critical Accounting Policies and Estimates — Tax Asset
Valuation”.
Segment Information
Management EBT is a measure that includes the cost of revenues,
SG&A expense, R&D expense, interest expense, other
income (expense) — net, minority interests - net of
tax and equity in net earnings (loss) of associated
companies — net of tax. Interest attributable to
long-term debt has not been allocated to a reportable segment
and is included in “Other”. “Other”
represents miscellaneous business activities and corporate
functions. None of these activities meet the quantitative
criteria to be disclosed separately as reportable segments.
Costs associated with shared services and other corporate costs
are allocated to the segments based on usage determined
generally by headcount. Costs not allocated to the segments are
primarily related to our corporate compliance and other
non-operational activities and are included in
“Other”. See “Segment information —
General description” in note 6 of the accompanying
audited consolidated financial statements.
85
The following tables set forth revenues and Management EBT of
our reportable segments, “Other” and reconciliation to
net earnings (loss) from continuing operations:
“Other” represents miscellaneous business activities
and corporate functions.
The following table sets forth the positive (negative)
contribution to segment Management EBT by each of its components
relative to the comparable prior year period:
2005 vs 2004
2004 vs 2003
Gross
Other
Total $
Gross
Other
Total $
Profit
SG&A
R&D
Items(b)
Change
Profit
SG&A
R&D
Items(b)
Change
Carrier Packet Networks
$
233
$
(10
)
$
111
$
15
$
349
$
(153
)
$
23
$
38
$
(75
)
$
(167
)
CDMA Networks
(17
)
13
6
(5
)
(3
)
(61
)
(5
)
(50
)
4
(112
)
GSM and UMTS Networks
101
12
53
27
193
30
(48
)
(4
)
(13
)
(35
)
Enterprise Networks
82
(51
)
(28
)
11
14
(89
)
(29
)
11
1
(106
)
Total reportable segments
399
(36
)
142
48
553
(273
)
(59
)
(5
)
(83
)
(420
)
Other(a)
(35
)
(244
)
(38
)
27
(290
)
6
(108
)
13
(118
)
(207
)
Total change
$
364
$
(280
)
$
104
$
75
$
263
$
(267
)
$
(167
)
$
8
$
(201
)
$
(627
)
(a)
“Other” represents miscellaneous business activities
and corporate functions.
(b)
“Other items” is comprised of interest expense, other
income (expense) — net, minority interests —
net of tax and equity in net loss of associated
companies — net of tax. Interest attributable to
long-term debt has not been allocated to a reportable segment
and is included in “Other”.
The following discussion should be read together with
“Consolidated Information — Revenues”, which
discusses certain demand trends for our networking solutions and
geographical factors that impacted our revenues.
86
Carrier Packet Networks
Revenues
The following chart summarizes recent quarterly revenues for
Carrier Packet Networks:
2005 vs. 2004
Carrier Packet Networks revenues increased 9% primarily due to a
substantial increase in packet voice solutions and optical
networking solutions (with revenues from metro networking
solutions exceeding long-haul solutions), partially offset by a
significant decrease in circuit voice solutions. Overall
revenues were slightly impacted by pricing pressures driven by
increased competition for service provider customers.
Revenues from packet voice solutions in this segment increased
substantially in the U.S., EMEA and Canada, and increased
significantly in CALA. Circuit voice solutions declined
substantially in EMEA and significantly in the U.S. and Canada.
Revenues from optical networking solutions increased
substantially in the U.S. and CALA and increased significantly
in EMEA and Canada. Revenues from data networking solutions
declined significantly in the U.S. and CALA and were higher in
EMEA and Asia Pacific. The increase in optical networking
solutions was negatively impacted by a decrease in optical
networking solutions in the first quarter of 2005 due to
shipping delays to our customers in the U.S. and Canada as a
result of the completion of a portion of the Flextronics
transaction relating to manufacturing facilities in Montreal
2004 vs. 2003
Carrier Packet Networks revenues decreased 17% in 2004 compared
to 2003.
Revenues from circuit voice solutions decreased substantially in
the U.S. and Canada and were lower in EMEA and Asia Pacific. The
substantial decrease in circuit voice solutions was partially
offset by increase in packet voice solutions across all regions.
Revenues in the optical long-haul portion of this segment
decreased substantially in the U.S., EMEA and Canada and
decreased significantly in Asia Pacific and slightly in CALA.
Revenues in the metro optical portion of this segment increased
primarily due to increased sales to certain service provider
customers primarily in the U.S. and EMEA. In 2004, the revenues
in the metro optical portion of this segment surpassed the
revenues in the optical long-haul portion of this segment.
Revenues from the data networking and security portion of this
segment decreased significantly primarily due to substantial
declines in the U.S., Canada and EMEA.
Management EBT
Management EBT for the Carrier Packet Networks segment increased
by $349 in 2005 compared to 2004 and decreased by $167 in 2004
compared to 2003 primarily as a result of the items discussed
below.
2005 vs. 2004
Carrier Packet Networks gross margin increased by approximately
5.2 percentage points (while gross profit increased $233)
primarily due to:
•
recovery in inventory provisions due to sale of optical
inventory that was previously fully provided for;
•
continued improvements in our cost structure primarily as a
result of lower material pricing; and
87
•
lower warranty costs during the first half of 2005; partially
offset by
•
increased expenses related to our employee bonus plan during the
first half of 2005;
•
unfavorable product mix associated with increased sales of our
next generation products which typically have lower gross
margins in the early stages of product evolution than our
traditional solutions; and
•
continued pricing pressures on certain of our products due to
increased competition.
Carrier Packet Networks SG&A expense increased $10 primarily
due to:
•
unfavorable foreign exchange rate fluctuation impacts associated
with the strengthening of the Canadian dollar against the
U.S. dollar;
•
increased expenses related to our employee bonus plan; and
•
lower net trade and customer financing receivable recoveries;
partially offset by
•
continued impact of our workforce reductions across all regions
and associated reductions in other related costs such as
information services and real estate.
Carrier Packet Networks R&D expense decreased $111 primarily
due to:
•
the continued impact of our workforce reductions that targeted a
level of R&D expense that was more representative of the
volume of our business; partially offset by
•
increased expenses related to our employee bonus plan;
•
investment in targeted programs to increase the feature content
in our Carrier Packet Networks portfolio; and
•
unfavorable foreign exchange rate fluctuation impacts associated
with the strengthening of the Canadian dollar against the
U.S. dollar.
2004 vs. 2003
Carrier Packet Networks gross margin increased by approximately
1.4 percentage points (while gross profit decreased $153)
primarily due to:
•
continued improvements in our cost structure primarily as a
result of lower material pricing;
•
absence of significant inventory provision costs that had been
incurred in prior years as a result of excess inventories due to
a decline in revenues of our business; and
•
lower warranty costs as a result of improved product quality;
partially offset by
•
unfavorable product mix associated with increased sales of our
next generation products which typically have lower gross
margins in the early stages of product evolution than our
traditional solutions;
•
a one-time reduction in accruals of $53 associated with a
certain customer bankruptcy settlement in the third quarter of
2003 not repeated in 2004; and
•
continued pricing pressures on certain of our products due to
increased competition.
Carrier Packet Networks SG&A expense decreased $23 primarily
due to:
•
the continued impact of our workforce reductions across all
regions and associated reductions in other related costs such as
information services and real estate; partially offset by
•
unfavorable foreign exchange rate impacts associated with the
strengthening of the Canadian dollar against the
U.S. dollar;
•
planned investment in strategic businesses; and
•
lower net trade and customer financing receivable recoveries.
Carrier Packet Networks R&D expense decreased $38 primarily
due to:
•
the continued impact of our workforce reductions that targeted a
level of R&D expense that was more representative of the
volume of our business; partially offset by
•
continued investment in the accelerated development of certain
new voice and data products; and
•
unfavorable foreign exchange rate impacts associated with the
strengthening of the Canadian dollar against the
U.S. dollar.
Carrier Packet Networks other items expense increased by $75 in
2004 compared to 2003 primarily due to:
•
release of accruals of $30 from a certain customer bankruptcy
settlement in 2003 not repeated in 2004; and
•
a gain of $25 in 2003 resulting from a settlement related to
intellectual property not repeated in 2004.
88
CDMA Networks
Revenues
The following chart summarizes recent quarterly revenues for
CDMA Networks:
2005 vs. 2004
CDMA Networks revenues increased 5% due primarily to a
significant increase in the U.S. and a substantial increase in
Canada, partially offset by substantial decreases in Asia
Pacific and EMEA due to the impact of network completions during
the first half of 2004 and, in the case of EMEA, due to industry
consolidation, and a significant decrease in CALA during the
first half of 2005. Revenues from TDMA solutions in 2005 were
not significant.
2004 vs. 2003
CDMA Networks revenues decreased 6% due primarily to substantial
decreases in TDMA solutions across all our regions partially
offset by a slight increase in revenues from CDMA solutions due
to an increase in the U.S. and substantial increases in EMEA and
CALA that was partially offset by substantial declines in Asia
Pacific and Canada primarily due to network completion during
the first half of 2003.
Management EBT
Management EBT for the CDMA Networks segment decreased by $3 in
2005 compared to 2004 and decreased by $112 in 2004 compared to
2003 primarily as a result of the items discussed below.
2005 vs. 2004
CDMA Networks gross margin decreased by approximately
3.3 percentage points (while gross profit decreased $17)
primarily due to:
•
unfavorable product mix associated with increased sales of our
next generation products which typically have lower gross
margins in the early stages of product evolution; and
•
pricing pressures on certain of our products due to increased
competition for service provider customers; partially offset by
•
continued improvements in our cost structure primarily as a
result of lower material pricing.
CDMA Networks SG&A expense decreased $13 primarily due to:
•
decreases in selling and marketing expenses in our Asia Pacific
region; and
•
the ongoing focus on efficiencies and cost reduction activities;
partially offset by
•
increased expenses related to our employee bonus plan.
CDMA Networks R&D expense decreased $6 primarily due to:
•
reduced spending due to project timing and completions;
partially offset by
•
incremental investment in targeted new programs;
•
increased expenses related to our employee bonus plan; and
•
unfavorable foreign exchange rate fluctuation impacts associated
with the strengthening of the Canadian dollar against the
U.S. dollar.
89
2004 vs. 2003
CDMA Networks gross margin increased by approximately
0.8 percentage points (while gross profit decreased $61)
primarily due to:
•
improvement in cost structure; partially offset by
•
pricing pressures on certain of our products due to increased
competition for service provider customers; and
•
unfavorable product mix associated with increased sales of our
next-generation products which typically have lower gross
margins in the early stages of product evolution.
CDMA Networks SG&A expense increased $5 primarily due to:
•
increases in employee related expenses; partially offset by
•
lower bad debt expense in 2004.
CDMA Networks R&D expense increased $50 primarily due to:
•
continued investment in the development of new products; and
•
unfavorable foreign exchange rate impacts associated with the
strengthening of the Canadian dollar against the
U.S. dollar.
GSM and UMTS Networks
Revenues
The following chart summarizes recent quarterly revenues for GSM
and UMTS Networks:
2005 vs. 2004
GSM and UMTS Networks revenues increased 16% driven by growth in
both our GSM and UMTS solutions.
Revenues from GSM solutions increased significantly due
primarily to a substantial increase in Asia Pacific (due
primarily to the BSNL contract described under
“Developments in 2005 and 2006 — Significant
Business Developments — Bharat Sanchar Nigam Limited
Contract”) and substantial increases in EMEA and CALA
partially offset by a significant decrease in the U.S. and a
substantial decrease in Canada due primarily to industry
consolidation which in the U.S. caused the loss of a
contract and reduced customer spending due to a mature installed
base of GSM solutions. Revenues from UMTS solutions increased
substantially in the U.S., EMEA and Asia Pacific.
2004 vs. 2003
GSM and UMTS Networks revenues increased 28% in 2004 compared to
2003. GSM and UMTS solutions revenues increased substantially
across all regions due to new contracts in certain regions as
new service providers entered the market.
Management EBT
Management EBT for the GSM and UMTS Networks segment increased
by $193 in 2005 compared to 2004 and decreased by $35 in 2004
compared to 2003 as a result of the items discussed below.
90
2005 vs. 2004
GSM and UMTS Networks gross margin remained essentially flat
(while gross profit increased $101) primarily due to:
•
estimated project loss of approximately $148 in 2005 compared to
an estimated project loss of $160 in 2004 related to our
contract in India with BSNL;
•
a decrease in contract-related costs including a reduction in
losses incurred from customer trials in the second quarter of
2004 not repeated in 2005; and
•
continued improvements in our cost structure primarily as a
result of lower material pricing; substantially offset by
•
pricing pressures on certain of our products due to increased
competition for service provider customers.
GSM and UMTS Networks SG&A expense decreased $12 primarily
due to:
•
the impact of our workforce reductions across all regions and
associated reductions in other related costs such as information
services and real estate; and
•
decreases in employee related expenses; partially offset by
•
increased expenses related to our employee bonus plan.
GSM and UMTS Networks R&D expense decreased $53 primarily
due to:
•
the impact of lower spending on certain R&D initiatives;
partially offset by
•
increased expenses related to our employee bonus plan; and
•
unfavorable foreign exchange rate impacts associated with the
strengthening of the Canadian dollar against the
U.S. dollar.
GSM and UMTS Networks other items expense decreased $27
primarily due to a cash settlement of $17 in connection with the
release of an exclusivity commitment agreement which has been
recorded as a gain in other income (expense).
2004 vs. 2003
GSM and UMTS Networks gross margin decreased by approximately
6.6 percentage points (while gross profit increased $30)
primarily due to:
•
an estimated project loss of approximately $160 related to our
contract with BSNL in India recognized in 2004;
•
pricing pressures on certain of our products due to increased
competition for service provider customers; and
•
unfavorable product mix associated with increased sales of our
next generation products which typically have lower gross
margins in the early stages of product evolution; partially
offset by
•
continued improvements in our cost structure primarily as a
result of lower material pricing.
GSM and UMTS Networks SG&A expense increased $48 primarily
due to:
•
increases in employee related expenses;
•
net trade and customer financing receivable recoveries in 2003
not repeated in 2004; and
•
unfavorable foreign exchange rate impacts associated with the
strengthening of the euro and British pound against the
U.S. dollar.
GSM and UMTS Networks R&D expense increased $4 primarily due
to:
•
unfavorable foreign exchange rate impacts associated with the
strengthening of the Canadian dollar and euro against the
U.S. dollar;
•
continued investment in the development of new UMTS
products; and
•
acceleration of programs to increase the feature content in our
GSM product offering.
91
Enterprise Networks
Revenues
The following chart summarizes recent quarterly revenues for
Enterprise Networks:
2005 vs. 2004
Enterprise Networks revenues increased 12% primarily due to
revenues from our acquisition of PEC in the second quarter of
2005 and a significant increase in circuit and packet voice
solutions; partially offset by a slight decrease in the data
networking and security solutions.
Revenues from circuit and packet voice solutions increased
significantly in the U.S., EMEA (in both regions primarily due
to the recognition of previously deferred revenues upon
deployment of a software upgrade) and CALA, were higher in Asia
Pacific and decreased in Canada. Revenues from data networking
and security solutions decreased substantially in CALA and
significantly in EMEA and Asia Pacific, partially offset by
significantly higher revenues in the U.S. and substantially
higher revenues in Canada.
2004 vs. 2003
Enterprise Networks revenues decreased 10% in 2004 compared to
2003 due to a significant decrease in circuit voice solutions
and a slight decrease in the data networking and security
solutions partially offset by an increase in packet voice
solutions.
Revenues from circuit voice solutions decreased significantly
primarily due to a substantial decrease in circuit switching and
interactive voice response solutions primarily in the
U.S. This substantial decrease in revenues was primarily a
result of the release of certain software, including in
connection with the general availability of Succession 3.0 in
the fourth quarter of 2003. The general availability of this
software triggered the recognition of associated revenues
deferred from prior periods, resulting in a net increase in
revenues of $150 in 2003 ($300 in the fourth quarter of 2003)
that did not occur to the same extent in 2004. In addition,
revenues from certain products associated with various software
upgrade marketing programs initiated in 2004 did not meet the
criteria for revenue recognition in 2004 and were deferred to
future periods. This decrease across all regions primarily
associated with our packet voice solutions.
Revenues associated with data networking and security solutions
decreased slightly primarily due to a decline in revenues
associated with our legacy routing portfolio and associated
declines in new service contracts and service contract renewals.
We also experienced a decline in revenue from certain of our
data networking products primarily due to pricing pressures
driven by increased competition. In addition, in 2003, we
recognized revenues of approximately $60 compared with revenues
of approximately $30 in 2004, primarily in the U.S., associated
with the delivery of certain data switch upgrades. These
declines were partially offset by growth from improved market
penetration of certain new products.
Management EBT
Management EBT for the Enterprise Networks segment increased by
$14 in 2005 compared to 2004 and decreased by $106 in 2004
compared to 2003 primarily as a result of the items discussed
below.
92
2005 vs. 2004
Enterprise Networks gross margin decreased by approximately
2.0 percentage points (while gross profit increased $82)
primarily due to:
•
pricing pressures on our data products due to increased
competition for enterprise customers primarily in EMEA and Asia
Pacific; and
•
increased warranty costs during the second half of 2005;
partially offset by
•
higher sales volumes of software upgrades that typically have
higher margins; and
•
continued improvements in our cost structure primarily as a
result of lower material pricing.
Enterprise Networks SG&A expense increased $51 primarily due
to:
•
increases in sales and marketing expenses primarily related to
our PEC acquisition;
•
unfavorable foreign exchange rate impacts associated with the
strengthening of the Canadian dollar against the
U.S. dollar;
•
increased expenses related to our employee bonus plan;
•
an increase in bad debt expense; and
•
increases in employee related expenses; partially offset by
•
the continued impact of our workforce reductions.
Enterprise Networks R&D expense increased $28 primarily due
to:
•
timing of recognition of certain software development costs;
•
increased expenses related to our employee bonus plan; and
•
acceleration of R&D programs related to IP technologies;
partially offset by
•
more effectively prioritizing investment in data products and
increased outsourcing to third parties of certain R&D
functions.
2004 vs. 2003
Enterprise Networks gross margin increased by approximately
1.1 percentage points (while gross profit decreased $89)
primarily due to:
•
continued improvements in our cost structure primarily as a
result of lower material pricing; and
•
lower warranty costs as a result of improved product quality;
partially offset by
•
pricing pressures on certain of our products due to increased
competition for enterprise customers; and
•
lower sales volumes of software upgrades that typically have
higher margins.
Enterprise Networks SG&A expense increased $29 primarily due
to:
•
increases in sales and marketing expenses; and
•
increases in employee related expenses; partially offset by
•
the continued impact of our workforce reductions.
Enterprise Networks R&D expense decreased $11 primarily due
to:
•
effectively prioritizing investment in data products and
increased outsourcing activity; partially offset by
•
acceleration of R&D programs related to IP technologies.
Other
Management EBT
Other Management EBT decreased by $290 in 2005 compared to 2004
and decreased by $207 in 2004 compared to 2003 primarily as a
result of the items discussed below.
2005 vs. 2004
Other segment SG&A expense increased $244 primarily due to:
•
costs associated with our internal control remedial measures,
investment in our finance processes and restatement related
activities;
93
•
expenses incurred in the fourth quarter of 2005 related to our
agreement to reimburse Mr. Zafirovski for his settlement
with Motorola and increased costs associated with the departure
of senior executives;
•
net trade receivable recoveries realized primarily in the second
half of 2004 not repeated in 2005; and
•
unfavorable foreign exchange rate impacts associated with the
strengthening of the Canadian dollar against the
U.S. dollar; partially offset by
•
cost savings associated with our 2004 Restructuring Plan and
cost containment initiatives;
•
lower stock based compensation in 2005 due to the RSU expense
incurred in the first quarter of 2004 that was not repeated in
2005 as the program was terminated in 2005.
Other segment R&D expense increased by $38 primarily due to
increases in employee related expenses and unfavorable foreign
exchange rate impacts associated with the strengthening of the
Canadian dollar against the U.S. dollar, partially offset
by savings associated with our 2004 Restructuring Plan.
2004 vs. 2003
Other segment SG&A expense increased $108 primarily due to:
•
costs associated with our restatement activities and additional
investment in our finance organization;
•
unfavorable foreign exchange rate impacts associated with the
strengthening of the Canadian dollar and euro against the
U.S. dollar; and
•
an increase in stock based compensation in 2004 which was not
allocated to our segments; partially offset by
•
a reduction in our employee return to profitability and regular
bonus plans.
Other segment R&D expense decreased by $13 primarily due to
a reduction in our employee bonus programs, partially offset by
an increase in stock based compensation.
Other segment other items expense increased by $118 primarily
due to:
•
gains related to the sale of our interest in EADS Telecom in
conjunction with the changes in ownership of our French and
German operations in 2003 not repeated in 2004;
•
losses related to changes in fair value of derivative financial
instruments that do not meet the criteria for hedge accounting
compared to a gain in 2003; and
•
a decrease in interest income.
Results of Operations — Discontinued Operations
In 2005, we recorded net earnings from discontinued operations
(net of tax) of $1.
In 2004, we recorded net earnings from discontinued operations
(net of tax) of $49. The significant items included in net
earnings are summarized below:
•
a gain of $32 related to the revaluation of a receivable. On
December 23, 2004, a customer financing arrangement was
restructured. The notes receivable that were restructured had a
net carrying amount of $1, net of a provision of $63. The
arrangement increased the net carrying amount of the receivable
to $33. On January 25, 2005, we sold this receivable for
cash proceeds; and
•
a net gain of $17 related to our reassessment of our remaining
provisions for discontinued operations consisting of changes in
estimates of $13 for liabilities, and $4 for both short-term and
long-term receivables.
In 2003, we recorded net earnings from discontinued operations
of $183 (net of tax) primarily related to a number of
transactions in 2003 as well as gains of $68 associated with
provision reassessments as follows:
•
a gain of $14 on the sale of certain assets related to our fixed
wireless access operations to Airspan Networks, Inc. for cash
consideration of $13 on December 23, 2003;
•
a gain of $17 in the fourth quarter of 2003 associated with a
cash settlement of $17 related to a certain note receivable
which had been previously provisioned;
•
a gain of $12 on March 24, 2003 from the sale of
8 million common shares of Arris Group, back to Arris Group
for cash consideration of $28 pursuant to a March 11, 2003
agreement. In addition, on March 18, 2003, we assigned our
membership interest in Arris Interactive LLC, or Arris, to ANTEC
Corporation, an Arris Group company, for cash consideration of
$88, resulting in a loss of $2. Also in connection with these
transactions, we received $11 upon the settlement of a sales
representation agreement with Arris Group and recorded a gain of
$11; and
94
•
a gain of $66 in the first quarter of 2003 from the settlement
of certain trade and customer financing receivables, the
majority of which was previously provisioned.
Following the March 2003 Arris Group transactions, we reduced
our interest in Arris Group to 18.8%, and ceased equity
accounting for the investment. As a result, we reclassified our
remaining ownership interest in Arris Group as an
available-for-sale investment within continuing operations
effective in the second quarter of 2003. We continued to dispose
of our interest in Arris Group in 2004 and 2003 and the gain or
loss on the sale of shares subsequent to the first quarter of
2003 was included in other income (expense) — net. We
sold 9 million common shares of Arris Group on
November 24, 2003 and 1.8 million shares on
March 10, 2004. During the year ended December 31,2005, we sold our remaining 3.2 million common shares of
Arris Group. As a result, we no longer hold any equity interest
in Arris Group.
For additional information, see “Discontinued
operations” in note 20 of the accompanying audited
consolidated financial statements and “Other income
(expense) — net”.
Liquidity and Capital Resources
Cash Flow
Cash and cash equivalents excluding restricted cash decreased
$734 during 2005 to $2,951 as of December 31, 2005,
primarily due to cash payments of $651, net of cash acquired,
relating to our acquisitions of PEC and LG-Nortel, expenditures
for plant and equipment of $258, and an outflow from operations
of $180 which included cash payments for restructuring of $293
and payments of approximately $180 for pension funding,
partially offset by cash proceeds of $470 primarily due to the
transfer of manufacturing assets to Flextronics and the sale of
certain investments. Fluctuations in foreign exchange rates
resulted in a $102 reduction in cash and cash equivalents in
2005.
The following table summarizes our cash flows by activity and
cash on hand as of December 31:
Net cash from (used in) operating activities of continuing
operations
$
(180
)
$
(179
)
$
(140
)
Net cash from (used in) investing activities of continuing
operations
(425
)
(138
)
145
Net cash from (used in) financing activities of continuing
operations
(60
)
(110
)
(359
)
Effect of foreign exchange rate changes on cash and cash
equivalents
(102
)
88
176
Net cash from (used in) continuing operations
(767
)
(339
)
(178
)
Net cash from (used in) operating activities of discontinued
operations
33
22
149
Net cash from (used in) investing activities of discontinued
operations
—
—
241
Net increase (decrease) in cash and cash equivalents
(734
)
(317
)
212
Cash and cash equivalents at beginning of period
3,685
4,002
3,790
Cash and cash equivalents at end of period
$
2,951
$
3,685
$
4,002
Operating activities
In recent years our operating results have produced negative
cash flow from operations due in large part to our inability to
reduce operating expenses as a percentage of revenue, the
continued negative impact on gross margin due to competitive
pressures and other factors discussed throughout our MD&A.
In addition we have made significant payments related to our
restructuring programs and pension plans.
In 2005, our cash flows used in operating activities were $180
due to net loss from continuing operations of $2,576, less
adjustments of $217 related to the net change in our operating
assets and liabilities plus net adjustments of $2,613 for
non-cash and other items.
In 2005, the primary adjustments to our net earnings from
continuing operations for non-cash and other items were
shareholder litigation settlement expense of $1,899,
amortization and depreciation of $302, substantially all of
which was depreciation, and stock option expense of $88. In
2006, amortization and depreciation is expected to be slightly
lower due to the sale of certain assets and stock option expense
is expected to be higher than in 2005 due to the planned
issuance of stock options in 2006 as part of our employee stock
option plans.
95
In 2004, our cash flows used in operating activities were $179
due to a net loss from continuing operations of $256, plus
adjustments of $732 for non-cash and other items less $655
related to the change in our operating assets and liabilities.
In 2004, the primary adjustments to our net loss from continuing
operations for non-cash and other items were amortization and
depreciation of $340, substantially all of which was
depreciation, and stock option expense of $77. In addition,
other adjustments included deferred income taxes, gain on sale
of businesses and assets and other items, partially offset by
foreign exchange impacts on long-term assets and liabilities,
accounted for the remaining $315.
Changes in Operating Assets and Liabilities
In 2005, the use of cash of $217 relating to the net change in
our operating assets and liabilities was primarily due to
restructuring outflows, other changes in operating assets and
liabilities, supplemental pension funding and $312 decrease in
cash flows associated with our working capital performance as
discussed further below under “Working capital
metrics”. This was partially offset by collection of cash
proceeds of approximately $76 from the sale of certain customer
financing notes receivable. We had cash outflows for
restructuring activities of $293 related to our 2004 and 2001
Restructuring Plan and approximately $180 for pension funding.
Other changes in operating assets and liabilities included the
following:
•
income tax payments of $48 in 2005 compared to $40 in 2004
primarily due to an increase in taxable income in certain
taxable jurisdictions; and
•
an increase of $540 from other changes in operating assets and
liabilities primarily due to the shareholder litigation
settlement provision of $575.
In 2004, the use of cash of $655 relating to the change in our
operating assets and liabilities was primarily due to changes in
accounts receivable, inventories and accounts payable,
restructuring outflows, supplemental pension funding and other
changes in assets and liabilities partially offset by collection
of long term or customer financing receivables. This included a
$648 reduction in cash flows associated with accounts
receivable, inventories and accounts payable as discussed
further under “working capital metrics” below.
In 2004, we received cash proceeds of approximately $147 from
the sale of certain customer financing notes receivable and
convertible notes receivable. We had cash outflows for
restructuring activities of $254 primarily related to our 2001
Restructuring Plan and approximately $140 in supplemental
pension funding cash outflows to contribute to the reduction of
our pension deficit. Other significant operating items included
payments of approximately $280 in the first quarter of 2004
associated with our employee bonus plan and restricted stock
unit program based on 2003 performance. In 2004, we had increase
in cash of $560 from other changes in operating assets and
liabilities primarily due to an increase in liabilities,
including the deferred revenue.
We expect to pay $575 in cash related to the Proposed
Class Action Settlement. The cash amount bears interest
commencing March 23, 2006 at a prescribed rate and is to be
placed in escrow on June 1, 2006 pending satisfactory
completion of all conditions to the Proposed Class Action
Settlement. Such cash payments would relate only to the
encompassed actions and would not relate to certain ERISA and
derivative actions and the ongoing regulatory and criminal
investigations. On March 17, 2006, we announced that we and
the lead plaintiffs reached an agreement on the related
insurance and corporate governance matters including our
insurers agreeing to pay $228.5 in cash towards the settlement
and us agreeing with our insurers to certain indemnification
obligations. On April 3, 2006, the insurance proceeds were
placed into escrow by the insurers. We believe that these
indemnification obligations would be unlikely to materially
increase our total cash payment obligations under the Proposed
Class Action Settlement. The insurance payments would not
reduce the amounts payable by us. For more information, see
“Developments in 2005 and 2006 — Proposed
Class Action Settlement”. We expect cash contributions
for pension funding for the full year 2006 to be approximately
$335, including a portion related to a pension funding agreement
in the United Kingdom that requires additional contributions
through April 2007. We are currently in discussions with the
Trustee of the United Kingdom pension plan to establish a
long-term funding agreement which would increase the level of
2006 contributions. In addition, we expect cash outflows of
approximately $110 for the full year 2006 related to both our
2001 Restructuring Plan and 2004 Restructuring Plan, and
payments related to our employee bonus program in 2006 based on
our 2005 performance. For the full year 2006, we expect to
generate minimal cash from the sale of customer financing
receivables.
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Working capital metrics
Working capital for each segment is primarily managed by our
regional finance organization which manages accounts receivable
performance and by our global operations organization which
manages inventory and accounts payable.
2005
2004
2003
Days sales outstanding in accounts receivable
86
90
74
Net inventory days
132
152
92
Days of purchases outstanding in accounts payable
58
63
45
Days sales outstanding in accounts receivables, or DSO, measures
the average number of days our accounts receivables are
outstanding. DSO is a metric that approximates the measure of
the average number of days from when we recognize revenue until
we collect cash from our customers. DSO for each quarter is
calculated by dividing the quarter end accounts receivable-net
balance by revenues for the quarter, in each case as determined
in accordance with U.S. GAAP, and multiplying by
90 days.
DSO decreased by approximately 4 days as of
December 31, 2005 compared to December 31, 2004 due to
an increase of approximately 6 days as a result of the
transfer of an estimated $238 of receivables from LG to
LG-Nortel with minimal
corresponding revenue impact; more than offset by an overall
decrease of approximately 10 days primarily as a result of
factors other than
LG-Nortel. In 2006, we
expect to focus on improving our collections process; however,
we expect to experience fluctuations in collections performance
in individual quarters.
DSO increased as of December 31, 2004 compared to
December 31, 2003 primarily due to reduction in accounts
receivable securitization, increase in deferred revenues,
one-time recognition of $300 of deferred revenue in our
Enterprise Networks segment in 2003, and reduced focus on
collection activities particularly in the first half of 2004,
due to our restatement activities. Also contributing to the
average increase of DSO was increased CDMA Networks and GSM and
UMTS Networks revenues from a large number of contracts
involving progress billing, due to significant portions of
collections occurring upon project completion.
Net inventory days, or NID, is a metric that approximates the
average number of days from procurement to sale of our product.
NID for each quarter is calculated by dividing the average of
the current quarter and prior quarter inventories —
net by the cost of revenues for the quarter, in each case as
determined in accordance with U.S. GAAP, and multiplying by
90 days. Finished goods inventory includes certain direct
and incremental costs associated with arrangements where title
and risk of loss was transferred to the customer but revenue was
deferred due to other revenue recognition criteria not being
met. As of December 31, 2005, 2004, these deferred costs
totaled $2,014 and $1,512, respectively.
NID decreased by approximately 20 days as of
December 31, 2005 compared to December 31, 2004
primarily due to lower inventory levels as a result of
outsourcing of our manufacturing operations to Flextronics
partially offset by increased deferred costs associated with
deferred revenues. In 2006, we expect that NID will fluctuate
from quarter to quarter as future cost of sales and inventory
levels fluctuate due in part to the movement in the deferred
costs associated with deferred revenues.
NID increased as of December 31, 2004 compared to
December 31, 2003 primarily due to an increase in deferred
costs associated with deferred revenues, and an increase in
inventory to meet new contract requirements, particularly in
Asia Pacific for Wireless projects, including BSNL.
Days of purchases outstanding in accounts payable, or DPO, is a
metric that approximates the average number of days from when we
receive purchased goods and services until we pay our suppliers.
DPO for each quarter is calculated by dividing the quarter end
trade and other accounts payable by the cost of revenues for the
quarter, in each case, as determined in accordance with
U.S. GAAP, and multiplying by 90 days.
DPO decreased by approximately 5 days as of
December 31, 2005 compared to December 31, 2004 due to
a transfer of accounts payable from LG to
LG-Nortel without a
corresponding cost of revenue impact. The increase in DPO was
more than offset by the stabilization of adhering to standard
contract terms of 60 days across our supplier base and
process improvement for paying our suppliers.
DPO increased by approximately 18 days as of
December 31, 2004 compared to December 31, 2003 as we
placed additional focus on establishing competitive payment
terms with our suppliers and improving the processing of
payments to match payment terms.
97
Investing activities
In 2005, cash flows used in investing activities were $425 and
were primarily due to payments of $651 for acquisitions of
investments and businesses, net of cash acquired, including $423
relating to the acquisition of PEC and $155 relating to our
contribution to LG-Nortel, and $258 for the purchase of plant
and equipment, which were partially offset by proceeds of $470
on the sale of assets including net proceeds of $334 related to
the transfer of certain manufacturing assets to Flextronics and
$136 from the sale of certain investments and businesses which
we no longer considered strategic including $27 related to the
sale of our remaining common shares of Arris Group, $45 related
to the sale of our investment in Axtel, $25 related to the sale
of our interest in VoltDelta and $20 related to the sale of
short-term investments. We also received proceeds of $10 from
the sale of plant and equipment.
In 2004, cash flows used in investing activities were $138 and
were primarily due to net expenditures of $276 on plant and
equipment and $5 associated with acquisitions of certain
investments and businesses. These amounts were partially offset
by proceeds of $150 from the sale of certain investments and
businesses which we no longer considered strategic, including
$80 from the sale of certain assets in CALA, $17 related to the
sale of the common shares of Arris Group and $33 related to the
sale of the common shares of Entrust.
Financing activities
In 2005, cash flows used in financing activities were $60 and
were primarily from dividends of $43 primarily paid by NNL on
its outstanding preferred shares, a repayment of capital leases
payable of $10 and a net reduction of our notes payable by $13.
These amounts were partially offset by $6 of proceeds from the
issuance of Nortel Networks Corporation common shares from the
exercise of stock options.
In 2005, our cash decreased $102 compared to an increase of $88
in 2004, due to unfavorable effects of changes in foreign
exchange rates primarily of the euro and the British pound
against the U.S. dollar.
In 2005, cash flows from our discontinued operations were $33
primarily related to the collection of customer financing
receivables in 2005.
In 2004, cash flows used in financing activities were $110 and
were primarily due to $107 used to reduce our long-term debt, a
repayment of capital leases payable of $9 and dividends of $33
paid by NNL related to its outstanding preferred shares. These
amounts were partially offset by $31 of proceeds from the
issuance of Nortel Networks Corporation common shares from the
exercise of stock options and an increase in our notes payable
by a net amount of $8. The reduction of our long-term debt was
primarily due to the extinguishment of debt of $87 related to
the purchase of land and two buildings in the U.S. that
were previously leased by us.
In 2004, our cash increased $88 compared to $176 in 2003 due to
favorable effects of changes in foreign exchange rates.
Approximately $75 ($150 in 2003) of the favorable impact was the
result of favorable changes in the euro and the British pound
against the U.S. dollar.
In 2004, our discontinued operations generated net cash of $22
related to the continued wind-down of our discontinued
operations.
Future Uses and Sources of Liquidity
The forward-looking statements below are subject to important
risks, uncertainties and assumptions, which are difficult to
predict and the actual outcome may be materially different from
that anticipated. See the “Risk Factors” section in
this report.
Future Uses of Liquidity
As of December 31, 2005, our cash requirements for the next
12 months are primarily expected to consist of funding for
operations, including our investments in R&D, and the
following items:
•
repayment of $150 of notes due in June 2006;
•
costs in relation to the restatement and remedial measure
activities, regulatory and other legal proceedings, including
the proposed $575 cash payment payable by NNC related to the
Proposed Class Action Settlement. The cash amount bears
interest commencing March 23, 2006 at a prescribed rate and
is to be held in escrow on June 1, 2006 pending
satisfactory completion of all conditions to the Proposed
Class Action Settlement. In addition, the resolution of
other matters not encompassed by the Proposed Class Action
Settlement, including
98
regulatory matters, is uncertain and we may be subject to
substantial additional payments, judgments, settlements, fines
or penalties;
•
capital expenditures of approximately $380;
•
pension and post-retirement and post-employment benefit funding
of approximately $372;
•
costs related to workforce reduction and other restructuring
activities of approximately $110;
•
investment in certain businesses including approximately $100
for the acquisition of Tasman Networks paid in February
2006; and
•
our finance transformation project which will include, among
other things, implementing SAP to provide an integrated global
financial system.
In addition, the 2006 Credit Facility of $1,300 due in February
2007 is subject to acceleration until such time that we obtain a
waiver for defaults under the 2006 Credit Facility. Any
inability to refinance the 2006 Credit Facility would adversely
affect our liquidity. Also, from time to time, we may purchase
our outstanding debt securities and/or convertible notes in
privately negotiated or open market transactions, by tender
offer or otherwise, in compliance with applicable laws. As well,
we expect to be required to fund some portion of our aggregate
undrawn customer financing commitments as further described
below.
Pension, post-retirement and post- employment obligations
372
—
—
—
—
—
372
Other long-term liabilities reflected on the balance sheet
8
10
8
2
4
30
62
Total contractual cash obligations
$
2,344
$
245
$
1,969
$
122
$
119
$
1,145
$
5,944
(a)
Amounts represent our known, undiscounted, minimum contractual
payment obligations under our long-term obligations and include
amounts identified as contractual obligations in current
liabilities of the accompanying audited consolidated financial
statements as of December 31, 2005.
(b)
Includes principal payments due on long-term debt and $219 of
capital lease obligations. As described in note 12 to the
accompanying audited consolidated financial statements, we have
entered into certain interest rate swap contracts which swap
fixed rate payments for floating rate payments and therefore,
interest payments are not included in the above table. For
additional information, also see note 11 “Long-term
debt, credit and support facilities” to the accompanying
audited consolidated financial statements.
(c)
For additional information, see note 14,
“Commitments”, to the accompanying audited
consolidated financial statements.
(d)
On February 14, 2006, we entered into a new one-year credit
facility in the aggregate principal amount of $1,300. This
facility was drawn down in the full amount on February 14,2006 to repay our outstanding $1,275 aggregate principal amount
of NNL’s 6.125% Notes due February 15, 2006
shifting $1,300 of contractual cash obligations from 2006 to, at
the latest, February 2007.
Purchase obligations
Purchase obligation amounts in the above table represent the
minimum obligation under our supply arrangements related to
product and/or services entered into in the normal course of our
business. Where the arrangement specifies quantity, pricing and
timing information, we have included that arrangement in the
amounts presented above. In certain cases, these arrangements
define an end date of the contract, but do not specify timing of
payments between December 31, 2005 and the end date of the
agreement. In those cases, we have estimated the timing of the
payments based on forecasted usage rates.
During the third quarter of 2003, we renegotiated a key supply
arrangement that was initially put into place prior to the
industry and economic downturn that commenced in 2001. The
renegotiated agreement is reflective of the current market
environment, and the terms include a reduction in our minimum
spending levels with an extension in the time period, from 2004
to 2009, within which these minimum levels must be met. As well,
we are no longer obligated to compensate
99
the supplier for direct costs if the minimum spending levels are
not met. The renegotiated agreement includes a graduated
liquidated damages remedy for the benefit of the supplier if the
minimum spending levels are not met by the end of the agreement
in 2009. However, based upon the renegotiated terms, we expect
to meet the minimum spending levels. The remaining minimum
purchase obligation has been reflected in the contractual cash
obligations table above.
As part of our agreement with Flextronics regarding the
divestiture of substantially all of our remaining manufacturing
operations, Flextronics has the ability in certain cases to
exercise rights to sell back to us certain inventory and
equipment after the expiration of a specified period (of up to
fifteen months) following each respective closing date. We do
not expect such rights to be exercised with respect to any
material amount of inventory and/or equipment.
Outsourcing contract amounts in the table above represent our
minimum contractual obligation for services provided to us for a
portion of our information services function. The amount payable
under our outsourcing contracts is variable to the extent that
our hardware volumes and workforce fluctuates from the baseline
levels contained in the contracts and our contractual obligation
could increase above such baseline amount. If our hardware
volumes or workforce were to fall below the baseline levels in
the contracts, we would be required to make the minimum payments
included above.
Obligations under special charges
Obligations under special charges in the above table reflect
undiscounted amounts related to contract settlement and lease
costs and are expected to be substantially drawn down by the end
of 2013. Balance sheet provisions of $24 for workforce reduction
costs, included in restructuring in current liabilities in the
accompanying audited consolidated financial statements, have not
been reflected in the contractual cash obligations table above.
Pension and post-retirement obligations
During 2005, we made cash contributions to our defined benefit
pension plans of $180 and to our post-retirement benefit plans
of $31. In 2006, we expect to make cash contributions of
approximately $335 to our defined benefit pension plans,
including a portion related to a pension funding agreement in
the United Kingdom that requires additional contributions
through April 2007 and approximately $20 to our post-retirement
benefit plans. We are currently in discussions with the Trustee
of our pension plan in the United Kingdom to establish a
long-term funding agreement which would increase the level of
2006 contributions.
Other long-term liabilities reflected on the balance
sheets
Other long-term liabilities reflected on the balance sheets
relate to asset retirement obligations and deferred compensation
accruals. Payment information related to our asset retirement
obligations has been presented based on the termination date
after the first renewal period of the associated lease
contracts. Payment information related to our deferred
compensation accruals has been presented based on the
anticipated retirement dates of the employees participating in
the programs.
Customer financing
Generally, customer financing arrangements may include financing
with deferred payment terms in connection with the sale of our
products and services, as well as funding for non-product costs
associated with network installation and integration of our
products and services. We may also provide funding to our
customers for working capital purposes and equity financing. The
following table provides information related to our customer
financing commitments, excluding our discontinued operations as
of:
Includes short-term and long-term amounts. Short-term and
long-term amounts were included in accounts
receivable — net and other assets, respectively, in
the consolidated balance sheets.
100
During the years ended December 31, 2005 and 2004, we
recorded net customer financing bad debt expense
(recovery) of $4 and ($45), respectively, as a result of
settlements and adjustments to other existing provisions. The
recoveries and expense were included in the consolidated
statements of operations within SG&A expense.
During the years ended December 31, 2005 and 2004, we
entered into certain agreements to restructure and/or settle
various customer financing and related receivables, including
rights to accrued interest. As a result of these transactions,
we received cash consideration of approximately $112 ($36 of the
proceeds was included in discontinued operations) and $147,
respectively, to settle outstanding receivables of approximately
$102 and $254 with net carrying value of $101 ($33 of the net
carrying value was included in discontinued operations) and $75
for the years ended December 31, 2005 and 2004,
respectively.
On December 10, 2004, we entered into an agreement to
restructure and/or settle customer financing receivables with a
certain customer. As a result of this transaction, we received
cash consideration of approximately $16 and a deferred senior
unsecured note of $33 (net carrying value of nil) to settle the
outstanding receivables of approximately $118 with a net
carrying value of nil.
On December 15 and 16, 2004, we sold certain notes
receivable and convertible notes receivable that had been
received as a result of the restructuring of a customer
financing arrangement for cash proceeds of $116. The net
carrying amount of the notes receivable and convertible notes
receivable was $61. We recorded a gain of $53, net of
transaction costs of $2, in other income (expense) —
net for the year ended December 31, 2004.
On December 23, 2004, a customer financing arrangement was
restructured. The notes receivable and other accounts receivable
that were restructured had a net carrying amount of $12 ($1 of
the net carrying amount was included in discontinued
operations), net of provisions for doubtful accounts of $182
($63 of the provision was included in discontinued operations).
The restructured notes were valued at $100 as of
December 31, 2004 and a gain of $88 ($32 of the gain was
included in discontinued operations) was recorded in the fourth
quarter of 2004. On January 25, 2005, we sold this
receivable, including rights to accrued interest, for cash
proceeds of $110.
During 2005, we reduced undrawn customer financing commitments
by $19 ($8 relating to a variable interest entity, or VIE, which
we began consolidating effective April 1, 2005) primarily
as a result of the expiration or cancellation of commitments and
changing customer business plans. As of December 31, 2005,
all undrawn commitments were available for funding under the
terms of our financing agreements.
Acquisitions
On February 24, 2006, we acquired Tasman Networks, an
established networking company that provides a portfolio of
secure enterprise routers, for $99.5 in cash.
As part of the LG-Nortel joint venture agreement, LG will be
entitled to payments from us over a two-year period up to a
maximum of $80 based on achievement by LG-Nortel of certain
business goals.
Future Sources of Liquidity
As of December 31, 2005 our primary source of liquidity was
cash and we expect this to continue throughout 2006. Based on
past performance and current expectations we do not expect our
operations to generate significant cash flow in 2006. In
addition, in 2006, we expect our continued transfer of certain
manufacturing assets to Flextronics, and the sale of other
non-core assets to continue to be a source of cash at similar
levels as in 2005. We believe our cash will be sufficient to
fund the changes to our business model in accordance with our
strategic plan (see “Business Overview — Our
Strategy”), fund our investments and meet our customer
commitments for at least the 12 month period commencing
December 31, 2005, including the cash expenditures outlined
in our future uses of liquidity. Our ability to generate
sustainable cash from operations will be dependent on our
ability to generate profitable revenue streams and reduce our
operating expenses. If capital spending by our customers changes
from what we currently expect, our revenues and cash flows may
be materially lower and we may be required to further reduce our
investments or take other measures in order to meet our cash
requirements. In making this statement, we have not assumed the
need to make any payments in respect of fines or other penalties
or judgments or settlements in connection with our pending civil
litigation not encompassed by the Proposed Class Action
Settlement or regulatory or criminal investigations related to
the restatements, which could
101
have a material adverse effect on our business, results of
operations, financial condition and liquidity, other than
anticipated professional fees and expenses.
The Proposed Class Action Settlement, if finalized and
approved, will have a material impact on our liquidity as a
result of the proposed $575 cash payment. The cash amount bears
interest commencing March 23, 2006 at a prescribed rate and
is to be placed in escrow on June 1, 2006 pending
satisfactory completion of all conditions to the Proposed
Class Action Settlement. We also expect that the proposed
issuance of 628,667,750 Nortel Networks Corporation common
shares (representing 14.5% of our equity as of February 7,2006) will result in a significant dilution of existing equity
positions and may adversely affect our ability to finance using
equity and equity related securities in the future. In the event
of a share consolidation of Nortel Networks Corporation common
shares, the number of Nortel Networks Corporation common shares
to be issued pursuant to the Proposed Class Action
Settlement would be adjusted accordingly. The Proposed
Class Action Settlement is subject to several conditions.
In addition, we continue to be subject to significant regulatory
and criminal investigations which could materially adversely
affect our business, results of operations, financial condition
and liquidity by requiring us to pay substantial fines or other
penalties or settlements or by limiting our access to capital
market transactions.
Our ability and willingness to access the capital markets is
based on many factors including market conditions and our
overall financial objectives. Currently, our ability is limited
by our and NNL’s credit ratings, the findings of the
Independent Review, the Third Restatement and related matters.
Although we have obtained a new one year credit facility in the
aggregate principal amount of $1,300 to refinance the maturing
$1,275 Notes paid on February 15, 2006, we can provide no
assurance that any future long-term capital markets transactions
will be completed on favorable terms, or at all. We are
currently in breach of our obligations under the 2006 Credit
Facility and the EDC Support Facility, see “Restatements;
Nortel Networks Audit Committee Independent Review; Material
Weaknesses; Related Matters — Third Restatement”.
We are currently in discussions with our lenders under the 2006
Credit Facility and with EDC under the EDC Support Facility to
negotiate waivers related to the Third Restatement and the delay
in filing this report and the anticipated delay in filing our
2006 First Quarter Report. Although we expect to reach an
agreement with the lenders and EDC with respect to the terms of
an acceptable waiver, there can be no assurance that we will
receive such waivers. We and NNI agreed to a demand right
exercisable at any time after May 31, 2006 pursuant to
which we will be required to take all reasonable actions to
issue senior unsecured debt securities in the capital markets to
repay the 2006 Credit Facility. Any inability to refinance the
2006 Credit Facility would adversely affect our liquidity. We
cannot provide any assurance that our net cash requirements will
be as we currently expect, that we will continue to have access
to the EDC Support Facility when and as needed or that liquidity
generating transactions, that we will be able to the finance the
2006 Credit Facility or that financings will be available to us
on acceptable terms, or at all.
We cannot predict the timing of developments relating to the
above matters. See the “Risk Factors” section of this
report.
We expect to receive the remainder in 2006 of the revised total
range of gross proceeds of approximately $575 to $625 from the
Flextronics transaction, which is expected to be partially
offset by cash outflows attributable to direct transaction costs
and other costs associated with the transaction. See
“Business Developments in 2005 and 2006 —
Significant Business Developments — Evolution of Our
Supply Chain Strategy”.
Credit facilities
As of December 31, 2005, we had no material credit
facilities in place. On February 14, 2006, we entered into
a new one-year credit facility in the aggregate principal amount
of $1,300, or the 2006 Credit Facility. This new facility
consists of (i) a senior secured one-year term loan
facility in the amount of $850, or Tranche A Term Loans,
and (ii) a senior unsecured one-year term loan facility in
the amount of $450, or Tranche B Term Loans.
The Tranche A Term Loans are secured equally and ratably
with NNL’s obligations under the $750 support facility with
Export Development Canada, or the EDC Support Facility, by a
lien on substantially all of the U.S. and Canadian assets of NNL
and the U.S. assets of NNI. The Tranche A Term Loans
are also secured equally and ratably with NNL’s obligations
under the EDC Support Facility and the 2023 Bonds by a lien on
substantially all of the U.S. and Canadian assets of NNC. The
Tranche A Term Loans and Tranche B Term Loans are also
guaranteed by NNC and NNL and NNL’s obligations under the
EDC Support Facility are also guaranteed by NNC and NNI, in each
case until the maturity or prepayment of the 2006 Credit
Facility. The 2006 Credit Facility, which will mature in
February 2007, was drawn down in the full amount on
February 14, 2006 and we used the net proceeds primarily to
repay the outstanding $1,275 aggregate principal amount of
NNL’s 6.125% Notes on February 15, 2006. We and
NNI agreed to a demand right
102
exercisable at any time after May 31, 2006 pursuant to
which we would be required to take all reasonable actions to
issue senior unsecured debt securities in the capital markets to
repay the 2006 Credit Facility.
The Tranche A Loans contain financial covenants that
require that we achieve Adjusted EBITDA of not less than $850,
$750, $850 and $900 for the twelve-month period ending
March 31, 2006, June 30, 2006, September 30, 2006
and December 31, 2006, respectively. Adjusted EBITDA is
generally defined as consolidated earnings before interest,
taxes, depreciation and amortization, adjusted for certain
restructuring charges and other one-time charges and gains.
Both the Tranche A Term Loans and the Tranche B Term
Loans contain a covenant that our consolidated unrestricted cash
and cash equivalents must at all times be equal or greater than
$1,000. In addition, the 2006 Credit Facility contains covenants
that limit our ability to create liens on our assets and the
assets of substantially all of our subsidiaries in excess of
certain baskets and permitted amounts, limit our ability and the
ability of substantially all of our subsidiaries to merge,
consolidate or amalgamate with another person. Payments of
dividends on our outstanding preferred shares of NNL and
payments under the Proposed Class Action Settlement are
permitted. NNI is required to prepay the facility in certain
circumstances, including in the event of certain debt or equity
offerings or asset dispositions of collateral by NNC, NNL or NNI.
At our option, loans bear interest based on the “Base
Rate” (defined as the higher of the Federal Funds Rate, as
published by the Federal Reserve Bank of New York, plus
1/2
of 1% and the prime commercial lending rate of JPMorgan
Chase Bank, N.A., established from time to time) or the
reserve-adjusted London Interbank Offered Rate, or LIBOR, plus
the Applicable Margin. The “Applicable Margin” is
defined as 225 basis points in the case of Tranche A
Term Loans that are LIBOR loans (125 basis points if such
Tranche A Term Loans are Base Rate loans) and
300 basis points in the case of Tranche B Term Loans
that are LIBOR loans (200 basis points if such
Tranche B Term Loans are Base Rate loans). The
Tranche A Loans initially as of February 14, 2006 bear
interest at 6.875% while the Tranche B Loans initially as
of February 14, 2006 bear interest at 7.625%.
As a result of the delayed filing of this report with the SEC,
an event of default occurred under the 2006 Credit Facility. As
a result of this and certain other related breaches, lenders
holding greater than 50% of each tranche under the 2006 Credit
Facility have the right to accelerate such tranche, and lenders
holding greater than 50% of all of the secured loans under the
2006 Credit Facility have the right to exercise rights against
certain collateral. The entire $1,300 under the 2006 Credit
Facility is currently outstanding. We are currently in
discussions with our lenders under the 2006 Credit Facility to
negotiate waivers related to the Third Restatement and the delay
in filing this report and the anticipated delay in filing our
2006 First Quarter Report. Although we expect to reach an
agreement with the lenders with respect to the terms of an
acceptable waiver, there can be no assurance that we will
receive such waivers.
Available support facility
On February 14, 2003, NNL entered into the EDC Support
Facility. As of December 31, 2005, the facility provided
for up to $750 in support including:
•
$300 of committed revolving support for performance bonds or
similar instruments, of which $142 was outstanding; and
•
$450 of uncommitted support for performance bonds or similar
instruments and/or receivables sales and/or securitizations, of
which $20 was outstanding.
On May 31, 2005, NNL obtained a permanent waiver from EDC
of certain defaults and related breaches under the EDC Support
Facility relating to the First and Second Restatement and the
related delayed filings and revisions to our and NNL’s
prior financial results by NNL under the EDC Support Facility.
Effective October 24, 2005, NNL and EDC entered into an
amendment of the EDC Support Facility, or the EDC Amendment,
that maintained the total EDC Support Facility at up to $750,
including the existing $300 of committed support for performance
bonds and similar instruments, and the extension of the maturity
date of the EDC Support Facility for an additional year to
December 31, 2007. The EDC Amendment modified the facility
by combining the two previously uncommitted tranches under the
EDC Support Facility (one for performance bonds or similar
instruments and one for receivables sales and securitizations)
into a single $450 uncommitted revolving general purpose tranche
to support our receivables sales, securitizations and
performance bonds issuance.
The EDC Support Facility provides that EDC may suspend its
obligation to issue NNL any additional support if events occur
that would have a material adverse effect on NNL’s
business, financial position or results of operation.
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The EDC Support Facility does not materially restrict NNL’s
ability to sell any of its assets (subject to certain maximum
amounts) or to purchase or pre-pay any of its currently
outstanding debt. The EDC Support Facility can be suspended or
terminated if NNL’s senior long-term debt rating by
Moody’s Investors Service, or Moody’s, has been
downgraded to less than B3 or if its debt rating by
Standard & Poor’s, or S&P, has been downgraded
to less than B-.
In connection with the EDC Amendment, each of the guarantee and
security agreements previously guaranteeing or securing the
obligations of Nortel and its subsidiaries under the EDC Support
Facility and Nortel’s public debt securities were
terminated and the assets of Nortel and its subsidiaries pledged
under the security agreements were released in full. EDC also
agreed to provide future support under the EDC Support Facility
on an unsecured basis and without the guarantees of NNL’s
subsidiaries provided that should NNL or its subsidiaries incur
or guarantee certain indebtedness in the future above agreed
thresholds of $25 in North America and $100 outside of North
America, equal and ratable security and/or guarantees of
NNL’s obligations under the EDC Support Facility would be
required at that time.
Effective February 14, 2006, NNL’s obligations under
the EDC Support Facility became equally and ratably secured with
the 2006 Credit Facility and the 2023 Bonds by a pledge of
substantially all of the U.S. and Canadian assets of NNC and NNL
and the U.S. assets of NNI in accordance with the terms of
the EDC Support Facility. NNL’s obligations under the EDC
Support Facility also were guaranteed by NNC and NNI at such
time. These guarantees and security agreements will terminate
when the 2006 Credit Facility is repaid.
As a result of the delayed filing of this report with the SEC
and other related breaches, EDC has the right to refuse to issue
additional support and terminate its commitments under the $750
support facility, or the EDC Support Facility, or require that
NNL cash collateralize all existing support. As of
April 14, 2006, there was approximately $162 of outstanding
support under the EDC Support Facility. We are currently in
discussions with EDC under the EDC Support Facility to negotiate
waivers related to the Third Restatement and the delay in filing
this report and the anticipated delay in filing our 2006 First
Quarter Report. Although we expect to reach an agreement with
EDC with respect to the terms of an acceptable waiver, there can
be no assurance that we will receive such waivers.
For information related to our outstanding public debt, see
“Long-term debt, credit and support facilities” in
note 11 of the accompanying audited consolidated financial
statements. For information related to our debt ratings, see
“Credit Ratings” below. See the “Risk
Factors” section of this report for factors that may affect
our ability to comply with covenants and conditions in our EDC
Support Facility in the future.
Shelf registration statement and base shelf
prospectus
In 2002, we and NNL filed a shelf registration statement with
the SEC and a base shelf prospectus with the applicable
securities regulatory authorities in Canada, to qualify the
potential sale of up to $2,500 of various types of securities in
the U.S. and/or Canada. The qualifying securities include common
shares, preferred shares, debt securities, warrants to purchase
equity or debt securities, share purchase contracts and share
purchase or equity units (subject to certain approvals). As of
December 31, 2005, approximately $1,700 under the shelf
registration statement and base shelf prospectus had been
utilized. As of June 6, 2004, the Canadian base shelf
prospectus expired. As a result of the delayed filing of our
Exchange Act reports with the SEC due to the multiple
restatements and revisions to our and NNL’s prior financial
results, we and NNL continue to be unable to use, in its current
form as a short-form shelf registration statement, the remaining
approximately $800 of capacity for various types of securities
under our SEC shelf registration statement. We will again become
eligible for short-form shelf registration with the SEC after we
have completed timely filings of our financial reports for
twelve consecutive months. See the “Risk Factors”
section in this report.
On June 1, 2005, S&P affirmed its ratings on NNL,
including its long-term corporate credit rating at
“B-” and its preferred shares rating at
“CCC-”. At the same time, the ratings on NNC were
removed from credit watch and were assigned a stable outlook. On
July 6, 2005, Moody’s confirmed the long-term
corporate ratings of NNL at “B3” and the preferred
shares at “Caa3” and maintained its negative outlook.
The ratings confirmation concluded a ratings review for possible
downgrade under effect since April 28, 2004. As a result of
the EDC Amendment, on October 27, 2005, both
104
S&P and Moody’s affirmed its long-term corporate credit
ratings of NNL at “B-” long-term and “B3”,
respectively. As a result of the Proposed Settlement Agreement,
on February 8, 2006, S&P revised its outlook from
stable to positive and at the same time affirmed its
“B-” long-term and
“B-2”
short-term corporate credit ratings on NNL. On March 10,2006, as a result of our announcement of the Third Restatement,
S&P placed its ratings on NNL, including the “B-”
long-term corporate rating, on creditwatch with negative
implications, but indicated that, should we complete our filings
by the end of April as expected and absent any further negative
consequences of the Third Restatement, S&P would likely
affirm the “B-” rating and assign a positive outlook.
There can be no assurance that our credit ratings will not be
lowered or that these ratings agencies will not issue adverse
commentaries, potentially resulting in higher financing costs
and reduced access to capital markets or alternative financing
arrangements. A reduction in our credit ratings may also affect
our ability, and the cost, to securitize receivables, obtain
bid, performance related and other bonds, access the EDC Support
Facility and/or enter into normal course derivative or hedging
transactions.
Off-Balance Sheet Arrangements
Bid, Performance Related and Other Bonds
We have entered into bid, performance related and other bonds in
connection with various contracts. Bid bonds generally have a
term of less than twelve months, depending on the length of the
bid period for the applicable contract. Performance related and
other bonds generally have a term of twelve months and are
typically renewed, as required, over the term of the applicable
contract. The various contracts to which these bonds apply
generally have terms ranging from two to five years. Any
potential payments which might become due under these bonds
would be related to our non-performance under the applicable
contract. Historically, we have not had to make material
payments and we do not anticipate that we will be required to
make material payments under these types of bonds.
The following table provides information related to these types
of bonds as of:
The criteria under which bid, performance related and other
bonds can be obtained changed due to the industry environment
primarily in 2002 and 2001. During that timeframe, in addition
to the payment of higher fees, we experienced significant cash
collateral requirements in connection with obtaining new bid,
performance related and other bonds. Given that the EDC Support
Facility is used to support bid and performance bonds with
varying terms, including those with at least 365 day terms,
we will likely need to increase our use of cash collateral to
support these obligations beginning on January 1, 2007
absent a further extension of the facility.
Any bid or performance related bonds with terms that extend
beyond December 31, 2007 are currently not eligible for the
support provided by this facility. See “Liquidity and
Capital Resources — Sources of Liquidity —
Available support facility” for additional information on
the EDC Support Facility and the related security agreements.
Receivables Securitization and Certain Variable Interest
Transactions
In January 2003, the Financial Accounting Standards Board, or
FASB, issued FASB Interpretation, or FIN, No. 46,
“Consolidation of Variable Interest Entities — an
Interpretation of Accounting Research Bulletin No. 51,
“Consolidated Financial Statements”, or FIN 46,
and in December 2003, the FASB issued a revision of
FIN 46 — FIN 46 (Revised 2003), or
FIN 46R. FIN 46R provides guidance with respect to the
consolidation of variable interest entities, or VIEs. VIEs are
characterized as entities in which equity investors do not have
the characteristics of a “controlling financial
interest” or there is not sufficient equity at risk for the
entity to finance its activities without additional subordinated
financial support. Reporting entities which have a variable
interest in such an entity and are deemed to be the primary
beneficiary must consolidate the variable interest entity.
105
Certain of our lease financing transactions were structured
through single transaction VIEs that did not have sufficient
equity at risk as defined in FIN 46R. Effective
July 1, 2003, we prospectively began consolidating two VIEs
for which we were considered the primary beneficiary following
the guidance of FIN 46, on the basis that we retained
certain risks associated with guaranteeing recovery of the
unamortized principal balance of the VIEs’ debt, which
represented the majority of the risks associated with the
respective VIEs’ activities. The amount of the guarantees
will be adjusted over time as the underlying debt matures.
During 2005, the debt related to one of the VIEs was
extinguished and as a result consolidation of this VIE was no
longer required. As of December 31, 2005, our consolidated
balance sheet included $83 of long-term debt and $82 of plant
and equipment — net related to these VIEs. These
amounts represented both the collateral and maximum exposure to
loss as a result of our involvement with these VIEs.
Effective April 1, 2005, we began consolidating a VIE for
which we were considered the primary beneficiary under
FIN 46R. The VIE is a cellular phone operator in Russia.
Loans to this entity comprise the majority of the entity’s
subordinated financial support. No creditor of the VIE has
recourse to us. This entity’s financial results have been
consolidated using the most recent financial information
available.
On June 3, 2005, we acquired PEC, a VIE, for which we were
considered the primary beneficiary under FIN 46R. No
creditor of the VIE has recourse to us. Our consolidated
financial results include PEC’s operating results from the
date of the acquisition.
On November 2, 2005, we formed LG-Nortel Co. Ltd., which is
a VIE. We are considered the primary beneficiary under
FIN 46R. No creditor of the entity has recourse to us. This
entity’s financial results have been consolidated from the
date of formation.
As a result of the Third Restatement adjustments, effective,
July 1, 2003, we began to consolidate the Health and
Welfare Trust, a VIE, for which we were considered the primary
beneficiary under FIN 46R. See “Restatements; Nortel
Audit Committee Independent Review; Material Weaknesses; Related
Matters”.
As of December 31, 2005, we did not have any variable
interests related to transfers of financial assets. We have
other financial interests and contractual arrangements which
would meet the definition of a variable interest under
FIN 46R, including investments in other companies and joint
ventures, customer financing arrangements, and guarantees and
indemnification arrangements. As of December 31, 2005, none
of these other interests or arrangements were considered
significant variable interests and, therefore, did not meet the
requirements for consolidation or disclosure under FIN 46R.
We have also conducted certain receivable sales transactions
either directly with financial institutions or with multi-seller
conduits. Under some of these agreements, we have continued as
servicing agent and/or have provided limited recourse. The fair
value of these retained interests is based on the market value
of servicing the receivables, historical payment patterns,
expected future cash flows and appropriate discount rates as
applicable. Where we have acted as the servicing agent, we
generally have not recorded an asset or liability related to
servicing as the annual servicing fees were equivalent to those
that would have been paid to a third party servicing agent.
Also, we have not historically experienced significant credit
losses with respect to receivables sold with limited recourse.
As of December 31, 2005, we were not required to, and did
not, consolidate or provide any of the additional disclosures
set out in FIN 46R with respect to the variable interest
entities involving receivable sales.
Additionally, we have agreed to indemnify some of our
counterparties in certain receivables securitization
transactions. The indemnifications provided to counterparties in
these types of transactions may require us to compensate
counterparties for costs incurred as a result of changes in laws
and regulations (including tax legislation) or in the
interpretations of such laws and regulations, or as a result of
regulatory penalties that may be suffered by the counterparty as
a consequence of the transaction. Certain receivables
securitization transactions include indemnifications requiring
the repurchase of the receivables if the particular transaction
becomes invalid. As of December 31, 2005, we had
approximately $247 of securitized receivables which were subject
to repurchase under this provision, in which case we would
assume all rights to collect such receivables. The
indemnification provisions generally expire upon expiration of
the securitization agreements, which extend through 2006, or
collection of the receivable amount by the counterparty. We are
generally unable to estimate the maximum potential liability for
all of these types of indemnification guarantees as certain
agreements do not specify a maximum amount and the amounts are
dependent upon the outcome of future contingent events, the
nature and likelihood of which cannot be determined at this
time. Historically, we have not made any significant
indemnification payments or receivable repurchases under these
agreements and no significant liability has been accrued in the
accompanying audited consolidated financial statements with
respect to the obligation associated with these guarantees.
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Other Indemnifications or Guarantees
Through our normal course of business, we have also entered into
other indemnifications or guarantees that arise in various types
of arrangements including:
•
third party debt agreements;
•
business sale and business combination agreements;
indemnification of banks and agents under credit and support
facilities and security agreements; and
•
other indemnification agreements.
In 2005, we did not make any significant payments under any of
these indemnifications or guarantees. We have agreed to
indemnify the banks and agents under our credit facilities
against costs or losses resulting from changes in laws and
regulations which would increase the banks’ costs or reduce
their return and from any legal action brought against the banks
or agents related to the use of loan proceeds. We have agreed to
indemnify EDC under the EDC Support Facility against any legal
action brought against EDC that relates to the provision of
support under the EDC Support Facility. This indemnification
generally applies to issues that arise during the term of the
EDC Support Facility. For additional information, see
note 11 and note 13 of the accompanying audited
consolidated financial statements. We are unable to estimate the
maximum potential liability for these types of indemnification
guarantees as the agreements typically do not specify a maximum
amount and the amounts are dependent upon the outcome of future
contingent events, the nature and likelihood of which cannot be
determined at this time. Historically, we have not made any
significant indemnification payments under such agreements and
no significant liability has been accrued in the consolidated
financial statements with respect to the obligations associated
with these indemnification guarantees.
As part of the Proposed Class Action Settlement, we agreed
with our insurers to certain indemnification obligations. We
believe that these indemnification obligations would be unlikely
to materially increase our total cash payment obligations under
the Proposed Class Action Settlement. The insurance
payments would not reduce the amounts payable by us. For more
information, see “Developments in 2005 and 2006 —
Significant Business Developments — Proposed
Class Action Settlement” and the “Risk
Factors” and “Legal Proceedings” section of this
report.
Application of Critical Accounting Policies and Estimates
Our accompanying audited consolidated financial statements are
based on the selection and application of accounting policies
generally accepted in the U.S., which require us to make
significant estimates and assumptions. We believe that the
following accounting policies and estimates may involve a higher
degree of judgment and complexity in their application and
represent our critical accounting policies and estimates:
revenue recognition, provisions for doubtful accounts,
provisions for inventory, provisions for product warranties,
income taxes, goodwill valuation, pension and post-retirement
benefits, special charges and other contingencies.
In general, any changes in estimates or assumptions relating to
revenue recognition, provisions for doubtful accounts,
provisions for inventory and other contingencies (excluding
legal contingencies) are directly reflected in the results of
our reportable operating segments. Changes in estimates or
assumptions pertaining to our tax asset valuations, our pension
and post-retirement benefits and our legal contingencies are
generally not reflected in our reportable operating segments,
but are reflected on a consolidated basis.
We have discussed the application of these critical accounting
policies and estimates with the Audit Committee of our Board of
Directors.
Revenue Recognition
Our material revenue streams are the result of a wide range of
activities, from custom design and installation over a period of
time to a single delivery of equipment to a customer. Our
networking solutions also cover a broad range of technologies
and are offered on a global basis. As a result, our revenue
recognition policies can differ depending on the level of
customization within the solution and the contractual terms with
the customer. Newer technologies within one of our reporting
segments may also have different revenue recognition policies,
depending on, among other factors, the specific performance and
acceptance criteria within the applicable contract. Therefore,
management must use significant judgment in determining how to
apply the current accounting standards and interpretations, not
only based on the networking solution, but also within
networking solutions based on reviewing the level of
customization and contractual
107
terms with the customer. As a result, our revenues may fluctuate
from period to period based on the mix of solutions sold and the
geographic region in which they are sold.
When a customer arrangement involves multiple deliverables where
the deliverables are governed by more than one authoritative
standard, we evaluate all deliverables to determine whether they
represent separate units of accounting based on the following
criteria:
•
whether the delivered item has value to the customer on a
stand-alone basis;
•
whether there is objective and reliable evidence of the fair
value of the undelivered item(s); and
•
if the contract includes a general right of return relative to
the delivered item, delivery or performance of the undelivered
item(s) is considered probable and is substantially in our
control.
Our determination of whether deliverables within a multiple
element arrangement can be treated separately for revenue
recognition purposes involves significant estimates and
judgment, such as whether fair value can be established on
undelivered obligations and/or whether delivered elements have
standalone value to the customer. Changes to our assessment of
the accounting units in an arrangement and/or our ability to
establish fair values could significantly change the timing of
revenue recognition.
If objective and reliable evidence of fair value exists for all
units of accounting in the contract, revenue is allocated to
each unit of accounting or element based on relative fair
values. In situations where there is objective and reliable
evidence of fair value for all undelivered elements, but not for
delivered elements, the residual method is used to allocate the
contract consideration. Under the residual method, the amount of
revenue allocated to delivered elements equals the total
arrangement consideration less the aggregate fair value of any
undelivered elements. Each unit of accounting is then accounted
for under the applicable revenue recognition guidance. If
sufficient evidence of fair value cannot be established for an
undelivered element, revenue related to delivered elements is
deferred until the earlier of when sufficient fair value is
established or all remaining elements have been delivered. Once
there is only one remaining element to be delivered within the
unit of accounting, the deferred revenue is recognized based on
the revenue recognition guidance applicable to the last
delivered element. For instance, where post-contract support is
the last delivered element within the unit of accounting, the
deferred revenue is recognized ratably over the remaining
post-contract support term once post-contract support is the
only undelivered element.
Our assessment of which revenue recognition guidance is
appropriate to account for a deliverable also can involve
significant judgment. For instance, the determination of whether
software is more than incidental to hardware can impact whether
the hardware is accounted for under software revenue recognition
guidance or based on general revenue recognition guidance. This
assessment could significantly impact the amount and timing of
revenue recognition.
For elements related to customized network solutions and certain
network build-outs, revenues are recognized under AICPA
Statement of
Position 81-1,
generally using the
percentage-of-completion
method. In using the
percentage-of-completion
method, revenues are generally recorded based on a measure of
the percentage of costs incurred to date on a contract relative
to the estimated total expected contract costs. Profit estimates
on long-term contracts are revised periodically based on changes
in circumstances and any losses on contracts are recognized in
the period that such losses become known. Generally, the terms
of long-term contracts provide for progress billing based on
completion of certain phases of work. Contract revenues
recognized, based on costs incurred towards the completion of
the project, that are unbilled are accumulated in the contracts
in progress account included in accounts receivable —
net. Billings in excess of revenues recognized to date on
long-term contracts are recorded as advance billings in excess
of revenues recognized to date on contracts within other accrued
liabilities. Significant judgment is often required when
estimating total contract costs and progress to completion on
these arrangements, as well as whether a loss is expected to be
incurred on the contract. Management uses historical experience,
project plans and an assessment of the risks and uncertainties
inherent in the arrangement to establish these estimates.
Uncertainties include implementation delays or performance
issues that may or may not be within our control. Changes in
these estimates could result in a material impact on revenues
and net earnings (loss).
Revenue for hardware that does not require significant
customization, and where any software is considered incidental,
is recognized under SEC Staff Accounting Bulletin 104,
“Revenue Recognition”, or SAB 104. Under
SAB 104, revenue is recognized provided that persuasive
evidence of an arrangement exists, delivery has occurred or
services have been rendered, the fee is fixed or determinable
and collectibility is reasonably assured.
For hardware, delivery is considered to have occurred upon
shipment provided that risk of loss, and title in certain
jurisdictions, have been transferred to the customer. For
arrangements where the criteria for revenue recognition have not
been met because legal title or risk of loss on products did not
transfer to the buyer until final payment had been
108
received or where delivery had not occurred, revenue is deferred
to a later period when title or risk of loss passes either on
delivery or on receipt of payment from the customer. For
arrangements where the customer agrees to purchase products but
we retain possession until the customer requests shipment, or
“bill and hold” arrangements, revenue is not
recognized until delivery to the customer has occurred and all
other revenue recognition criteria have been met.
We make certain sales through multiple distribution channels,
primarily resellers and distributors. These customers are
generally given certain rights of return. For products sold
through these distribution channels, revenue is recognized from
product sale at the time of shipment to the distribution channel
when persuasive evidence of an arrangement exists, delivery has
occurred, the fee is fixed or determinable and collection is
reasonably assured. Accruals for estimated sales returns and
other allowances and deferrals are recorded as a reduction of
revenue at the time of revenue recognition. These provisions are
based on contract terms and prior claims experience and involve
significant estimates. If these estimates are significantly
different from actual results, our revenue could be impacted.
We provide extended payment terms on certain software contracts
and may sell these receivables to third parties. The fees on
these contracts are considered fixed or determinable if the
contracts are similar to others for which we have a standard
business practice of providing extended payment terms and have a
history of successfully collecting under the original payment
terms without making concessions. If fees are not considered
fixed or determinable at the outset of the arrangement, revenue
for delivered products is deferred until the fees become legally
due and payable and therefore estimates and judgment in this
area can impact the timing of revenue recognition.
The collectibility of trade and notes receivables is also
critical in determining whether revenue should be recognized. As
part of the revenue recognition process, we determine whether
trade or notes receivables are reasonably assured of collection
and whether there has been deterioration in the credit quality
of our customers that could result in our inability to collect
the receivables. We will defer revenue but recognize related
costs if we are uncertain about whether we will be able to
collect the receivable. As a result, our estimates and judgment
regarding customer credit quality could significantly impact the
timing and amount of revenue recognition.
For further information on our revenue recognition policies
relating to our material revenue streams, you should also refer
to note 2(d) of the accompanying audited consolidated
financial statements.
Provisions for Doubtful Accounts
In establishing the appropriate provisions for trade, notes and
long-term receivables due from customers, we make assumptions
with respect to their future collectibility. Our assumptions are
based on an individual assessment of a customer’s credit
quality as well as subjective factors and trends. Generally,
these individual credit assessments occur prior to the inception
of the credit exposure and at regular reviews during the life of
the exposure and consider:
•
age of the receivables;
•
a customer’s ability to meet and sustain its financial
commitments;
•
a customer’s current and projected financial condition;
•
collection experience with the customer;
•
historical bad debt experience with the customer;
•
the positive or negative effects of the current and projected
industry outlook; and
•
the economy in general
Once we consider all of these individual factors, an appropriate
provision is then made, which takes into consideration the
likelihood loss and our ability to establish a reasonable
estimate.
In addition to these individual assessments, a regional (except
Asia) accounts past due provision is established for outstanding
trade accounts receivable amounts based on a review of balances
greater than six months past due. A regional trend analysis,
based on past and expected write-off activity, is performed on a
regular basis to determine the likelihood of loss and establish
a reasonable estimate.
We recorded net trade and customer financing receivable
recoveries related to continuing operations of $9, $118 and $189
in 2005, 2004 and 2003, respectively, primarily related to
favorable settlements related to our sale or restructuring of
various receivables as well as net recoveries on other trade and
customer financing receivables due to subsequent collections for
amounts exceeding our original estimates of net recovery. These
recoveries were partially offset by receivable provisions
recorded during 2005 and 2003 related to our normal business
activity.
109
The following table summarizes our accounts receivable and
long-term receivable balances and related reserves of our
continuing operations as of:
Accounts receivable provision as a percentage of gross accounts
receivables
5
%
4
%
Gross long-term receivables
$
57
$
159
Provision for doubtful accounts
(33
)
(65
)
Net long-term receivables
$
24
$
94
Long-term receivable provision as a percentage of gross
long-term receivables
58
%
41
%
Provisions for Inventory
Management must make estimates about the future customer demand
for our products when establishing the appropriate provisions
for inventory.
When making these estimates, we consider general economic
conditions and growth prospects within our customers’
ultimate marketplace, and the market acceptance of our current
and pending products. These judgments must be made in the
context of our customers’ shifting technology needs and
changes in the geographic mix of our customers. With respect to
our provisioning policy, in general, we fully reserve for
surplus inventory in excess of our 365 day demand forecast
or that we deem to be obsolete. Generally, our inventory
provisions have an inverse relationship with the projected
demand for our products. For example, our provisions usually
increase as projected demand decreases due to adverse changes in
the conditions mentioned above. We have experienced significant
changes in required provisions in recent periods due to changes
in strategic direction, such as discontinuances of product
lines, as well as declining market conditions. A
misinterpretation or misunderstanding of any of these conditions
could result in inventory losses in excess of the provisions
determined to be appropriate as of the balance sheet date.
Our inventory includes certain direct and incremental deferred
costs associated with arrangements where title and risk of loss
was transferred to customers but revenue was deferred due to
other revenue recognition criteria not being met. We have not
recorded provision against this type of inventory.
The following table summarizes our inventory balances and other
related reserves of our continuing operations as of:
Inventory provisions as a percentage of gross inventory
28
%
31
%
(a)
Includes long-term portion of inventory related to the deferred
costs, which is included in other assets.
Inventory provisions decreased $104 as a result of $141 of
scrapped inventory and $111 of reductions due to sale of
inventory partially offset by $99 of additional inventory
provisions and $49 of foreign exchange fluctuations,
reclassifications and other adjustments. In the future, we may
be required to make significant adjustments to these provisions
for the sale and/or disposition of inventory that was provided
for in prior periods.
Provisions for Product Warranties
Provisions are recorded for estimated costs related to
warranties given to customers on our products to cover defects.
These provisions are calculated based on historical return rates
as well as on estimates, which take into consideration the
historical material replacement costs and the associated labor
costs to correct the product defect. Known product defects are
specifically provided for as we become aware of such defects.
Revisions are made when actual experience differs materially
from historical experience. These provisions for product
warranties are part of the cost of revenues and are accrued when
the revenue is recognized. They represent the best possible
estimate, at the time the sale is made, of the expenses to be
incurred under the warranty granted. Warranty terms generally
range from one to six years from the date
110
of sale depending upon the product. As part of our warranty
provision review, we reduced our provision by approximately $21
in the fourth quarter of 2005. This adjustment was in addition
to any provisions we have taken in the year.
We accrue for warranty costs as part of our cost of revenues
based on associated material costs and technical support labor
costs. Material cost is estimated based primarily upon
historical trends in the volume of product returns within the
warranty period and the cost to repair or replace the product.
Technical support labor cost is estimated based primarily upon
historical trends in the rate of customer warranty claims and
projected claims within the warranty period.
The following table summarizes the accrual for product
warranties that was recorded as part of other accrued
liabilities in the consolidated balance sheets as of
December 31:
2005
2004
Balance at the beginning of the year
$
273
$
387
Payments
(176
)
(267
)
Warranties issued
190
229
Revisions
(79
)
(76
)
Balance at the end of the year
$
208
$
273
We engage in extensive product quality programs and processes,
including actively monitoring and evaluating the quality of our
component suppliers. Our estimated warranty obligation is based
upon warranty terms, ongoing product failure rates, historical
material replacement costs and the associated labor to correct
the product defect. If actual product failure rates, material
replacement costs, service or labor costs differ from our
estimates, revisions to the estimated warranty provision would
be required. If we experience an increase in warranty claims
compared with our historical experience, or if the cost of
servicing warranty claims is greater than the expectations on
which the accrual is based, our gross margin could be negatively
affected.
Income Taxes
Tax asset valuation
Our net deferred tax assets balance, excluding discontinued
operations, was $3,902 as of December 31, 2005 and $3,849
as of December 31, 2004. The $53 increase was primarily due
to the impact of foreign exchange effects and the release of a
liability related to the retroactive application of the APA. We
currently have deferred tax assets resulting from net operating
loss carryforwards, tax credit carryforwards and deductible
temporary differences, all of which are available to reduce
future taxes payable in our significant tax jurisdictions.
Generally, our loss carryforward periods range from seven years
to an indefinite period. As a result, we do not expect that a
significant portion of these carryforwards will expire in the
near future.
We assess the realization of these deferred tax assets quarterly
to determine whether an income tax valuation allowance is
required. Based on available evidence, both positive and
negative, we determine whether it is more likely than not that
all or a portion of the remaining net deferred tax assets will
be realized. The main factors that we consider include:
•
cumulative losses in recent years;
•
history of loss carryforwards and other tax assets expiring;
•
the carryforward period associated with the deferred tax assets;
•
the nature of the income that can be used to realize the
deferred tax assets;
•
our net earnings (loss); and
•
future earnings potential determined through the use of internal
forecasts.
In evaluating the positive and negative evidence, the weight
given to each type of evidence must be proportionate to the
extent to which it can be objectively verified. If it is our
belief that it is more likely than not that some portion of
these assets will not be realized, an income tax valuation
allowance is recorded.
We are in a cumulative loss position in certain of our material
jurisdictions. Primarily for this reason, we have recorded an
income tax valuation allowance against a portion of these
deferred income tax assets. However, due to the fact that the
majority of the carryforwards do not expire in the near future
and our future expectations of earnings, we concluded that it is
more likely than not that the remaining net deferred income tax
asset recorded as of December 31, 2005 will be realized. We
continue to review all available positive and negative evidence
in each jurisdiction and our valuation allowance may need to be
adjusted in the future as a result of this ongoing review. Given
the magnitude of our valuation
111
allowance, future adjustments to this allowance based on actual
results could result in a significant adjustment to our net
earnings (loss).
As of December 31, 2005, our gross income tax valuation
allowances decreased to $3,410 compared to $3,717 as of
December 31, 2004. The decrease was primarily due to the
impacts of foreign exchange, deferred taxes that expired during
the year and tax return and other adjustments offset by
additional valuation allowances recorded against the tax benefit
of current period losses in certain jurisdictions. We assessed
positive evidence including forecasts of future taxable income
to support realization of the net deferred tax assets, and
negative evidence including our cumulative loss position, and
concluded that the valuation allowances as of December 31,2005 were appropriate.
Tax contingencies
We are subject to ongoing examinations by certain taxation
authorities of the jurisdictions in which we operate. We
regularly assess the status of these examinations and the
potential for adverse outcomes to determine the adequacy of the
provision for income and other taxes. We believe that we have
adequately provided for tax adjustments that we believe are
probable as a result of any ongoing or future examination.
Specifically, the tax authorities in Brazil have completed an
examination of a prior taxation years and have issued
assessments in the amount of $56. We are currently in the
process of appealing these assessments and believe that we have
adequately provided for tax adjustments that are probable as a
result of the outcome of the ongoing appeals process.
In addition, tax authorities in France have issued two
preliminary notices of proposed assessment in respect of the
2001 and 2002 taxation years. These assessments collectively
propose adjustments to taxable income of approximately $800 as
well as certain adjustments to withholding and other taxes of
approximately $50 plus applicable interest and penalties. Other
than the withholding and other taxes, we have sufficient loss
carry-forwards to absorb the entire amount of the proposed
assessment. However, no amount has been provided for these
assessments since we believe that the proposed assessments are
without merit and any potential tax adjustments that could
result from these ongoing examinations cannot be quantified at
this time.
We had previously entered into APAs with the taxation
authorities of the U.S. and Canada in connection with our
intercompany transfer pricing and cost sharing arrangements
between Canada and the U.S. These arrangements expired in
1999 and 2000. In 2002, we filed APA requests with the taxation
authorities of the U.S., Canada and the United Kingdom
(“U.K.”) that applied to the taxation years beginning
in 2000. The APA requests are currently under consideration but
the tax authorities have not begun to negotiate the terms of the
arrangement. We have applied the transfer pricing methodology
proposed in the APA requests in preparing our tax returns and
accounts beginning in 2001.
As part of the APA applications, we have requested that the
methodology adopted in 2001 be applied retroactively to the 2000
taxation year. Such retroactive application would result in an
increase in taxable income in certain jurisdictions offset by an
equal decrease in taxable income in the other jurisdictions. We
had previously concluded that it was probable that the
retroactive application of the proposed methodology would be
accepted by the tax authorities and prepared our income tax
estimates (both current and deferred taxes) on the basis that
the 2000 taxation year would be governed by the APA submission.
As a result, we had previously provided approximately $140 for
taxes and interest in various tax jurisdictions that would be
due as a result of retroactive application of the APA. In the
fourth quarter of 2005, we obtained new information and as a
result can no longer conclude that it is probable that the APA
will be retroactively applied. We have recalculated our current
and deferred tax balances assuming the 2000 tax year would not
be subject to the retroactive application of the APA. As a
result, the gross deferred income tax balances in our material
jurisdictions were recalculated on an as filed basis, and the
liability of $140 for taxes and interest that was previously
accrued was released in the fourth quarter of 2005.
The outcome of the APA applications is uncertain and additional
possible losses, as they relate to the APA negotiations, cannot
be determined at this time. However, we do not believe it is
probable that the ultimate resolution of these negotiations will
have a material adverse effect on our consolidated financial
position, results of operations or cash flows. Despite our
current belief, if this matter is resolved unfavorably, it could
have a material adverse effect on our consolidated financial
position, results of operations or cash flows.
112
Goodwill Valuation
We test goodwill for possible impairment on an annual basis as
of October 1 of each year and at any other time if an event
occurs or circumstances change that would more likely than not
reduce the fair value of a reporting unit below its carrying
amount. Circumstances that could trigger an impairment test
between annual tests include, but are not limited to:
•
a significant adverse change in the business climate or legal
factors;
•
an adverse action or assessment by a regulator;
•
unanticipated competition;
•
loss of key personnel;
•
the likelihood that a reporting unit or a significant portion of
a reporting unit will be sold or disposed of;
•
a change in reportable segments;
•
results of testing for recoverability of a significant asset
group within a reporting unit; and/or
•
recognition of a goodwill impairment loss in the financial
statements of a subsidiary that is a component of a reporting
unit.
The impairment test for goodwill is a two-step process. Step one
consists of a comparison of the fair value of a reporting unit
with its carrying amount, including the goodwill allocated to
the reporting unit. Measurement of the fair value of a reporting
unit is based on one or more fair value measures. These measures
involve significant management judgment and as a result are
subject to change.
If the carrying amount of the reporting unit exceeds the fair
value, step two requires the fair value of the reporting unit to
be allocated to the underlying assets and liabilities of that
reporting unit, resulting in an implied fair value of goodwill.
If the carrying amount of the reporting unit goodwill exceeds
the implied fair value of that goodwill, an impairment loss
equal to the excess is recorded in net earnings (loss).
The fair value of each reporting unit is determined by
allocating our total fair value among our reporting units using
an average of three valuation models; a discounted cash flow
model, or the DCF model, a model based on estimated 2006 revenue
multiples, or the Revenue Multiple model, and a model based on a
multiple of estimated 2006 earnings before interest, taxes,
depreciation and amortization, or the EBITDA Multiple model. All
of these valuation models involve significant assumptions
regarding our future operating performance. The following are
the significant assumptions involved in each model:
Revenue Multiple model: estimates of 2006 revenue growth and the
selection of comparable companies to determine an appropriate
multiple; and
•
EBITDA Multiple model: 2006 projected EBITDA and the selection
of comparable companies to determine an appropriate multiple.
Of our total goodwill of $2,592 as of December 31, 2005,
$1,999 was attributable to our Enterprise Networks business.
Accordingly, changes in our assumptions related to the fair
value of our Enterprise Networks business are most likely to
result in an impairment charge in the future. Based on a
sensitivity analysis, we changed certain significant assumptions
in order to assess the impact on the value of our Enterprise
Networks goodwill. We determined that a decrease as high as 20%
in projected 2006 Enterprise revenues, coupled with the
assumption of no future Enterprise Networks revenue growth,
would not trigger a goodwill impairment. Accordingly, a
substantial change in our assumptions would be required before a
goodwill impairment would be triggered.
In 2005 and 2004, we concluded that an impairment of our
goodwill did not exist and no write down was recorded. In the
first quarter of 2005, we changed our reportable segments (see
“Business Overview — Our Segments”). This
triggered an interim impairment test in the first quarter of
2005 in accordance with SFAS No. 142, “Goodwill
and other Intangible Assets”. We performed this test and
concluded that there was no impairment.
The carrying value of goodwill was $2,592 as of
December 31, 2005 and $2,303 as of December 31, 2004.
The increase in goodwill primarily related to the acquisition of
PEC and the formation of LG-Nortel. For additional information
on this transaction, including the allocation of the purchase
price, see “Acquisitions, divestitures and closures”
in note 10 of the accompanying audited consolidated
financial statements.
113
Pension and Post-retirement Benefits
We maintain various pension and post-retirement benefit plans
for our employees globally. These plans include significant
pension and post-retirement benefit obligations which are
calculated based on actuarial valuations. Key assumptions are
made in determining these obligations and related expenses,
including expected rates of return on plan assets and discount
rates.
For 2005, the expected long-term rate of return on plan assets
used to estimate pension expenses was 7.4% on a weighted average
basis, which was the rate determined at September 30, 2004.
The expected long-term rate of return on plan assets remained
the same as 2004. The discount rates used to estimate the net
pension obligations and expenses for 2005 were 5.1% and 5.7%,
respectively, on a weighted average basis, compared to 5.7% and
5.8%, respectively, in 2004.
The key assumption used to estimate the post-retirement benefit
costs for 2005 was an expected discount rate of 5.4% and 5.9%
for the obligations and costs, respectively, both on a weighted
average basis. The discount rates for the obligations and costs
decreased in 2005 to 5.4% and 5.9%, respectively, from 5.9% and
6.0%, respectively, in 2004 due to the decline experienced in
global interest rates during 2003 through 2005.
The difference between the discount rate reported for the net
pension obligations and expenses and discount rate reported for
the net post-retirement benefit obligations and costs is due to
the weighted-average calculation as a result of the number of
countries in which we offer either pension or pension and
post-retirement benefits. In developing these assumptions, we
evaluated, among other things, input from our actuaries,
duration of the liabilities, and current high-quality bond rates.
Changes in net periodic pension and post-retirement benefit
expense may occur in the future due to changes in our expected
rate of return on plan assets and discount rate resulting from
economic events. The following table highlights the sensitivity
of our pension and post-retirement benefit expense to changes in
these assumptions, assuming all other assumptions remain
constant:
Effect on 2005 Pre-tax
Effect on 2005 Pre-tax Post-
Change in Assumption
Pension Expense*
Retirement Benefit Expense
Increase/(Decrease)
Increase/(Decrease)
1 percentage point increase in the expected return on assets
$
(58
)
N/A
1 percentage point decrease in the expected return on assets
58
N/A
1 percentage point increase in the discount rate
(88
)
<1
1 percentage point decrease in the discount rate
88
4
*
excludes settlement costs (lump sum and termination payments to
participants which discharges our obligations)
Plan assets were primarily comprised of debt and equity
securities. Included in the equity securities of the defined
benefit plan were common shares of Nortel Networks Corporation,
held directly or through pooled funds, with an aggregate market
value of $5 (0.1% of total plan assets) as of December 31,2005 and $11 (0.2% of total plan assets) as of December 31,2004.
Unrecognized actuarial gains and losses are being recognized
over approximately a 12 year period, which represents the
weighted-average expected remaining service life of the employee
group. Unrecognized actuarial gains and losses arise from
several factors including experience and assumption changes in
the obligations and from the difference between expected returns
and actual returns on assets. At the end of 2005, we had
unrecognized net actuarial losses related to the defined benefit
plans of $2,125 which could result in an increase to pension
expenses in future years depending on several factors, including
whether such losses exceed the corridor in accordance with
SFAS No. 87, “Employers’ Accounting for
Pensions”. The post-retirement benefit plans had
unrecognized actuarial losses of $129 at the end of 2005.
The estimated accumulated benefit obligations for the defined
benefit plans exceeded the fair value of the plan assets at
September 30, 2005 as a result of reductions in discount
rates which more than offset the favorable impacts of strong
pension asset returns and the contributions made by us during
2005. Accordingly, we recorded a non-cash charge of $216 (before
tax) to other comprehensive income for the minimum pension
liability. A similar charge may be required in the future as the
impact of changes in global capital markets and interest rates
on the value of our pension plan assets and obligations are
measured.
During 2005, we made cash contributions to our defined benefit
pension plans of $180 and to our post-retirement benefit plans
of $31. In 2006, we expect to make cash contributions of
approximately $335 to our defined benefit pension plans,
including a portion related to a pension funding agreement in
the United Kingdom that requires contributions through
114
April 2007 and approximately $20 to our post-retirement benefit
plans. We are currently in discussions with the Trustee of our
pension plan in the United Kingdom pension to establish a
long-term funding agreement which would increase the level of
2006 contributions.
For 2006, we are lowering our expected rate of return on plan
assets from 7.4% to 7.2% for defined benefit pension plans. Also
for 2006, we are lowering our discount rate on a
weighted-average basis for pension expenses from 5.7% to 5.1%
for the defined benefit pension plans and from 5.9% to 5.4% for
post-retirement benefit plans given the declining trend in
current global interest rates. We will continue to evaluate our
expected long-term rates of return on plan assets and discount
rates at least annually and make adjustments as necessary, which
could change the pension and post-retirement obligations and
expenses in the future. If the actual operation of the plans
differs from the assumptions, additional contributions by us may
be required. If we are required to make significant
contributions to fund the defined benefit plans, reported
results could be materially and adversely affected and our cash
flow available for other uses may be significantly reduced.
For additional information, see “Employee benefit
plans” in note 9 of the accompanying audited
consolidated financial statements.
Special Charges
In 2001, we entered into an unprecedented period of business
realignment in response to a significant adjustment in the
industry. We implemented a company-wide restructuring plan to
streamline our operations and activities around core markets and
operations, which included significant workforce reductions,
global real estate closures and dispositions, substantial
write-downs of our plant and equipment, goodwill and other
intangible assets and extensive contract settlements with
customers and suppliers around the world. As a result of these
actions, our workforce declined significantly from
January 1, 2001 to December 31, 2003 and over the same
time period, we significantly reduced our facilities.
In 2005, our focus was on managing each of our businesses based
on financial performance, the market and customer priorities. In
the third quarter of 2004, we announced a 2004 Restructuring
Plan that includes a work plan involving focused workforce
reductions, including a voluntary retirement program, of
approximately 3,250 employees, real estate optimization and
other cost containment actions such as reductions in information
services costs, outsourced services and other discretionary
spending across all segments but primarily in Carrier Packet
Networks.
We record provisions for workforce reduction costs and exit
costs when they are probable and estimable. Severance paid under
ongoing benefit arrangements is recorded in accordance with
SFAS No. 112 “Employers’ Accounting for
Post-employment Benefits”. One-time termination benefits
and contract settlement and lease costs are recorded in
accordance with SFAS No. 146 “Accounting for
Costs Associated with Exit or Disposal Activities”.
At each reporting date, we evaluate our accruals related to
workforce reduction charges, contract settlement and lease costs
and plant and equipment write downs to ensure that these
accruals are still appropriate. As of December 31, 2005, we
had $24 in accruals related to workforce reduction charges and
$274 in accruals related to contract settlement and lease costs,
which included significant estimates, primarily related to
sublease income over the lease terms and other costs for vacated
properties. In certain instances, we may determine that these
accruals are no longer required because of efficiencies in
carrying out our restructuring work plan. Adjustments to
workforce reduction accruals may also be required when employees
previously identified for separation do not receive severance
payments because they are no longer employed by us or were
redeployed due to circumstances not foreseen when the original
plan was initiated. In these cases, we reverse any related
accrual to earnings when it is determined it is no longer
required. Alternatively, in certain circumstances, we may
determine that certain accruals are insufficient as new events
occur or as additional information is obtained. In these cases,
we would increase the applicable existing accrual with the
offset recorded against earnings. Increase or decreases to the
accruals for changes in estimates are classified within special
charges in the statement of operations.
Other Contingencies
We are subject to the possibility of various loss contingencies
arising in the ordinary course of business. As a result, we
consider the likelihood of loss or impairment of an asset or the
incurrence of a liability, as well as our ability to reasonably
estimate the amount of loss, in determining loss contingencies.
We recognize a provision for an estimated loss contingency when
it is probable that an asset has been impaired or a liability
has been incurred and the amount of loss
115
can be reasonably estimated. We regularly evaluate current
information available to us to determine whether such accruals
should be adjusted.
We are also subject to proceedings, lawsuits, investigations and
other claims (some of which may involve substantial dollar
amounts), including proceedings under laws and government
regulations related to securities, income and other taxes,
environmental, labor, product and other matters which are in the
normal course of business. Our restatements of our consolidated
financial statements and related events have caused us to be
subject to ongoing regulatory and criminal investigations and
significant pending civil litigation actions in the U.S. and
Canada. We are required to assess the likelihood of any adverse
judgments or outcomes in any of these matters, as well as
potential ranges of probable losses. A determination of the
amount of provision required, if any, for these contingencies is
based on an analysis of each individual issue The required
reserves may change in the future due to new developments in
each matter or changes in approach such as a change in
settlement strategy in dealing with these matters.
On February 8, 2006, we first announced that we had reached
a settlement in principle with the lead plaintiffs in two
significant class action lawsuits. As a result of the Proposed
Class Action Settlement, we have established a litigation
reserve and recorded a charge to our full-year 2005 financial
results of $2,474, $1,899 of which relates to the proposed
equity component of the Proposed Class Action Settlement
and will be adjusted in future quarters until the finalization
of the settlement based on the market price of the Nortel
Networks Corporation common shares issuable. See the “Risk
Factors” section of this report.
For more information related to our outstanding legal and other
proceedings, see “Contingencies” in note 22 of
the accompanying audited consolidated financial statements and
“Developments in 2005 and 2006 — Significant
Business Developments — Proposed Class Action
Settlement”, “Restatements; Nortel Audit Committee
Independent Review; Material Weaknesses; Related
Matters — Regulatory Actions and Pending
Litigation”; the “Legal Proceedings” and
“Risk Factors” sections of this report.
Accounting Changes and Recent Accounting Pronouncements
Accounting Changes
Our consolidated financial statements are based on the selection
and application of accounting policies, generally accepted in
the U.S. For more information related to the accounting
policies that we adopted as a result of new accounting
standards, see “Accounting changes” in note 3 of
the accompanying audited consolidated financial statements. The
following summarizes the accounting changes that we have adopted:
•
Consolidation of VIEs — the adoption of new
accounting guidance for VIEs resulted in the inclusion of $83 in
long-term debt and $82 of plant and equipment — net as
of December 31, 2005. These amounts represented both the
collateral and maximum exposure to loss as a result of our
involvement with VIEs.
•
Accounting for certain financial instruments with
characteristics of both liabilities and equity —
the adoption of SFAS No. 150, “Accounting for
Certain Financial Instruments with Characteristics of both
Liabilities and Equity” in 2003 did not have a material
impact on our results of operations and financial condition.
•
The effect of contingently convertible debt on diluted
earnings per share — the adoption of
EITF 04-8,
“The Effect of Contingently Convertible Debt on Diluted
Earnings per Share”, in 2004 did not have an impact on our
diluted earnings (loss) per share.
•
Implicit variable interests — in March 2005,
the FASB issued FSP FIN 46(R)-5, “Implicit Variable
Interests under FASB Interpretation No., or FIN, 46 (revised
December 2003), “Consolidation of Variable Interest
Entities”, or FSP FIN 46R-5. This FSP is effective in
the first period beginning after March 3, 2005 in
accordance with the transition provisions of FIN 46. The
adoption of FSP FIN 46R-5 had no material impact on our
results of operations and financial condition.
•
Accounting for electronic equipment waste
obligation — the adoption of the
FSP FAS 143-1,
“Accounting for Electronic Equipment Waste
Obligations”, did not have a material impact on our results
of operations and financial condition for the fiscal year ended
December 31, 2005. Due to the fact that certain EU-member
countries have not yet enacted country-specific laws, we cannot
estimate the impact of applying this guidance in future periods.
Recent Accounting Pronouncements
In March 2004, the Emerging Issues Task Force, or EITF, reached
consensus on Issue
No. 03-1,
“The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments”
(“EITF 03-1”).
EITF 03-1 provides
116
guidance on determining when an investment is considered
impaired, whether that impairment is other than temporary and
the measurement of an impairment loss.
EITF 03-1 is
applicable to marketable debt and equity securities within the
scope of SFAS No. 115, “Accounting for Certain
Investments in Debt and Equity Securities”
(“SFAS 115”), and SFAS No. 124,
“Accounting for Certain Investments Held by Not-for-Profit
Organizations”, and equity securities that are not subject
to the scope of SFAS 115 and not accounted for under the
equity method of accounting. The FASB, at its June 29, 2005
Board meeting, decided not to provide additional guidance on the
meaning of other-than-temporary impairment, but instead issued
proposed FASB Staff Position (“FSP”)
EITF 03-1-a,
“Implementation Guidance for the Application of
Paragraph 16 of EITF Issue
No. 03-1”, as
final, superseding
EITF 03-1 and EITF
Topic No. D-44,
“Recognition of Other-Than-Temporary Impairment upon the
Planned Sale of a Security Whose Cost Exceeds Fair Value”.
The final FSP, retitled
FSP FAS 115-1
and FAS 124-1,
“The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments”
(“FSP FAS 115-1
and
FAS 124-1”),
would be applied prospectively and the effective date would be
reporting periods beginning after December 15, 2005. The
adoption of
FSP FAS 115-1
and FAS 124-1,
issued by the FASB, is not expected to have a material impact on
our results of operations and financial condition.
In November 2004, the FASB issued SFAS No. 151,
“Inventory Costs” (“SFAS 151”).
SFAS 151 requires that abnormal amounts of idle facility
expense, freight, handling costs and wasted material
(spoilage) be recognized as current period charges rather
than capitalized as a component of inventory costs. In addition,
SFAS 151 requires allocation of fixed production overheads
to inventory based on the normal capacity of the production
facilities. This statement is effective for inventory costs
incurred in fiscal years beginning after June 15, 2005. The
guidance should be applied prospectively. The adoption of
SFAS 151 is not expected to have a material impact on our
results of operations and financial condition.
In December 2004, the FASB issued SFAS No. 123
(Revised 2004), “Share-Based Payment”
(“SFAS 123R”), which requires all share-based
payments to employees, including grants of employee stock
options, to be recognized as compensation expense in the
consolidated financial statements based on their fair values.
SFAS 123R also modifies certain measurement and expense
recognition provisions of SFAS 123, that will impact us,
including the requirement to estimate employee forfeitures each
period when recognizing compensation expense, and requiring that
the initial and subsequent measurement of the cost of
liability-based awards each period be based on the fair value
(instead of the intrinsic value) of the award. This statement is
effective as of January 1, 2006. We previously elected to
expense employee stock-based compensation using the fair value
method prospectively for all awards granted or modified on or
after January 1, 2003 in accordance with SFAS 148.
SAB 107 was issued by the SEC in March 2005, and provides
supplemental SFAS 123R application guidance based on the
views of the SEC. The adoption of SFAS 123R is not expected
to have a material impact on our results of operations and
financial condition.
In May 2005, the FASB issued SFAS No. 154,
“Accounting Changes and Error Corrections”
(“SFAS 154”), which replaces APB Opinion
No. 20, “Accounting Changes”, and
SFAS No. 3, “Reporting Accounting Changes in
Interim Financial Statements — An Amendment of APB
Opinion No. 28”. SFAS 154 provides guidance on
the accounting for and reporting of changes in accounting
principles and error corrections. SFAS 154 requires
retrospective application to prior period financial statements
of voluntary changes in accounting principle and changes
required by new accounting standards when the standard does not
include specific transition provisions, unless it is
impracticable to do so. SFAS 154 also requires certain
disclosures for restatements due to correction of an error.
SFAS 154 is effective for accounting changes and
corrections of errors made in fiscal years beginning after
December 15, 2005, and is required to be adopted by us as
of January 1, 2006. The impact that the adoption of
SFAS 154 will have on our consolidated results of
operations and financial condition will depend on the nature of
future accounting changes adopted by us and the nature of
transitional guidance provided in future accounting
pronouncements.
In September 2005, the EITF reached consensus on Issue
No. 04-13,
“Accounting for Purchases and Sales of Inventory with the
Same Counterparty”
(“EITF 04-13”).
EITF 04-13
provides guidance on the purchase and sale of inventory to
another entity that operates in the same line of business. The
purchase and sale transactions may be pursuant to a single
contractual arrangement or separate contractual arrangements and
the inventory purchased or sold may be in the form of raw
materials,
work-in-process, or
finished goods.
EITF 04-13 applies
to new arrangements entered into, or modifications or renewals
of existing arrangements in reporting periods beginning after
March 15, 2006. The impact of the adoption of
EITF 04-13 on our
consolidated results of operations and financial condition will
depend on the nature of future arrangements entered into, or
modifications or renewals of existing arrangements.
In November 2005, the FASB issued FSP
FAS 123R-3,
“Transition Election Related to Accounting for the Tax
Effects of Share-Based Payment Awards” (“FSP
FAS 123R-3”).
FSP FAS 123R-3
provides an elective alternative transition
117
method, to SFAS 123R, in accounting for the tax effects of
share-based payment awards to employees. The elective method
comprises of a computational component that establishes a
beginning balance of the APIC pool related to employee
compensation and a simplified method to determine the subsequent
impact on the APIC pool of employee awards that are fully vested
and outstanding upon the adoption of SFAS 123R. The impact
on the APIC pool of awards partially vested upon, or granted
after, the adoption of SFAS 123R should be determined in
accordance with the guidance in SFAS 123R. The guidance in
FSP FAS 123R-3 is
effective for us in the first quarter of 2006. We are currently
assessing whether we will adopt the transition election of FSP
FAS 123R-3 and
what the impact will be on our results of operations and
financial condition.
Canadian Supplement
New Canadian securities regulations and, as of March 8,2005, amendments to the regulations under the Canada Business
Corporations Act, allow issuers that are required to file
reports with the SEC, upon meeting certain conditions, to
satisfy their Canadian continuous disclosure obligations by
using financial statements prepared in accordance with
U.S. GAAP. We have provided the following supplemental
information to highlight the significant differences that would
have resulted in the MD&A had it been prepared using
Canadian GAAP information.
The principal continuing reconciling differences that affect
consolidated net earnings (loss) under Canadian GAAP are
derivative accounting, financial instruments and goodwill
impairment arising from historical differences in carrying
value. We adopted new Canadian accounting standards for asset
retirement obligations and for derivatives in 2004 and for VIEs
in 2003 that are substantially consistent with U.S. GAAP.
Also in 2003, we elected to expense employee stock-based
compensation using the fair value based method for
U.S. GAAP, which has resulted in no significant continuing
reconciling difference for stock-based compensation under
Canadian GAAP. Other historical differences between
U.S. GAAP and Canadian GAAP were primarily due to facts and
circumstances related to prior years.
See note 24 of the accompanying audited consolidated
financial statements for a reconciliation from U.S GAAP to
Canadian GAAP, including a description of the material
differences affecting our consolidated statements of operations
and consolidated balance sheets. There were no significant
differences affecting the consolidated statements of cash flows.
Accounting Changes
Under Canadian GAAP, we adopted the following accounting changes
as more fully described in note 24 (j) of the
accompanying audited consolidated financial statements:
•
Determining whether an arrangement contains a
lease — effective January 1, 2005, we adopted
EIC 150, “Determining Whether an Arrangement Contains a
Lease” (“EIC 150”). EIC 150 provides guidance on
how to determine whether an arrangement contains a lease that is
within the scope of CICA Handbook Section 3065,
“Leases”. Equivalent guidance in U.S. GAAP has
already been adopted by us. The adoption of EIC 150 did not have
any material impact on our results of operations and financial
condition.
•
Financial Instruments — presentation and
disclosure — effective January 1, 2005, we
adopted amendments to CICA Handbook Section 3860,
“Financial Instruments — Presentation and
Disclosure” (“Section 3860”). The adoption
of the amendments to Section 3860 did not have any material
impact on our results of operations and financial condition.
•
Accounting by a customer (including a reseller) for certain
consideration received from a vendor — in January
2005, the EIC issued amended abstract 144, “Accounting by a
Customer (including a Reseller) for Certain Consideration
Received from a Vendor”. The amendment requires companies
to recognize the benefit of non-discretionary rebates for
achieving specified cumulative purchasing levels as a reduction
of the cost of purchases over the relevant period, provided the
rebate is probable and reasonably estimable. Otherwise, the
rebates would be recognized as purchasing milestones are
achieved. We adopted the amendment effective retroactively for
periods commencing on or after February 15, 2005. The
adoption of the new amendment did not have a material impact on
our results of operations and financial condition.
•
Derivative accounting — Effective
January 1, 2004, we adopted Accounting Guideline 13,
“Hedging Relationships”, or AcG-13, which establishes
specific criteria for derivatives to qualify for hedge
accounting. We had been previously applying these criteria under
U.S. GAAP, therefore, there was no impact on adoption of
AcG-13. Concurrent with the adoption of AcG-13, we also adopted
the CICA’s Emerging Issues Committee, or EIC, 128,
“Accounting for Trading, Speculative or Non-Hedging
Derivative Financial Instruments”, or EIC 128. As a result
of the adoption of EIC 128, certain warrants, which had been
previously recorded at cost under
118
Canadian GAAP, are required to be recorded at fair value
consistent with U.S. GAAP. The impact of this accounting
change, which has been recorded prospectively as of
January 1, 2004, was an increase to investments and other
income of $23 during the year ended December 31, 2004.
•
Revenue recognition — In December 2003, the EIC
issued abstract 142, “Accounting for Revenue Arrangements
with Multiple Deliverables”, or EIC 142. EIC 142 was
applicable to us beginning January 1, 2004 and was applied
prospectively. The application of EIC 142 did not have a
material impact on our results of operations and financial
condition. In December 2003, the EIC issued abstract 141,
“Revenue Recognition”, or EIC 141. EIC 141 was
applicable to us beginning January 1, 2004 and was applied
prospectively. The application of EIC 141 did not have a
material impact on our results of operations and financial
condition.
•
Asset retirement obligations — Under
U.S. GAAP, we adopted SFAS 143 effective
January 1, 2003, and recorded a cumulative effect of
accounting change, net of tax, within net earnings (loss) on the
date of adoption. We adopted similar Canadian guidance, CICA
Handbook Section 3110, “Asset Retirement
Obligations”, effective January 1, 2004, with
retroactive restatement of prior periods. Under Canadian GAAP,
the cumulative effect of adoption as of January 1, 2003 was
recorded as an adjustment to opening accumulated deficit, as
opposed to an adjustment within net earnings (loss) under
U.S. GAAP, resulting in a difference of $12. The
retroactive adjustment to earnings for the year ended
December 31, 2003 and 2002 under Canadian GAAP was not
significant. Plant and equipment — net, other
liabilities and accumulated deficit as of December 31, 2003
have been increased by $4, $16 and $12, respectively, to reflect
the retroactive restatement.
•
Stock-based compensation — In November 2001,
the CICA issued Handbook Section 3870, “Stock-based
Compensation and Other Stock-based Payments”, or
Section 3870, which was revised in November 2003.
Section 3870 outlines a fair value based method of
accounting required for certain stock-based transactions,
effective January 1, 2002, and applied to awards granted on
or after that date. Prior to October 1, 2003, as permitted
by Section 3870, we did not adopt the provisions in respect
of the fair value based method of accounting for our employee
stock-based transactions. On October 1, 2003, we elected to
expense employee stock-based compensation using the fair value
based method prospectively for all awards granted, modified, or
settled on or after January 1, 2003, in accordance with the
transitional provisions of Section 3870 and concurrent with
the adoption of expense recognition under the fair value based
method for U.S. GAAP.
•
Restructuring charges — Under U.S. GAAP,
effective January 1, 2003, we adopted SFAS 146.
SFAS 146 requires that costs associated with an exit or
disposal activity be recognized when the liability is incurred.
Under Canadian GAAP, EIC 134, “Accounting for Severance and
Termination Benefits”, or EIC 134, and EIC 135,
“Accounting for Costs Associated with Exit and Disposal
Activities (Including Costs Incurred in a Restructuring)”,
or EIC 135, were issued to harmonize the Canadian GAAP
requirement with SFAS 146. Effective April 1, 2003, we
adopted EIC 134 and EIC 135.
•
Impairment and disposal of long-lived assets —
In May 2003, the CICA issued an updated Section 3475
“Disposal of Long-Lived Assets and Discontinued
operations”, or Section 3475. In April 2003, the CICA
issued Handbook Section 3063, “Impairment of
Long-Lived Assets”, or Section 3063. The adoption of
Sections 3475 and 3063, which are substantially consistent
with U.S. GAAP, did not have a material impact on our
results of operations and financial condition.
•
Guarantees — In February 2003, the CICA issued
AcG-14, “Disclosure of Guarantees”, or AcG-14. AcG-14
expands on previously issued accounting guidance and requires
additional disclosure by a guarantor of information about each
guarantee, or each group of similar guarantees, even when the
likelihood of the guarantor having to make any payments under
the guarantee is slight. AcG-14 does not address the recognition
or measurement of a guarantor’s liability for obligations
under a guarantee. We adopted the requirements of AcG-14
effective January 1, 2003 which are substantially
consistent with the disclosure requirements under U.S. GAAP
for guarantees.
•
Consolidation of VIEs — In June 2003, the CICA
issued AcG-15, which is consistent with FASB Interpretation
No. 46, “Consolidation of Variable Interest
Entities”. AcG-15 clarifies the application of
consolidation guidance to those entities defined as VIEs (which
includes, but is not limited to, special purpose entities,
trusts, partnerships, certain joint ventures and other legal
structures) in which equity investors do not have the
characteristics of a “controlling financial interest”
or there is not sufficient equity at risk for the entity to
finance its activities without additional subordinated financial
support. The requirements of AcG-15 were effective for all
annual and interim periods beginning on or after
November 1, 2004. Earlier application was encouraged and
effective July 1, 2003, we adopted AcG-15 at the same time
as equivalent guidance under U.S. GAAP and prospectively
began consolidating two VIEs for which we were considered the
primary beneficiary.
119
Outstanding Share Data
As of April 17, 2006, Nortel Networks Corporation had
4,335,644,313 outstanding common shares.
As of April 17, 2006, 11,392,222 issued and assumed
stock options were outstanding and are exercisable for common
shares of Nortel Networks Corporation on a one-for-one basis.
As of April 17, 2006, 6,972,000 restricted stock units
were outstanding. Once vested, each restricted stock unit
entitles the holder to receive one common share of Nortel
Networks Corporation, or in our discretion, cash in lieu of
common shares in certain circumstances from treasury or through
open market purchases at our option.
In addition, Nortel Networks Corporation previously issued
U.S. $1,800 of 4.25% Convertible Senior Notes, or
Senior Notes, due on September 1, 2008. The Senior Notes
are convertible, at any time, by holders into common shares of
Nortel Networks Corporation, at an initial conversion price of
$10 per common share, subject to adjustment upon the
occurrence of certain events including the potential
consolidation of Nortel Networks Corporation common shares.
Market Risk
Market risk represents the risk of loss that may impact our
consolidated financial statements through adverse changes in
financial market prices and rates. Our market risk exposure
results primarily from fluctuations in interest rates and
foreign exchange rates. To manage the risk from these
fluctuations, we enter into various derivative-hedging
transactions that we have authorized under our policies and
procedures. We maintain risk management control systems to
monitor market risks and counterparty risks. These systems rely
on analytical techniques including both sensitivity analysis and
value-at-risk estimations. We do not hold or issue financial
instruments for trading purposes.
Additional disclosure of our financial instruments is included
in “Financial instruments and hedging activities” in
note 12 of the accompanying audited consolidated financial
statements.
We manage foreign exchange exposures using forward and option
contracts to hedge sale and purchase commitments. Our most
significant foreign exchange exposures are in the Canadian
dollar, the British pound and the euro. We enter into
U.S. to Canadian dollar forward and option contracts
intended to hedge the U.S. to Canadian dollar exposure on
future revenues and expenditure streams. In accordance with
SFAS No. 133, “Accounting for Derivative
Instruments and Hedging Activities”, we recognize the gains
and losses on the effective portion of these contracts in
earnings when the hedged transaction occurs. Any ineffective
portion of these contracts is recognized in earnings immediately.
We expect to continue to expand our business globally and, as
such, expect that an increasing proportion of our business may
be denominated in currencies other than U.S. dollars. As a
result, fluctuations in foreign currencies may have a material
impact on our business, results of operations and financial
condition. We try to minimize the impact of such currency
fluctuations through our ongoing commercial practices and by
attempting to hedge our major currency exposures. In attempting
to manage this foreign exchange risk, we identify operations and
transactions that may have exposure based upon the excess or
deficiency of foreign currency receipts over foreign currency
expenditures. Given our exposure to international markets, we
regularly monitor all of our material foreign currency
exposures. Our significant currency flows for the year ended
December 31, 2005 were in U.S. dollars, Canadian
dollars, British pounds and euros. The net impact of foreign
exchange fluctuations resulted in gains of $68 in 2005, a gain
of $57 in 2004 and a gain of $107 in 2003. We cannot predict
whether we will incur foreign exchange gains or losses in the
future. However, if significant foreign exchange losses are
experienced, they could have a material adverse effect on our
business, results of operations and financial condition.
We use sensitivity analysis to measure our foreign currency risk
by computing the potential decrease in cash flows that may
result from adverse changes in foreign exchange rates. The
balances are segregated by source currency, and a hypothetical
unfavorable variance in foreign exchange rates of 10% is applied
to each net source currency position using year-end rates, to
determine the potential decrease in cash flows over the next
year. The sensitivity analysis includes all foreign
currency-denominated cash, short-term and long-term debt, and
derivative instruments that will impact cash flows over the next
year that are held at December 31, 2005 and 2004,
respectively. The underlying cash flows that relate to the
hedged firm commitments are not included in the analysis. The
analysis is performed at the reporting date and assumes no
future changes in the balances or timing of cash flows from the
year-end position. Further, the model assumes no correlation in
the movement of foreign exchange rates. Based on a one-year time
horizon, a 10% adverse change in exchange rates would result in
a potential decrease in after-tax earnings (increase in loss) of
$127 as of December 31, 2005 and would have resulted in a
potential decrease in after-tax earnings (increase in loss) of
$110 as of
120
December 31, 2004. This potential decrease would result
primarily from our exposure to the Canadian dollar, the British
pound and the euro.
A portion of our long-term debt is subject to changes in fair
value resulting from changes in market interest rates. We have
hedged a portion of this exposure to interest rate volatility
using fixed for floating interest rate swaps. The change in fair
value of the swaps are recognized in earnings with offsetting
amounts related to the change in the fair value of the hedged
debt attributable to interest rate changes. Any ineffective
portion of the swaps is recognized in income immediately. We
record net settlements on these swap instruments as adjustments
to interest expense.
Historically, we have managed interest rate exposures, as they
relate to interest expense, using a diversified portfolio of
fixed and floating rate instruments denominated in several major
currencies. We use sensitivity analysis to measure our interest
rate risk. The sensitivity analysis includes cash, our
outstanding floating rate long-term debt and any outstanding
instruments that convert fixed rate long-term debt to floating
rate. A 100 basis point adverse change in interest rates
would result in a potential decrease in earnings (increase in
loss) of $40 as of December 31, 2005 and would have
resulted in a potential decrease in earnings (increase in loss)
of $47 as of December 31, 2004.
Equity Price Risk
The values of our equity investments in several publicly traded
companies are subject to market price volatility. These
investments are generally in companies in the technology
industry sector and are classified as available for sale. We
typically do not attempt to reduce or eliminate the market
exposure on these investment securities. We also hold certain
derivative instruments or warrants that are subject to market
price volatility because their value is based on the common
share price of a publicly traded company. These derivative
instruments are generally acquired through business acquisitions
or divestitures. In addition, derivative instruments may also be
purchased to hedge exposure to certain compensation obligations
that vary based on future Nortel Networks Corporation common
share prices. We do not hold equity securities or derivative
instruments for trading purposes.
As of December 31, 2005, a hypothetical 20% adverse change
in the stock prices of our publicly traded equity securities and
the related underlying stock prices of publicly traded equity
securities for certain of our derivative instruments would
result in a loss in their aggregate fair value of $15. As of
December 31, 2004, a hypothetical 20% adverse change in the
stock prices of our publicly traded equity securities and the
related underlying stock prices of publicly traded equity
securities for certain of our derivative instruments would have
resulted in a loss in their aggregate fair value of $23. This
includes a loss of $5 related to derivative instruments that
were purchased to hedge exposure to compensation obligations.
Environmental Matters
We are subject to numerous environmental protection laws and
regulations in various jurisdictions around the world, primarily
due to our manufacturing operations. As a result, we are exposed
to liabilities and compliance costs arising from our past and
current generation, management and disposition of hazardous
substances and wastes.
We have remedial activities under way at 14 of our facilities
which are either currently occupied or were previously owned or
occupied. We have also been listed as a potentially responsible
party at four Superfund sites in the U.S. An estimate of
our anticipated remediation costs associated with all such
facilities and sites, to the extent probable and reasonably
estimable, is included in our environmental accruals in an
approximate amount of $27.
For a discussion of Environmental matters, see
“Contingencies” in note 22 of the accompanying
audited consolidated financial statements.
Legal Proceedings
For additional information related to our legal proceedings, see
“Contingencies” in note 22 of the accompanying
consolidated financial statements, “Developments in 2005
and 2006 — Significant Business
Developments — Proposed Class Action
Settlement”, “Restatements; Nortel Audit Committee
Independent Review; Material Weaknesses; Related
Matters — Regulatory Actions and Pending
Litigation”; the “Legal Proceedings” and
“Risk Factors” section of this report.
121
ITEM 7A.
Quantitative and Qualitative Disclosures about Market Risk
Refer to “Market risk” in Management’s Discussion
and Analysis of Financial Condition and Results of Operations.
ITEM 8. Consolidated
Financial Statements and Supplementary Data
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Independent Registered Chartered Accountants
123
Consolidated Statements of Operations
124
Consolidated Balance Sheets
125
Consolidated Statements of Changes in Equity and Comprehensive
Income (Loss)
126
Consolidated Statements of Cash Flows
127
Notes to Consolidated Financial Statements
128
*********
Quarterly Financial Data (Unaudited)
214
Consolidated Statements of Operations
214
Consolidated Balance Sheets
220
Condensed Consolidated Statements of Cash Flows
221
Supplemental information
223
122
REPORT OF INDEPENDENT REGISTERED CHARTERED ACCOUNTANTS
To the Shareholders and Board of Directors of Nortel Networks
Corporation
We have audited the accompanying consolidated balance sheets of
Nortel Networks Corporation and its subsidiaries
(“Nortel”) as of December 31, 2005 and 2004 and
the related consolidated statements of operations, changes in
equity and comprehensive income (loss) and cash flows for each
of the years in the three year period ended December 31,2005. These financial statements are the responsibility of
Nortel’s management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with Canadian generally
accepted auditing standards and the standards of the Public
Company Accounting Oversight Board (United States). These
standards require that we plan and perform an audit to obtain
reasonable assurance whether the financial statements are free
of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by
management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, these consolidated financial statements present
fairly, in all material respects, the financial position of
Nortel as of December 31, 2005 and 2004 and the results of
its operations and its cash flows for each of the years in the
three year period ended December 31, 2005 in accordance
with accounting principles generally accepted in the United
States of America.
As described in Note 4 and 24(i) to the consolidated
financial statements, the accompanying consolidated financial
statements of Nortel as of December 31, 2004 and for the
years ended December 31, 2004 and 2003 have been restated.
We therefore withdraw our previous report dated April 29,2005 on those financial statements, as originally filed.
We have also audited, in accordance with the standards of the
Public Company Accounting Oversight Board (United States), the
effectiveness of Nortel’s internal control over financial
reporting as of December 31, 2005, based on the criteria
established in Internal Control — Integrated Framework
issued by the Committee of Sponsoring Organizations of the
Treadway Commission, and our report dated April 28, 2006
expressed an unqualified opinion on management’s assessment
of the effectiveness of Nortel’s internal control over
financial reporting and an adverse opinion on the effectiveness
of Nortel’s internal control over financial reporting
because of material weaknesses.
COMMENTS BY INDEPENDENT REGISTERED CHARTERED ACCOUNTANTS
ON
CANADIAN-U.S. REPORTING DIFFERENCES
In the United States, the standards of the Public Company
Accounting Oversight Board (United States) for auditors require
the addition of an explanatory paragraph (following the
opinion paragraph) when there are changes in accounting
principles that have a material effect on the comparability of
the Company’s financial statements, such as the changes
described in Note 3 to the financial statements. Our report
to the Shareholders and Board of Directors of Nortel dated
April 28, 2006 with respect to the consolidated financial
statements is expressed in accordance with Canadian reporting
standards which would not include a reference to such changes in
accounting principles in the auditors’ report when the
change is properly accounted for and adequately disclosed in the
financial statements.
Unrealized derivative gain (loss) on cash flow
hedges — net
(11
)
6
15
Minimum pension liability adjustment — net
(210
)
(110
)
(186
)
Other comprehensive income (loss)
(369
)
20
408
Balance at the end of the year
(902
)
(533
)
(553
)
Total shareholders’ equity
$
786
$
3,640
$
3,719
Total comprehensive income (loss) for the year
Net earnings (loss)
$
(2,575
)
$
(207
)
$
293
Other comprehensive income (loss)
(369
)
20
408
Total comprehensive income (loss) for the year
$
(2,944
)
$
(187
)
$
701
*
See note 4
The accompanying notes are an integral part of these
consolidated financial statements
126
NORTEL NETWORKS CORPORATION
Consolidated Statements of Cash Flows for the years ended
December 31
2005
2004
2003
As restated*
As restated*
(Millions of U.S. dollars)
Cash flows from (used in) operating activities
Net earnings (loss) from continuing operations
$
(2,576
)
$
(256
)
$
122
Adjustments to reconcile net earnings (loss) from continuing
operations to net cash from (used in) operating activities, net
of effects from acquisitions and divestitures of businesses:
Non-cash portion of shareholder litigation settlement expense
1,899
—
—
Amortization and depreciation
302
340
546
Non-cash portion of special charges and related asset write downs
27
6
87
Equity in net (earnings) loss of associated companies
(4
)
—
36
Stock option compensation
88
77
42
Deferred income taxes
(79
)
(46
)
(53
)
Other liabilities
294
271
163
(Gain) loss on repurchases of outstanding debt securities
—
—
(4
)
(Gain) loss on sale or write down of investments, businesses and
assets
(20
)
(110
)
(147
)
Other — net
106
194
(53
)
Change in operating assets and liabilities
(217
)
(655
)
(879
)
Net cash from (used in) operating activities of continuing
operations
(180
)
(179
)
(140
)
Cash flows from (used in) investing activities
Expenditures for plant and equipment
(258
)
(276
)
(169
)
Proceeds on disposals of plant and equipment
10
10
38
Restricted cash and cash equivalents
4
(17
)
200
Acquisitions of investments and businesses — net of
cash acquired
(651
)
(5
)
(31
)
Proceeds on sale of investments and businesses
470
150
107
Net cash from (used in) investing activities of continuing
operations
(425
)
(138
)
145
Cash flows from (used in) financing activities
Dividends paid by subsidiaries to minority interests
(43
)
(33
)
(35
)
Increase in notes payable
70
92
80
Decrease in notes payable
(83
)
(84
)
(125
)
Repayments of long-term debt
—
(107
)
(270
)
Repayments of capital leases payable
(10
)
(9
)
(12
)
Issuance of common shares
6
31
3
Net cash from (used in) financing activities of continuing
operations
(60
)
(110
)
(359
)
Effect of foreign exchange rate changes on cash and cash
equivalents
(102
)
88
176
Net cash from (used in) continuing operations
(767
)
(339
)
(178
)
Net cash from (used in) operating activities of discontinued
operations
33
22
149
Net cash from (used in) investing activities of discontinued
operations
—
—
241
Net increase (decrease) in cash and cash equivalents
(734
)
(317
)
212
Cash and cash equivalents at beginning of year
3,685
4,002
3,790
Cash and cash equivalents at end of year
$
2,951
$
3,685
$
4,002
*
See note 4
The accompanying notes are an integral part of these
consolidated financial statements
127
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements
(millions of U.S. dollars, except per share amounts,
unless otherwise stated)
1.
Nortel Networks Corporation
Nortel Networks Corporation (“Nortel”) is a global
supplier of communication equipment serving both service
provider and enterprise customers. Nortel’s technologies
span access and core networks, support multimedia and
business-critical applications. Nortel’s networking
solutions consist of hardware, software and services.
Nortel’s business activities include the design,
development, assembly, marketing, sale, licensing, installation,
servicing and support of these networking solutions.
The common shares of Nortel Networks Corporation are publicly
traded on the New York Stock Exchange (“NYSE”) and
Toronto Stock Exchange (“TSX”) under the symbol
“NT”. Nortel Networks Limited (“NNL”) is
Nortel’s principal direct operating subsidiary and its
results are consolidated into Nortel’s results. Nortel
holds all of NNL’s outstanding common shares but none of
its outstanding preferred shares. NNL’s preferred shares
are reported in minority interests in subsidiary companies in
the consolidated balance sheets, and dividends and the related
taxes on preferred shares are reported in minority
interests — net of tax in the consolidated statements
of operations.
2.
Significant accounting policies
Basis of presentation
The consolidated financial statements of Nortel have been
prepared in accordance with accounting principles generally
accepted in the United States (“U.S.”)
(“GAAP”) and the rules and regulations of the
U.S. Securities and Exchange Commission (the
“SEC”) for the preparation of financial statements.
Although Nortel is headquartered in Canada, the consolidated
financial statements are expressed in U.S. dollars as the
greater part of the financial results and net assets of Nortel
are denominated in U.S. dollars.
(a)
Principles of consolidation
The financial statements of entities which are controlled by
Nortel through voting equity interests, referred to as
subsidiaries, are consolidated. Entities which are jointly
controlled, referred to as joint ventures, and entities which
are not controlled but over which Nortel has the ability to
exercise significant influence, referred to as associated
companies, are accounted for using the equity method. Variable
Interest Entities (“VIEs”) (which include, but are not
limited to, special purpose entities, trusts, partnerships,
certain joint ventures and other legal structures), as defined
by the Financial Accounting Standards Board (“FASB”)
in FASB Interpretation No. (“FIN”) 46 (Revised 2003),
“Consolidation of Variable Interest Entities — an
Interpretation of Accounting Research
Bulletin No. 51” (“FIN 46R”), are
entities in which equity investors generally do not have the
characteristics of a “controlling financial interest”
or there is not sufficient equity at risk for the entity to
finance its activities without additional subordinated financial
support. VIEs are consolidated by Nortel when it is determined
that it will, as the primary beneficiary, absorb the majority of
the VIEs expected losses and/or expected residual returns.
Intercompany accounts and transactions are eliminated upon
consolidation and unrealized intercompany gains and losses are
eliminated when accounting under the equity method.
(b)
Use of estimates
Nortel makes estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent
assets and liabilities as of the date of the consolidated
financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results may differ
from those estimates. Estimates are used when accounting for
items and matters such as revenue recognition and accruals for
losses on contracts, allowances for uncollectible accounts
receivable and customer financing, receivables sales, inventory
obsolescence, product warranty, amortization, asset valuations,
asset retirement obligations, impairment assessments, employee
benefits including pensions, taxes and related valuation
allowances and provisions, restructuring and other provisions,
stock-based compensation and contingencies.
(c)
Translation of foreign currencies
The consolidated financial statements of Nortel are presented in
U.S. dollars. The financial statements of Nortel’s
operations whose functional currency is not the U.S. dollar
(except for highly inflationary economies as described below)
are translated into U.S. dollars at the exchange rates in
effect at the balance sheet dates for assets and liabilities,
and at
128
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
average rates for the period for revenues and expenses. The
unrealized translation gains and losses on Nortel’s net
investment in these operations, including long-term intercompany
advances considered to form part of the net investment, are
accumulated as a component of other comprehensive income (loss)
(“OCI”).
Transactions and financial statements for Nortel’s
operations in countries considered to have highly inflationary
economies and whose functional currency is not the
U.S. dollar are translated into U.S. dollars at the
exchange rates in effect at the balance sheet dates for monetary
assets and liabilities, and at historical exchange rates for
non-monetary assets and liabilities. Revenue and expenses are
translated at average rates for the period, except for
amortization and depreciation which are translated on the same
basis as the related assets. Resulting translation gains or
losses are reflected in net earnings (loss).
When appropriate, Nortel may hedge a designated portion of the
exposure to foreign exchange gains and losses incurred on the
translation of specific foreign operations. Hedging instruments
used by Nortel can include foreign currency denominated debt,
foreign currency swaps and foreign currency forward and option
contracts that are denominated in the same currency as the
hedged foreign operations. The translation gains and losses on
the effective portion of the hedging instruments that qualify
for hedge accounting are recorded in OCI; other translation
gains and losses are recorded in net earnings (loss).
(d)
Revenue recognition
Nortel’s products and services are generally sold as part
of a contract and the terms of the contracts, taken as a whole,
determine the appropriate revenue recognition methods.
Depending upon the terms of the contract and types of products
and services sold, Nortel recognizes revenue under American
Institute of Certified Public Accountants Statement of Position
(“SOP”) 81-1,
“Accounting for Performance of Construction-Type and
Certain Production-Type Contracts”
(“SOP 81-1”),
SOP 97-2,
“Software Revenue Recognition”
(“SOP 97-2”),
and SEC Staff Accounting Bulletin (“SAB”) 104,
“Revenue Recognition” (“SAB 104”),
which was preceded by SAB 101, “Revenue Recognition in
Financial Statements” (“SAB 101”), prior to
December 2003. Revenue is recognized net of cash discounts and
allowances.
Effective July 1, 2003, for contracts involving multiple
deliverables, where the deliverables are governed by more than
one authoritative accounting standard, Nortel generally applies
the FASB Emerging Issues Task Force (“EITF”) Issue
No. 00-21,
“Revenue Arrangements with Multiple Deliverables”
(“EITF 00-21”),
and evaluates each deliverable to determine whether it
represents a separate unit of accounting based on the following
criteria: (a) whether the delivered item has value to the
customer on a standalone basis, (b) whether there is
objective and reliable evidence of the fair value of the
undelivered item(s), and (c) if the contract includes a
general right of return relative to the delivered item, delivery
or performance of the undelivered item(s) is considered probable
and substantially in the control of Nortel. If objective and
reliable evidence of fair value exists for all units of
accounting in the arrangement, revenue is allocated to each unit
of accounting or element based on relative fair values. In
situations where there is objective and reliable evidence of
fair value for all undelivered elements, but not for delivered
elements, the residual method is used to allocate the contract
consideration. Under the residual method, the amount of revenue
allocated to delivered elements equals the total arrangement
consideration less the aggregate fair value of any undelivered
elements. Each unit of accounting is then accounted for under
the applicable revenue recognition guidance. So long as elements
otherwise governed by separate authoritative accounting
standards cannot be treated as separate units of accounting
under the guidance in
EITF 00-21, the
elements are combined into a single unit of accounting for
revenue recognition purposes. In this case, revenue allocated to
the unit of accounting is deferred until all combined elements
have been delivered or, once there is only one remaining element
to be delivered, based on the revenue recognition guidance
applicable to the last delivered element within the unit of
accounting.
For arrangements that include hardware and software where
software is considered more than incidental to the hardware,
provided that the software is not essential to the functionality
of the hardware and the hardware and software represent separate
units of accounting, revenue related to the software element is
recognized under
SOP 97-2 and
revenue related to the hardware element is recognized under
SOP 81-1 or
SAB 104. For arrangements where the software is considered
more than incidental and essential to the functionality of the
hardware, or where the hardware is not considered a separate
unit of accounting from the software deliverables, revenue is
recognized for the software and the hardware as a single unit of
accounting pursuant to
SOP 97-2 for
off-the-shelf products
and pursuant to
SOP 81-1 for
customized products.
129
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Prior to July 1, 2003, for contracts involving multiple
elements, Nortel allocated revenue to each element based on the
relative fair value or the residual method, as applicable.
Provided none of the undelivered elements were essential to the
functionality of the delivered elements, revenue related to the
software element was recognized under
SOP 97-2 and
revenue related to the hardware element was recognized under
SOP 81-1 or
SAB 101.
For elements related to customized network solutions and certain
network build-outs, revenues are recognized under
SOP 81-1,
generally using the
percentage-of-completion
method. In using the
percentage-of-completion
method, revenues are generally recorded based on a measure of
the percentage of costs incurred to date on a contract relative
to the estimated total expected contract costs. Profit estimates
on long-term contracts are revised periodically based on changes
in circumstances and any losses on contracts are recognized in
the period that such losses become known. Generally, the terms
of long-term contracts provide for progress billing based on
completion of certain phases of work. Contract revenues
recognized, based on costs incurred towards the completion of
the project, that are unbilled are accumulated in the contracts
in progress account included in accounts receivable —
net. Billings in excess of revenues recognized to date on
long-term contracts are recorded as advance billings in excess
of revenues recognized to date on contracts within other accrued
liabilities. In certain circumstances where reasonable cost
estimates cannot be made for a customized network solution or
build-out element and there is no assurance that a loss will not
be incurred on the element, all revenues and certain costs are
deferred until completion of the element (“completed
contract accounting”).
Revenue for hardware that does not require significant
customization, and where any software is considered incidental,
is recognized under SAB 104. Under SAB 104, revenue is
recognized provided that persuasive evidence of an arrangement
exists, delivery has occurred or services have been rendered,
the fee is fixed or determinable and collectibility is
reasonably assured.
For hardware, delivery is considered to have occurred upon
shipment provided that risk of loss, and title in certain
jurisdictions, have been transferred to the customer.
For arrangements where the criteria for revenue recognition have
not been met because legal title or risk of loss on products
does not transfer to the customer until final payment has been
received or where delivery has not occurred, revenue is deferred
to a later period when title or risk of loss passes either on
delivery or on receipt of payment from the customer. For
arrangements where the customer agrees to purchase products but
Nortel retains possession until the customer requests shipment
(“bill and hold arrangements”), revenue is not
recognized until delivery to the customer has occurred and all
other revenue recognition criteria have been met.
Engineering, installation and other service revenues are
recognized as the services are performed.
Nortel makes certain sales through multiple distribution
channels, primarily resellers and distributors. These customers
are generally given certain rights of return. For products sold
through these distribution channels, revenue is recognized from
product sale at the time of shipment to the distribution channel
when persuasive evidence of an arrangement exists, delivery has
occurred, the fee is fixed or determinable and collectibility is
reasonably assured. Accruals for estimated sales returns and
other allowances are recorded at the time of revenue recognition
and are based on contract terms and prior claims experience.
Software revenue is generally recognized under
SOP 97-2. For
software arrangements involving multiple elements, Nortel
allocates revenue to each element based on the relative fair
value or the residual method, as applicable, and using vendor
specific objective evidence of fair values, which is based on
prices charged when the element is sold separately. Software
revenue accounted for under
SOP 97-2 is
recognized when persuasive evidence of an arrangement exists,
the software is delivered in accordance with all terms and
conditions of the customer contracts, the fee is fixed or
determinable and collectibility is reasonably assured. Revenue
related to post-contract support (“PCS”), including
technical support and unspecified when-and-if available software
upgrades, is recognized ratably over the PCS term.
Under SAB 104 or
SOP 97-2, if fair
value does not exist for any undelivered element, revenue is not
recognized until the earlier of (i) the undelivered element
is delivered or (ii) fair value of the undelivered element
exists, unless the undelivered element is a service, in which
case revenue is recognized as the service is performed once the
service is the only undelivered element.
(e)
Research and development
Research and development (“R&D”) costs are charged
to net earnings (loss) in the periods in which they are
incurred. However, costs incurred pursuant to specific contracts
with third parties for which Nortel is obligated to deliver a
130
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
product are charged to cost of revenues in the same period as
the related revenue is recognized. Related global investment tax
credits are deducted from the income tax provision.
(f)
Income taxes
Nortel provides for income taxes using the asset and liability
method. This approach recognizes the amount of taxes payable or
refundable for the current year as well as deferred tax assets
and liabilities for the future tax consequence of events
recognized in the consolidated financial statements and tax
returns. Deferred income taxes are adjusted to reflect the
effects of changes in tax laws or enacted tax rates.
In establishing the appropriate income tax valuation allowances,
Nortel assesses its net deferred tax assets quarterly and based
on all available evidence, both positive and negative,
determines whether it is more likely than not that the remaining
net deferred tax assets or a portion thereof will be realized.
(g)
Earnings (loss) per common share
Basic earnings (loss) per common share is calculated by dividing
the net earnings (loss) by the weighted-average number of Nortel
Networks Corporation’s common shares outstanding during the
period. Diluted earnings (loss) per common share is calculated
by dividing the applicable net earnings (loss) by the sum of the
weighted-average number of common shares outstanding and all
additional common shares that would have been outstanding if
potentially dilutive common shares had been issued during the
period. The treasury stock method is used to compute the
dilutive effect of warrants, options and similar instruments.
The if-converted method is used to compute the dilutive effect
of convertible debt. A comparison of the conditions required for
issuance of shares compared to those existing at the end of the
period is used to compute the dilutive effect of contingently
issuable shares.
(h)
Cash and cash equivalents
Cash and cash equivalents consist of cash on hand, balances with
banks and short-term investments. All highly liquid investments
with original maturities of three months or less are classified
as cash and cash equivalents. The fair value of cash and cash
equivalents approximates the amounts shown in the consolidated
financial statements.
(i)
Restricted cash and cash equivalents
Cash and cash equivalents are considered restricted when they
are subject to contingent rights of a third party customer under
bid, performance related and other bonds associated with
contracts that Nortel is not able to unilaterally revoke. Cash
and cash equivalents collateral may be provided, often in
addition to the payment of fees to the other party, as a result
of the general economic and industry environment and NNL’s
credit rating.
(j)
Provision for doubtful accounts
The provision for doubtful accounts for trade, notes and
long-term receivables due from customers is established based on
an assessment of a customer’s credit quality, as well as
subjective factors and trends, including the aging of receivable
balances. Generally, these credit assessments occur prior to the
inception of the credit exposure and at regular reviews during
the life of the exposure.
Customer financing receivables include receivables from
customers with deferred payment terms. Customer financing
receivables are considered impaired when they are classified as
non-performing, payment arrears exceed 90 days or a major
credit event such as a material default has occurred, and
management determines that collection of amounts due according
to the contractual terms is doubtful. Provisions for impaired
customer financing receivables are recorded based on the
expected recovery of defaulted customer obligations, being the
present value of expected cash flows, or the realizable value of
the collateral if recovery of the receivables is dependent upon
a liquidation of the assets. Interest income on impaired
customer finance receivables is recognized as the cash payments
are collected.
(k)
Inventories
Inventories are valued at the lower of cost (calculated
generally on a
first-in, first-out
basis) or market. The cost of finished goods and work in process
is comprised of material, labor and manufacturing overhead.
Provisions for inventory are based on estimates of future
customer demand for products, including general economic
conditions, growth prospects
131
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
within the customer’s ultimate marketplaces and market
acceptance of current and pending products. In addition, full
provisions are generally recorded for surplus inventory in
excess of one year’s forecast demand or inventory deemed
obsolete.
Inventory includes certain direct and incremental deferred costs
associated with arrangements where title and risk of loss was
transferred to customers but revenue was deferred due to other
revenue recognition criteria not being met.
(l)
Receivables sales
Transfers of accounts receivable that meet the criteria for
surrender of control under FASB Statement of Financial
Accounting Standard (“SFAS”) No. 140,
“Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities”, are accounted for as
sales. Generally, Nortel retains servicing rights and, in some
cases, provides limited recourse when it sells receivables. A
gain or loss is recorded in other income (expense) —
net at the date of the receivables sale and is based upon, in
part, the previous carrying amount of the receivables involved
in the transfer allocated between the assets sold and the
retained interests based on their relative fair values at the
date of the transfer. Fair value is generally estimated based on
the present value of the estimated future cash flows expected
under management’s assumptions, including discount rates
assigned commensurate with risks. Retained interests are
classified as available-for-sale securities.
Nortel, when acting as the servicing agent, generally does not
record an asset or liability related to servicing as the annual
servicing fees are equivalent to those that would be paid to a
third party servicing agent.
Nortel reviews the fair value assigned to retained interests at
each reporting date subsequent to the date of the transfer to
determine if there is an other than temporary impairment. Fair
value is reviewed using similar valuation techniques as those
used to initially measure the retained interest and, if a change
in events or circumstances warrants, the fair value is adjusted
and any other than temporary impairments are recorded in other
income (expense) — net.
(m)
Investments
Investments in publicly traded equity securities of companies
over which Nortel does not exert significant influence are
accounted for at fair value and are classified as available for
sale. Unrealized holding gains and losses related to these
securities are excluded from net earnings (loss) and are
included in OCI until such gains or losses are realized or an
other than temporary impairment is determined to have occurred.
Investments in equity securities of private companies over which
Nortel does not exert significant influence are accounted for
using the cost method. Investments in associated companies and
joint ventures are accounted for using the equity method. An
impairment loss is recorded when there has been a loss in value
of the investment that is other than temporary.
Nortel monitors its investments for factors indicating other
than temporary impairment and records a charge to net earnings
(loss) when appropriate.
(n)
Plant and equipment
Plant and equipment are stated at cost less accumulated
depreciation. Depreciation is generally calculated on a
straight-line basis over the expected useful lives of the plant
and equipment. The expected useful lives of buildings are twenty
to forty years, and of machinery and equipment are five to ten
years. Capitalized software is amortized over three years.
(o)
Software development and business reengineering
costs
Software development costs
Costs to develop, acquire or modify software solely for
Nortel’s internal use are capitalized pursuant to SOP
No. 98-1,
“Accounting for Costs of Computer Software Developed or
Obtained for Internal Use”
(“SOP 98-1”).
SOP 98-1 requires
qualified internal and external costs (related to such software)
incurred during the application development stage to be
capitalized and any preliminary project costs (related to such
software) and post-implementation costs to be expensed as
incurred.
132
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Business reengineering costs
Internal and external costs of business process reengineering
activities are expensed pursuant to EITF Issue
No. 97-13,
“Accounting for Costs Incurred in Connection with a
Consulting Contract or an Internal Project that Combines
Business Process Reengineering and Information Technology
Transformation”
(“EITF 97-13”).
Information technology transformation projects typically involve
implementation of enterprise software packages whereby entities
must reengineer their business processes to connect into the
software rather than modify the software to connect into their
existing business processes. Software development costs relating
to the information technology transformation are capitalized
under SOP 98-1 as described above.
(p)
Impairment or disposal of long-lived assets (plant and
equipment and acquired technology)
Long-lived assets held and used
Nortel tests long-lived assets or asset groups held and used for
recoverability when events or changes in circumstances indicate
that their carrying amount may not be recoverable. Circumstances
which could trigger a review include, but are not limited to:
significant decreases in the market price of the asset;
significant adverse changes in the business climate or legal
factors; the accumulation of costs significantly in excess of
the amount originally expected for the acquisition or
construction of the asset; current period cash flow or operating
losses combined with a history of losses or a forecast of
continuing losses associated with the use of the asset; and a
current expectation that the asset will more likely than not be
sold or disposed of significantly before the end of its
previously estimated useful life.
Recoverability is assessed based on the carrying amount of the
asset and the sum of the undiscounted cash flows expected to
result from the use and the eventual disposal of the asset or
asset group. An impairment loss is recognized when the carrying
amount is not recoverable and exceeds the fair value of the
asset or asset group. The impairment loss is measured as the
amount by which the carrying amount exceeds fair value.
Long-lived assets held for sale
Long-lived assets are classified as held for sale when certain
criteria are met, which include: management’s commitment to
a plan to sell the assets; the assets are available for
immediate sale in their present condition; an active program to
locate buyers and other actions to sell the assets have been
initiated; the sale of the assets is probable and their transfer
is expected to qualify for recognition as a completed sale
within one year; the assets are being actively marketed at
reasonable prices in relation to their fair value; and it is
unlikely that significant changes will be made to the plan to
sell the assets or that the plan will be withdrawn.
Nortel measures long-lived assets to be disposed of by sale at
the lower of carrying amount or fair value less cost to sell.
These assets are not depreciated.
Long-lived assets to be disposed of other than by sale
Nortel classifies assets that will be disposed of other than by
sale as held and used until the disposal transaction occurs. The
assets continue to be depreciated based on revisions to their
estimated useful lives until the date of disposal or abandonment.
Recoverability is assessed based on the carrying amount of the
asset and the sum of the undiscounted cash flows expected to
result from the remaining period of use and the eventual
disposal of the asset or asset group. An impairment loss is
recognized when the carrying amount is not recoverable and
exceeds the fair value of the asset or asset group. The
impairment loss is measured as the amount by which the carrying
amount exceeds fair value.
Fair value for the purposes of measuring impairment or a planned
disposal of long-lived assets is determined using quoted market
prices or the anticipated cash flows discounted at a rate
commensurate with the risk involved.
(q)
Goodwill
Goodwill represents the excess of the purchase price of an
acquired business over the fair value of the identifiable assets
acquired and liabilities assumed. Nortel tests for impairment of
goodwill on an annual basis as of October 1 and at any
other time if events occur or circumstances change that would
indicate that it is more likely than not that the fair value of
the reporting unit has been reduced below its carrying amount.
133
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Circumstances that could trigger an impairment test include: a
significant adverse change in the business climate or legal
factors; an adverse action or assessment by a regulator;
unanticipated competition; the loss of key personnel; change in
reportable segments; the likelihood that a reporting unit or
significant portion of a reporting unit will be sold or
otherwise disposed of; the results of testing for recoverability
of a significant asset group within a reporting unit; and the
recognition of a goodwill impairment loss in the financial
statements of a subsidiary that is a component of a reporting
unit.
The impairment test for goodwill is a two-step process. Step one
consists of a comparison of the fair value of a reporting unit
with its carrying amount, including the goodwill allocated to
the reporting unit. Measurement of the fair value of a reporting
unit is based on one or more fair value measures including
present value techniques of estimated future cash flows and
estimated amounts at which the unit as a whole could be bought
or sold in a current transaction between willing parties. Nortel
also considers its market capitalization as of the date of the
impairment test. If the carrying amount of the reporting unit
exceeds the fair value, step two requires the fair value of the
reporting unit to be allocated to the underlying assets and
liabilities of that reporting unit, resulting in an implied fair
value of goodwill. If the carrying amount of the reporting unit
goodwill exceeds the implied fair value of that goodwill, an
impairment loss equal to the excess is recorded in net earnings
(loss).
(r)
Intangible assets
Intangible assets consist of acquired technology and other
intangible assets. Acquired technology represents the value of
the proprietary know-how which was technologically feasible as
of the acquisition date, and is charged to net earnings (loss)
on a straight-line basis over its estimated useful life of two
to three years. Other intangible assets are amortized into net
earnings (loss) based on their expected pattern of benefit to
future periods using estimates of undiscounted cash flows.
(s)
Warranty costs
As part of the normal sale of product, Nortel provides its
customers with product warranties that extend for periods
generally ranging from one to six years from the date of sale. A
liability for the expected cost of warranty-related claims is
established when revenue is recognized. In estimating warranty
liability, historical material replacement costs and the
associated labor costs to correct the product defect are
considered. Revisions are made when actual experience differs
materially from historical experience. Known product defects are
specifically accrued for as Nortel becomes aware of such defects.
(t)
Pension, post-retirement and post-employment
benefits
Pension expense, based on management’s assumptions,
consists of: actuarially computed costs of pension benefits in
respect of the current year’s service; imputed returns on
plan assets and imputed interest on pension obligations; and
straight-line amortization under the corridor approach of
experience gains and losses, assumption changes and plan
amendments over the expected average remaining service life of
the employee group.
The expected costs of post-retirement and certain
post-employment benefits, other than pensions, for active
employees are accrued in the consolidated financial statements
during the years employees provide service to Nortel. These
costs are recorded based on actuarial methods and assumptions.
Other post-employment benefits are recognized when the event
triggering the obligation occurs.
(u)
Derivative financial instruments
Nortel’s policy is to formally document all relationships
between hedging instruments and hedged items, as well as its
risk management objectives and strategy for undertaking various
hedge transactions. Where hedge accounting will be applied, this
process includes linking all derivatives to specific assets and
liabilities on the consolidated balance sheet or to specific
firm commitments or forecasted transactions. Nortel also
formally assesses, both at the hedge’s inception and on an
ongoing basis, as applicable, whether the derivatives that are
used in hedging transactions are highly effective in offsetting
changes in fair values or cash flows of hedged items.
For a derivative designated as a fair value hedge, changes in
the fair value of the derivative and of the hedged item
attributable to the hedged risk are recognized in net earnings
(loss). For a derivative designated as a cash flow hedge, the
134
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
effective portions of changes in the fair value of the
derivative are recorded in OCI and are recognized in net
earnings (loss) when the hedged item affects net earnings
(loss). Ineffective portions of changes in the fair value of
cash flow hedges are recognized in other income
(expense) — net. If the derivative used in an economic
hedging relationship is not designated in an accounting hedging
relationship or if it has become ineffective, changes in the
fair value of the derivative are recognized in net earnings
(loss).
When a cash flow or fair value hedging relationship is
terminated because the derivative is sold, terminated or
de-designated as a hedge, the accumulated OCI balance to the
termination date or the fair value basis adjustment recorded on
the hedged item is amortized into other income
(expense) — net or interest expense on an effective
yield basis over the original term of the hedging relationship.
If a cash flow or fair value hedging relationship is terminated
because the underlying hedged item is repaid or is sold, or it
is no longer probable that the hedged forecasted transaction
will occur, the accumulated balance in OCI or the fair value
basis adjustment recorded on the hedged item is recorded
immediately in net earnings (loss).
Nortel generally classifies cash flows resulting from its
derivative financial instruments in the same manner as the cash
flows from the item that the derivative is hedging. Typically,
this is within cash flows from (used in) operating activities in
the consolidated statements of cash flows, or, for derivatives
designated as hedges relating to the cash flows associated with
settlement of the principal component of long-term debt, within
cash flows from (used in) financing activities.
Nortel may also invest in warrants to purchase securities of
other companies as a strategic investment or receive warrants in
various transactions. Warrants that relate to publicly traded
companies or that can be net share settled are deemed to be
derivative financial instruments. Such warrants, however, are
generally not eligible to be designated as hedging instruments
as there is no corresponding underlying exposure. In addition,
Nortel may enter into certain commercial contracts containing
embedded derivative financial instruments. Generally, for these
embedded derivatives, for which the economic characteristics and
risks are not clearly and closely related to the economic
characteristics and risks of the host contract, the changes in
fair value are recorded in net earnings (loss).
In April 2003, the FASB issued SFAS No. 149,
“Amendment of Statement 133 on Derivative Instruments
and Hedging Activities” (“SFAS 149”).
SFAS 149 amends and clarifies the accounting for derivative
instruments, including certain derivative instruments embedded
in other contracts and hedging activities under
SFAS No. 133, “Accounting for Derivative
Instruments and Hedging Activities”
(“SFAS 133”). In particular, SFAS 149
clarifies under what circumstances a contract with an initial
net investment meets the characteristic of a derivative as
discussed in SFAS 133, when a derivative contains a
financing component, amends the definition of an
“underlying” to conform it to the language used in
FIN 45, “Guarantor’s Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of
Others — an interpretation of FASB Statements
No. 5, 57 and 107 and rescission of FASB Interpretation
No. 34” (“FIN 45”), and amends certain
other existing pronouncements. SFAS 149 is effective for
contracts entered into or modified after June 30, 2003,
except as stated below, and for hedging relationships designated
after June 30, 2003.
The provisions of SFAS 149 that relate to guidance in
SFAS 133 that have been effective for fiscal quarters which
began prior to June 15, 2003 continue to be applied in
accordance with their respective effective dates. In addition,
certain provisions relating to forward purchases or sales of
when-issued securities or other securities that do not yet exist
are applied to both existing contracts as well as new contracts
entered into after June 30, 2003.
Effective July 1, 2003, Nortel applied the requirements of
SFAS 149 on a prospective basis to contracts entered into
or modified after June 30, 2003. The adoption of
SFAS 149 did not have a material impact on Nortel’s
results of operations and financial condition.
(v)
Stock-based compensation
Nortel employees and directors participate in a number of
stock-based compensation plans that are described in
note 19.
In December 2002, the FASB issued SFAS No. 148,
“Accounting for Stock-Based Compensation Transition and
Disclosure — an Amendment of FASB Statement
No. 123” (“SFAS 148”), which amended
the transitional provisions of SFAS No. 123,
“Accounting for Stock-based Compensation”
(“SFAS 123”), for companies electing to recognize
employee stock-based compensation using the fair value based
method.
135
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Prior to January 1, 2003, Nortel, as permitted under
SFAS 123, applied the intrinsic value method under
Accounting Principles Board Opinion (“APB”)
No. 25, “Accounting for Stock Issued to
Employees” (“APB 25”), and related
interpretations in accounting for its employee stock-based
compensation plans.
Effective January 1, 2003, Nortel elected to adopt the fair
value based method for measurement and recognition of all
stock-based compensation prospectively for all awards granted,
modified or settled on or after January 1, 2003. The impact
of the adoption of the fair value based method for expense
recognition of employee awards resulted in $26 (net of tax of
nil) of stock option expense during 2003.
The accounting for Nortel’s stock-based compensation plans
under the fair value based method is as follows:
Stock Options
The fair value at grant date of stock options is estimated using
the Black-Scholes-Merton option-pricing model. Compensation
expense is recognized on a straight-line basis over the stock
option vesting period. Adjustments to compensation expense due
to not meeting employment vesting requirements are accounted for
in the period when they occur.
Restricted Stock Units (“RSUs”), Deferred Stock
Units (“DSUs”) and Stock Appreciation Rights
(“SARs”)
RSUs that are only settled in equity are valued using the grant
date market price of the underlying stock. This valuation is not
subsequently adjusted for changes in the market price of the
stock prior to settlement of the award. Compensation expense is
recognized on a straight-line basis over the vesting period
based on the estimated number of RSU awards that are expected to
vest. If there are performance vesting criteria, such as
achievement of earnings or revenue targets, this estimate is
updated each period for changes in estimates or as actual
results become known. Adjustments to compensation expense for
employment vesting requirements are accounted for in the period
when they occur.
Grants of RSUs, DSUs or SARs that are settled or may be settled
in cash or stock purchased on the open market at the option of
employees or directors are accounted for as liabilities. The
value of the liability is remeasured each period based on the
cumulative compensation expense recognized for the awards at
each period end. Prior to vesting, this is determined based on
the current market price of the underlying stock at period end,
the estimated number of RSU, DSU or SAR awards that are expected
to vest calculated in the same manner as equity settled RSUs and
the portion of the vesting period that has elapsed. Subsequent
to vesting and prior to settlement of the award, changes in
Nortel’s payment obligations are based on changes in the
stock price and are recorded as compensation expense each period.
The payment obligation is established for RSUs on the vesting
date of the award, for DSUs on the later of the date of
termination of employment and/or directorship, and for SARs on
the date of exercise of the award by the employee.
Stock-based awards, which are substantively discretionary in
nature, are measured and recorded fully as compensation expense
in the period that the issuance and settlement of the award is
approved.
Employee Stock Purchase Plans
Nortel has stock purchase plans for eligible employees in
eligible countries, and a stock purchase plan for eligible
unionized employees in Canada (collectively, the
“ESPPs”), to facilitate the acquisition of common
shares of Nortel Networks Corporation at a discount. The
discount is such that the plans are considered compensatory
under the fair value based method. Nortel’s contribution to
the ESPPs is recorded as compensation expense on a quarterly
basis as the obligation to contribute is incurred.
136
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Pro forma disclosure required due to a change in accounting
policy
Had Nortel applied the fair value based method to all
stock-based awards in all periods, reported net earnings (loss)
and earnings (loss) per common share would have been adjusted to
the pro forma amounts indicated below for the following years
ended December 31:
2005
2004
2003
Net earnings (loss) — reported
$
(2,575
)
$
(207
)
$
293
Stock-based compensation — reported
89
117
55
Deferred stock option compensation —
reported(a)
—
—
16
Stock-based compensation — pro
forma(b)
(96
)
(224
)
(481
)
Net earnings (loss) — pro forma
$
(2,582
)
$
(314
)
$
(117
)
Basic earnings (loss) per common share:
Reported
$
(0.59
)
$
(0.05
)
$
0.07
Pro forma
$
(0.60
)
$
(0.07
)
$
(0.03
)
Diluted earnings (loss) per common share:
Reported
$
(0.59
)
$
(0.05
)
$
0.07
Pro forma
$
(0.60
)
$
(0.07
)
$
(0.03
)
(a)
Deferred stock option compensation — reported,
represented the amortization of deferred stock option
compensation related primarily to unvested stock options held by
employees of companies acquired in a purchase acquisition. For
the years ended December 31, 2005, 2004 and 2003, the
amounts were net of tax of nil, nil and nil, respectively.
(b)
Stock-based compensation — pro forma expense for the
years ended December 31, 2005, 2004 and 2003 was net of tax
of nil, nil and nil, respectively.
(w)
Recent accounting pronouncements
(i)
In March 2004, the EITF reached consensus on Issue
No. 03-1,
“The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments”
(“EITF 03-1”).
EITF 03-1 provides
guidance on determining when an investment is considered
impaired, whether that impairment is other than temporary and
the measurement of an impairment loss.
EITF 03-1 is
applicable to marketable debt and equity securities within the
scope of SFAS No. 115, “Accounting for Certain
Investments in Debt and Equity Securities”
(“SFAS 115”), and SFAS No. 124,
“Accounting for Certain Investments Held by Not-for-Profit
Organizations”, and equity securities that are not subject
to the scope of SFAS 115 and not accounted for under the
equity method of accounting. The FASB, at its June 29, 2005
Board meeting, decided not to provide additional guidance on the
meaning of other-than-temporary impairment, but instead issued
proposed FASB Staff Position (“FSP”)
EITF 03-1-a,
“Implementation Guidance for the Application of
Paragraph 16 of EITF Issue
No. 03-1”, as
final, superseding
EITF 03-1 and EITF
Topic No. D-44, “Recognition of Other-Than-Temporary
Impairment upon the Planned Sale of a Security Whose Cost
Exceeds Fair Value”. The final FSP, retitled FSP
FAS 115-1 and
FAS 124-1,
“The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments” (“FSP
FAS 115-1 and
FAS 124-1”),
will be applied prospectively and the effective date is for
reporting periods beginning after December 15, 2005. The
adoption of FSP
FAS 115-1 and
FAS 124-1 is not
expected to have a material impact on Nortel’s results of
operations and financial condition.
(ii)
In November 2004, the FASB issued SFAS No. 151,
“Inventory Costs” (“SFAS 151”).
SFAS 151 requires that abnormal amounts of idle facility
expense, freight, handling costs and wasted material
(spoilage) be recognized as current period charges rather
than capitalized as a component of inventory costs. In addition,
SFAS 151 requires allocation of fixed production overheads
to inventory based on the normal capacity of the production
facilities. This statement is effective for inventory costs
incurred during fiscal years beginning after June 15, 2005.
The guidance should be applied prospectively. The adoption of
SFAS 151 is not expected to have a material impact on
Nortel’s results of operations and financial condition.
(iii)
In December 2004, the FASB issued SFAS No. 123
(Revised 2004), “Share-Based Payment”
(“SFAS 123R”), which requires all share-based
payments to employees, including grants of employee stock
options, to be recognized as compensation expense in the
consolidated financial statements based on their fair values.
SFAS 123R also modifies certain measurement and expense
recognition provisions of SFAS 123 that will impact Nortel,
including
137
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
the requirement to estimate employee forfeitures each period
when recognizing compensation expense and requiring that the
initial and subsequent measurement of the cost of
liability-based awards each period be based on the fair value
(instead of the intrinsic value) of the award. This statement is
effective for Nortel as of January 1, 2006. Nortel
previously elected to expense employee stock-based compensation
using the fair value method prospectively for all awards granted
or modified on or after January 1, 2003 in accordance with
SFAS 148. SAB 107, “Share-Based Payment”
(“SAB 107”), was issued by the SEC in March 2005,
and provides supplemental SFAS 123R application guidance
based on the views of the SEC. The adoption of SFAS 123R is
not expected to have a material impact on Nortel’s results
of operations and financial condition for the 2006 fiscal year.
(iv)
In May 2005, the FASB issued SFAS No. 154,
“Accounting Changes and Error Corrections”
(“SFAS 154”), which replaces APB Opinion
No. 20, “Accounting Changes”, and
SFAS No. 3, “Reporting Accounting Changes in
Interim Financial Statements — An Amendment of APB
Opinion No. 28”. SFAS 154 provides guidance on
the accounting for and reporting of changes in accounting
principles and error corrections. SFAS 154 requires
retrospective application to prior period financial statements
of voluntary changes in accounting principles and changes
required by new accounting standards when the standard does not
include specific transition provisions, unless it is
impracticable to do so. SFAS 154 also requires certain
disclosures for restatements due to correction of an error.
SFAS 154 is effective for accounting changes and
corrections of errors made in respect of fiscal years beginning
after December 15, 2005, and is required to be adopted by
Nortel as of January 1, 2006. The impact that the adoption
of SFAS 154 will have on Nortel’s consolidated results
of operations and financial condition will depend on the nature
of future accounting changes adopted by Nortel and the nature of
transitional guidance provided in future accounting
pronouncements.
(v)
In September 2005, the EITF reached consensus on Issue No.
04-13, “Accounting for Purchases and Sales of Inventory
with the Same Counterparty”
(“EITF 04-13”).
EITF 04-13
provides guidance on the purchase and sale of inventory to
another entity that operates in the same line of business. The
purchase and sale transactions may be pursuant to a single
contractual arrangement or separate contractual arrangements and
the inventory purchased or sold may be in the form of raw
materials,
work-in-process or
finished goods.
EITF 04-13 applies
to new arrangements entered into, or modifications or renewals
of existing arrangements, in reporting periods beginning after
March 15, 2006. The impact of the adoption of
EITF 04-13 on
Nortel’s consolidated results of operations and financial
condition will depend on the nature of future arrangements
entered into, or modifications or renewals of existing
arrangements, by Nortel.
(vi)
In November 2005, the FASB issued FSP FAS 123R-3,
“Transition Election Related to Accounting for the Tax
Effects of Share-Based Payment Awards” (“FSP
FAS 123R-3”).
FSP FAS 123R-3
provides an elective alternative transition method, to
SFAS 123R, in accounting for the tax effects of share-based
payment awards to employees. The elective method comprises a
computational component that establishes a beginning balance of
the Additional Paid In Capital (“APIC”) pool related
to employee compensation and a simplified method to determine
the subsequent impact on the APIC pool of employee awards that
are fully vested and outstanding upon the adoption of
SFAS 123R. The impact on the APIC pool of awards partially
vested upon, or granted after, the adoption of SFAS 123R
should be determined in accordance with the guidance in
SFAS 123R, if adopted. The guidance in FSP
FAS 123R-3 is
effective for Nortel in the first quarter of 2006. Nortel is
currently assessing whether it will adopt the transition
election of FSP
FAS 123R-3 and
what the impact would be on Nortel’s results of operations
and financial condition.
3. Accounting changes
(a) Consolidation
of Variable Interest Entities
In January 2003, the FASB issued FIN 46,
“Consolidation of Variable Interest Entities — an
interpretation of Accounting Research Bulletin No. 51,
’Consolidated Financial Statements”’
(“FIN 46”). FIN 46 clarifies the application
of consolidation guidance to those entities defined as VIEs
(which include, but are not limited to, special purpose
entities, trusts, partnerships, certain joint ventures and other
legal structures) in which equity investors do not have the
characteristics of a “controlling financial interest”
or there is not sufficient equity at risk for the entity to
finance its activities without additional subordinated financial
support. FIN 46 applied immediately to all VIEs created
after January 31, 2003 and by the beginning of the first
interim or annual reporting period commencing after
June 15, 2003 for VIEs created prior to February 1,2003. In October 2003, the FASB issued FSP FIN 46-6,
“Effective Date of FASB
138
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Interpretation No. 46”, deferring the effective date
for applying the provisions of FIN 46 for VIEs created
prior to February 1, 2003 to the end of the first interim
or annual period ending after December 15, 2003. While the
criteria for deferral were met, Nortel elected early application
of FIN 46 (see note 15).
In December 2003, the FASB issued FIN 46R which amends and
supersedes the original FIN 46. Effective December 2003,
Nortel adopted FIN 46R. Any impacts of applying
FIN 46R to an entity to which FIN 46 had previously
been applied are considered immaterial to Nortel’s results
of operations and financial condition and Nortel’s
accounting treatment of VIEs.
(b) Accounting
for Certain Financial Instruments with Characteristics of both
Liabilities and Equity
In May 2003, the FASB issued SFAS No. 150,
“Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity”
(“SFAS 150”). SFAS 150 clarifies the
accounting for certain financial instruments with
characteristics of both liabilities and equity, including
mandatorily redeemable non-controlling interests, and requires
that those instruments be classified as liabilities on the
balance sheets. Previously, many of those financial instruments
were classified as equity. SFAS 150 became effective for
financial instruments entered into or modified after
May 31, 2003 and otherwise became effective at the
beginning of the first interim period beginning after
June 15, 2003. In November 2003, the FASB issued FSP
FAS 150-3, “Effective Date, Disclosures, and
Transition for Mandatorily Redeemable Financial Instruments of
Certain Nonpublic Entities and Certain Mandatorily Redeemable
Non-controlling Interests under FASB Statement No. 150,
Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity” (“FSP
FAS 150-3”), which deferred indefinitely the effective
date for applying the specific provisions within SFAS 150
related to the classification and measurement of mandatorily
redeemable non-controlling interests.
Nortel continues to consolidate two enterprises with limited
lives, which have mandatory liquidation at the end of their
prescribed lives in 2024. Upon liquidation, the net assets of
these entities will be distributed to the owners based on their
relative interests at that time. The minority interests included
in the consolidated balance sheets related to these entities
were a total of $57 and $47 as of December 31, 2005 and
2004, respectively. As of December 31, 2005, the fair value
of these minority interests was approximately $94. The adoption
of SFAS 150, as amended by FSP FAS 150-3, did not have
a material impact on Nortel’s results of operations and
financial condition.
(c) The
Effect of Contingently Convertible Debt on Diluted Earnings per
Share
On September 30, 2004, the EITF reached a consensus on
Issue No. 04-8, “The Effect of Contingently
Convertible Instruments on Diluted Earnings per Share”
(“EITF 04-8”),
which addresses when the dilutive effect of contingently
convertible debt instruments should be included in diluted
earnings (loss) per share.
EITF 04-8 requires
that contingently convertible debt instruments be included in
the computation of diluted earnings (loss) per share regardless
of whether the market price trigger has been met.
EITF 04-8 also
requires that prior period diluted earnings (loss) per share
amounts presented for comparative purposes be restated.
EITF 04-8 became
effective for reporting periods ending after December 15,2004. The adoption of
EITF 04-8 did not
have a material impact on Nortel’s diluted earnings (loss)
per share.
(d) Implicit
Variable Interests
In March 2005, the FASB issued FSP FIN 46(R)-5,
“Implicit Variable Interests under FASB Interpretation
No. 46 (revised December 2003), Consolidation of Variable
Interest Entities” (“FSP FIN 46R-5”). FSP
FIN 46R-5 provides guidance for a reporting enterprise on
determining whether it holds an implicit variable interest in
VIEs or potential VIEs when specific conditions exist. This FSP
is effective in the first period beginning after March 3,2005 in accordance with the transition provisions of
FIN 46. The adoption of FSP FIN 46R-5 had no material
impact on Nortel’s results of operations and financial
condition.
(e) Accounting
for Electronic Equipment Waste Obligations
In June 2005, the FASB issued FSP
FAS 143-1,
“Accounting for Electronic Equipment Waste
Obligations” (“FSP
FAS 143-1”).
FSP FAS 143-1
provides guidance on how commercial users and producers of
electronic equipment should recognize and measure asset
retirement obligations associated with the European Union
(“EU”) Directive
139
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
2002/96/ EC on Waste Electrical and Electronic Equipment. FSP
FAS 143-1, along
with the EU Directive, effectively obligates a commercial user
to accrue costs associated with the retirement of a specified
asset that qualifies as historical waste equipment.
FSP FAS 143-1
directs the commercial user to apply the provisions of
SFAS No. 143, “Accounting for Asset Retirement
Obligations”, and the related FIN 47, “Accounting
for Conditional Asset Retirement Obligations”, to an
obligation associated with historical waste. FSP
FAS 143-1 applies
to the later of Nortel’s fiscal quarter ended June 30,2005 or the date of the adoption of the law by the applicable
EU-member country. In the second, third and fourth quarters of
2005, Nortel adopted FSP
FAS 143-1 with
respect to those EU-member countries that enacted the directive
into country specific laws. The adoption of FSP
FAS 143-1 did not
have a material impact on Nortel’s results of operations
and financial condition for the fiscal year ended
December 31, 2005. Due to the fact that certain EU-member
countries have not yet enacted country-specific laws, Nortel
cannot estimate the impact of applying this guidance in future
periods.
4. Restatement of previously
issued financial statements
Nortel has effected successive restatements of prior
periods’ financial results. Following the restatement
(effected in December 2003) of its consolidated financial
statements for the years ended December 31, 2002, 2001 and
2000 and for the quarters ended March 31, 2003 and
June 30, 2003 (the “First Restatement”), the
Audit Committees of Nortel and NNL’s Boards of Directors
(the “Audit Committee”) initiated an independent
review of the facts and circumstances leading to the First
Restatement (the “Independent Review”) and engaged
Wilmer Cutler Pickering Hale & Dorr LLP
(“WilmerHale”) to advise it in connection with the
Independent Review. This review, and other errors and accounting
issues identified by management, led to the restatement
(effected in 2005) of Nortel’s consolidated financial
statements for the years ended December 31, 2002 and 2001
and the quarters ended March 31, 2003 and 2002,
June 30, 2003 and 2002 and September 30, 2003 and 2002
(the “Second Restatement”).
Over the course of the Second Restatement process, Nortel,
together with its independent registered chartered accountants,
identified a number of material weaknesses in Nortel’s
internal control over financial reporting as at
December 31, 2003. Five of those material weaknesses
continued to exist as at December 31, 2004 and 2005. In
addition, in January 2005, Nortel and NNL’s Boards of
Directors adopted in their entirety the governing principles for
remedial measures identified through the Independent Review.
Nortel continues to develop and implement these remedial
measures.
As part of these remedial measures and to compensate for the
unremedied material weaknesses in its internal control over
financial reporting, Nortel undertook intensive efforts in 2005
to enhance its controls and procedures relating to the
recognition of revenue. These efforts included, among other
measures, extensive documentation and review of customer
contracts for revenue recognized in 2005 and earlier periods. As
a result of the contract review, it became apparent that certain
of the contracts had not been accounted for properly under
U.S. GAAP. Most of these errors related to contractual
arrangements involving multiple deliverables, for which revenue
recognized in prior periods should have been deferred to later
periods, under SAB 104 and
SOP 97-2.
In addition, based on Nortel’s review of its revenue
recognition policies and discussions with its independent
registered chartered accountants as part of the 2005 audit,
Nortel determined that in its previous application of these
policies, Nortel misinterpreted certain of these policies
principally related to complex contractual arrangements with
customers where multiple deliverables were accounted for using
the percentage-of-completion method of accounting under
SOP 81-1, as
described in more detail below:
•
Certain complex arrangements with multiple deliverables were
previously fully accounted for under the
percentage-of-completion method of SOP 81-1, but elements
outside of the scope of SOP 81-1 should have been examined
for separation under the guidance in
EITF 00-21; and
•
Certain complex arrangements accounted for under the
percentage-of-completion method did not meet the criteria for
this treatment in
SOP 81-1 and
should instead have been accounted for using completed contract
accounting under
SOP 81-1.
In correcting for both application errors, the timing of revenue
recognition was frequently determined to be incorrect, with
revenue having generally been recognized prematurely when it
should have been deferred and recognized in later periods.
140
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Management’s determination that these errors required
correction led to the Audit Committee’s decision on
March 9, 2006 to effect a further restatement of
Nortel’s consolidated financial statements (the “Third
Restatement”). Nortel has restated its consolidated balance
sheet as of December 31, 2004 and consolidated statements
of operations, changes in equity and comprehensive income (loss)
and cash flows for each of the years ended December 31,2004 and 2003. The Third Restatement also corrected other
miscellaneous accounting errors, as well as the classification
of certain items within the consolidated statements of
operations and cash flows, as described below. The impact of the
Third Restatement to periods prior to 2003 was a net increase of
$70 to opening accumulated deficit as of January 1, 2003.
The following tables present the impact of the Third Restatement
on Nortel’s previously issued consolidated statements of
operations for the years ended December 31, 2004 and 2003.
The effects of the restatement on the consolidated balance sheet
as of December 31, 2004 are shown following the discussion
below.
Consolidated Statement of Operations for the year ended
December 31, 2004
Revenues and
As Previously
Cost of Revenues
Other
As
Reported
Adjustments
Adjustments
Restated
Revenues
$
9,828
$
(312
)
$
—
$
9,516
Cost of revenues
5,750
(180
)
4
5,574
Gross profit
4,078
(132
)
(4
)
3,942
Selling, general and administrative expense
2,138
—
(5
)
2,133
Research and development expense
1,959
—
1
1,960
Amortization of intangibles
10
—
(1
)
9
Special charges
180
—
1
181
(Gain) loss on sale of businesses and assets
(98
)
—
7
(91
)
Operating earnings (loss)
(111
)
(132
)
(7
)
(250
)
Other income — net
231
—
(19
)
212
Interest expense
Long-term debt
(193
)
—
1
(192
)
Other
(10
)
—
—
(10
)
Earnings (loss) from continuing operations before income taxes,
minority interests and equity in net earnings (loss) of
associated companies
(83
)
(132
)
(25
)
(240
)
Income tax benefit
29
1
—
30
(54
)
(131
)
(25
)
(210
)
Minority interests — net of tax
(46
)
—
—
(46
)
Net earnings (loss) from continuing operations
(100
)
(131
)
(25
)
(256
)
Net earnings from discontinued operations — net of tax
49
—
—
49
Net earnings (loss) before cumulative effect of accounting change
(51
)
(131
)
(25
)
(207
)
Cumulative effect of accounting change — net of tax
—
—
—
—
Net earnings (loss)
$
(51
)
$
(131
)
$
(25
)
$
(207
)
Basic and diluted earnings (loss) per common share
— from continuing operations
$
(0.02
)
$
(0.03
)
$
(0.01
)
$
(0.06
)
— from discontinued operations
0.01
0.00
0.00
0.01
Basic and diluted earnings (loss) per common share
$
(0.01
)
$
(0.03
)
$
(0.01
)
$
(0.05
)
141
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Consolidated Statement of Operations for the year ended
December 31, 2003
Revenues and
As Previously
Cost of Revenues
Other
Reported
Adjustments
Adjustments
As Restated
Revenues
$
10,193
$
(261
)
$
—
$
9,932
Cost of revenues
5,852
(139
)
10
5,723
Gross profit
4,341
(122
)
(10
)
4,209
Selling, general and administrative expense
1,939
—
27
1,966
Research and development expense
1,960
—
8
1,968
Amortization of intangibles
101
—
—
101
Deferred stock option compensation
16
—
—
16
Special charges
284
—
4
288
(Gain) loss on sale of businesses and assets
(4
)
—
—
(4
)
Operating earnings (loss)
45
(122
)
(49
)
(126
)
Other income — net
445
(10
)
31
466
Interest expense
Long-term debt
(181
)
—
3
(178
)
Other
(28
)
—
—
(28
)
Earnings (loss) from continuing operations before income taxes,
minority interests and equity in net earnings (loss) of
associated companies
281
(132
)
(15
)
134
Income tax benefit
80
3
—
83
361
(129
)
(15
)
217
Minority interests — net of tax
(63
)
4
—
(59
)
Equity in net earnings (loss) of associated
companies — net of tax
(36
)
—
—
(36
)
Net earnings (loss) from continuing operations
262
(125
)
(15
)
122
Net earnings from discontinued operations — net of tax
184
—
(1
)
183
Net earnings (loss) before cumulative effect of accounting change
446
(125
)
(16
)
305
Cumulative effect of accounting change — net of tax
(12
)
—
—
(12
)
Net earnings (loss)
$
434
$
(125
)
$
(16
)
$
293
Basic and diluted earnings (loss) per common share
— from continuing operations
$
0.06
$
(0.03
)
$
(0.00
)
$
0.03
— from discontinued operations
0.04
0.00
0.00
0.04
Basic and diluted earnings (loss) per common share
$
0.10
$
(0.03
)
$
(0.00
)
$
0.07
Revenues and cost of revenues adjustments
The Third Restatement adjustments that related to revenue
recognition errors resulted in a net decrease to revenues of
$312 and $261 for the years ended December 31, 2004 and
2003, respectively. These errors related to revenue previously
recognized that should have been deferred to subsequent periods.
Corresponding adjustments to cost of revenues were made,
resulting in a net decrease to cost of revenues of $180 and $139
related to the revenue recognition adjustments, and a total net
decrease of $176 and $129 including other adjustments, for the
years ended December 31, 2004 and 2003 respectively.
142
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Revenues
Cost of Revenues
2004
2003
2004
2003
As previously reported
$
9,828
$
10,193
$
5,750
$
5,852
Adjustments:
Application of SOP 81-1
$
(84
)
$
(118
)
$
(55
)
$
(103
)
Interaction between multiple revenue recognition accounting
standards
(174
)
(49
)
(127
)
(26
)
Application of SAB 104 and SOP 97-2
(38
)
(84
)
14
(36
)
Other revenue recognition adjustments
(16
)
(10
)
(12
)
26
Other
adjustments(a)
—
—
4
10
As restated
$
9,516
$
9,932
$
5,574
$
5,723
(a)
For further details see explanations of ‘Other
adjustments’.
Application of SOP 81-1
Nortel determined that in certain arrangements, it had
misinterpreted the guidance in SOP 81-1 relating to the
application of
percentage-of-completion
accounting. Under the
percentage-of-completion
method, revenues are generally recorded based on a measure of
the percentage of costs incurred to date relative to the total
expected costs of the contract. In certain circumstances where a
reasonable estimate of costs cannot be made, but it is assured
that no loss will be incurred, revenue is recognized to the
extent of direct costs incurred (“zero margin
accounting”). If a reasonable estimate of costs cannot be
made and Nortel is not assured that no loss will be incurred,
revenue should be recognized using completed contract accounting.
For certain arrangements accounted for under the
percentage-of-completion
method which included rights to future software upgrades, Nortel
has now determined that it did not have a sufficient basis to
estimate the total costs of the arrangements, due to the
inability to estimate the cost of providing these future
software upgrades. In addition, in one arrangement, Nortel had
previously applied zero margin accounting on the basis that it
believed that no loss would be incurred. Nortel has now
determined that assurance that no loss would be incurred exists
only in very limited circumstances, such as in cost recovery
arrangements. Accordingly, Nortel has determined that
percentage-of-completion
accounting should not have been used to account for these
specific arrangements, and the completed contract method should
have been applied under
SOP 81-1. Under
the completed contract method, revenues and certain costs are
deferred until completion of the arrangement, which results in a
delay in the timing of revenue recognition as compared to
arrangements accounted for under
percentage-of-completion
accounting.
Interaction between multiple revenue recognition
accounting standards
Nortel determined there were accounting errors related to the
application of SOP 81-1,
SOP 97-2 and
related interpretive guidance under
EITF 00-21.
Some of Nortel’s customer arrangements have multiple
deliverable elements for which different accounting standards
may govern the appropriate accounting treatment. For those
arrangements that contained more-than-incidental software and
involved significant production, modification or customization
of software or software related elements (“customized
elements”), Nortel had previously applied the
percentage-of-completion
method of accounting under SOP 81-1 to all the elements
under the arrangement, in accordance with its interpretation of
SOP 97-2. This
included certain future software, software-related or
non-software related deliverables.
Nortel has now determined that it should have applied the
separation criteria set forth in
EITF 00-21 and
SOP 97-2 to
non-software and software/software-related elements,
respectively, to determine whether the various elements under
these arrangements should be treated as separate units of
accounting. Generally, the applicable separation criteria in
EITF 00-21 and
SOP 97-2 requires
sufficient objective and reliable evidence of fair value for
each element. If an undelivered non-SOP 81-1 element cannot
be separated from an SOP 81-1 element, depending on the
nature of the elements and the timing of their delivery, the
combined unit of accounting may be required to be accounted for
under SOP 97-2
rather than under SOP 81-1.
SOP 97-2 provides
that the entire revenue associated with the combined elements
should typically be deferred until the earlier of the point at
which (i) the undelivered element(s) meet the criteria for
separation or (ii) all elements within the combined unit of
accounting have been delivered. Once there is only one
143
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
remaining element to be delivered within the unit of accounting,
the deferred revenue is recognized based on the revenue
recognition guidance applicable to the last delivered element.
For certain of Nortel’s multiple element arrangements
involving customized elements where elements such as PCS,
specified upgrade rights and/or non-essential hardware or
software products remained undelivered, Nortel frequently
determined that the undelivered element could not be treated as
a separate unit of accounting because fair value could not be
established for all undelivered non-customized elements.
Accordingly, Nortel should not have accounted for the revenue
using
percentage-of-completion
accounting. Instead, the revenue should have been deferred in
accordance with
SOP 97-2 until
such time as the fair value of the undelivered element could be
established or all remaining elements have been delivered. Once
there is only one remaining element to be delivered within the
unit of accounting, the deferred revenue is recognized based on
the revenue recognition guidance applicable to that last element.
Application of SAB 104 and
SOP 97-2
Primarily as a result of Nortel’s contract review, Nortel
determined that in respect of certain contracts providing for
multiple deliverables, revenues had previously been recognized
for which the revenue recognition criteria under
SOP 97-2 or
SAB 104, as applicable, had not been met. These errors
related primarily to situations in which the fair value of an
undelivered element under the arrangement could not be
established.
In certain arrangements, Nortel had treated commitments to make
available a specified quantity of upgrades during the contract
period as PCS. Under
SOP 97-2, where
fair value cannot be established for PCS, revenue is recognized
for the entire arrangement ratably over the PCS term. Nortel has
now determined that commitments to make available a specified
quantity of upgrades do not qualify as PCS and should be
accounted for as a separate element of the arrangement from the
PCS. Fair value could not be established for these commitments
to make available a specified quantity of upgrades and as a
result, the revenue related to the entire arrangement should
have been deferred until the earlier of when (i) fair value
of the undelivered element could be established or (ii) the
undelivered element is delivered. Adjustments were made to defer
the revenue and related costs until the upgrades were delivered.
In certain multiple element arrangements, Nortel had recognized
revenue upon delivery of products under the arrangement although
other elements under the arrangement, such as future contractual
or implicit PCS, had not been delivered. If sufficient evidence
of fair value cannot be established for an undelivered element,
revenue related to the delivered products should be deferred
until the earlier of when VSOE for the undelivered element can
be established or all the remaining elements have been
delivered. Once there is only one remaining element, the
deferred revenue is recognized based on the revenue recognition
guidance applicable to that last undelivered element. For
instance, where PCS is the last undelivered element within the
unit of accounting, deferred revenue is recognized ratably over
the PCS term. As Nortel identified a number of contracts where
sufficient evidence of fair value could not be established for
the undelivered elements, adjustments were made to defer the
revenue and related costs from the periods in which they were
originally recorded and until such time as the appropriate
criteria recognition were met.
In addition, Nortel identified and corrected certain revenue
recognition errors that related to the application of SAB 104
and SOP 97-2. The cumulative adjustments were previously
recorded in 2004, rather than restating prior periods, because
they were not material either to 2004, or the prior period
results as originally reported. As part of the Third
Restatement, these adjustments have now been recorded in the
appropriate periods as follows:
•
A cumulative correction previously recorded in the third quarter
of 2004 has now been recorded primarily in 2003, and prior
periods resulting in an increase to revenue of $89 in the third
quarter of 2004. The adjustment was to correct for previously
recognized revenue relating to past sales of Optical Networks
equipment which we determined should have been deferred and
recognized with the delivery of future contractual PCS and other
services over the term of the PCS.
•
A cumulative correction in the fourth quarter of 2004 has now
been recorded in the appropriate prior periods resulting in an
increase to revenue of $40 in the fourth quarter of 2004. The
adjustment was to correct for previously recognized revenue
related to an EMEA contract which should have been deferred
until the delivery of certain undelivered elements such as
services.
144
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Other revenue recognition adjustments
In addition, errors related to application of profit center
definitions were identified and corrected. Nortel made other
revenue corrections related to the treatment of non-cash
incentives, and certain errors related to the classification of
revenue. Other revenue recognition adjustments also reflect the
impact on cost of revenues of corrections to standard costing on
deferred costs (related to deferred revenue) included in
inventory, and other adjustments to inventory to correct
standard costing.
Other adjustments
Other miscellaneous adjustments were identified and recorded in
the Third Restatement, the more significant of which are
summarized below.
Health and Welfare Trust
In prior periods, Nortel had incorrectly netted employee benefit
plan assets against the post-employment and post-retirement
liabilities and incorrectly recognized gains and losses through
the consolidated statement of operations related to certain
assets held in an employee benefit trust in Canada (“Health
and Welfare Trust”). Historically, Nortel had accounted for
the assets of the Health and Welfare Trust in accordance with
SFAS No. 106 “Employers Accounting for Post
Retirement Benefit Plans” (“SFAS 106”) and
SFAS No. 112, “Employers Accounting for
Post-Employment Benefit Plans” (“SFAS 112”)
which, among other things, permitted the netting of these plan
assets against the post-employment and post-retirement
liabilities if the assets are appropriately segregated and
restricted. Upon further review, Nortel determined that these
assets should not have been netted against the liabilities
because the Health and Welfare Trust was not legally structured
so as to segregate and restrict its assets to meet the
definition of plan assets under SFAS 106 and SFAS 112.
As a result, Nortel corrected prior periods to present plan
assets and liabilities on a gross basis, and to recognize gains
and losses in OCI. Nortel further determined that it is the
primary beneficiary of the Health and Welfare Trust, which met
the definition of a variable interest entity under FIN 46R.
As a result, Nortel has corrected prior periods to consolidate
the Health and Welfare Trust into its results as of July 1,2003, the effective date of FIN 46R. The combined impact of
these adjustments in the Third Restatement was an increase in
cost of revenues of $2 and $10, an increase in selling, general
and administrative expense of $3 and $12, an increase in R&D
expense of $4 and $6 and an increase in other income of $8 and
$9 for the years ended December 31, 2004 and 2003,
respectively. As of December 31, 2004, total assets
increased by $138 and liabilities increased by $144, including
the related foreign exchange impact, as a result of these
adjustments.
Foreign exchange
Nortel had previously recorded foreign exchange gains in its
2004 consolidated financial statements, to correct a cumulative
error from prior periods related to the functional currency
designation of an entity in Brazil. This adjustment was
previously recorded in 2004 rather than restating the prior
periods, because the adjustment was not material either to the
2004 or the prior period results as originally reported. As part
of the Third Restatement, the impact of this adjustment has now
been recorded in the appropriate prior periods, resulting in a
decrease to other income for the year ended December 31,2004 of $33 and an increase for the year ended December 31,2003 of $18.
Nortel also identified and corrected additional foreign currency
translation errors related to a pension liability under the
Supplemental Executive Retirement Plan and historical balances
for certain long-term debt issue and discount costs. The impact
of the adjustments in the Third Restatement to correct these
errors resulted in a net decrease to other income of $3 for the
year ended December 31, 2004 and a decrease of $8 for the
year ended December 31, 2003.
In addition, the foreign exchange gains and losses, if any,
resulting from the Third Restatement adjustments were recorded
in other income-net, and are presented in ‘Other
adjustments’ in the consolidated statements of operations
tables above.
Other
Nortel had previously capitalized legal and professional fees
and real estate impairment costs relating to its transaction
with Flextronics International Ltd. (“Flextronics”)
for the divestiture of substantially all of Nortel’s
remaining
145
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
manufacturing operations and related activities, accumulating
those costs in the consolidated balance sheet as deferred costs
starting in 2004. Nortel has determined that these costs should
instead have been recognized as incurred in prior periods.
Accordingly, Nortel has made adjustments to record these costs
in the appropriate prior period, resulting in a decrease to gain
(loss) on sale of businesses and assets of $6 for the year ended
December 31, 2004.
In 2004, Nortel corrected certain other accounting errors it had
identified that related to prior periods. These adjustments were
previously recorded in 2004 rather than restating prior periods
because they were not material to 2004 or to the financial
statements as originally reported. However, as part of the Third
Restatement, these adjustments have now been recorded in the
appropriate prior periods. These adjustments were as follows:
•
During 2004, Nortel had recorded a cumulative correction to
reclassify an operating lease to a capital lease. These
adjustments have now been recorded to the appropriate prior
periods which resulted in a decrease in selling, general and
administrative expense in the year ended December 31, 2004
of $16 and an increase in the year ended December 31, 2003
of $5.
•
Nortel had previously recorded the release of a customer
financing provision of $9 in 2004 that should have been recorded
in 2003. As a result, selling, general and administrative
expense has increased by $9 for the year ended December 31,2004 and decreased by $9 for the year ended December 31,2003.
•
Nortel has corrected the useful lives of various leasehold
improvement assets, included in plant and equipment —
net, which resulted in a decrease to depreciation expense for
the year ended December 31, 2004 of $6 and an increase for
the year ended December 31, 2003 of $3.
Reclassifications
Nortel had previously classified changes in restricted cash and
cash equivalents as a component of net cash from (used in)
operating activities of continuing operations. Nortel has now
determined that, under SFAS No. 95, “Statement of
Cash Flows”, changes in restricted cash and cash
equivalents should instead be recorded as a component of net
cash from (used in) investing activities of continuing
operations. Accordingly, Nortel has made adjustments of $17 and
$200 for the years ended December 31, 2004 and 2003,
respectively, to reclassify changes in restricted cash and cash
equivalents from net cash from (used in) operating activities of
continuing operations to net cash from (used in) investing
activities of continuing operations in the consolidated
statements of cash flows.
Certain sublease income has been reclassified in the
consolidated statement of operations. The impact of this
adjustment resulted in an increase of $10 and $2 in selling,
general and administrative expense and cost of revenues,
respectively and an increase in other income of $12 for the year
ended December 31, 2004. For the year ended
December 31, 2003, sublease income of $15 was reclassified
from selling, general and administrative expense to other income.
146
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Balance sheet
The following table presents the impact of the Third Restatement
adjustments on Nortel’s previously reported consolidated
balance sheet as of December 31, 2004.
Notes to Consolidated Financial
Statements — (Continued)
5. Consolidated financial
statement details
The following consolidated financial statement details are
presented as of December 31, 2005 and 2004 for the
consolidated balance sheets and for each of the three years
ended December 31, 2005 for the consolidated statements of
operations and consolidated statements of cash flows.
Consolidated statements of operations
Cost of revenues:
In August 2004, Nortel entered into a contract with Bharat
Sanchar Nigam Limited (“BSNL”) to establish a wireless
network in India. Nortel’s commitments for orders received
as of December 31, 2005 and 2004 under this contract have
resulted in estimated project losses in each of these years of
approximately $148 and $160, respectively, which were recorded
as a charge to cost of revenues and accrued within contractual
liabilities in the years ended December 31, 2005 and 2004.
During the year ended December 31, 2003, reversals of
provisions of $87 relating to a customer bankruptcy settlement
reduced cost of revenues and SG&A expense by $53 and $4,
respectively, and increased other income (expense) —
net by $30.
Selling, general and administrative expense:
SG&A expense included bad debt recoveries of $9, $118 and
$188 in the years ended December 31, 2005, 2004 and 2003,
respectively.
Research and development expense:
2005
2004
2003
R&D expense
$
1,856
$
1,960
$
1,968
R&D costs incurred on behalf of
others(a)
28
40
72
Total
$
1,884
$
2,000
$
2,040
(a)
These costs included R&D costs charged to customers of
Nortel pursuant to contracts that provided for full recovery of
the estimated cost of development, material, engineering,
installation and other applicable costs, which were accounted
for as contract costs.
Shareholder litigation settlement expense
During the year ended December 31, 2005, Nortel recorded a
charge of $2,474 related to an agreement reached in principle
for the proposed global settlement of certain shareholder class
action litigation. For additional information see notes 22
and 23.
Other income — net:
2005
2004
2003
Interest income
$
73
$
70
$
84
Write down or gain on sale of investments
67
19
143
Currency exchange gains
68
57
107
Other — net
95
66
132
Other income — net
$
303
$
212
$
466
148
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Long-term portion of deferred costs is included in other assets.
Other current assets:
2005
2004
Prepaid expenses
$
198
$
177
Income taxes recoverable
68
38
Current assets of discontinued operations (note 20)
—
14
Other
530
129
Other current assets
$
796
$
358
Plant and equipment — net:
2005
2004
Cost:
Land
$
45
$
48
Buildings
1,265
1,278
Machinery and equipment
2,190
2,444
Capital lease assets
213
176
Sale lease-back assets
80
59
3,793
4,005
Less accumulated depreciation:
Buildings
(455
)
(399
)
Machinery and equipment
(1,679
)
(1,884
)
Capital lease assets
(78
)
(66
)
Sale lease-back assets
(17
)
(16
)
(2,229
)
(2,365
)
Plant and equipment —
net(a)
$
1,564
$
1,640
(a)
Included assets held for sale with a carrying value of $136 and
$29 as of December 31, 2005 and 2004, respectively, related
to owned facilities that were being actively marketed. These
assets were written down in previous periods to their estimated
fair values less costs to sell. The write downs were included in
special charges. Nortel expects to dispose of all of these
facilities during 2006.
149
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Goodwill:
The following table outlines goodwill by reportable segment:
During each of the years ended December 31, 2005 and 2004,
Nortel performed its annual goodwill impairment test in
accordance with SFAS No. 142, “Goodwill and Other
Intangible Assets” (“SFAS 142”) and
concluded that there was no impairment.
Intangible assets — net:
2005
2004
Other intangible
assets(a)
$
135
$
38
Pension intangible assets (note 9)
37
40
Intangible assets —
net(b)
$
172
$
78
(a)
Other intangible assets are being amortized over a weighted
average period of approximately nine years ending in 2014.
Amortization expense for the next five years commencing in 2006
is expected to be $28, $26, $19, $17 and $14, respectively. The
majority of amortization expense is denominated in a foreign
currency and may fluctuate due to changes in foreign exchange
rates.
(b)
The increase related primarily to intangible assets acquired in
the PEC Solutions, Inc. acquisition and the formation of the
joint venture with LG Electronics Inc., see note 10.
Other accrued liabilities:
2005
2004
Outsourcing and selling, general and administrative related
provisions
$
256
$
322
Customer deposits
38
28
Product related provisions
42
57
Warranty provisions (note 13)
208
273
Deferred revenue
1,289
1,420
Miscellaneous taxes
66
53
Income taxes payable
83
112
Interest payable
65
62
Advance billings in excess of revenues recognized to date on
contracts
1,195
1,146
Shareholder litigation settlement provision (notes 22 and
23)
804
—
Other
154
119
Other accrued liabilities
$
4,200
$
3,592
150
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Other liabilities:
2005
2004
Pension, post-employment and post-retirement benefit liabilities
$
2,459
$
2,350
Restructuring liabilities (note 7)
203
209
Deferred revenue
1,073
783
Shareholder litigation settlement provision (notes 22 and
23)
1,899
—
Other long-term provisions
301
236
Other liabilities
$
5,935
$
3,578
Minority interests in subsidiary companies:
2005
2004
Preferred shares of NNL (Authorized: unlimited number of
Class A and Class B)
Series 5, issued November 26, 1996 for consideration
of Canadian
$400(a)
$
294
$
294
Series 7, issued November 28, 1997 for consideration
of Canadian
$350(b)
242
242
Other(c)
244
90
Minority interests in subsidiary companies
$
780
$
626
(a)
As of December 31, 2005 and 2004, 16 million
Class A Series 5 preferred shares were outstanding.
Since December 1, 2001, holders of Series 5 preferred
shares are entitled to, if declared, a monthly floating
cumulative preferential cash dividend based on Canadian prime
rates.
(b)
As of December 31, 2005 and 2004, 14 million
Class A Series 7 preferred shares were outstanding.
Since December 1, 2002, holders of the Series 7
preferred shares are entitled to, if declared, a monthly
floating non-cumulative preferential cash dividend based on
Canadian prime rates.
(c)
Other includes minority interest in joint ventures primarily in
Europe and Asia.
Consolidated statements of cash flows
Change in operating assets and liabilities:
2005
2004
2003
Accounts receivable — net
$
(248
)
$
(66
)
$
(197
)
Inventories — net
(266
)
(692
)
352
Income taxes
(58
)
(63
)
18
Restructuring liabilities
(138
)
(57
)
(230
)
Accounts payable, payroll and contractual liabilities
283
255
(615
)
Other operating assets and liabilities
210
(32
)
(207
)
Change in operating assets and liabilities
$
(217
)
$
(655
)
$
(879
)
Cash and cash equivalents:
2005
2004
2003
Cash on hand and balances with banks
$
767
$
773
$
761
Short-term investments
2,184
2,912
3,241
Cash and cash equivalents at end of year
$
2,951
$
3,685
$
4,002
151
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Acquisitions of investments and businesses — net of
cash acquired:
2005
2004
2003
Cash acquired
$
(26
)
$
(6
)
$
(5
)
Total net assets acquired other than cash
(651
)
(5
)
(114
)
Total purchase price
(677
)
(11
)
(119
)
Less:
Cash acquired
26
6
5
Non-cash consideration paid other than common share options and
contingent consideration
—
—
83
Acquisitions of investments and businesses — net of
cash acquired
$
(651
)
$
(5
)
$
(31
)
Interest and taxes paid (recovered):
2005
2004
2003
Cash interest paid
$
203
$
189
$
186
Cash taxes paid (recovered) — net
$
48
$
40
$
(4
)
6.
Segment information
General description
Effective January 1, 2005, Nortel changed its reportable
segments to the following: (a) Carrier Packet Networks,
which is substantially an amalgamation of Nortel’s previous
Wireline Networks and Optical Networks operating segments;
(b) Code Division Multiple Access (“CDMA”)
Networks, which previously represented a portion of
Nortel’s Wireless Networks operating segment;
(c) Global System for Mobile communications
(“GSM”) and Universal Mobile Telecommunications
Systems (“UMTS”) Networks, which also previously
represented a portion of Nortel’s Wireless Networks
operating segment; and (d) Enterprise Networks, which
remains substantially unchanged from the previous Enterprise
Networks operating segment. The 2004 and 2003 full year segment
results have been restated to conform to the new segments that
were reported commencing in the first quarter of 2005. There is
no impact to Nortel’s consolidated statements of
operations, consolidated balance sheets or consolidated
statements of cash flows. Nortel’s four reportable segments
and other business activities are described below:
•
Carrier Packet Networks provides: (i) circuit and packet
voice solutions, (ii) data networking and security
solutions and (iii) optical networking solutions. Together,
these solutions provide data, voice and multimedia
communications solutions to Nortel’s service provider
customers that operate wireline networks. These service provider
customers include local and long distance telephone companies,
wireless service providers, cable operators and other
communication service providers.
•
CDMA Networks provides communication network solutions to
Nortel’s wireless service provider customers based on CDMA
and Time Division Multiple Access (“TDMA”)
technologies to enable those service providers to offer their
customers, the subscribers for wireless communication services,
the ability to be mobile while they send and receive voice and
data communications using wireless devices, such as cellular
telephones, personal digital assistants and other computing and
communications devices.
•
GSM and UMTS Networks also provides communication network
solutions to Nortel’s wireless service provider customers;
however, these solutions are based on GSM and UMTS technologies.
•
Enterprise Networks provides: (i) circuit and packet voice
solutions and (ii) data networking and security solutions
which provide data, voice and multimedia communications
solutions to Nortel’s enterprise customers. Nortel’s
Enterprise Networks customers consist of a broad range of
enterprise customers around the world, including large
businesses and their branch offices, small businesses and home
offices, as well as government agencies, educational and other
institutions and utility organizations.
•
“Other” represents miscellaneous business activities
and corporate functions. None of these activities meet the
quantitative criteria to be disclosed separately as reportable
segments. Costs associated with shared services and other
corporate costs are allocated to the segments based on usage
determined generally by headcount. Costs not
152
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
allocated to the segments are primarily related to Nortel’s
corporate compliance and other non-operational activities and
are included in “Other”.
Nortel’s president and chief executive officer (“the
CEO”) has been identified as the Chief Operating Decision
Maker in assessing the performance of the segments and the
allocation of resources to the segments. The CEO relies on the
information derived directly from Nortel’s management
reporting system. The primary financial measure used by the CEO
in assessing performance and allocating resources to the
segments is management earnings (loss) before income taxes
(“Management EBT”), a measure that includes the cost
of revenues, SG&A expense, R&D expense, interest
expense, other income (expense) — net, minority
interests — net of tax and equity in net earnings
(loss) of associated companies — net of tax. Interest
attributable to long-term debt is not allocated to a reportable
segment and is included in “Other”. The CEO does not
review asset information on a segmented basis in order to assess
performance and allocate resources. The accounting policies of
the reportable segments are the same as those applied to the
consolidated financial statements. Prior period segment results
have been adjusted to conform to the current period presentation
to reflect the movement of certain products and functional
allocations.
On September 30, 2005, Nortel announced a new
organizational structure that it expects will strengthen its
enterprise focus, drive product efficiencies and enhance
Nortel’s delivery of global services. The new alignment
includes two product groups: (i) Enterprise Solutions and
Packet Networks, which combines optical networking solutions
(included in Carrier Packet Networks segment in 2005), and
portions of circuit and packet voice solutions and data
networking and security solutions (included in both Carrier
Packet Networks segment and Enterprise Networks segment in 2005)
into a unified product group; and (ii) Mobility and
Converged Core Networks, which combines Nortel’s CDMA
solutions and GSM and UMTS solutions (each a separate segment in
2005) and other circuit and packet voice solutions and data
networking and security solutions (included in both Carrier
Packet Networks segment and Enterprise Networks segment in
2005). By creating two product groups, Nortel expects to
simplify its business model and create new cost efficiencies by
leveraging common hardware and software platforms. Nortel
expects these two product groups to form its reportable segments
commencing in the first quarter of 2006.
Nortel is also in the process of establishing an operating
segment that focuses on providing professional services in five
key areas: integration services, security services, managed
services, optimization services and maintenance services. Nortel
expects this operating segment to become a third reportable
segment in the second half of 2006.
153
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Segments
The following tables set forth information by segment for the
years ended December 31:
2005
2004
2003
Revenues
Carrier Packet Networks
$
2,828
$
2,589
$
3,132
CDMA Networks
2,321
2,216
2,356
GSM and UMTS Networks
2,799
2,411
1,882
Enterprise Networks
2,570
2,289
2,531
Total reportable segments
10,518
9,505
9,901
Other(a)
5
11
31
Total revenues
$
10,523
$
9,516
$
9,932
Management EBT
Carrier Packet Networks
$
51
$
(298
)
$
(131
)
CDMA Networks
685
688
800
GSM and UMTS Networks
(4
)
(197
)
(162
)
Enterprise Networks
150
136
242
Total reportable segments
882
329
749
Other(b)
(806
)
(516
)
(309
)
Total management EBT
76
(187
)
440
Amortization of intangibles
(17
)
(9
)
(101
)
Deferred stock option compensation
—
—
(16
)
Special charges
(170
)
(181
)
(288
)
Gain (loss) on sale of businesses and assets
(47
)
91
4
Shareholder litigation settlement expense
(2,474
)
—
—
Income tax benefit (expense)
56
30
83
Net earnings (loss) from continuing operations
$
(2,576
)
$
(256
)
$
122
(a)
“Other” represents miscellaneous revenues that do not
correspond to any individual reportable segment.
(b)
“Other” represents miscellaneous business activities,
corporate functions, non-operating costs and includes interest
attributable to long-term debt.
Product revenues
The following table sets forth external revenues by product for
the years ended December 31:
2005
2004
2003
CDMA solutions
$
2,321
$
2,216
$
2,356
GSM and UMTS solutions
2,799
2,411
1,882
Circuit and packet voice solutions
2,748
2,582
2,989
Optical networking solutions
1,186
958
1,172
Data networking and security solutions
1,321
1,338
1,501
Other
148
11
32
Total
$
10,523
$
9,516
$
9,932
For the years ended December 31, 2005, 2004 and 2003, no
customer had revenues greater than 10 percent of
consolidated revenues.
154
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Geographic information
The following table sets forth external revenues by geographic
region based on the location of the customer for the years ended
December 31:
2005
2004
2003
U.S.
$
5,206
$
4,646
$
5,329
EMEA
2,725
2,496
2,253
Canada
576
553
599
Asia Pacific
1,405
1,261
1,258
CALA
611
560
493
Total
$
10,523
$
9,516
$
9,932
Long-lived assets
The following table sets forth long-lived assets representing
plant and equipment — net, goodwill and other
intangible assets — net by geographic region as of
December 31:
2005
2004
U.S.
$
2,926
$
2,583
EMEA
475
607
Canada
702
744
Other
regions(a)
225
87
Total
$
4,328
$
4,021
(a)
The Asia Pacific and CALA regions.
7.
Special charges
During 2001, Nortel implemented a work plan to streamline
operations and activities around core markets and leadership
strategies in light of the significant downturn in both the
telecommunications industry and the economic environment, and
capital market trends impacting operations and expected future
growth rates (the “2001 Restructuring Plan”).
In addition, as described below, activities were initiated in
2003 to exit certain leased facilities and leases for assets no
longer used across all segments. The liabilities associated with
these activities were measured at fair value and recognized
under SFAS 146.
In 2004 and 2005, Nortel’s focus was on managing each of
its businesses based on financial performance, the market and
customer priorities. In the third quarter of 2004, Nortel
announced a strategic plan that includes a work plan involving
focused workforce reductions, including a voluntary retirement
program, of approximately 3,250 employees, real estate
optimization and other cost containment actions such as
reductions in information services costs, outsourced services
and other discretionary spending across all segments, but
primarily in Carrier Packet Networks (the “2004
Restructuring Plan”). Nortel estimates total charges to
earnings associated with the 2004 Restructuring Plan in the
aggregate of approximately $410 comprised of approximately $240
with respect to the workforce reductions and approximately $170
with respect to the real estate actions. No additional special
charges are expected to be recorded with respect to the other
cost containment actions. Approximately $165 of the aggregate
charges were incurred in 2004 and $177 in 2005 with the
remainder expected to be substantially incurred during 2006.
155
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
As of December 31, 2005 and 2004, the short-term provision
balance was $95 and $254, respectively, and the long-term
provision balance was $203 and $209, respectively.
156
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Regular full-time (“RFT”) employee notifications
resulting in special charges for both restructuring plans were
as follows:
Employees (Approximate)
Direct(a)
Indirect(b)
Total
RFT employee notifications by period:
During 2003
400
1,400
1,800
During 2004
200
1,700
1,900
During 2005
61
893
954
RFT employee notifications for the three years ended
December 31, 2005
661
3,993
4,654
(a)
Direct employees included employees performing manufacturing,
assembly, test and inspection activities associated with the
production of Nortel’s products.
(b)
Indirect employees included employees performing manufacturing,
management, sales, marketing, research and development and
administrative activities.
For the year ended December 31, 2005, Nortel recorded
special charges of $177, which included revisions of $7, related
to prior accruals.
Workforce reduction charges of $68 were related to severance and
benefit costs associated with 954 employees notified of
termination during the year ended December 31, 2005. The
workforce reduction provision balance was drawn down by cash
payments of $167 during 2005. The workforce reduction was
primarily in the U.S., Canada and EMEA and extended across all
segments. The remaining provision is expected to be
substantially drawn down by the end of the first half of 2006.
Contract settlement and lease costs of $78 included revisions to
prior accruals of $6 and consisted of negotiated settlements to
cancel or renegotiate contracts and net lease charges related to
leased facilities (comprised of office space) and leased
furniture that were identified as no longer required primarily
in the U.S. and EMEA and in the Carrier Packet Networks and
Enterprise Networks segments. These lease costs, net of
anticipated sublease income, included costs relating to
non-cancelable lease terms from the date leased facilities
ceased to be used and termination penalties. During 2005, the
provision balance for contract settlement and lease costs was
drawn down by cash payments of $13. The remaining provision, net
of approximately $32 in estimated sublease income, is expected
to be substantially drawn down by the end of 2018.
Plant and equipment charges of $31 were related to current
period write downs to fair value less costs to sell owned
facilities and plant and manufacturing related equipment.
Included in these charges were revisions of $1 related to prior
write downs of assets held for sale related primarily to
adjustments to original plans or estimated amounts for certain
facility closures.
For the year ended December 31, 2004, Nortel recorded total
special charges of $165.
Workforce reduction charges of $163 were related to severance
and benefit costs associated with approximately 1,850 employees,
of which 1,800 had been notified of termination during 2004. The
remaining charge related to termination benefits attributable to
ongoing employee benefit arrangements. The workforce reduction
was primarily in the U.S., Canada and EMEA and extended across
all segments.
During the year ended December 31, 2004, the workforce
reduction provision balance was drawn down by cash payments of
$38.
Plant and equipment charges of $2 were related to current period
write downs to fair value less costs to sell for various
leasehold improvements and excess equipment held for sale.
157
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
2004 Restructuring Plan — by Segment
The following table outlines special charges incurred by segment
for each of the two years ended December 31:
For the year ended December 31, 2005, Nortel recorded
revisions of $(7), of which $(5) related to revisions of prior
accruals for workforce reductions.
The workforce reduction provision balance was drawn down by cash
payments of $6 during 2005. The remaining provision is expected
to be substantially drawn down by the end of 2006.
Revisions of $1 were recorded during the period related to prior
contract settlement and lease costs. The provision balance for
contract settlement and lease costs was drawn down by cash
payments of $107. The remaining provision, net of approximately
$183 in estimated sublease income, is expected to be
substantially drawn down by the end of 2013.
No new plant and equipment charges were incurred during 2005.
Revisions of $(3) to prior write downs of assets held for sale
related primarily to adjustments to original plans or estimated
amounts for certain facility closures.
For the year ended December 31, 2004, Nortel recorded total
special charges of $16, which included revisions of $9 related
to prior accruals.
Workforce reduction charges of $7 were related to severance and
benefit costs associated with approximately 80 employees
notified of termination. The workforce reduction occurred in
Canada and related entirely to Carrier Packet Networks.
Offsetting these charges were revisions to prior accruals of $4
which were primarily related to termination benefits where
actual costs were lower than the estimated amounts across all
segments. During 2004, the workforce reduction provision balance
was drawn down by cash payments of $49.
No new contract settlement and lease costs were incurred during
2004. Revisions to prior accruals of $13 resulted primarily from
changes in estimates for sublease income and costs to vacate
certain properties, across all segments. During 2004, the
provision balance for contract settlement and lease costs was
drawn down by cash payments of $167. The remaining provision,
net of approximately $248 in estimated sublease income, is
expected to be substantially drawn down by the end of 2013.
No new plant and equipment charges were incurred during 2004.
158
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
The table below summarizes the total costs estimated to be
incurred as a result of the exit activities initiated in 2003,
which have met the criteria described in SFAS 146, the
balance of these accrued expenses as of December 31, 2005
and the movement in the accrual for the year ended
December 31, 2005. These costs are included in the
provision balance above for the 2001 Restructuring Plan as of
December 31, 2005.
Total estimated costs, net of estimated sublease income,
associated with these accruals are $69, of which $19 was drawn
down by cash payments of $21 and non-cash adjustments of $(2)
prior to January 1, 2005.
For the year ended December 31, 2003, Nortel recorded total
special charges of $288, which were net of revisions of $53
related to prior accruals.
Workforce reduction charges of $199 were related to severance
and benefit costs associated with approximately
1,800 employees notified of termination. The workforce
reduction was primarily in the U.S., Canada and EMEA and
extended across all segments. Offsetting these charges were
revisions to prior accruals of $44 which were primarily related
to termination benefits where actual costs were lower than the
estimated amounts across all segments. During 2003, the
workforce reduction provision balance was drawn down by cash
payments of $274 and by a non-cash pension settlement loss of
$41.
Contract settlement and lease costs of $68 consisted of
negotiated settlements to cancel or renegotiate contracts and
net lease charges related to leased facilities (comprised of
office, warehouse and manufacturing space) and leased furniture
that were identified as no longer required across all segments.
These lease costs, net of anticipated sublease income, included
non-cancelable lease terms from the date leased facilities
ceased to be used and termination penalties. In addition to
these charges were revisions to prior accruals of $19 resulting
primarily from changes in estimates for sublease income and
costs to vacate certain properties, across all segments. During
2003, the provision balance for contract settlement and lease
costs was drawn down by cash payments of $275.
Plant and equipment charges of $74 were largely related to
current period write downs to fair value less costs to sell for
various leasehold improvements and excess Carrier Packet
Networks equipment held for sale. Offsetting these charges were
revisions of $28 to prior write downs of assets held for sale
related primarily to adjustments to original plans or estimated
amounts for certain facility closures.
159
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
2001 Restructuring Plan — by Segment
The following table outlines special charges incurred by segment
for each of the three years ended December 31:
As described in note 6, segment Management EBT does not
include special charges. A significant portion of Nortel’s
provisions for workforce reductions and contract settlement and
lease costs are associated with shared services. These costs
have been allocated to the segments in the table above based
generally on headcount.
8. Income taxes
As of December 31, 2005, Nortel’s net deferred tax
assets, excluding discontinued operations, were $3,902,
reflecting temporary differences between the financial reporting
and tax treatment of certain current assets and liabilities and
non-current assets and liabilities, in addition to the tax
benefit of net operating and capital loss carry forwards and tax
credit carry forwards.
In accordance with SFAS No. 109, “Accounting for
Income Taxes” (“SFAS 109”), Nortel reviews
all available positive and negative evidence to evaluate the
recoverability of the deferred tax assets. This includes a
review of such evidence as the carry forward periods of the
significant tax assets, Nortel’s history of generating
taxable income in its material tax jurisdictions, Nortel’s
cumulative profits or losses in recent years, and Nortel’s
forecast of earnings in its material jurisdictions. On a
jurisdictional basis, Nortel is in a cumulative loss position in
certain of its material jurisdictions. For these jurisdictions,
Nortel continues to maintain a valuation allowance against a
portion of its deferred income tax assets. Nortel has concluded
that it is more likely than not that the remaining deferred tax
assets in these jurisdictions will be realized.
Nortel is subject to ongoing examinations by certain tax
authorities of the jurisdictions in which it operates. Nortel
regularly assesses the status of these examinations and the
potential for adverse outcomes to determine the adequacy of the
provision for income and other taxes. Nortel believes that it
has adequately provided for tax adjustments that are probable as
a result of any ongoing or future examinations.
Specifically, the tax authorities in Brazil have completed an
examination of prior taxation years and have issued assessments
in the amount of $56. Nortel is currently in the process of
appealing these assessments and believes that it has adequately
provided for tax adjustments that are probable as a result of
the outcome of the ongoing appeals process.
160
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
In addition, the tax authorities in France have issued two
preliminary notices of proposed assessment in respect of the
2001 and 2002 taxation years. These assessments collectively
propose adjustments to taxable income of approximately $800 as
well as certain adjustments to withholding and other taxes of
approximately $50 plus applicable interest and penalties. Other
than the withholding and other taxes, Nortel has sufficient loss
carry forwards to absorb the entire amount of the proposed
assessment. However, no amount has been provided for these
assessments since Nortel believes that the proposed assessments
are without merit and any potential tax adjustments that could
result from these ongoing examinations cannot be quantified at
this time.
Nortel had previously entered into Advance Pricing Arrangements
(“APAs”) with the taxation authorities of the U.S. and
Canada in connection with its intercompany transfer pricing and
cost sharing arrangements between Canada and the U.S. These
arrangements expired in 1999 and 2000. In 2002, Nortel filed APA
requests with the taxation authorities of the U.S., Canada and
the United Kingdom (“U.K.”) that applied to the
taxation years beginning in 2000. The APA requests are currently
under consideration but the tax authorities have not begun to
negotiate the terms of the arrangements. Nortel has applied the
transfer pricing methodology proposed in the APA requests in
preparing its tax returns and accounts beginning in 2001.
As part of the APA applications, Nortel has requested that the
methodology adopted in 2001 be applied retroactively to the 2000
taxation year. Such retroactive application would result in an
increase in taxable income in certain jurisdictions offset by an
equal decrease in taxable income in the other jurisdictions.
Nortel had previously concluded that it was probable that the
retroactive application of the proposed methodology would be
accepted by the tax authorities and prepared its income tax
estimates (both current and deferred taxes) on the basis that
the 2000 taxation year would be governed by the APA submission.
As a result, Nortel had previously provided approximately $140
for taxes and interest in various tax jurisdictions that would
be due as a result of retroactive application of the APA. In the
fourth quarter of 2005, Nortel obtained new information and as a
result can no longer conclude that it is probable that the APA
will be retroactively applied. Nortel has recalculated its
current and deferred tax balances assuming the 2000 tax year
would not be subject to the retroactive application of the APA.
As a result, the gross deferred income tax balances in its
material jurisdictions were recalculated on an as filed basis,
and the liability of $140 for taxes and interest that was
previously accrued was released in the fourth quarter of 2005.
The outcome of the APA applications is uncertain and possible
additional losses, as they relate to the APA negotiations,
cannot be determined at this time. However, Nortel does not
believe it is probable that the ultimate resolution of these
negotiations will have a material adverse effect on its
consolidated financial position, results of operations or cash
flows. Despite Nortel’s current belief, if this matter is
resolved unfavorably, it could have a material adverse effect on
Nortel’s consolidated financial position, results of
operations and cash flows.
161
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
The following is a reconciliation of income taxes, calculated at
the Canadian combined federal and provincial income tax rate, to
the income tax benefit (expense) included in the consolidated
statements of operations for each of the years ended
December 31:
2005
2004
2003
Income taxes at Canadian rates
(2005 — 34.5%, 2004 — 33.3%,
2003 — 35.8%)
$
892
$
80
$
(48
)
Difference between Canadian rates and rates applicable to
subsidiaries in the U.S. and other jurisdictions
34
(2
)
(23
)
Valuation allowances on tax benefits
(138
)
(203
)
(16
)
Utilization of losses
18
2
98
Tax benefit of investment tax credits, net of valuation allowance
39
43
41
Shareholder litigation settlement
(854
)
—
—
Adjustments to provisions and reserves
141
25
29
Foreign withholding and other taxes
(13
)
(14
)
(13
)
Corporate minimum taxes
(14
)
(8
)
(9
)
Impact of non-taxable/(non-deductible) items and other
differences
(49
)
107
24
Income tax benefit (expense)
$
56
$
30
$
83
Details of Nortel’s income (loss):
Earnings (loss) from continuing operations before income taxes,
minority interests and equity in net loss of associated
companies:
Canadian, excluding gain (loss) on sale of businesses and assets
$
(2,622
)
$
(306
)
$
(242
)
U.S. and other, excluding gain (loss) on sale of businesses and
assets
83
(25
)
372
Gain (loss) on sale of businesses and assets
(47
)
91
4
$
(2,586
)
$
(240
)
$
134
Income tax benefit (expense):
Canadian, excluding gain (loss) on sale of businesses and assets
$
21
$
16
$
188
U.S. and other, excluding gain (loss) on sale of businesses and
assets
35
14
(105
)
$
56
$
30
$
83
Income tax benefit (expense):
Current
$
(23
)
$
(16
)
$
30
Deferred
79
46
53
Income tax benefit (expense)
$
56
$
30
$
83
Details of movement in valuation allowance
Opening Valuation Allowance
$
(3,717
)
$
(3,416
)
$
(3,046
)
Amounts charged to income tax benefit (expense)
(116
)
(201
)
82
Amounts charged to other comprehensive loss
(72
)
(57
)
(20
)
Other
(additions)/deductions(a)
495
(43
)
(432
)
Closing Valuation Allowance
$
(3,410
)
$
(3,717
)
$
(3,416
)
(a)
Other additions and deductions represent the net impacts of
foreign exchange, deferred tax assets that expired during the
period, tax rate changes, and tax return and other adjustments.
162
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
The following table shows the significant components included in
deferred income taxes as of December 31:
2005
2004
Assets:
Tax benefit of loss carryforwards
$
4,433
$
4,990
Investment tax credits, net of deferred tax liability
1,174
1,123
Provisions and reserves
786
734
Post-retirement benefits other than pensions
306
255
Plant and equipment
96
133
Pension plan liabilities
610
442
Deferred compensation
256
208
7,661
7,885
Valuation allowance
(3,410
)
(3,717
)
4,251
4,168
Liabilities:
Provisions and reserves
109
157
Plant and equipment
34
—
Unrealized foreign exchange and other
206
162
349
319
Net deferred income tax assets
$
3,902
$
3,849
No deferred income tax asset has been recorded at this time with
respect to any tax benefit relating to the proposed shareholder
litigation settlement (see notes 22 and 23) since the
amount of the settlement that is deductible for income tax
purposes cannot be reasonably determined until such time as the
definitive agreements have been concluded.
Nortel has not provided for foreign withholding taxes or
deferred income tax liabilities for temporary differences
related to the undistributed earnings of foreign subsidiaries
since Nortel does not currently expect to repatriate these
earnings. It is not practical to reasonably estimate the amount
of additional deferred income tax liabilities or foreign
withholding taxes that may be payable should these earnings be
distributed in the future.
As of December 31, 2005, Nortel had the following net
operating and capital loss carryforwards and tax credits which
are scheduled to expire in the following years:
Net
Operating
Capital
Tax
Losses
Losses(a)
Credits(b)
Total
2006 - 2008
$
135
$
1
$
322
$
458
2009 - 2011
1,594
—
643
2,237
2012 - 2018
674
11
368
1,053
2019 - 2025
2,682
—
235
2,917
Indefinitely
2,669
4,436
33
7,138
$
7,754
$
4,448
$
1,601
$
13,803
(a)
The capital losses related primarily to the U.K. and may only be
used to offset future capital gains. Nortel has recorded a full
valuation allowance against this future tax benefit.
(b)
Global investment tax credits of $39, $43 and $41 have been
applied against the income tax provision in 2005, 2004 and 2003,
respectively. Unused tax credits can be utilized to offset
deferred taxes payable primarily in Canada.
9. Employee benefit plans
Nortel maintains various retirement programs covering
substantially all of its employees, consisting of defined
benefit, defined contribution and investment plans.
Nortel has four kinds of capital accumulation and retirement
programs: balanced capital accumulation and retirement programs
(the “Balanced Program”) and investor capital
accumulation and retirement programs (the “Investor
Program”) available to substantially all of its North
American employees; flexible benefits plan, which includes a
group
163
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
personal pension plan (the “Flexible Benefits Plan”),
available to substantially all of its employees in the U.K.; and
traditional capital accumulation and retirement programs that
include defined benefit pension plans (the “Traditional
Program”) which are closed to new entrants in the U.K. and
portions of which are closed to new entrants in the U.S. and
Canada. Although these four kinds of programs represent
Nortel’s major retirement programs and may be available to
employees in combination and/or as options within a program,
Nortel also has smaller pension plan arrangements in other
countries.
Nortel also provides other benefits, including post-retirement
benefits and post-employment benefits. Employees in the
Traditional Program are eligible for their existing company
sponsored post-retirement benefits or a modified version of
these benefits, depending on age or years of service. Employees
in the Balanced Program are eligible for post-retirement
benefits at reduced company contribution levels, while employees
in the Investor Program have access to post-retirement benefits
by purchasing a Nortel-sponsored retiree health care plan at
their own cost.
Nortel’s policy is to fund defined benefit pension and
other benefits based on accepted actuarial methods as permitted
by regulatory authorities. The funded amounts reflect actuarial
assumptions regarding compensation, interest and other
projections. Pension and other benefit costs reflected in the
consolidated statements of operations are based on the projected
benefit method of valuation. A measurement date of
September 30 is used annually to determine pension and
other post-retirement benefit measurements for the pension plans
and other post-retirement benefit plans that make up the
majority of plan assets and obligations.
In 2005, the impact of reductions in discount rates more than
offset the favorable impacts of strong pension asset returns and
the contributions made by Nortel. As a result, Nortel was
required to adjust the minimum pension liability for certain
plans, representing the amount by which the accumulated benefit
obligation less the fair value of the plan assets was greater
than the recorded liability. The effect of this adjustment and
the related foreign currency translation adjustment was to
increase accumulated other comprehensive loss (before tax) by
$216, decrease intangible assets by $3 and increase pension
liabilities by $213.
164
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
The following details the unfunded status of the defined benefit
plans and post-retirement benefits other than pensions, and the
associated amounts recognized in the consolidated balance sheets
as of December 31:
Post-Retirement
Defined Benefit Plans
Benefits
2005
2004
2005
2004
Change in benefit obligation:
Benefit obligation — beginning
$
8,311
$
7,378
$
719
$
754
Service cost
123
122
8
9
Interest cost
458
422
42
43
Plan participants’ contributions
6
8
8
8
Plan amendments
3
1
—
(22
)
Actuarial loss (gain)
835
398
82
(57
)
Acquisitions/divestitures/settlements
9
—
—
—
Special and contractual termination benefits
21
7
—
—
Curtailments
9
—
(1
)
—
Benefits paid
(541
)
(506
)
(43
)
(43
)
Foreign exchange
(282
)
481
19
27
Benefit obligation — ending
$
8,952
$
8,311
$
834
$
719
Change in plan assets:
Fair value of plan assets — beginning
$
6,105
$
5,415
$
—
$
—
Actual return on plan assets
919
542
—
—
Employer contributions
174
284
35
35
Plan participants’ contributions
6
8
8
8
Acquisitions/divestitures/settlements
(4
)
—
—
—
Special termination benefits
—
2
—
—
Benefits paid
(541
)
(506
)
(43
)
(43
)
Foreign exchange
(203
)
360
—
—
Fair value of plan assets — ending
$
6,456
$
6,105
$
—
$
—
Unfunded status of the plans
$
(2,496
)
$
(2,206
)
$
(834
)
$
(719
)
Unrecognized prior service cost (credit)
16
18
(44
)
(48
)
Unrecognized net actuarial losses (gains)
2,125
1,955
129
44
Contributions after measurement date
40
34
4
8
Net amount recognized
$
(315
)
$
(199
)
$
(745
)
$
(715
)
Amounts recognized in the accompanying consolidated balance
sheets consist of:
Other liabilities — long-term
$
(1,533
)
$
(1,508
)
$
(725
)
$
(686
)
Other liabilities — current
(332
)
(93
)
(20
)
(29
)
Intangible assets — net
37
40
—
—
Other assets
2
1
—
—
Foreign currency translation adjustment
163
229
—
—
Accumulated other comprehensive loss
1,348
1,132
—
—
Net amount recognized
$
(315
)
$
(199
)
$
(745
)
$
(715
)
The following details selected information for defined benefit
plans, all of which have accumulated benefit obligations in
excess of the fair value of plan assets as of December 31:
2005
2004
Projected benefit obligation
$
8,938
$
8,293
Accumulated benefit obligation
$
8,312
$
7,692
Fair value of plan assets
$
6,438
$
6,086
165
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
The following details the net pension expense, all related to
continuing operations, and the underlying assumptions for the
defined benefit plans for the years ended December 31:
2005
2004
2003
Pension expense:
Service cost
$
123
$
122
$
122
Interest cost
458
422
401
Expected return on plan assets
(427
)
(411
)
(395
)
Amortization of prior service cost
2
4
9
Amortization of net losses
97
77
50
Settlement losses
—
—
41
Curtailment losses
12
—
—
Special and Contractual termination benefits
21
7
8
Net pension expense
$
286
$
221
$
236
Weighted-average assumptions used to determine benefit
obligations as of December 31:
Discount rate
5.1
%
5.7
%
5.8
%
Rate of compensation increase
4.4
%
4.5
%
4.2
%
Weighted-average assumptions used to determine net pension
expense for years ended December 31:
Discount rate
5.7
%
5.8
%
6.3
%
Expected rate of return on plan assets
7.4
%
7.4
%
7.8
%
Rate of compensation increase
4.5
%
4.2
%
4.2
%
The following details the amounts included within other
comprehensive income (loss) for the years ended December 31:
Defined Benefit
Plans
2005
2004
Increase in minimum pension liability adjustment included in
other comprehensive income (loss)
$
216
$
117
The following details the net cost components, all related to
continuing operations, and underlying assumptions of
post-retirement benefits other than pensions for the years ended
December 31:
2005
2004
2003
Post-retirement benefit cost:
Service cost
$
8
$
9
$
9
Interest cost
42
43
40
Expected return on plan assets
—
—
—
Amortization of net losses (gains)
—
2
(1
)
Amortization of prior service cost
(4
)
(3
)
(3
)
Net post-retirement benefit cost
$
46
$
51
$
45
Weighted-average assumptions used to determine benefit
obligations as of December 31:
Discount rate
5.4
%
5.9
%
6.0
%
Weighted-average assumptions used to determine net
post-retirement benefit cost for years ended
December 31:
Discount rate
5.9
%
6.0
%
6.8
%
Weighted-average health care cost trend rate
7.8
%
8.3
%
8.5
%
Weighted-average ultimate health care cost trend rate
4.8
%
4.8
%
4.8
%
166
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Assumed health care cost trend rates have a significant effect
on the amounts reported for health care plans. A one percentage
point change in assumed health care cost trend rates would have
the following effects for the years ended December 31:
2005
2004
2003
Effect on aggregate of service and interest costs
1% increase
$
5
$
5
$
5
1% decrease
$
(4
)
$
(4
)
$
(4
)
Effect on accumulated post-retirement benefit obligations
1% increase
$
86
$
67
$
66
1% decrease
$
(70
)
$
(55
)
$
(55
)
As of December 31, 2005, the expected benefit payments for
the next ten years for the defined benefit plans and the
post-retirement benefits other than pensions are as follows,
along with the expected reimbursement amounts related to the
Medicare Prescription Drug, Improvement and Modernization Act of
2003 (the “MPDIM Act”):
Expected
MPDIM Subsidy
Defined Benefit
Post-Retirement
(Post-Retirement
Plans
Benefit Plans
Benefit Plans)
2006
$
490
$
41
$
(1
)
2007
459
43
(1
)
2008
470
45
(1
)
2009
485
46
(1
)
2010
501
48
(1
)
2011 - 2015
2,797
253
(8
)
The target allocation percentages and the year-end percentages
based on actual asset balances of the defined benefit plans as
of December 31 are as follows:
2005
2004
Target
Actual
Target
Actual
Debt instruments
43
%
41
%
41
%
40
%
Equity securities
56
%
57
%
59
%
59
%
Other
1
%
2
%
0
%
1
%
The primary investment performance objective is to obtain
competitive rates of return on investments at or above their
assigned benchmarks while minimizing risk and volatility by
maintaining an appropriately diversified portfolio. The
benchmarks selected are industry-standard and widely-accepted
indices. The defined benefit plans maintain a long-term
perspective in regard to investment philosophy and return
expectations which are reflective of the fact that the
liabilities of the defined benefit plans mature over an extended
period of time. The investments have risk characteristics
consistent with underlying defined benefit plan demographics and
liquidity requirements, and are consistent and compliant with
all regulatory standards.
The primary method of managing risk within the portfolio is
through diversification among and within asset categories, and
through the utilization of a wide array of active and passive
investment managers. Broadly, the assets are allocated between
debt and equity instruments. Included within the debt
instruments are government and corporate fixed income
securities, money market securities, mortgage-backed securities
and inflation indexed securities. Generally, these debt
instruments are considered investment grade. Included in equity
securities are developed and emerging market stocks of companies
at a variety of capitalization levels. The securities are
predominantly publicly traded. The amount of employer and
related-party securities that the defined benefit plans may hold
is governed by the statutory limitations of the jurisdictions of
the applicable plans. Included in equity securities of the
defined benefit plans are common shares of Nortel Networks
Corporation, held directly or through pooled funds, with an
aggregate market value of $5 (0.1 percent of total plan
assets) and $11 (0.2 percent of total plan assets) as of
December 31, 2005 and 2004, respectively.
As a policy, assets within the defined benefit plans are
reviewed to the target allocations at least on a quarterly basis
and adjustments made as appropriate. The plans commission
periodic asset and liability studies to determine the optimal
allocation of the portfolio’s assets. These studies
consider a variety of the plan characteristics, including
membership,
167
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
benefits and liquidity needs, and utilize mean-variance analysis
of historic and projected investment returns to develop a range
of acceptable asset mixes among a variety of asset classes.
To develop the expected long-term rate of return on assets
assumption, Nortel considered the weighted-average historical
returns and the future expectations for returns for each asset
class.
Nortel expects to make cash contributions of approximately $335
in 2006 to the defined benefit plans, including a portion
related to a pension funding agreement in the United Kingdom
that requires additional contributions through April 2007 and
approximately $20 in 2006 to the post-retirement benefit plans.
Nortel currently is in discussions with the Trustee of
Nortel’s pension plan in the U.K. to establish a long term
funding agreement which would increase the level of 2006
contributions.
Under the terms of the Balanced Program, Investor Program and
Traditional Program, eligible employees may contribute a portion
of their compensation to an investment plan. Based on the
specific program that the employee is enrolled in, Nortel
matches a percentage of the employee’s contributions up to
a certain limit. The cost of these investment plans was $67, $75
and $73 for the years ended December 31, 2005, 2004 and
2003, respectively.
Under the terms of the Balanced Program and Flexible Benefits
Plan, Nortel contributes a fixed percentage of employees’
eligible earnings to a defined contribution plan arrangement.
The cost of these plan arrangements was $20, $20 and $17 for the
years ended December 31, 2005, 2004 and 2003, respectively.
10. Acquisitions, divestitures
and closures
Acquisitions
PEC Solutions, Inc.
On June 3, 2005, Nortel Networks Inc. (“NNI”), an
indirect subsidiary of Nortel, indirectly acquired approximately
26,693,725 shares of PEC Solutions, Inc. (“PEC”)
representing approximately 95.6 percent of the outstanding
shares of common stock of PEC, through a cash tender offer at a
price of $15.50 per share. The aggregate cash consideration
in connection with the acquisition of PEC (including $33 paid on
June 9, 2005, with respect to stock options) was
approximately $449, including estimated costs of acquisition of
$8. Nortel acquired more than 90 percent of the outstanding
shares of PEC pursuant to the tender offer. Any shares that were
not purchased in the tender offer ceased to be outstanding and
were converted into the right to receive cash in the amount of
$15.50 per share.
PEC (now Nortel Government Solutions, Incorporated) provides
professional technology services that enable government entities
to use the Internet to enhance productivity and improve services
to the public. PEC’s primary customers are executive
agencies and departments of the U.S. Federal Government,
the U.S. Federal Judiciary and prime contractors to the
U.S. government. Nortel expects the PEC acquisition to
allow Nortel to pursue opportunities in areas that complement
Nortel’s existing products and to increase its
competitiveness in the government market. In order to comply
with the U.S. National Industrial Security Program and to
mitigate foreign ownership, control or influence, voting control
of PEC must be vested in citizens of the U.S. Accordingly,
proxy holders for Nortel’s shares of PEC have been
appointed and approved by the U.S. Defense Security
Service. In accordance with a proxy agreement executed in July
2005, the proxy holders exercise all prerogatives of ownership
with complete freedom to act independently and have assumed full
responsibility for the voting stock. Notwithstanding, for
accounting purposes, Nortel has determined that PEC is a VIE,
and Nortel is the primary beneficiary (see note 15).
This acquisition was accounted for using the purchase method.
Nortel has recorded approximately $278 of non-amortizable
intangible assets associated with the acquisition of PEC, which
assets consist solely of goodwill. The goodwill of PEC is not
deductible for tax purposes, and has been allocated to
Nortel’s Enterprise Networks segment.
The allocation of the purchase price presented below is based on
management’s best estimate of the relative values of the
assets acquired and liabilities assumed in the PEC acquisition.
168
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
The following table sets out the purchase price allocation
information for the PEC acquisition.
Purchase price
$
449
Assets acquired:
Cash and cash equivalents
$
26
Accounts receivable — net
65
Other current assets
34
Investments
8
Plant and equipment — net
32
Intangible assets — net
84
Goodwill
278
Other assets
5
532
Less liabilities assumed:
Trade and other accounts payable
6
Payroll and benefit-related liabilities
24
Other accrued liabilities
17
Long-term debt
33
Other liabilities
3
83
Fair value of net assets acquired
$
449
As a result of the acquisition of PEC, a net deferred tax
liability of $23 was recognized, due to differences between the
estimated fair value of assets acquired and liabilities assumed,
and PEC’s tax basis in those assets and liabilities. This
deferred tax liability is fully offset, however, by an
adjustment to Nortel’s deferred tax valuation allowance
because Nortel will be able to offset the tax liability by
drawing down previously unrecognized loss carryforwards.
The estimated fair values and amortization periods of other
intangible assets are as follows:
The consolidated financial statements of Nortel include
PEC’s operating results from the date of the acquisition.
The following unaudited pro forma information presents a summary
of consolidated results of operations of Nortel and PEC as if
the acquisition had occurred on January 1, 2004, with pro
forma adjustments to give effect to amortization of intangible
assets and certain other adjustments:
2005
2004
Revenues
$
10,632
$
9,723
Net earnings (loss)
$
(2,584
)
$
(196
)
Basic earnings (loss) per common share
$
(0.60
)
$
(0.05
)
Diluted earnings (loss) per common share
$
(0.60
)
$
(0.05
)
LG-Nortel Co. Ltd. Joint Venture
On November 3, 2005, Nortel entered into a joint venture
with LG Electronics Inc. (“LG”) named LG-Nortel Co.
Ltd. (“LG-Nortel”). LG-Nortel combines the
telecommunications infrastructure business of LG with
Nortel’s South Korean distribution and services business to
offer telecom and networking solutions to customers in the
Republic of Korea and other markets globally. Nortel acquired
approximately 1,000,001 common shares of LG-Nortel, which
represents ownership of 50 percent plus one share of the
common shares of the joint venture in exchange for consideration
consisting principally of cash and its South Korean distribution
and services business totaling approximately $155.
169
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Separately, LG will be entitled to payments from Nortel over a
two-year period based on achievement by LG-Nortel of certain
business goals, up to a maximum of $80. In conjunction with the
formation of the joint venture, certain related party agreements
were entered into between LG-Nortel and LG including those for
the supply of equipment and between LG-Nortel and Nortel
including those for product distribution, service supply and
R&D services.
The aggregate purchase price for Nortel’s interest in
LG-Nortel is approximately $155, including estimated costs of
acquisition of $10. The allocation of the purchase price
presented below is based on management’s current best
estimate of the relative values of the assets acquired and
liabilities assumed in LG-Nortel. However, because a full
valuation of those assets and liabilities has not yet been
finalized, the final allocation of the purchase price may differ
from the allocation presented below, and the difference may be
material. Any contingent payments would be recorded as an
adjustment to the purchase price.
The following table sets out the preliminary purchase price
allocation information for LG-Nortel.
Purchase price
$
155
Assets acquired:
Accounts receivable — net
$
186
Other current assets
5
Investments
9
Plant and equipment — net
20
Intangible assets — net
26
Goodwill
64
Other assets
37
347
Less liabilities assumed:
Trade and other accounts payable
20
Payroll and benefit-related liabilities
12
Other accrued liabilities
14
Minority interests in subsidiary companies
146
192
Fair value of net assets acquired
$
155
The preliminary estimates of the fair values and amortization
periods of other intangible assets are as follows:
Amortization
Fair Value
Period (Years)
Patents
$
26
10
LG-Nortel is being consolidated under FIN 46R as Nortel has
determined that LG-Nortel is a VIE, and Nortel is the primary
beneficiary (see note 15). The consolidated financial
statements of Nortel include the operating results of
LG-Nortel from
November 3, 2005, the date of the formation of the joint
venture.
Nortel Networks Germany and Nortel Networks France
On October 19, 2002, Nortel, through various subsidiaries,
entered into a number of put option and call option agreements
as well as a share exchange agreement with European Aeronautic
Defence and Space Company EADS N.V. (“EADS”), its
partner at that time in three European joint ventures. The
written options were marked to fair value through the
consolidated statements of operations at each period end until
they were exercised. At December 31, 2002, Nortel estimated
the fair value of the written options to be approximately $81,
which was included within other accrued liabilities, and the
corresponding loss was recorded in other income
(expense) — net during the year ended
December 31, 2002. A further mark to fair value adjustment
and loss of $18 was recorded during the year ended
December 31, 2003. The purchased options and the share
exchange were initially recorded at fair value and were assessed
for impairment throughout their term until they were exercised
or expired. The estimated fair values of the options were based
on an estimate of the current fair values of the respective
joint ventures using an option-pricing model that is dependent
on the assumptions used concerning the amount of volatility and
the discount rates that reflect varying degrees of risk.
170
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
On July 1, 2003, EADS exercised its put option to sell its
minority interest of 45 percent in Nortel Networks France
S.A.S. (“NNF”) to Nortel. On July 18, 2003,
Nortel exercised its call option and share exchange rights to
acquire the minority interest held by EADS of 42 percent in
Nortel Networks Germany GmbH & Co. KG (“NNG”)
and to sell Nortel’s equity interest of 41 percent in
EADS Telecom S.A.S., formerly EADS Defence and Security Networks
S.A.S. (“EADS Telecom”) to EADS. The transactions were
completed on September 18, 2003.
During the three months ended September 30, 2003, Nortel
recorded the acquisitions of the minority interests of NNF and
NNG based on preliminary valuation estimates totaling $241. The
purchase price of $241 included $58 of cash, an in-kind
component of approximately $82 representing the return of a loan
note that was owed to Nortel by EADS Telecom and the remaining
shares of EADS Telecom held by Nortel. The allocation of the
purchase price resulted in the elimination of $23 of minority
interest, settlement of a net liability of $94 related to the
put and call options and an increase of approximately $45 in
intangible assets and $79 in goodwill. The intangible assets of
approximately $45 related primarily to customer contracts and
customer relationships and are being amortized based on their
expected pattern of benefit to future periods using estimates of
undiscounted cash flows, and were included in intangible assets
on the consolidated balance sheet as of December 31, 2003.
The sale of Nortel’s 41 percent interest in EADS
Telecom resulted in the receipt of cash of $12 and a reduction
in equity investments of $23. As a result of this transaction,
Nortel recognized a gain of $79 which is included in other
income (expense) — net for the year ended
December 31, 2003. Except as noted below, there was no
additional impact on the results of operations and financial
condition, as NNF and NNG were already included in the
consolidated results.
During the three months ended December 31, 2003, the
valuation report for NNF and NNG was completed by a third party
appraiser. As a result of the finalization of this valuation, an
additional gain of $17 was recorded with a corresponding
increase in goodwill on the transaction (see note 5 for
goodwill by reportable segment).
Divestitures
Manufacturing operations
On June 29, 2004, Nortel entered into an agreement with
Flextronics, regarding the divestiture of substantially all of
Nortel’s remaining manufacturing operations and related
activities, including certain product integration, testing,
repair operations, supply chain management, third party
logistics operations and design assets.
Nortel and Flextronics have also entered into a four-year supply
agreement for manufacturing services (whereby after completion
of the transaction, Flextronics will manage approximately $2,500
of Nortel’s annual cost of revenues) and a three-year
supply agreement for design services. Commencing in the fourth
quarter of 2004 and throughout 2005, Nortel completed the
transfer to Flextronics of certain of Nortel’s optical
design activities in Ottawa, Canada and Monkstown, Northern
Ireland and the manufacturing activities in Montreal, Canada and
Chateaudun, France. In order to allow completion of several
major information systems changes that are expected to simplify
and improve the quality of operations during the transition,
Nortel now expects to transfer the remaining manufacturing
operations in Calgary, Canada to Flextronics by the end of the
second quarter of 2006. Nortel and Flextronics have agreed that
Nortel will retain its Monkstown manufacturing operations and
establish a regional supply chain center to lead Nortel’s
EMEA supply chain operations. Nortel expects that the decision
to retain its Monkstown manufacturing operations will result in
a reduction of estimated cash proceeds from assets divested of
approximately $100.
The successful completion of the agreement with Flextronics will
result in the transfer of approximately 2,100 employees to
Flextronics, of which approximately 1,450 were transferred as of
December 31, 2005. Nortel expects gross cash proceeds
ranging between $575 and $625, of which approximately $380 has
been received as of December 31, 2005 partially offset by
cash outflows incurred to date and expected to be incurred in
2006 attributable to direct transaction costs and other costs
associated with the transaction. These proceeds will be subject
to a number of adjustments, including potential post-closing
date asset valuations and potential post-closing indemnity
payments. Any net gain on the sale of this business will be
recognized once substantially all of the risks and other
incidents of ownership have been transferred.
As of December 31, 2005, Nortel had transferred
approximately $247 of inventory and equipment to Flextronics
relating to the transfer of the optical design activities in
Ottawa and Monkstown and the manufacturing activities in
Montreal and Chateaudun and recorded deferred income of
approximately $65. As Flextronics has the ability to exercise
rights to sell
171
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
back to Nortel certain inventory and equipment after the
expiration of a specified period (up to fifteen months)
following each respective transfer date, Nortel has retained
these assets on its balance sheet to the extent they have not
been consumed as part of ongoing operations as at
December 31, 2005. Nortel does not expect that rights will
be exercised with respect to any material amount of inventory
and/or equipment.
During the year ended December 31, 2005, Nortel recorded
charges through gain (loss) on sale of businesses and assets of
$40, related to this ongoing divestiture to Flextronics. The
charges relate to legal and professional fees, pension
adjustments and real estate impairments.
Directory and operator services business
On August 2, 2004, Nortel completed the contribution of
certain fixed assets, intangible assets including customer
contracts, software and other licenses, and liabilities of its
directory and operator services (“DOS”) business to
VoltDelta Resources LLC (“VoltDelta”), a wholly owned
subsidiary of Volt Information Sciences, Inc. (“VIS”),
in return for a 24 percent interest in VoltDelta which was
valued at $57. After a period of two years, Nortel and VIS
each have an option to cause Nortel to sell its VoltDelta shares
to VIS for proceeds ranging from $25 to $70. As a result of this
transaction, approximately 160 Nortel DOS employees in North
America and Mexico joined VoltDelta. This non-monetary exchange
was recorded at fair value, and Nortel recorded a gain of $30
within sale of businesses and assets during 2004.
On December 28, 2005, VoltDelta entered into a Letter of
Agreement to repurchase the 24% minority interest held by
Nortel, for an approximate aggregate purchase price equal to
$62. The payment terms of the Letter of Agreement included
VoltDelta paying Nortel $25 on December 29, 2005, and
issuing a promissory note of $37 which was paid in full on
February 15, 2006. Nortel continues to provide transitional
services to VoltDelta over the initial agreement period of
ten years with no additional material financial impact to
Nortel. The sale resulted in a net gain of approximately $7.
Sale of Arris Group, Inc. investment
On November 24, 2003, Nortel sold 9 million shares of
Arris Group, Inc. (“Arris Group”) for cash
consideration of $49, which resulted in a gain of $31 reported
in other income (expense) — net. Following this
transaction, Nortel owned 5 million Arris Group common
shares or 6.6 percent of Arris Group outstanding common
shares (see note 20).
In March 2004, Nortel sold 1.8 million shares of Arris
Group for cash consideration of $17, which resulted in a gain of
$13, which was recorded in other income (expense) —
net. Following this transaction, Nortel owned 3.2 million
Arris Group common shares or 4.2 percent of Arris Group
outstanding common shares (see note 20).
During the second quarter of 2005, Nortel sold 3.2 million
common shares of Arris Group for net cash proceeds of $27 and
recorded a gain of $21 in other income (expense) —
net. As a result, Nortel no longer holds any equity interest in
Arris Group.
Optical components operations
On November 8, 2002, Nortel sold certain plant and
equipment, inventory, patents and other intellectual property
and trademarks relating to its optical components business to
Bookham, Inc. (“Bookham”). Included in the sale was
the transfer of Nortel’s transmitter and receiver, pump
laser and amplifier businesses located in Paignton, U.K.,
Harlow, U.K., Ottawa, Canada, Zurich, Switzerland and
Poughkeepsie, New York. Nortel also transferred approximately
1,200 employees to Bookham in the transaction. Nortel received
61 million common shares of Bookham, 9 million
warrants with a strike price of one-third pence Sterling, notes
receivable of $50 and cash of $10. The transaction included a
minimum purchase commitment with Bookham requiring Nortel to
purchase approximately $120 of product from Bookham between
November 8, 2002 and March 31, 2004.
During the three months ended September 30, 2002,
Nortel classified the assets sold to Bookham as held for sale
and assigned an estimated fair value of $47 to them resulting in
a charge of $123 ($89 to cost of revenues and $34 to special
charges). A subsequent increase in Bookham’s common share
price prior to the November 8, 2002 close date resulted in
an increase in the value assigned to the consideration received.
As a result, Nortel recorded a gain on sale of businesses and
assets of $29 during the year ended December 31, 2002.
172
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
As a result of the transaction, Nortel received a
29.8 percent ownership interest in Bookham. Due to
restrictions on Nortel’s ability to vote the common shares,
ability to appoint directors to the board or otherwise exercise
significant influence over Bookham, the investment has been
accounted for using the cost method.
During 2003, Nortel sold 30 million shares of Bookham for
cash proceeds of $32 and recorded a gain of $6 which is included
in other income (expense) — net for the year ended
December 31, 2003. As a result of this transaction, Nortel
reduced its ownership interest in Bookham to approximately
14 percent.
On December 2, 2004, Nortel and Bookham entered into a
restructuring agreement which, among other changes, extended the
maturity date of a senior secured note (the “Series B
Note”) by one year from November 8, 2005 to
November 8, 2006, and eliminated the conversion feature of
a senior unsecured note (the “Series A Note”).
Bookham also agreed to secure the Series A Note, provide
additional collateral for the Series A Note and the
Series B Note, and provide Nortel with other debt
protection covenants.
In February 2005, Nortel agreed to waive until November 6,2006 the requirement under the Series A Note and
Series B Note for Bookham to maintain a minimum cash
balance. In May 2005, Nortel entered into an amendment to adjust
the prepayment provisions of these notes and received additional
collateral for these notes. In May 2005, Nortel entered into an
amendment to its supply agreement with Bookham to include for a
twelve month period price increases for certain products, and
acceleration of certain planned purchase orders and invoice
payment terms. These May 2005 amendments were agreed to by
Nortel to provide Bookham with financial flexibility to continue
the supply of optical components for Nortel’s Carrier
Packet Networks products. These notes have been settled
subsequent to year end (see note 23). For further
information see note 21 and, relating to the Series A
Note and Series B Note, see note 23.
Other
On February 3, 2004, Nortel sold approximately
7 million common shares of Entrust Inc.
(“Entrust”) for cash consideration of $33, and
recorded a gain of $18 in other income (expense) —
net. As a result of this transaction, Nortel no longer holds any
equity interest in Entrust.
On May 7, 2004, Nortel received $80 in proceeds from the
sale of certain assets in connection with a customer contract
settlement in the CALA region. This resulted in a gain of $78,
which was included in (gain) loss on sale of businesses and
assets for the year ended December 31, 2004.
11. Long-term debt, credit and support facilities
Long-term
debt
The following table shows the components of long-term debt as of
December 31:
Other long-term debt with various repayment terms and a
weighted-average interest rate of 5.65% for 2005 and 2004
7
3
Fair value adjustment attributable to hedged debt obligations
1
13
Obligation associated with a consolidated VIE with interest rate
of 3.1% for 2005 and 2.9% for 2004
83
100
Obligations under capital leases and sale leasebacks with a
weighted-average interest rate of 8.98% for 2005 and 9.49% for
2004
219
175
3,885
3,866
Less: Long-term debt due within one year
1,446
14
Long-term debt
$
2,439
$
3,852
(a)
Notes were issued by Nortel Networks Capital Corporation, an
indirect wholly owned finance subsidiary of NNL, and are fully
and unconditionally guaranteed by NNL.
173
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
As of December 31, 2005, the amounts of long-term debt
payable for each of the years ending December 31 consisted
of:
2006
$
1,446
2007
19
2008
1,815
2009
15
2010
15
Thereafter
575
Total long-term debt payable
$
3,885
On February 8, 2001, NNL completed an offering of $1,500 of
6.125% Notes due on February 15, 2006 (the
“6.125% Notes”). The 6.125% Notes pay
interest on a semi-annual basis on February 15 and
August 15, which began on August 15, 2001. The
6.125% Notes are redeemable, at any time at NNL’s
option, at a redemption price equal to the principal amount
thereof plus accrued and unpaid interest and a make-whole
premium.
During the year ended December 31, 2003, Nortel purchased a
portion of its 6.125% Notes with a face value of $39. The
transaction resulted in a gain of $4 which was included in the
consolidated statement of operations within other income
(expense) — net for the year ended December 31,2003.
On August 15, 2001, Nortel completed an offering of $1,800
of 4.25% Convertible Senior Notes (the “Senior
Notes”), due on September 1, 2008. The Senior Notes
pay interest on a semi-annual basis on March 1 and
September 1, which began March 1, 2002. The Senior
Notes are convertible at any time by holders into common shares
of Nortel Networks Corporation, at an initial conversion price
of $10 per common share, subject to adjustment upon the
occurrence of certain events. Nortel may redeem some or all of
the Senior Notes in cash at any time on or after
September 7, 2004 at a redemption price of between 100% and
102.125% of the principal amount of the Senior Notes, depending
on the redemption date, plus accrued and unpaid interest and
additional interest, if any, to the date of the redemption. In
addition, Nortel may be required to redeem the Senior Notes in
cash and/or common shares of Nortel Networks Corporation under
certain circumstances such as a change in control, or Nortel may
redeem the Senior Notes at its option under certain
circumstances such as a change in the applicable Canadian
withholding tax legislation. NNL is the full and unconditional
guarantor of the Senior Notes in the event Nortel does not make
payments for the principal, interest, premium, if any, or other
amounts, if any, as they are due. The guarantee is a direct,
unconditional and unsubordinated obligation of NNL.
As a result of the delay in the filing of Nortel’s and
NNL’s 2003 Annual Reports on
Form 10-K (the
“2003 Annual Reports”), 2004 Quarterly Reports on
Form 10-Q for the
first, second and third quarters of 2004 (the “2004
Quarterly Reports”), 2004 Annual Reports on
Form 10-K (the
“2004 Annual Reports”) and 2005 Quarterly Reports on
Form 10-Q for the
first quarter of 2005 (the “2005 First Quarter
Reports”, and together with the 2003 Annual Reports, the
2004 Quarterly Reports and the 2004 Annual Reports, the
“Reports”), Nortel and NNL were not in compliance with
their obligations to deliver their respective SEC filings to the
trustees under Nortel’s and NNL’s public debt
indentures. As a result of the delay in the filing of
Nortel’s and NNL’s 2005 Annual Reports on
Form 10-K. Nortel
and NNL are not in compliance with their obligations to deliver
their respective SEC filings to the trustees under Nortel’s
and NNL’s public debt indentures. See note 23 for
additional information.
Approximately $1,275 of NNL’s 6.125% Notes were due in
February 2006 and $150 of Nortel’s 7.40% Notes issued
by an indirect wholly-owned subsidiary of NNL and guaranteed by
NNL are due in June 2006. These Notes have been reclassified
from long-term debt to current liabilities in the first quarter
of 2005. Nortel expects to have sufficient cash to meet these
future obligations. See note 23 for additional information
on the repayment of the 6.125% Notes due in February 2006.
174
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Support facility
On February 14, 2003, Nortel’s principal operating
subsidiary, NNL, entered into an agreement with Export
Development Canada (“EDC”) regarding arrangements to
provide for support of certain performance related obligations
arising out of normal course business activities for the benefit
of Nortel (the “EDC Support Facility”). On
December 10, 2004, NNL and EDC amended the terms of the EDC
Support Facility by extending the termination date of the EDC
Support Facility to December 31, 2006 from
December 31, 2005.
The delayed filing of the Reports with the SEC, the trustees
under Nortel’s and NNL’s public debt indentures and
EDC gave EDC the right to (i) terminate its commitments
under the EDC Support Facility, relating to certain of
Nortel’s performance related obligations arising out of
normal course business activities, and (ii) exercise
certain rights against the collateral pledged under related
security agreements or require NNL to cash collateralize all
existing support.
Throughout 2004 and into 2005, NNL obtained waivers from EDC
with respect to these matters to permit continued access to the
EDC Support Facility in accordance with its terms while Nortel
and NNL worked to complete their filing obligations. The waivers
also applied to certain related breaches under the EDC Support
Facility relating to the delayed filings and the restatements
and revisions to Nortel’s and NNL’s prior financial
results (the “Related Breaches”). In connection with
such waivers, EDC reclassified the previously committed $300
revolving small bond sub-facility of the EDC Support Facility as
uncommitted support during the applicable waiver period. On
May 31, 2005, NNL obtained a permanent waiver from EDC of
certain defaults and the Related Breaches by NNL under the EDC
Support Facility (the “Permanent Waiver”). As a result
of the filing and delivery to the trustees under Nortel’s
and NNL’s public debt indentures and EDC of the 2005 First
Quarter Reports and obtaining the Permanent Waiver, NNL was in
compliance with its obligations under the EDC Support Facility
and the $300 revolving small bond sub-facility was reclassified
as committed support.
Effective October 24, 2005, NNL and EDC entered into an
amendment of the EDC Support Facility that maintained the total
EDC Support Facility at up to $750, including the existing $300
of committed support for performance bonds and similar
instruments, and the extension of the maturity date of the EDC
Support Facility for an additional year to December 31,2007. In connection with this amendment (the “EDC
Amendment”), all guarantee and security agreements
previously guaranteeing or securing the obligations of Nortel
and its subsidiaries under the EDC Support Facility and
Nortel’s public debt securities were terminated and the
assets of Nortel and its subsidiaries pledged under the security
agreements were released in full. EDC also agreed to provide
future support under the EDC Support Facility on an unsecured
basis and without the guarantees of NNL’s subsidiaries
provided that, should NNL or its subsidiaries incur or guarantee
certain indebtedness in the future above agreed thresholds of
$25 in North America and $100 outside of North America, equal
and ratable security and/or guarantees of NNL’s obligations
under the EDC Support Facility will be required at that time.
As a result of the delayed filing of Nortel’s and
NNL’s 2005 Annual Reports on Form 10-K, an event of
default occurred under the EDC Support Facility. See
note 23 for additional information.
The EDC Support Facility provides up to $750 in support. As of
December 31, 2005, there was approximately $162 of
outstanding support utilized under the EDC Support Facility,
approximately $142 of which was outstanding under the revolving
small bond sub-facility.
12.
Financial instruments and hedging activities
Risk management
Nortel’s net earnings (loss) and cash flows may be
negatively impacted by fluctuating interest rates, foreign
exchange rates and equity prices. To effectively manage these
market risks, Nortel enters into foreign currency forwards,
foreign currency swaps, foreign currency option contracts,
interest rate swaps and equity forward contracts. Nortel does
not hold or issue derivative financial instruments for trading
purposes.
Foreign currency risk
Nortel enters into option contracts to limit its exposure to
exchange fluctuations on future revenue or expenditure streams
expected to occur within the next twelve months, and
forward contracts, which are denominated in various currencies,
to
175
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
limit its exposure to exchange fluctuations on existing assets
and liabilities and on future revenue or expenditure streams
expected to occur within the next twelve months. Option and
forward contracts used to hedge future revenue or expenditure
streams are designated as cash flow hedges and hedge specific
exposures. Option and forward contracts that do not meet the
criteria for hedge accounting are also used to economically
hedge the impact of fluctuations in exchange rates on existing
assets and liabilities and on future revenue and expenditure
streams.
The following table provides the total notional amounts of the
purchase and sale of currency options and forward contracts as
of December 31:
2005(a)
2004(b)
Net
Net
Buy
Sell
Buy/(Sell)
Buy
Sell
Buy/(Sell)
Currency
Options(c):
Canadian dollar
$22
$22
$0
$50
$51
$(1
)
Forwards(c):
Canadian dollar
$302
$799
($497)
$344
$16
$328
British pound
£597
£27
£570
£370
£0
£370
Euro
37
€
96
€
(59
€)
40
€
130
€
(90
€)
Other (U.S. dollar)
$49
$95
$(46)
$4
$55
$(51
)
(a)
All notional amounts of option and forward contracts will mature
no later than the end of 2006.
(b)
All notional amounts of option and forward contracts matured no
later than the end of 2005.
(c)
All amounts are stated in source currency.
On January 27, 2003, various cross currency coupon swaps
(notional amount of Canadian $350) were terminated. There was no
impact to net earnings (loss) on termination as these
instruments were not designated as hedges and changes in fair
value were previously accounted for in the consolidated
statements of operations.
Nortel did not execute any foreign currency swaps in 2005 and
had no such agreements in place as of December 31, 2005.
Interest rate risk
Nortel enters into interest rate swap contracts to minimize the
impact of interest rate fluctuations on the fair value of its
long-term debt. These contracts swap fixed interest rate
payments for floating rate payments and certain swaps are
designated as fair value hedges. The fair value adjustment
related to the effective portion of interest rate swaps and the
corresponding fair value adjustment to the hedged debt
obligation included within long-term debt are recorded to
interest expense within the consolidated statements of
operations. These swap contracts have remaining terms to
maturity up to 0.5 years.
The following table provides a summary of interest rate swap
contracts and their aggregated weighted-average rates as of
December 31:
From time to time, Nortel enters into equity forward contracts
to hedge the variability in future cash flows associated with
certain compensation obligations that vary based on future
Nortel Networks Corporation common share prices. These contracts
fix the price of Nortel Networks Corporation common shares and
are cash settled on maturity to offset changes in the
compensation liability based on changes in the share price from
the inception of the forward contract. These equity forward
contracts are not designated in a hedging relationship, and are
considered economic hedges of the compensation obligation. They
are carried at fair value with changes in fair value recorded in
other income (expense) —
176
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
net. As of December 31, 2005, Nortel did not have any
equity forward contracts outstanding. As of December 31,2004, the total notional amount and fair value of these
contracts were $31 and $(9), respectively, and the average fixed
Nortel Networks Corporation common share price was
$4.52 per share.
Fair value
The estimated fair values approximate amounts at which financial
instruments could be exchanged in a current transaction between
willing parties. The fair values are based on estimates using
present value and other valuation techniques that are
significantly affected by the assumptions used concerning the
amount and timing of estimated future cash flows and discount
rates that reflect varying degrees of risk. Specifically, the
fair value of interest rate swaps and forward contracts
reflected the present value of the expected future cash flows if
settlement had taken place on December 31, 2005 and 2004;
the fair value of option contracts reflected the cash flows due
to or by Nortel if settlement had taken place on
December 31, 2005 and 2004; and the fair value of long-term
debt instruments reflected a current yield valuation based on
observed market prices as of December 31, 2005 and 2004.
Accordingly, the fair value estimates are not necessarily
indicative of the amounts that Nortel could potentially realize
in a current market exchange.
The following table provides the carrying amounts and fair
values for financial assets and liabilities for which fair value
differed from the carrying amount and fair values recorded for
derivative financial instruments in accordance with
SFAS 133 as of December 31:
2005
2004
Carrying
Fair
Carrying
Fair
Amount
Value
Amount
Value
Financial liabilities:
Long-term debt due within one year
$
1,446
$
1,442
$
14
$
14
Long-term debt
$
2,439
$
2,308
$
3,852
$
3,811
Derivative financial instruments net asset
(liability) position:
Comprised of other assets of $14 and other liabilities of $26 as
of December 31, 2005, and other assets of $31 and other
liabilities of $26 as of December 31, 2004.
Credit risk
Credit risk on financial instruments arises from the potential
for counterparties to default on their contractual obligations
to Nortel. Nortel is exposed to credit risk in the event of
non-performance, but does not anticipate non-performance by any
of the counterparties. Nortel limits its credit risk by dealing
with counterparties that are considered to be of high credit
quality. The maximum potential loss on all financial instruments
may exceed amounts recognized in the consolidated financial
statements. However, Nortel’s maximum exposure to credit
loss in the event of non-performance by the other party to the
derivative contracts is limited to those derivatives that had a
positive fair value of $6 as of December 31, 2005. Nortel
is also exposed to credit risk from customers. However,
Nortel’s global orientation has resulted in a large number
of diverse customers which minimizes concentrations of credit
risk.
Other derivatives
Nortel may invest in warrants to purchase securities of other
companies as a strategic investment or receive warrants in
various transactions. Warrants that relate to publicly traded
companies or that can be net share settled are deemed derivative
financial instruments under SFAS 133. Such warrants are
generally not eligible to be designated as hedging instruments
as there is no corresponding underlying exposure. In addition,
Nortel may enter into certain commercial contracts containing
derivative financial instruments.
Hedge ineffectiveness and the discontinuance of cash flow hedges
and fair value hedges that were accounted for in accordance with
SFAS 133 had no material impact on the net earnings (loss)
for the years ended December 31, 2005, 2004 and 2003 and
were reported within other income (expense) — net in
the consolidated statements of operations.
177
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Transfers of receivables
In 2005, 2004 and 2003, Nortel entered into various agreements
to transfer certain of its receivables. These receivables were
transferred at discounts of $19, $37 and $20 from book value for
the years ended December 31, 2005, 2004 and 2003,
respectively, at annualized discount rates of approximately
2 percent to 8 percent, 2 percent to
6 percent and 2 percent to 6 percent for the
years ended December 31, 2005, 2004 and 2003, respectively.
Certain receivables have been sold with limited recourse, not
exceeding 10 percent, of nil, nil and $7 as of
December 31, 2005, 2004 and 2003, respectively.
Under certain agreements, Nortel has continued as servicing
agent and/or has provided limited recourse. The fair value of
these retained interests is based on the market value of
servicing the receivables, historical payment patterns and
appropriate discount rates as applicable. Generally, trade
receivables that are sold do not experience prepayments. Nortel,
when acting as the servicing agent, generally does not record an
asset or liability related to servicing as the annual servicing
fees are equivalent to those that would be paid to a third party
servicing agent. Also, Nortel has not historically experienced
significant credit losses with respect to receivables sold with
limited recourse and, as such, no liability was recognized.
As of December 31, 2005 and 2004, total accounts receivable
transferred and under Nortel’s management were $247 and
$266, respectively.
There is a possibility that the actual performance of
receivables or the cost of servicing the receivables will differ
from the assumptions used to determine fair values at the
transfer date and at each reporting date. Assuming hypothetical,
simultaneous, unfavorable variations of up to 20 percent in
credit losses, discount rate used and cost of servicing the
receivables, the pre-tax impact on the value of the retained
interests and servicing assets would not be significant.
Proceeds from receivables for the years ended December 31
were as follows:
2005
2004
2003
Proceeds from new transfers of financial assets
$
298
$
137
$
651
Proceeds from collections reinvested in revolving period
transfers
$
260
$
373
$
52
13.
Guarantees
Nortel has entered into agreements that contain features which
meet the definition of a guarantee under FIN 45.
FIN 45 defines a guarantee as a contract that contingently
requires Nortel to make payments (either in cash, financial
instruments, other assets, common shares of Nortel Networks
Corporation or through the provision of services) to a third
party based on changes in an underlying economic characteristic
(such as interest rates or market value) that is related to an
asset, a liability or an equity security of the guaranteed party
or a third party’s failure to perform under a specified
agreement. A description of the major types of Nortel’s
outstanding guarantees as of December 31, 2005 is provided
below:
(a)
Business sale and business combination agreements
In connection with agreements for the sale of portions of its
business, including certain discontinued operations, Nortel has
typically retained the liabilities of a business which relate to
events occurring prior to its sale, such as tax, environmental,
litigation and employment matters. Nortel generally indemnifies
the purchaser of a Nortel business in the event that a third
party asserts a claim against the purchaser that relates to a
liability retained by Nortel. Some of these types of guarantees
have indefinite terms while others have specific terms extending
to June 2008.
Nortel also entered into guarantees related to the escrow of
shares in business combinations in prior periods. These types of
agreements generally include indemnities that require Nortel to
indemnify counterparties for loss incurred from litigation that
may be suffered by counterparties arising under such agreements.
These types of indemnities apply over a specified period of time
from the date of the business combinations and do not provide
for any limit on the maximum potential amount.
178
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Nortel is unable to estimate the maximum potential liability for
these types of indemnification guarantees as the business sale
agreements generally do not specify a maximum amount and the
amounts are dependent upon the outcome of future contingent
events, the nature and likelihood of which cannot be determined.
Historically, Nortel has not made any significant
indemnification payments under such agreements and no
significant liability has been accrued in the consolidated
financial statements with respect to the obligations associated
with these guarantees.
In conjunction with the sale of a subsidiary to a third party,
Nortel guaranteed to the purchaser that specified annual volume
levels would be achieved by the business sold over a ten year
period ending December 31, 2007. The maximum amount that
Nortel may be required to pay under the volume guarantee as of
December 31, 2005 is $10. A liability of $8 has been
accrued in the consolidated financial statements with respect to
the obligation associated with this guarantee as of
December 31, 2005.
(b)
Intellectual property indemnification obligations
Nortel has periodically entered into agreements with customers
and suppliers that include intellectual property indemnification
obligations that are customary in the industry. These types of
guarantees typically have indefinite terms and generally require
Nortel to compensate the other party for certain damages and
costs incurred as a result of third party intellectual property
claims arising from these transactions.
The nature of the intellectual property indemnification
obligations generally prevents Nortel from making a reasonable
estimate of the maximum potential amount it could be required to
pay to its customers and suppliers. Historically, Nortel has not
made any significant indemnification payments under such
agreements. As of December 31, 2005, Nortel had no
intellectual property indemnification obligations for which
compensation would be required.
(c)
Lease agreements
Nortel has entered into agreements with its lessors that
guarantee the lease payments of certain assignees of its
facilities to lessors. Generally, these lease agreements relate
to facilities Nortel vacated prior to the end of the term of its
lease. These lease agreements require Nortel to make lease
payments throughout the lease term if the assignee fails to make
scheduled payments. Most of these lease agreements also require
Nortel to pay for facility restoration costs at the end of the
lease term if the assignee fails to do so. These lease
agreements have expiration dates through June 2015. The maximum
amount that Nortel may be required to pay under these types of
agreements is $44 as of December 31, 2005. Nortel generally
has the ability to attempt to recover such lease payments from
the defaulting party through rights of subrogation.
Historically, Nortel has not made any significant payments under
these types of guarantees and no significant liability has been
accrued in the consolidated financial statements with respect to
the obligations associated with these guarantees.
(d)
Third party debt agreements
From time to time, Nortel guarantees the debt of certain
customers. These third party debt agreements require Nortel to
make debt payments throughout the term of the related debt
instrument if the customer fails to make scheduled debt
payments. Under most such arrangements, the Nortel guarantee is
secured, usually by the assets being purchased or financed. As
of December 31, 2005, Nortel had no third party debt
agreements that would require it to make any debt payments for
its customers.
(e)
Indemnification of banks and agents under credit
facilities and EDC Support Facility
As of December 31, 2005, Nortel had agreed to indemnify the
banks and agents under its credit facilities against costs or
losses resulting from changes in laws and regulations which
would increase the banks’ costs or reduce their return and
from any legal action brought against the banks or agents
related to the use of loan proceeds. Nortel has agreed to
indemnify EDC under the EDC Support Facility against any legal
action brought against EDC that relates to the provision of
support under the EDC Support Facility. This indemnification
generally applies to issues that arise during
179
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
the term of the EDC Support Facility. For additional
information related to the recent amendment of the EDC Support
Facility, see note 11.
Nortel is unable to estimate the maximum potential liability for
these types of indemnification guarantees as the agreements
typically do not specify a maximum amount and the amounts are
dependent upon the outcome of future contingent events, the
nature and likelihood of which cannot be determined at this time.
Historically, Nortel has not made any significant
indemnification payments under such agreements and no
significant liability has been accrued in the consolidated
financial statements with respect to the obligations associated
with these indemnification guarantees.
Nortel has agreed to indemnify certain of its counterparties in
certain receivables securitization transactions. The
indemnifications provided to counterparties in these types of
transactions may require Nortel to compensate counterparties for
costs incurred as a result of changes in laws and regulations
(including tax legislation) or in the interpretations of such
laws and regulations, or as a result of regulatory penalties
that may be suffered by the counterparty as a consequence of the
transaction. Certain receivables securitization transactions
include indemnifications requiring the repurchase of the
receivables if the particular transaction becomes invalid. As of
December 31, 2005, Nortel had approximately $247 of
securitized receivables which were subject to repurchase under
this provision, in which case Nortel would assume all rights to
collect such receivables. The indemnification provisions
generally expire upon expiration of the securitization
agreements, which extend through 2006, or collection of the
receivable amounts by the counterparty.
Nortel is generally unable to estimate the maximum potential
liability for these types of indemnification guarantees as
certain agreements do not specify a maximum amount and the
amounts are dependent upon the outcome of future contingent
events, the nature and likelihood of which cannot be determined
at this time.
Historically, Nortel has not made any significant
indemnification payments or receivable repurchases under such
agreements and no significant liability has been accrued in the
consolidated financial statements with respect to the
obligations associated with these guarantees.
(f)
Other indemnification agreements
Nortel has also entered into other agreements that provide
indemnifications to counterparties in certain transactions
including investment banking agreements, guarantees related to
the administration of capital trust accounts, guarantees related
to the administration of employee benefit plans, indentures for
its outstanding public debt and asset sale agreements (other
than the business sale agreements noted above). These
indemnification agreements generally require Nortel to indemnify
the counterparties for costs incurred as a result of changes in
laws and regulations (including tax legislation) or in the
interpretations of such laws and regulations and/or as a result
of losses from litigation that may be suffered by the
counterparties arising from the transactions. These types of
indemnification agreements normally extend over an unspecified
period of time from the date of the transaction and do not
typically provide for any limit on the maximum potential payment
amount. In addition, Nortel has entered into indemnification
agreements with certain of its directors and officers for the
costs reasonably incurred in any proceeding in which they become
involved by reason of their position as directors or officers to
the extent permitted under applicable law.
The nature of such agreements prevents Nortel from making a
reasonable estimate of the maximum potential amount it could be
required to pay to its counterparties and directors and
officers. The difficulties in assessing the amount of liability
result primarily from the unpredictability of future changes in
laws, the inability to determine how laws apply to
counterparties and the lack of limitations on the potential
liability.
Historically, Nortel has not made any significant
indemnification payments under such agreements and no
significant liability has been accrued in the consolidated
financial statements with respect to the obligations associated
with these guarantees.
On March 17, 2006, Nortel announced that Nortel, NNL and
the lead plaintiffs reached an agreement on the related
insurance and corporate governance matters including
Nortel’s and NNL’s insurers agreeing to pay $228.5 in
cash towards the settlement and Nortel and NNL agreeing with
their insurers to certain indemnification obligations. Nortel
and NNL believe that these indemnification obligations would be
unlikely to materially increase their total cash payment
180
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
obligations under the Proposed Class Action Settlement. The
insurance payments would not reduce the amounts payable by
Nortel or NNL as disclosed in notes 22 and 23. Nortel and
NNL also agreed to certain corporate governance enhancements,
including the codification or certain of their current
governance practices (such as the annual election by their
directors of a non-executive Board chair) in their respective
Board of Directors written mandates and the inclusion in their
respective annual proxy circulars and proxy statements of a
report on certain of their other governance practices (such as
the process followed for the annual evaluation of the Board,
committees of the Board and individual directors). The Proposed
Class Action Settlement would contain no admission of
wrongdoing by Nortel, NNL or any of the other defendants.
Product warranties
The following summarizes the accrual for product warranties that
was recorded as part of other accrued liabilities in the
consolidated balance sheets as of December 31:
2005
2004
Balance at the beginning of the year
$
273
$
387
Payments
(176
)
(267
)
Warranties issued
190
229
Revisions
(79
)
(76
)
Balance at the end of the year
$
208
$
273
14.
Commitments
Bid, performance related and other bonds
Nortel has entered into bid, performance related and other bonds
associated with various contracts. Bid bonds generally have a
term of less than twelve months, depending on the length of the
bid period for the applicable contract. Other bonds primarily
relate to warranty, rental, real estate and customs contracts.
Performance related and other bonds generally have a term of
twelve months and are typically renewed, as required, over the
term of the applicable contract. The various contracts to which
these bonds apply generally have terms ranging from two to five
years. Any potential payments which might become due under these
bonds would be related to Nortel’s non-performance under
the applicable contract. Historically, Nortel has not had to
make material payments under these types of bonds and does not
anticipate that any material payments will be required in the
future.
The following table sets forth the maximum potential amount of
future payments under bid, performance related and other bonds,
net of the corresponding restricted cash and cash equivalents,
as of December 31:
2005
2004
Bid and performance related
bonds(a)
$
222
$
362
Other
bonds(b)
44
68
Total bid, performance related and other bonds
$
266
$
430
(a)
Net of restricted cash and cash equivalent amounts of $36 and
$36 as of December 31, 2005 and 2004, respectively.
(b)
Net of restricted cash and cash equivalent amounts of $31 and
$28 as of December 31, 2005 and 2004, respectively.
Venture capital financing
Nortel has entered into agreements with selected venture capital
firms where the venture capital firms make and manage
investments in
start-ups and emerging
enterprises. The agreements require Nortel to fund requests for
additional capital up to its commitments when and if requests
for additional capital are solicited by the venture capital
firm. Nortel had remaining commitments, if requested, of $25 as
of December 31, 2005. These commitments expire at various
dates through to 2012.
181
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Purchase commitments
Nortel has entered into purchase commitments with certain
suppliers under which it commits to buy a minimum amount or
percentage of designated products in exchange for price
guarantees or similar concessions. In certain of these
agreements, Nortel may be required to acquire and pay for such
products up to the prescribed minimum or forecasted purchases.
As of December 31, 2005, Nortel had aggregate purchase
commitments of $386. Significant purchase commitments are
described below.
During the third quarter of 2003, Nortel renegotiated a supply
arrangement with a key supplier. The renegotiated agreement
requires that $2,800 in aggregate purchases with the supplier be
made between June 2003 and June 2009. As of December 31,2005, the remaining purchase commitment under the agreement was
$232. The renegotiated agreement includes a graduated liquidated
damages remedy for the benefit of the supplier if the minimum
purchase commitment is not met by the end of the agreement in
2009. However, Nortel expects to meet the minimum purchase
commitment.
The following table sets forth the expected purchase commitments
to be made over the next several years:
Total
2006
2007
2008
Thereafter
Obligations
Purchase commitments
$
320
$
56
$
10
$
—
$
386
Amounts paid by Nortel under the above purchase commitments
during the years ended December 31 2005, 2004 and 2003 were
$1,134, $1,088 and $1,082, respectively.
Operating leases and other commitments
As of December 31, 2005, the future minimum payments under
operating leases, outsourcing contracts, special charges related
to lease commitments accrued for as part of restructuring
contract settlement and lease costs and related sublease
recoveries under contractual agreements consisted of:
Rental expense on operating leases for the years ended
December 31, 2005, 2004 and 2003, net of applicable
sublease income, amounted to $175, $179 and $260, respectively.
During the year ended December 31, 2003, Nortel entered
into sale-leaseback transactions for certain of its properties
with a carrying value of approximately $17, which resulted in a
loss on disposal of $6.
Expenses related to outsourcing contracts for the years ended
December 31, 2005, 2004 and 2003 amounted to $96, $253 and
$308, respectively, and were for services provided to Nortel
primarily related to a portion of its information services
function. The amount payable under Nortel’s outsourcing
contracts is variable to the extent that Nortel’s workforce
fluctuates from the baseline levels contained in the contracts.
The table above shows the minimum commitment contained in the
outsourcing contracts.
15.
Financing arrangements and variable interest entities
Customer financing
Pursuant to certain financing agreements with its customers,
Nortel is committed to provide future financing in connection
with purchases of Nortel’s products and services.
Generally, Nortel facilitates customer financing agreements
182
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
through customer loans, and Nortel’s commitment to extend
future financing is generally subject to conditions related to
funding, fixed expiration or termination dates, specific
interest rates and qualified purposes. Where permitted, customer
financings may also be utilized by Nortel’s customers for
their own working capital purposes and may be in the form of
equity financing. Nortel’s internal credit committee
monitors and attempts to limit Nortel’s exposure to credit
risk. Nortel’s role in customer financing consists
primarily of arranging financing by matching its customers’
needs with external financing sources. Nortel only provides
direct customer financing where a compelling strategic customer
or technology purpose supports such financing. The following
table sets forth customer financing related information and
commitments, excluding discontinued operations, as of
December 31:
2005
2004
Drawn and outstanding — gross
$
51
$
118
Provisions for doubtful accounts
(35
)
(38
)
Drawn and outstanding —
net(a)
16
80
Undrawn commitments
50
69
Total customer financing
$
66
$
149
(a)
Included short-term and long-term amounts. Short-term and
long-term amounts were included in accounts
receivable — net and other assets, respectively, in
the consolidated balance sheets.
During the years ended December 31, 2005, 2004 and 2003,
Nortel recorded net customer financing bad debt expense
(recovery) of $4, $(45) and $(122), respectively, as a
result of settlements and adjustments to other existing
provisions. The recoveries and expense were included in the
consolidated statements of operations within SG&A expense.
During the years ended December 31, 2005 and 2004, Nortel
entered into certain agreements to restructure and/or settle
various customer financing and related receivables, including
rights to accrued interest. As a result of these transactions,
Nortel received cash consideration of approximately $112 ($36 of
the proceeds was included in discontinued operations) and $147,
respectively, to settle outstanding receivables of approximately
$102 with a net carrying value of $101 ($33 of the net carrying
value was included in discontinued operations) and $254 with a
net carrying value of $75, for the years ended December 31,2005 and 2004, respectively.
On December 10, 2004, Nortel entered into an agreement to
settle customer financing receivables with a certain customer.
As a result of these transactions, Nortel received cash
consideration of approximately $16 and a deferred senior
unsecured note of $33 (net carrying value of nil) to settle the
outstanding receivables of approximately $118 with the net
carrying value of nil.
On December 15 and 16, 2004, Nortel sold certain notes
receivable and convertible notes receivable that had been
received as a result of the restructuring of a customer
financing arrangement for total cash proceeds of $116. The net
carrying amount of the notes receivable and convertible notes
receivable was $61. Nortel recorded a gain of $53, net of
transaction costs of $2, in other income (expense) —
net for the year ended December 31, 2004.
On December 23, 2004, a customer financing arrangement was
restructured. The notes receivable and other accounts receivable
that were restructured had a net carrying amount of $12 ($1 of
the net carrying amount was included in discontinued
operations), net of provisions for doubtful accounts of $182
($63 of the provision was included in discontinued operations).
The restructured notes were valued at $100 as of
December 31, 2004 and a gain of $88 ($32 of the gain was
included in discontinued operations) was recorded in the fourth
quarter of 2004. On January 25, 2005, Nortel sold this
receivable, including rights to accrued interest, for cash
proceeds of $110.
During the years ended December 31, 2005 and 2004, Nortel
reduced undrawn customer financing commitments by $19 ($8
relates to a VIE which Nortel began consolidating effective
April 1, 2005) and $111, respectively, as a result of the
expiration or cancellation of commitments and changing customer
business plans. As of December 31, 2005, all undrawn
commitments were available for funding under the terms of the
financing agreements.
Consolidation of variable interest entities
Certain lease financing transactions of Nortel were structured
through single transaction VIEs that did not have sufficient
equity at risk as defined in FIN 46R. Effective
July 1, 2003, Nortel prospectively began consolidating two
VIEs for
183
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
which Nortel was considered the primary beneficiary following
the guidance of FIN 46, on the basis that Nortel retained
certain risks associated with guaranteeing recovery of the
unamortized principal balance of the VIEs debt, which
represented the majority of the risks associated with the
respective VIEs activities. The amount of the guarantees will be
adjusted over time as the underlying debt matures. During 2004,
the debt related to one of the VIEs was extinguished and as a
result consolidation of this VIE was no longer required. As of
December 31, 2005, Nortel’s consolidated balance sheet
included $83 of long-term debt (see note 11) and $82 of
plant and equipment — net related to the remaining
VIE. These amounts represented both the collateral and maximum
exposure to loss as a result of Nortel’s involvement with
the VIE.
Effective April 1, 2005, Nortel began consolidating a VIE
for which Nortel was considered the primary beneficiary under
FIN 46R. The VIE is a cellular phone operator in Russia.
Loans to this entity comprise the majority of the entity’s
subordinated financial support. No creditor of the VIE has
recourse to Nortel. This entity’s financial results have
been consolidated using the most recent financial information
available.
On June 3, 2005, Nortel acquired PEC, a VIE, for which
Nortel was considered the primary beneficiary under
FIN 46R. The consolidated financial results of Nortel
include PEC’s operating results from the date of the
acquisition (see note 10).
On November 2, 2005, Nortel formed LG-Nortel, which is a
VIE. Nortel is considered the primary beneficiary under
FIN 46R. No creditor of the entity has recourse to Nortel.
This entity’s financial results have been consolidated from
the date of formation (see note 10).
As of December 31, 2005, Nortel did not have any variable
interests related to transfers of financial assets. Nortel has
other financial interests and contractual arrangements which
would meet the definition of a variable interest under
FIN 46R, including investments in other companies and joint
ventures, customer financing arrangements, and guarantees and
indemnification arrangements. As of December 31, 2005, none
of these other interests or arrangements were considered
significant variable interests and, therefore, did not meet the
requirements for consolidation or disclosure under FIN 46R.
As a result of the Third Restatement adjustments, effective
July 1, 2003, Nortel began to consolidate the Health and
Welfare Trust, a VIE, for which Nortel was considered the
primary beneficiary under FIN 46R (see note 4).
184
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
16.
Capital stock
Common shares
Nortel Networks Corporation is authorized to issue an unlimited
number of common shares without nominal or par value. The
outstanding number of common shares and prepaid forward purchase
contracts included in shareholders’ equity consisted of the
following as of December 31:
Common shares issued as part of the purchase price
consideration. During the years ended December 31, 2005,
2004 and 2003, common shares were cancelled as earn out
provisions were forfeited pursuant to their applicable
agreements.
(b)
Included in additional paid in capital in the consolidated
balance sheets. During the years ended December 31, 2005,
2004 and 2003, 64,842, 98,833 and 321,322 common shares were
issued as a result of the early settlement of 3,840, 5,853 and
19,029 prepaid forward purchase contracts, respectively.
The net proceeds from the settled contracts of $82, $127 and
$413, respectively, were transferred from additional paid-in
capital to common shares.
(c)
Relates to common shares of Nortel Networks Corporation
surrendered by members and former members of Nortel’s core
executive team for cancellation in connection with the voluntary
undertaking by each such individual to pay over a three year
period an amount equal to the return to profitability bonus paid
in 2003.
As of December 31, 2005, the remaining 3,840 forward
purchase contracts outstanding were settled by the holders,
resulting in an issuance of approximately 65 million common
shares of Nortel Networks Corporation.
Preferred shares
Nortel Networks Corporation is authorized to issue an unlimited
number of Class A preferred shares, which rank senior to
the Class B preferred shares and the common shares upon a
distribution of capital or assets, and an unlimited number of
Class B preferred shares, which rank junior to the
Class A preferred shares and senior to the common shares
upon a distribution of capital or assets, in each case without
nominal or par value. Each of the Class A and Class B
preferred shares is issuable in one or more series, each series
having such rights, restrictions and provisions as determined by
the Board of Directors of Nortel Networks Corporation at the
time of issue. None of the Class A or Class B
preferred shares of Nortel Networks Corporation has been issued.
185
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Shareholder rights plan
At the Nortel annual and special shareholders’ meeting on
April 24, 2003, shareholders approved the reconfirmation
and amendment of Nortel’s shareholder rights plan, which
will expire at the annual meeting of shareholders to be held in
2006 unless it is reconfirmed at that time. Under the rights
plan, Nortel issues one right for each Nortel Networks
Corporation common share outstanding. These rights become
exercisable upon the occurrence of certain events associated
with an unsolicited takeover bid.
17.
Earnings (loss) per common share
The following table details the weighted-average number of
Nortel Networks Corporation common shares outstanding for the
purposes of computing basic and diluted earnings (loss) per
common share for the following periods:
As a result of the net loss from continuing operations for the
years ended December 31, 2005 and 2004, all potential
dilutive securities were considered anti-dilutive.
(b)
The impact of the minimum number of common shares to be issued
upon settlement of the prepaid forward purchase contracts on a
weighted-average basis was 41 and 73 for the years ended
December 31, 2005 and 2004, respectively. As of
December 31, 2005 and 2004, the minimum number of Nortel
Networks Corporation common shares to be issued upon settlement
of the prepaid forward purchase contracts was nil and 65,
respectively. Had the weighted-average number of prepaid forward
purchase contracts been settled as of December 31, 2005 and
2004, no additional Nortel Networks Corporation common shares
would have been issued above the minimum number of Nortel
Networks Corporation common shares based on the market price of
Nortel Networks Corporation common shares on the respective
dates.
(c)
These notes were anti-dilutive for the year ended
December 31, 2003.
186
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
18.
Accumulated other comprehensive loss
The components of accumulated other comprehensive loss, net of
tax, were as follows:
Change in foreign currency translation
adjustment(a)
(146
)
188
509
Balance at the end of the year
207
353
165
Unrealized gain (loss) on investments — net
Balance at the beginning of the year
30
94
24
Change in unrealized gain (loss) on investments
(2
)
(64
)
70
Balance at the end of the
year(b)
28
30
94
Unrealized derivative gain (loss) on cash flow
hedges — net
Balance at the beginning of the year
18
12
(3
)
Change in unrealized derivative gain (loss) on cash flow
hedges(c)
(11
)
6
15
Balance at the end of the year
7
18
12
Minimum pension
liability(d)
Balance at the beginning of the year
(934
)
(824
)
(638
)
Change in minimum pension liability adjustment
(210
)
(110
)
(186
)
Balance at the end of the year
(1,144
)
(934
)
(824
)
Accumulated other comprehensive loss
$
(902
)
$
(533
)
$
(553
)
(a)
The change in the foreign currency translation adjustment was
not adjusted for income taxes since it related to indefinite
term investments in
non-U.S. subsidiaries.
(b)
Certain securities deemed available-for-sale by Nortel were
measured at fair value. Unrealized holding gains (losses)
related to these securities were excluded from net earnings
(loss) and were included in accumulated other comprehensive loss
until realized. Unrealized gain (loss) on investments was net of
tax of nil, for each of the years ended December 31, 2005,
2004 and 2003. During the years ended December 31, 2005,
2004 and 2003, realized (gains) losses on investments of
$(9), $(14) and $(6), respectively, were reclassified to other
income (expense) — net in the consolidated statements
of operations.
(c)
During the years ended December 31, 2005, 2004 and 2003,
net derivative gains of $18, $14 and $32 were reclassified to
other income (expense)-net. Unrealized derivative gain (loss) on
cash flow hedges is net of tax of nil, nil and nil for the years
ended December 31, 2005, 2004 and 2003, respectively.
Nortel estimates that $7 of net derivative gains (losses)
included in accumulated other comprehensive loss will be
reclassified into net earnings (loss) within the next
12 months.
(d)
Represents non-cash charges to shareholders’ equity related
to the increase in the minimum required recognizable liability
associated with Nortel’s pension plans (see note 9).
The change in minimum pension liability adjustment is presented
net of tax of $6, $7 and $31 for the years ended
December 31, 2005, 2004 and 2003, respectively.
19.
Stock-based compensation plans
Stock options
Prior to 2005, Nortel granted options to purchase Nortel
Networks Corporation common shares under two existing stock
option plans, the 2000 Plan and the 1986 Plan. Under these two
plans, options to purchase Nortel Networks Corporation common
shares could be granted to employees and, under the 2000 Plan,
options could be granted to directors of Nortel. The options
under both plans entitle the holders to purchase one common
share at a subscription price of not less than 100 percent
of market value on the effective date of the grant. Subscription
prices are stated and payable in U.S. dollars for
U.S. options and in Canadian dollars for Canadian options.
Generally, options granted prior to 2003 vest
331/3
percent on the anniversary date of the grant for
three years. Commencing in 2003, options granted generally vest
25 percent each year over a four year period on the
anniversary date of the grant. The committee of the Board of
Directors of Nortel that administers both plans generally has
the discretion to vary the period during which the holder has
the right to exercise options and, in certain circumstances, may
accelerate the right of the holder to exercise options, but in
no case shall the term of an option exceed ten years. Nortel
meets its obligations under both plans by issuing Nortel
Networks Corporation common shares.
187
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
During 2005, the shareholders of Nortel approved a new
stock-based compensation plan, the Nortel 2005 Stock Incentive
Plan (“SIP”), which permits grants of stock options,
including incentive stock options, stock appreciation rights,
performance stock units and RSUs. Stock options granted under
the SIP may be granted only to employees of the Company. The
subscription price for each share subject to an option shall not
be less than 100% of the market value on the effective date of
the grant. Subscription prices are stated and payable in
U.S. dollars for U.S. options and in Canadian dollars
for Canadian options. The options granted generally vest 25%
each year over a four year period on the anniversary date of the
grant. The committee of the Board of Directors of Nortel that
administers the SIP generally has the discretion to vary the
period during which the holder has the right to exercise options
and, in certain circumstances, may accelerate the right of the
holder to exercise options, but in no case shall the term of the
option exceed ten years.
Options granted under the SIP, 2000 Plan and 1986 Plan may be
granted with or without a SAR. A SAR entitles the holder to
receive payment of an amount equivalent to the excess of the
market value of a common share at the time of exercise of the
SAR over the subscription price of the common share to which the
option relates. Options with SARs may be granted on a
cancellation basis, in which case the exercise of one causes the
cancellation of the other, or on a simultaneous basis, in which
case the exercise of one causes the exercise of the other. As of
December 31, 2005 and 2004, there were no SARs outstanding.
As of December 31, 2005, the maximum number of common
shares authorized by the shareholders and reserved for issuance
by the Board of Directors of Nortel under each of the 1986 Plan,
2000 Plan and SIP is as follows:
Maximum
(Number of Common
Shares in Thousands)
1986 Plan
Issuable to
employees(a)
469,718
(b)
2000 Plan
Issuable to non-employee directors
500
(b)
Issuable to employees
94,000
(b)
SIP
Issuable to employees
122,000
(b)
(a)
As of December 31, 2005, the maximum number of Nortel
Networks Corporation common shares with respect to which options
may be granted in any given year under the 1986 Plan is three
percent of Nortel Networks Corporation common shares issued and
outstanding at the commencement of the year, subject to certain
adjustments.
(b)
Common shares remaining available for grant after
December 31, 2005 under the 1986 Plan and the 2000 Plan
(and common shares that become available upon expiration or
termination of options granted under such plans) will roll-over
to the SIP effective January 1, 2006.
In January 1995, a key contributor stock option program (the
“Key Contributor Program”) was established that
applies to both the 1986 Plan and the 2000 Plan. Under that
program, a participant was granted concurrently an equal number
of initial options and replacement options. The initial options
and the replacement options expire ten years from the date of
grant. The initial options have an exercise price equal to the
market value of common shares of Nortel Networks Corporation on
the date of grant and the replacement options have an exercise
price equal to the market value of common shares of Nortel
Networks Corporation on the date all of the initial options are
fully exercised, provided that in no event will the exercise
price be less than the exercise price of the initial options.
Replacement options are generally exercisable commencing
36 months after the date all of the initial options are
fully exercised, provided that the participant beneficially owns
a number of common shares of Nortel Networks Corporation at
least equal to the number of common shares subject to the
initial options less any common shares sold to pay for options
costs, applicable taxes and brokerage costs associated with the
exercise of the initial options. No Key Contributor Program
options were granted for the years ended December 31, 2005
and 2004, respectively, under either stock option plan.
During the year ended December 31, 2005, approximately
1,633,651 Nortel Networks Corporation common shares were issued
pursuant to the exercise of stock options granted under the 1986
Plan and 899,415 Nortel Networks Corporation common shares were
issued pursuant to the exercise of stock options granted under
the 2000 Plan. There were no stock options granted or exercised
under the SIP.
188
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Nortel also assumed stock option plans in connection with the
acquisition of various companies. Common shares of Nortel
Networks Corporation are issuable upon the exercise of options
under the assumed stock option plans, although no further
options may be granted under the assumed plans. The vesting
periods for options granted under these assumed stock option
plans may differ from the SIP, 2000 Plan and 1986 Plan, but are
not considered to be significant to Nortel’s overall use of
stock-based compensation.
The following is a summary of the total number of outstanding
stock options and the maximum number of stock options available
for grant:
The following table summarizes information about stock options
outstanding and exercisable as of December 31, 2005:
Options Outstanding
Options Exercisable
Weighted-
Average
Weighted-
Weighted-
Remaining
Average
Average
Number
Contractual
Exercise
Number
Exercise
Range of Exercise Prices
Outstanding
Life
Price
Exercisable
Price
(Thousands)
(In Years)
(Thousands)
$0.0084 - $2.3900
47,121
6.9
$
2.33
24,121
$
2.30
$2.3901 - $3.5852
79,364
8.8
$
2.97
11,444
$
3.09
$3.5853 - $5.3779
7,095
5.1
$
5.04
7,082
$
5.04
$5.3780 - $8.0670
77,478
(a)
5.6
$
6.92
60,037
$
6.71
$8.0671 - $12.1006
41,978
(a)
4.6
$
9.36
33,943
$
9.51
$12.1007 - $18.1510
12,581
2.1
$
14.64
11,981
$
14.63
$18.1511 - $27.2267
16,620
3.5
$
22.70
16,337
$
22.74
$27.2268 - $40.8402
9,771
3.6
$
32.98
9,761
$
32.98
$40.8403 - $61.2605
7,237
3.3
$
53.64
7,115
$
53.74
$61.2606 - $102.2916
3,673
3.8
$
74.34
3,649
$
74.33
302,918
6.1
$
9.43
185,470
(b)
$
12.80
(a)
Included approximately 32,603 stock options granted under the
Exchange Program.
(b)
Total number of exercisable options for the years ended
December 31, 2005 and 2003 were 185,470 and 168,923,
respectively. As of December 31, 2004, the exercise of
otherwise exercisable stock options was suspended, until such
time, at the earliest, that Nortel and NNL are in compliance
with U.S. and Canadian regulatory securities filing requirements.
189
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Restricted stock unit plans
The Nortel Networks Limited Restricted Stock Unit Plan is a
long-term incentive plan that generally provides executive
officers and certain senior management with the opportunity to
receive RSUs over a specified period of time if assigned
performance thresholds are achieved and the compensation and
human resources committee (formerly the joint leadership
resources committee) of the Boards of Directors of Nortel and
NNL (the “Committee”) determines, in its discretion,
to issue and settle all or a portion of the allocated RSUs. Each
RSU issued entitles the holder, upon exercise, to receive one
authorized, but until selling of the RSUs unissued, common share
of Nortel Networks Corporation, purchased either on the open
market, or from shares held in third party trusts. As a result
of changes to the NYSE listing standards effective June 30,2004, no further RSUs may be allocated without shareholder
approval.
The RSUs allocated in 2003 had a three year performance period
ended December 31, 2005, which included four performance
thresholds. The performance criteria for each of the four
performance thresholds were distinct “Return on Sales
Before Tax” percentage targets, calculated on a rolling
four-quarter basis. In order to receive a payout, the recipient
must have continued employment until the date the allocated RSUs
were issued and settled. Once the Committee determined that a
threshold had been achieved, the Committee had the discretion to
determine whether additional factors should be considered in
determining the number of allocated RSUs to be issued and
settled. Such additional factors included the performance of
competitors and other relevant business, financial, competitive,
political and other criteria deemed appropriate by the
Committee. Nortel issued and settled approximately
13 million units of the RSUs allocated in 2003.
On January 10, 2005, the Committee exercised the discretion
reserved to it with respect to the RSUs allocated in 2003 and
determined, and the Boards of Directors of Nortel and NNL
confirmed and approved, that no additional RSUs allocated in
2003 would be issued (including in connection with the
achievement of the third and fourth “Return on Sales Before
Tax” performance targets or otherwise) and that all
unissued RSUs relating to 2003 were immediately terminated and
cancelled in their entirety.
The SIP, an additional equity incentive plan, was approved by
shareholders of Nortel at the June 29, 2005 combined 2004
and 2005 annual meeting of shareholders. Under the SIP, time
based or performance based RSUs may be amended.
The number of RSUs (in millions) allocated as of
December 31, 2005, 2004 and 2003 were approximately 7,
11 and 20, respectively. All of the RSUs awarded to
executive officers in 2005 are time based awards granted
pursuant to the SIP. Generally, each award vests in equal
installments on the first three anniversary dates of the date of
the award. The RSUs awarded in 2005 under the SIP will be
settled in shares at the time of vesting.
Directors’ deferred share compensation plans
Under the Nortel Networks Corporation Directors’ Deferred
Share Compensation Plan and the Nortel Networks Limited
Directors’ Deferred Share Compensation Plan, non-employee
directors can elect to receive all or a portion of their
compensation for services rendered as a director of Nortel or
NNL, any committees thereof, and as board or committee
chairperson, in cash, share units or a combination of cash and
share units. Generally, the share units are settled four trading
days following the release of Nortel’s financial results
after the director ceases to be a member of the applicable
board, and each share unit entitles the holder to receive one
common share of Nortel Networks Corporation purchased on the
open market. As of December 31, 2005 and 2004, the number
of share units outstanding (in millions) was 1 and 2,
respectively.
Employee stock purchase plans
Nortel has ESPPs to facilitate the acquisition of common shares
of Nortel Networks Corporation by eligible employees. On
June 29, 2005, the shareholders of Nortel approved three
new stock purchase plans, the Nortel Global Stock Purchase Plan,
the Nortel U.S. Stock Purchase Plan and the Nortel Stock
Purchase Plan for Members of the Savings and Retirement Program
which have been launched in jurisdictions throughout the world.
The ESPPs are designed to have four offering periods each year,
with each offering period beginning on the first day of each
calendar quarter. Eligible employees were permitted to have up
to 10 percent of their eligible compensation deducted from
their pay during each offering period to contribute towards the
purchase of Nortel Networks Corporation
190
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
common shares. The Nortel Networks Corporation common shares
were purchased by an independent broker through the facilities
of the TSX and/or NYSE, and held by a custodian on behalf of the
plan participants.
For eligible employees, Nortel Networks Corporation common
shares were purchased on the TSX at fair market value but
employees effectively paid only 85% of that price as a result of
Nortel contributing the remaining 15% of the price.
The purchases under the ESPPs for the years ended
December 31 are shown below:
(number of shares in thousands)
2005
2004
2003
Nortel Networks Corporation common shares
purchased(a)
776
—
11,532
Weighted-average price of shares purchased
$
3.08
$
—
$
3.10
(a)
Compensation expense was recognized for Nortel’s portion of
the contributions. Nortel contributed an amount equal to the
difference between the market price and the purchase price.
The delay in filing the 2003, 2004 and 2005 Annual Reports (see
note 23) resulted in suspension of the purchase of Nortel
Networks Corporation common shares under the stock purchase
plans. In lieu of the employer portion of stock purchase plan
contributions, Nortel made equivalent pre-tax payments to
eligible employees during the year ended December 31, 2005
totaling $5, which was recorded as compensation expense.
Stock-based compensation
Effective January 1, 2003, Nortel elected to adopt the fair
value based method for measurement and recognition of all
stock-based compensation prospectively for all awards granted,
modified or settled on or after January 1, 2003 in
accordance with SFAS 148. Prior to January 1, 2003,
Nortel, as permitted under SFAS 123, applied the intrinsic
value method under APB 25, and related interpretations in
accounting for its employee stock-based compensation plans.
The fair value at grant date of stock options is estimated using
the Black-Scholes-Merton option-pricing model. Compensation
expense is recognized on a straight-line basis over the stock
option vesting period. Adjustments to compensation expense due
to not meeting employment vesting requirements are accounted for
in the period when they occur.
Stock-based compensation recorded during the years ended
December 31 was as follows:
2005
2004
2003
Stock-based compensation:
Stock option expense
$
87
$
77
$
26
Employer portion of
ESPPs(a)
—
—
6
RSU
expense(a)
1
41
19
DSU
expense(a)
1
(1
)
4
Total stock-based compensation reported — net of tax
$
89
$
117
$
55
(a)
Compensation related to employer portion of ESPPs, RSUs and DSUs
was net of tax of nil in each period.
During the year ended December 31, 2005, approximately
64 million stock options were granted. During the year
ended December 31, 2004, approximately 38 million
stock options were granted.
191
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
The following weighted-average assumptions were used in
computing the fair value of stock options for purposes of
expense recognition and pro forma disclosures, as applicable,
for the following periods:
2005
2004
2003
Black-Scholes weighted-average assumptions
Expected dividend yield
0.00
%
0.00
%
0.00
%
Expected volatility
86.26
%
94.47
%
92.49
%
Risk-free interest rate
4.11
%
2.96
%
2.81
%
Expected option life in years
4
4
4
Weighted-average stock option fair value per option
granted
$
1.88
$
5.21
$
1.57
20.
Discontinued operations
In 2001, Nortel’s Board of Directors approved a plan to
discontinue Nortel’s access solutions operations consisting
of all of Nortel’s narrowband and broadband access
solutions, including copper, cable and fixed wireless solutions,
as well as Nortel’s then consolidated membership interest
in Arris Group and equity investment in Elastic Networks, Inc.
(“Elastic Networks”). Also affected by the decision
were Nortel’s prior acquisitions of Sonoma Systems
(“Sonoma”), Promatory Communications, Inc.
(“Promatory”), Aptis Communications, Inc.
(“Aptis”) and Broadband Networks Inc.
Certain disposal activities were delayed beyond the original
planned timeframe of one year due to the prolonged deterioration
in industry and market conditions during 2003. Accordingly,
during the year ended December 31, 2003, Nortel continued
to wind down its access solutions operations and, as of
December 31, 2003, Nortel had substantially completed the
wind down of these operations.
The following consolidated financial results for discontinued
operations are presented as of December 31 for the
consolidated statements of operations and consolidated
statements of cash flows:
Consolidated statements of operations:
2005
2004
2003
Revenues
$
—
$
4
$
14
Net gain (loss) on disposal of operations — net of tax
(a)
$
1
$
49
$
183
Net earnings (loss) from discontinued operations — net
of tax
$
1
$
49
$
183
(a)
Net gain (loss) on disposal of operations was net of an
applicable income tax expense (benefit) of nil, nil and $1 for
the years ended December 31, 2005, 2004 and 2003,
respectively.
Consolidated statements of cash flows:
2005
2004
2003
Cash flows from (used in) discontinued operations
Operating activities
$
33
$
22
$
149
Investing activities
—
—
241
Net cash from discontinued operations
$
33
$
22
$
390
2005 Activity
Nortel recorded net earnings from discontinued
operations — net of tax, of $1 in 2005.
2004 Activity
Nortel recorded net earnings from discontinued
operations — net of tax, of $49 in 2004. The
significant items included in net earnings are summarized below.
192
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
During the year ended December 31, 2004, Nortel reassessed
its remaining provisions for discontinued operations and
recorded a net gain of $17, consisting of changes in estimates
of $13 for liabilities and $4 for both short-term and long-term
receivables.
On December 23, 2004, a customer financing arrangement was
restructured. The notes receivable that were restructured had a
net carrying amount of $1, net of a provision of $63. The
arrangement increased the net carrying amount of the receivable
to $33 and resulted in a gain of $32 due to the revaluation of
the receivable. On January 25, 2005, Nortel sold this
receivable for cash proceeds (see note 15).
2003 Activity
Nortel recorded net earnings from discontinued
operations — net of tax, of $183 in 2003. The
significant items included in net earnings are summarized below.
During the year ended December 31, 2003, Nortel reassessed
its remaining provisions for discontinued operations and
recorded a net gain of $68, consisting of changes in estimates
of $149 for liabilities, offset by additional provisions for
both short-term and long-term receivables of $81.
On December 17, 2003, Nortel entered into an agreement to
settle an outstanding $21 note receivable from one of its
customers, which was previously provisioned, for total cash
proceeds of approximately $17. A gain of $17 was recorded as a
result of this transaction.
On December 23, 2003, Nortel sold certain plant and
equipment, inventory, patent and other intellectual property
related to its fixed wireless access operations, to Airspan
Networks Inc. (“Airspan”). Nortel received cash
proceeds of $13. The majority of the assets transferred to
Airspan had previously been written off by Nortel as part of its
discontinued operations. As a result of this transaction, Nortel
recorded a gain of $14 during the year ended December 31,2003.
On March 24, 2003, Nortel sold 8 million common shares
of Arris Group back to Arris Group for cash consideration of $28
pursuant to a March 11, 2003 agreement, which resulted in a
gain of $12. Following this transaction, Nortel’s interest
in Arris Group was reduced to 18.8 percent, and it ceased
equity accounting for the investment. As a result, Nortel
classified its remaining ownership interest in Arris Group as an
available-for-sale investment within continuing operations.
On March 18, 2003, Nortel assigned its subordinated
redeemable preferred interest (“membership interest”)
in Arris Interactive, L.L.C. (“Arris Interactive”) to
ANTEC Corporation, an Arris Group company, for cash
consideration of $88. As a result of this transaction, Nortel
recorded a loss of $2. Also in connection with the March 2003
transactions, Nortel received $11 upon settlement of a sales
representation agreement with Arris Group and recorded a gain of
$11.
On March 20, 2003, Nortel entered into an agreement with a
customer to restructure approximately $465 of trade and customer
financing receivables owed to Nortel, the majority of which was
previously provisioned. As a result of the restructuring
agreement, Nortel received consideration including cash of $125,
notes receivable and an ownership interest which were fully
provided for and the mutual release of all other claims between
the parties. A gain of $66 was recorded as a result of the
transaction. In addition to the restructuring agreement, a five
year equipment and services supply agreement was entered into
requiring customer payment terms of either cash in advance or
guarantee by letters of credit in favor of Nortel.
21.
Related party transactions
In the ordinary course of business, Nortel engages in
transactions with certain of its equity-owned investees that are
under or are subject to Nortel’s significant influence and
with joint ventures of Nortel. These transactions are sales and
purchases of goods and services under usual trade terms and are
measured at their exchange amounts.
193
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Transactions with related parties for the years ended
December 31 are summarized as follows:
2005
2004
2003
Revenues
$
4
$
1
$
1
Purchases:
Bookham
$
20
$
73
$
84
LG Electronics
Inc.(a)
41
—
—
Sasken Communications Technology
Ltd.(b)
18
—
—
Other
10
—
—
Total
$
89
$
73
$
84
(a)
LG is a minority interest holder of LG-Nortel. Nortel’s
purchases relate primarily to certain inventory related items.
As of December 31, 2005, accounts payable to LG were $18.
(b)
Nortel currently owns a minority interest in Sasken
Communications Technology Ltd (“Sasken”).
Nortel’s purchases from Sasken relate primarily to software
and other software development related purchases. As of
December 31, 2005, accounts payable to Sasken were $2.
As at December 31, 2005 and 2004, accounts receivable from
related parties were $8 and nil, respectively. As at
December 31, 2005 and 2004, accounts payable to related
parties were $26 and $5, respectively.
Nortel purchases certain inventory for its Carrier Packet
Networks business from Bookham, a related party due to
Nortel’s equity interest in Bookham. During the years ended
December 31, 2005, 2004 and 2003, Nortel’s aggregate
purchases from Bookham were $20, $73 and $84, respectively. As
of December 31, 2005 and December 31, 2004, accounts
payable to Bookham were nil and $5, respectively. Nortel also
has certain notes receivable due from Bookham with a carrying
amount of $20 and $20 as of December 31, 2005 and 2004,
respectively.
Nortel currently relies on Bookham as its sole supplier of key
components to Nortel’s optical networks solutions in its
Carrier Packet Networks segment. On December 2, 2004,
Nortel and Bookham entered into a restructuring agreement which,
among other changes, extended the maturity date of a senior
secured note (the “Series B Note”) by one year
from November 8, 2005 to November 8, 2006, and
eliminated the conversion feature of a senior unsecured note
(the “Series A Note”). Bookham also agreed to
secure the Series A Note, provide additional collateral for
the Series A Note and the Series B Note, and provide
Nortel with other debt protection covenants. See note 10
for additional information on the Bookham transactions
In 2001, Nortel completed the sale of substantially all of the
assets in the Cogent Defence Systems (“CDS”) business
to EADS Telecom. At that time, Nortel held a 41 percent
ownership interest in EADS Telecom and EADS held the remaining
59 percent. Under the terms of the agreement, Nortel sold
substantially all of its assets in the CDS business including:
fixed assets; accounts receivable; inventory; intellectual
property; and licenses (but excluding cash on hand as at the
closing date) for consideration of approximately $143, comprised
of a loan note due in 2002 and a call option to acquire an
additional approximate 7 percent ownership interest in NNF
beginning in 2004. Nortel recorded a gain on the sale of
approximately $37 which was included in (gain) loss on sale
of businesses and assets, and a deferred gain of $26, which is
amortized into (gain) loss on sale of businesses and assets
over the life of the assets sold to EADS Telecom. In 2002, in
connection with negotiations with EADS, the loan note and call
option were cancelled and a new loan note was issued to satisfy
the remaining consideration owing in 2003. As a result, Nortel
recorded an additional gain on the sale of approximately $30,
which was included in (gain) loss on sale of businesses and
assets and a further deferred gain of $21, which is amortized
into (gain) loss on sale of businesses and assets over the
remaining life of the assets sold to EADS Telecom in 2001.
During the years ended December 31, 2003 and 2002, $13 and
$11, respectively, of the deferred gain was amortized into
(gain) loss on sale of businesses and assets. On
September 18, 2003, as a result of the sale of
Nortel’s 41 percent interest in EADS Telecom (see
note 10), the remaining unamortized deferred gain of $23
related to the sale of substantially all of the assets in the
CDS business during the year ended December 31, 2001, was
recognized and included in (gain) loss on sale of
businesses and assets.
194
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
22.
Contingencies
Subsequent to the February 15, 2001 announcement in which
Nortel provided revised guidance for financial performance for
the 2001 fiscal year and the first quarter of 2001, Nortel and
certain of its then current officers and directors were named as
defendants in more than twenty-five purported class action
lawsuits. These lawsuits in the U.S. District Courts for
the Eastern District of New York, the Southern District of New
York and the District of New Jersey and in courts in the
provinces of Ontario, Québec and British Columbia in
Canada, on behalf of shareholders who acquired Nortel Networks
Corporation securities as early as October 24, 2000 and as
late as February 15, 2001, allege, among other things,
violations of U.S. federal and Canadian provincial
securities laws. These matters also have been the subject of
review by Canadian and U.S. securities regulatory
authorities. On May 11, 2001, the defendants filed motions
to dismiss and/or stay in connection with the three proceedings
in Québec primarily based on the factual allegations
lacking substantial connection to Québec and the inclusion
of shareholders resident in Québec in the class claimed in
the Ontario lawsuit. The plaintiffs in two of these proceedings
in Québec obtained court approval for discontinuances of
their proceedings on January 17, 2002. The motion to
dismiss and/or stay the third proceeding (the “Québec
I Action”) was heard on November 6, 2001 and the court
deferred any determination on the motion to the judge who will
hear the application for authorization to commence a class
proceeding. On December 6, 2001, the defendants filed a
motion seeking leave to appeal that decision. The motion for
leave to appeal was dismissed on March 11, 2002. On
October 16, 2001, an order in the U.S. District Court
for the Southern District of New York was filed consolidating
twenty-five of the related U.S. class action lawsuits into
a single case, appointing class plaintiffs and counsel for such
plaintiffs (the “Nortel I Class Action”). The
plaintiffs served a consolidated amended complaint on
January 18, 2002. On December 17, 2001, the defendants
in the British Columbia action (the “British Columbia
Action”) served notice of a motion requesting the court to
decline jurisdiction and to stay all proceedings on the grounds
that British Columbia is an inappropriate forum. The motion has
been adjourned at the plaintiffs’ request to a future date
to be set by the parties.
On April 1, 2002, Nortel filed a motion to dismiss the
Nortel I Class Action on the ground that it failed to state
a cause of action under U.S. federal securities laws. On
January 3, 2003, the District Court denied the motion to
dismiss the consolidated amended complaint for the Nortel I
Class Action. The plaintiffs served a motion for class
certification on March 21, 2003. On May 30, 2003, the
defendants served an opposition to the motion for class
certification. Plaintiffs’ reply was served on
August 1, 2003. The District Court held oral arguments on
September 3, 2003 and issued an order granting class
certification on September 5, 2003. On September 23,2003, the defendants filed a motion in the U.S. Court of
Appeals for the Second Circuit for permission to appeal the
class certification decision. The plaintiffs’ opposition to
the motion was filed on October 2, 2003. On
November 24, 2003, the U.S. Court of Appeals for the
Second Circuit denied the motion. On March 10, 2004, the
District Court approved the form of notice to the class, which
was published and mailed.
On July 17, 2002, a purported class action lawsuit (the
“Ontario Claim”) was filed in the Ontario Superior
Court of Justice, Commercial List, naming Nortel, certain of its
current and former officers and directors and its auditors as
defendants. The factual allegations in the Ontario Claim are
substantially similar to the allegations in the Nortel I
Class Action. The Ontario Claim is on behalf of all
Canadian residents who purchased Nortel Networks Corporation
securities (including options on Nortel Networks Corporation
securities) between October 24, 2000 and February 15,2001. The plaintiffs claim damages of Canadian $5,000, plus
punitive damages in the amount of Canadian $1,000, prejudgment
and postjudgment interest and costs of the action. On
September 23, 2003, the Court issued an order allowing the
plaintiffs to proceed to amend the Ontario Claim and requiring
that the plaintiffs serve class certification materials by
December 15, 2003. On September 24, 2003, the
plaintiffs filed a notice of discontinuance of the original
action filed in Ontario. On December 12, 2003,
plaintiffs’ counsel requested an extension of time to
January 21, 2004 to deliver class certification materials.
On January 21, 2004, plaintiffs’ counsel advised the
Court that the two representative plaintiffs in the action no
longer wished to proceed, but counsel was prepared to deliver
draft certification materials pending the replacement of the
representative plaintiffs. On February 19, 2004, the
plaintiffs’ counsel advised the Court of a potential new
representative plaintiff. On February 26, 2004, the
defendants requested the Court to direct the plaintiffs’
counsel to bring a motion to permit the withdrawal of the
current representative plaintiffs and to substitute the proposed
representative plaintiff. On June 8, 2004, the Court signed
an order allowing a Second Fresh as Amended Statement of Claim
that substituted one new representative plaintiff, but did not
change the substance of the prior claim.
195
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Subsequent to the March 10, 2004 announcement in which
Nortel indicated it was likely that it would need to revise its
previously announced unaudited results for the year ended
December 31, 2003, and the results reported in certain of
its quarterly reports for 2003, and to restate its previously
filed financial results for one or more earlier periods, Nortel
and certain of its then current and former officers and
directors were named as defendants in 27 purported class action
lawsuits. These lawsuits in the U.S. District Court for the
Southern District of New York on behalf of shareholders who
acquired Nortel Networks Corporation securities as early as
February 16, 2001 and as late as May 15, 2004, allege,
among other things, violations of U.S. federal securities
laws. These matters are also the subject of investigations by
Canadian and U.S. securities regulatory and criminal
investigative authorities. On June 30, 2004, the Court
signed Orders consolidating the 27 class actions (the
“Nortel II Class Action”) and appointing
lead plaintiffs and lead counsel. The plaintiffs filed a
consolidated class action complaint on September 10, 2004,
alleging a class period of April 24, 2003 through and
including April 27, 2004. On November 5, 2004, Nortel
and the Audit Committee Defendants filed a motion to dismiss the
consolidated class action complaint. On January 18, 2005,
the lead plaintiffs, Nortel and the Audit Committee Defendants
reached an agreement in which Nortel would withdraw its motion
to dismiss and plaintiffs would dismiss Count II of the
complaint, which asserts a claim against the Audit Committee
Defendants. On May 13, 2005, the plaintiffs filed a motion
for class certification. On September 16, 2005, lead
plaintiffs filed an amended consolidated class action complaint
that rejoined the previously dismissed Audit Committee
Defendants as parties to the action. On March 16, 2006, the
plaintiffs withdrew their motion for class certification.
On July 28, 2004, Nortel and NNL, and certain of their
current and former officers and directors, were named as
defendants in a purported class proceeding in the Ontario
Superior Court of Justice on behalf of shareholders who acquired
Nortel Networks Corporation securities as early as
November 12, 2002 and as late as July 28, 2004 (the
“Ontario I Action”). This lawsuit alleges, among other
things, breaches of trust and fiduciary duty, oppressive conduct
and misappropriation of corporate assets and trust property in
respect of the payment of cash bonuses to executives, officers
and employees in 2003 and 2004 under the Nortel Return to
Profitability bonus program and seeks damages of Canadian $250
and an order under the Canada Business Corporations Act
directing that an investigation be made respecting these bonus
payments.
On February 16, 2005, a motion for authorization to
institute a class action on behalf of residents of Québec,
who purchased Nortel securities between January 29, 2004
and March 15, 2004, was filed in the Québec Superior
Court naming Nortel as a defendant (the
“Québec II Action”). The motion alleges that
Nortel made misrepresentations about 2003 financial results.
On March 9, 2005, Nortel and certain of its current and
former officers and directors and its auditors were named as
defendants in a purported class action proceeding filed in the
Ontario Superior Court of Justice, Commercial List, on behalf of
all Canadian residents who purchased Nortel Networks Corporation
securities from April 24, 2003 to April 27, 2004 (the
“Ontario II Action”). This lawsuit alleges, among
other things, negligence, misrepresentations, oppressive
conduct, insider trading and violations of Canadian corporation
and competition laws in connection with Nortel’s 2003
financial results and seeks damages of Canadian $3,000, plus
punitive damages in the amount of Canadian $1,000, prejudgment
and postjudgment interest and costs of the action.
On September 30, 2005, Nortel announced that a mediator had
been jointly appointed by the two U.S. District Court
Judges presiding over the Nortel I Class Action and the
Nortel II Class Action to oversee settlement
negotiations between Nortel and the lead plaintiffs in these two
actions. The appointment of the mediator was pursuant to a
request by Nortel and the lead plaintiffs for the Courts’
assistance to facilitate the possibility of achieving a global
settlement regarding these actions. The settlement discussions
before the mediator are confidential and non-binding on the
parties without prejudice to their respective positions in the
litigation. The mediator, United States District Court Judge the
Honorable Robert W. Sweet, is not presiding over either of these
actions. On February 8, 2006, Nortel announced first that,
as a result of this mediation process, Nortel and the lead
plaintiffs in the Nortel I Class Action and the
Nortel II Class Action have reached an agreement in
principle to settle these lawsuits (the “Proposed
Class Action Settlement”).
The Proposed Class Action Settlement would be part of, and
is conditioned on, Nortel reaching a global settlement
encompassing all pending shareholder class actions and proposed
shareholder class actions commenced against Nortel and certain
other defendants following Nortel’s announcement of revised
financial guidance during 2001, and Nortel’s revision of
its 2003 financial results and restatement of other prior
periods, including, without limitation, the Nortel I
Class Action, the Nortel II Class Action, the
Ontario Claim, the Québec I Action, the British Columbia
Action, the
196
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Ontario I Action, the Québec II Action and the
Ontario II Action. The Proposed Class Action
Settlement is also conditioned on the receipt of all required
court, securities regulatory and stock exchange approvals. The
Proposed Class Action Settlement would contain no admission
of wrongdoing by Nortel or any of the other defendants.
The Proposed Class Action Settlement was also conditioned
on Nortel and the lead plaintiffs reaching agreement on
corporate governance related matters and the resolution of
insurance related issues. On March 17, 2006 Nortel
announced that it and the lead plaintiff had reached such an
agreement with Nortel’s insurers agreeing to pay $228.5 in
cash towards the settlement and Nortel agreeing with its
insurers to certain indemnification obligations. On
April 3, 2006, the insurance proceeds were placed into
escrow by the insurers. Nortel believes that these
indemnification obligations would be unlikely to materially
increase its total cash payment obligations under the Proposed
Class Action Settlement. The insurance payments would not reduce
the amounts payable by Nortel as noted below. Nortel also agreed
to certain corporate governance enhancements, including the
codification of certain of its current governance practices in
its Board of Directors written mandate and the inclusion in its
annual proxy circular and proxy statement of a report on certain
of its governance practices.
Under the terms of the proposed global settlement contemplated
by the Proposed Class Action Settlement, Nortel would make
a payment of $575 in cash, issue 628,667,750 of Nortel Networks
Corporation common shares (representing 14.5% of Nortel’s
equity as of February 7, 2006), and contribute one-half of
any recovery in Nortel’s existing litigation against
Messrs. Frank Dunn, Douglas Beatty and Michael Gollogly,
Nortel’s former senior officers who were terminated for
cause in April 2004, seeking the return of payments made to them
under Nortel’s bonus plan in 2003. In the event of a share
consolidation of Nortel Networks Corporation common shares, the
number of Nortel Networks Corporation common shares to be issued
pursuant to the Proposed Class Action Settlement would be
adjusted accordingly. The total settlement amount would include
all plaintiffs’ court-approved attorneys’ fees. As a
result of the Proposed Class Action Settlement, Nortel has
established a litigation provision and recorded a charge to its
full-year 2005 financial results of $2,474, $575 of which
relates to the proposed cash portion of the Proposed
Class Action Settlement, while $1,899 relates to the
proposed equity component and will be adjusted in future
quarters based on the fair value of the Nortel Networks
Corporation common shares issuable until the finalization of the
settlement. Any change to the terms of the Proposed
Class Action Settlement would likely result in an
adjustment to the litigation provision.
Nortel and the lead plaintiffs in the Nortel I Class Action
and the Nortel II Class Action are continuing
discussions towards a definitive settlement agreement based on
the Proposed Class Action Settlement. At this time, it is
not certain that such an agreement can be reached, that each of
the actions noted above can be brought into, or otherwise bound
by, the proposed settlement, if finalized, or that any such
definitive settlement agreement would receive the required court
and other approvals in all applicable jurisdictions, and the
timing of any developments related to these matters is not
certain.
In addition to the shareholder class actions encompassed by the
Proposed Class Action Settlement, Nortel is also subject to
ongoing regulatory and criminal investigations and related
matters relating to its accounting restatements, and to certain
other class actions, securities litigation and other actions
described below. The Proposed Class Action Settlement and
the litigation provision charge taken in connection with the
Proposed Class Action Settlement do not relate to these
matters. Nortel has not provided any additional provisions at
this time for any potential judgments, fines, penalties or
settlements that may arise from these other pending
investigations or actions (other than for professional fees and
expenses incurred).
On April 5, 2004, Nortel announced that the SEC had issued
a formal order of investigation in connection with Nortel’s
previous restatement of its financial results for certain
periods, as announced in October 2003, and Nortel’s
announcements in March 2004 regarding the likely need to revise
certain previously announced results and restate previously
filed financial results for one or more periods. The matter had
been the subject of an informal SEC inquiry. On April 13,2004, Nortel announced that it had received a letter from the
staff of the Ontario Securities Commission (the “OSC”)
advising that there is an OSC Enforcement Staff investigation
into the same matters that are the subject of the SEC
investigation.
On May 14, 2004, Nortel announced that it had received a
federal grand jury subpoena for the production of certain
documents, including financial statements and corporate,
personnel and accounting records, in connection with an ongoing
criminal investigation being conducted by the
U.S. Attorney’s Office for the Northern District of
Texas, Dallas
197
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Division. On August 23, 2005, Nortel received an additional
federal grand jury subpoena in this investigation seeking
production of additional documents, including documents relating
to the Nortel Retirement Income Plan and the Nortel Long-Term
Investment Plan.
On August 16, 2004, Nortel received a letter from the
Integrated Market Enforcement Team of the Royal Canadian Mounted
Police (“RCMP”) advising Nortel that the RCMP would be
commencing a criminal investigation into Nortel’s financial
accounting situation.
A purported class action lawsuit was filed in the
U.S. District Court for the Middle District of Tennessee on
December 21, 2001, on behalf of participants and
beneficiaries of the Nortel Long-Term Investment Plan (the
“Plan”) at any time during the period of March 7,2000 through the filing date and who made or maintained Plan
investments in Nortel Networks Corporation common shares, under
the Employee Retirement Income Security Act (“ERISA”)
for Plan-wide relief and alleging, among other things, material
misrepresentations and omissions to induce Plan participants to
continue to invest in and maintain investments in Nortel
Networks Corporation common shares in the Plan. A second
purported class action lawsuit, on behalf of the Plan and Plan
participants for whose individual accounts the Plan purchased
Nortel Networks Corporation common shares during the period from
October 27, 2000 to February 15, 2001 and making
similar allegations, was filed in the same court on
March 12, 2002. A third purported class action lawsuit, on
behalf of persons who are or were Plan participants or
beneficiaries at any time since March 1, 1999 to the filing
date and making similar allegations, was filed in the same court
on March 21, 2002. The first and second purported class
action lawsuits were consolidated by a new purported class
action complaint, filed on May 15, 2002 in the same court
and making similar allegations, on behalf of Plan participants
and beneficiaries who directed the Plan to purchase or hold
shares of certain funds, which held primarily Nortel Networks
Corporation common shares, during the period from March 7,2000 through December 21, 2001. On September 24, 2002,
plaintiffs in the consolidated action filed a motion to
consolidate all the actions and to transfer them to the
U.S. District Court for the Southern District of New York.
The plaintiffs then filed a motion to withdraw the pending
motion to consolidate and transfer. The withdrawal was granted
by the District Court on December 30, 2002. A fourth
purported class action lawsuit, on behalf of the Plan and Plan
participants for whose individual accounts the Plan held Nortel
Networks Corporation common shares during the period from
March 7, 2000 through March 31, 2001 and making
similar allegations, was filed in the U.S. District Court
for the Southern District of New York on March 12, 2003. On
March 18, 2003, plaintiffs in the fourth purported class
action filed a motion with the Judicial Panel on Multidistrict
Litigation to transfer all the actions to the U.S. District
Court for the Southern District of New York for coordinated or
consolidated proceedings pursuant to 28 U.S.C.
section 1407. On June 24, 2003, the Judicial Panel on
Multidistrict Litigation issued a transfer order transferring
the Southern District of New York action to the
U.S. District Court for the Middle District of Tennessee
(the “Consolidated ERISA Action”). On
September 12, 2003, the plaintiffs in all the actions filed
a consolidated class action complaint. On October 28, 2003,
the defendants filed a motion to dismiss the complaint and a
motion to stay discovery pending disposition of the motion to
dismiss. On March 30, 2004, the plaintiffs filed a motion
for certification of a class consisting of participants in, or
beneficiaries of, the Plan who held shares of the Nortel Stock
Fund during the period from March 7, 2000 through
March 31, 2001. On April 27, 2004, the Court granted
the defendants’ motion to stay discovery pending resolution
of defendants’ motion to dismiss. On June 15, 2004,
the plaintiffs filed a First Amended Consolidated
Class Action Complaint that added additional current and
former officers and employees as defendants and expanded the
purported class period to extend from March 7, 2000 through
to June 15, 2004. On June 17, 2005, the plaintiffs
filed a Second Amended Consolidated Class Action Complaint
that added additional current and former directors, officers and
employees as defendants and alleged breach of fiduciary duty on
behalf of the Plan and as a purported class action on behalf of
participants and beneficiaries of the Plan who held shares of
the Nortel Networks Stock Fund during the period from
March 7, 2000 through June 17, 2005. On July 8,2005, the defendants filed a Renewed Motion to Dismiss
Plaintiffs’ Second Amended Class Action Complaint. On
July 29, 2005, plaintiffs filed an opposition to the
motion, and defendants filed a reply memorandum on
August 12, 2005. On March 30, 2006, the defendants
filed an additional motion to dismiss raising the jurisdictional
challenge that all former plan participants, including one of
the named plaintiffs, lack standing to assert a claim under
ERISA. On April 17, 2006, the plaintiffs filed a motion to
strike this motion to dismiss.
On May 18, 2004, a purported class action lawsuit was filed
in the U.S. District Court for the Middle District of
Tennessee on behalf of individuals who were participants and
beneficiaries of the Plan at any time during the period of
December 23, 2003 through the filing date and who made or
maintained Plan investments in Nortel Networks
198
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Corporation common shares, under the ERISA for Plan-wide relief
and alleging, among other things, breaches of fiduciary duty. On
September 3, 2004, the Court signed a stipulated order
consolidating this action with the Consolidated ERISA Action
described above. On June 16, 2004, a second purported class
action lawsuit, on behalf of the Plan and Plan participants for
whose individual accounts the Plan purchased Nortel Networks
Corporation common shares during the period from
October 24, 2000 to June 16, 2004, and making similar
allegations, was filed in the U.S. District Court for the
Southern District of New York. On August 6, 2004, the
Judicial Panel on Multidistrict Litigation issued a conditional
transfer order to transfer this action to the U.S. District
Court for the Middle District of Tennessee for coordinated or
consolidated proceedings pursuant to 28 U.S.C.
section 1407 with the Consolidated ERISA Action described
above. On August 20, 2004, plaintiffs filed a notice of
opposition to the conditional transfer order with the Judicial
Panel. On December 6, 2004, the Judicial Panel denied the
opposition and ordered the action transferred to the
U.S. District Court for the Middle District of Tennessee
for coordinated or consolidated proceedings with the
Consolidated ERISA Action described above. On January 3,2005, this action was received in the U.S. District Court
for the Middle District of Tennessee and consolidated with the
Consolidated ERISA Action described above.
On July 30, 2004, a shareholders’ derivative complaint
was filed in the U.S. District Court for the Southern
District of New York against certain current and former officers
and directors, of Nortel alleging, among other things, breach of
fiduciary duties owed to Nortel during the period from 2000 to
2003 including by causing Nortel to engage in unlawful conduct
or failing to prevent such conduct; causing Nortel to issue
false statements; and violating the law (the
“U.S. Derivative Action”). On February 14,2005, the defendants filed motions to dismiss the derivative
complaint. On April 29, 2005, the plaintiffs filed an
opposition to the motions to dismiss. On May 26, 2005, the
defendants filed a reply memorandum in support of the motions to
dismiss. On August 24, 2005, the Court issued an opinion
and order granting the defendants’ motions to dismiss the
derivative complaint. Since the plaintiffs did not appeal the
dismissal and the time to file an appeal has passed, this action
is concluded.
On December 21, 2005, an application was filed in the
Ontario Superior Court of Justice for leave to commence a
shareholders’ derivative action on Nortel’s behalf
against certain current and former officers and directors, of
Nortel alleging, among other things, breach of fiduciary duties,
breach of duty of care and negligence, and unjust enrichment in
respect of various alleged acts and omissions including causing
or permitting Nortel to issue alleged materially false and
misleading statements regarding expected growth in revenues and
earnings for 2000 and 2001 and endorsing or permitting
accounting practices relating to provisions not in compliance
with GAAP. The proposed derivative action would seek on
Nortel’s behalf, among other things, compensatory damages
of Canadian $1,000 and punitive damages of Canadian $10 from the
individual defendants (the “Proposed Ontario Derivative
Action”). In the Proposed Ontario Derivative Action, the
defendants are the same and the allegations are substantially
similar to the derivative complaint in the U.S. Derivative
Action. The Proposed Ontario Derivative Action would also seek
an order directing Nortel’s Board of Directors to reform
and improve Nortel’s corporate governance and internal
control procedures as the Court may deem necessary or desirable
and an order that Nortel pay the legal fees and other costs in
connection with the Proposed Ontario Derivative Action. The
application for leave to commence the Proposed Ontario
Derivative Action has not yet been heard. However, in response
to a motion brought by the applicants to preserve potential
claims against the possible expiration of potential limitation
periods, Nortel consented to an order, entered February 14,2006, permitting the applicants to file and have issued by the
Court, on an interim basis and pending final determination of
the application, the Proposed Ontario Derivative Action without
prejudice to Nortel’s position on the merits of the
application itself. The order provides that no further steps
shall be taken against the individual defendants in the Proposed
Ontario Derivative Action unless the application is granted and
if the application is denied the Proposed Ontario Derivative
Action is to be discontinued.
Except as otherwise described herein, in each of the matters
described above, the plaintiffs are seeking an unspecified
amount of monetary damages. Nortel is unable to ascertain the
ultimate aggregate amount of monetary liability or financial
impact to Nortel of the above matters, which, unless otherwise
specified, seek damages from the defendants of material or
indeterminate amounts or could result in fines and penalties.
With the exception of $2,474 which Nortel has taken as a charge
in its 2005 financial results as a result of the Proposed
Class Action Settlement, Nortel has not made any provisions
for any potential judgments, fines, penalties or settlements
that may result from these actions, suits, claims and
investigations. Nortel cannot determine whether these actions,
suits, claims and proceedings will, individually or
collectively, have a material adverse effect on the business,
results of operations, financial condition or liquidity of
Nortel. Except for matters encompassed by the Proposed
Class Action Settlement, as to which Nortel and the lead
199
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
plaintiffs are continuing discussions towards a definitive
settlement agreement, Nortel intends to defend these actions,
suits, claims and proceedings, litigating or settling cases
where in management’s judgement it would be in the best
interest of shareholders to do so. Nortel will continue to
cooperate fully with all authorities in connection with the
regulatory and criminal investigations.
Nortel is also a defendant in various other suits, claims,
proceedings and investigations which arise in the normal course
of business.
Environmental matters
Nortel’s operations are subject to a wide range of
environmental laws in various jurisdictions around the world.
Nortel seeks to operate its business in compliance with such
laws. Nortel is subject to new European product content laws and
product takeback and recycling requirements that will require
full compliance commencing in July 2006. As a result of these
laws and requirements, Nortel will incur additional compliance
costs. Although costs relating to environmental matters have not
resulted in a material adverse effect on the business, results
of operations, financial condition or liquidity in the past,
there can be no assurance that Nortel will not be required to
incur such costs in the future. Nortel is actively working on
compliance plans and risk mitigation strategies relating to the
new laws and requirements. Although Nortel is working with its
strategic suppliers in this regard, it is possible that some of
Nortel’s products may not be compliant by the legislated
compliance date. In such event, Nortel expects that it will have
the ability to rely on available exemptions under the new
legislation for most of such products and currently expects
minimal disruption to the distribution of such products. Nortel
intends to manufacture products that are compliant with all
applicable legislation and meet its quality and reliability
requirements.
Nortel has a corporate environmental management system standard
and an environmental program to promote such compliance.
Moreover, Nortel has a periodic, risk-based, integrated
environment, health and safety audit program. Nortel’s
environmental program focuses its activities on design for the
environment, supply chain and packaging reduction issues. Nortel
works with its suppliers and other external groups to encourage
the sharing of non-proprietary information on environmental
research.
Nortel is exposed to liabilities and compliance costs arising
from its past and current generation, management and disposal of
hazardous substances and wastes. As of December 31, 2005,
the accruals on the consolidated balance sheet for environmental
matters were $27. Based on information available as of
December 31, 2005, management believes that the existing
accruals are sufficient to satisfy probable and reasonably
estimable environmental liabilities related to known
environmental matters. Any additional liabilities that may
result from these matters, and any additional liabilities that
may result in connection with other locations currently under
investigation, are not expected to have a material adverse
effect on the business, results of operations, financial
condition and liquidity of Nortel.
Nortel has remedial activities under way at 14 sites which are
either currently or previously owned or occupied facilities. An
estimate of Nortel’s anticipated remediation costs
associated with all such sites, to the extent probable and
reasonably estimable, is included in the environmental accruals
referred to above in an approximate amount of $27.
Nortel is also listed as a potentially responsible party under
the U.S. Comprehensive Environmental Response, Compensation
and Liability Act (“CERCLA”) at four Superfund sites
in the U.S. (at two of the Superfund sites, Nortel is
considered a de minimis potentially responsible party). A
potentially responsible party within the meaning of CERCLA is
generally considered to be a major contributor to the total
hazardous waste at a Superfund site (typically 10% or more,
depending on the circumstances). A de minimis potentially
responsible party is generally considered to have contributed
less than 10% (depending on the circumstances) of the total
hazardous waste at a Superfund site. An estimate of
Nortel’s share of the anticipated remediation costs
associated with such Superfund sites is expected to be de
minimis and is included in the environmental accruals of $27
referred to above.
Liability under CERCLA may be imposed on a joint and several
basis, without regard to the extent of Nortel’s
involvement. In addition, the accuracy of Nortel’s estimate
of environmental liability is affected by several uncertainties
such as additional requirements which may be identified in
connection with remedial activities, the complexity and
evolution of environmental laws and regulations, and the
identification of presently unknown remediation requirements.
Consequently, Nortel’s liability could be greater than its
current estimate.
200
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Other
In August 2004, Nortel entered into a contract with BSNL to
establish a wireless network in India. Nortel recognized
revenues of $228 and $20 in 2005 and 2004, respectively, and
project losses of approximately $148 and $160 in the
corresponding years. Nortel expects to recognize additional
revenues of approximately $92 and additional project losses of
approximately $19 in 2006. The losses are primarily driven by
the existing contractual terms negotiated in response to pricing
pressures as a result of the competitive nature of India’s
telecommunications market and an increase in project
implementation costs. The time limit within which BSNL could
have exercised its 50% business expansion option under the
contract has passed and Nortel will not supply BSNL with
products or services for this expansion.
23.
Subsequent events
Sale of Brampton facility
On January 4, 2006, Nortel announced that it had finalized
an agreement to sell its facility in Brampton, Ontario to Rogers
Communications Inc. (“Rogers”) for approximately $84.
The sale includes the buildings, which comprises approximately
one million square feet, fixtures and certain personal property
located at the facility and 63 acres of land. Included in
the sale was the sale-leaseback of a portion of the buildings on
the Brampton facility to Nortel for lease terms of five years.
The gain on sale is expected to be approximately $18. As of
December 31, 2005, Nortel classified the carrying value of
the Brampton facility as held for sale (see note 5).
Bookham transactions
On January 13, 2006, Nortel received $20 in cash plus
accrued interest from Bookham to retire its $20 aggregate
principal amount Series A secured note receivable due
November 2007. In addition, Nortel sold its $25.9 aggregate
principal amount Series B secured note receivable due
November 2006 for approximately $26 to a group of unrelated
investors.
On January 13, 2006, Nortel announced that it had entered
into an agreement with Bookham to amend the current supply
agreement and extend certain purchase commitments, which were
scheduled to expire on April 29, 2006. Under the terms of
the amended supply agreement, Nortel will purchase a minimum of
$72 in product from Bookham during the calendar year of 2006. In
addition, Nortel has entered into an agreement on the same date
as the supply agreements under which Nortel agreed not to sell
the approximately 4 million shares of Bookham common stock
that it currently owns until after June 30, 2006.
Credit and Support Facilities
On February 14, 2006, Nortel entered into a new one-year
credit facility in the aggregate principal amount of $1,300
(“2006 Credit Facility”). This new facility consists
of (i) a senior secured one-year term loan facility in the
amount of $850 (“Tranche A Term Loans”), and
(ii) a senior unsecured one-year term loan facility in the
amount of $450 (“Tranche B Term Loans”). The
Tranche A Term Loans are secured equally and ratably with
NNL’s obligations under the EDC Support Facility and
NNL’s 6.875% Bonds due 2023 by a lien on substantially all
of the U.S. and Canadian assets of NNL and the U.S. assets
of NNL’s indirect subsidiary, Nortel Networks Inc.
(“NNI”). The Tranche A Term Loans are also
secured equally and ratably with NNL’s obligations under
the EDC Support Facility by a lien on substantially all of
NNC’s U.S. and Canadian assets. The Tranche A Term
Loans and Tranche B Term Loans are also guaranteed by NNC
and NNL and NNL’s obligations under the EDC Support
Facility are also guaranteed by Nortel and NNI, in each case
until the maturity or prepayment of the 2006 Credit Facility.
The 2006 Credit Facility, which will mature in February 2007,
was drawn down in the full amount on February 14, 2006 and
Nortel used the net proceeds primarily to repay the outstanding
$1,275 aggregate principal amount of NNL’s
6.125% Notes that matured on February 15, 2006. Nortel
and NNI agreed to a demand right exercisable at any time after
May 31, 2006 pursuant to which Nortel would be required to
take all reasonable actions to issue senior unsecured debt
securities in the capital markets to repay the 2006 Credit
Facility.
At Nortel’s option, loans bear interest based on the
“Base Rate” (defined as the higher of the Federal
Funds Rate, as published by the Federal Reserve Bank of New
York, plus 0.5% and the prime commercial lending rate of
JPMorgan Chase Bank, N.A., established from time to time) or the
reserve-adjusted London Interbank Offered Rate
(“LIBOR”),
201
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
plus the Applicable Margin. The “Applicable Margin” is
defined as 225 basis points in the case of Tranche A
Term Loans that are LIBOR loans (125 basis points if such
Tranche A Term Loans are Base Rate loans) and
300 basis points in the case of Tranche B Term Loans
that are LIBOR loans (200 basis points if such
Tranche B Term Loans are Base Rate loans). The
Tranche A Loans initially as of February 14, 2006 bear
interest at 6.875% while the Tranche B Loans initially as
of February 14, 2006 bear interest at 7.625%.
The Tranche A Loans contain financial covenants that
require that Nortel achieve Adjusted Earnings before interest,
taxes, depreciation and amortization (“Adjusted
EBITDA”) of not less than $850, $750, $850 and $900 for the
twelve-month period ending March 31, 2006, June 30,2006, September 30, 2006 and December 31, 2006,
respectively. Adjusted EBITDA is generally defined as
consolidated earnings before interest, taxes, depreciation and
amortization, adjusted for certain restructuring charges and
other one-time charges and gains that will be excluded from the
calculation of Adjusted EBITDA. Both the Tranche A Term
Loans and the Tranche B Term Loans contain a covenant that
consolidated unrestricted cash and cash equivalents of Nortel
must at all times exceed $1,000. In addition, the 2006 Credit
Facility contains covenants that limit Nortel’s ability to
create liens on its assets and the assets of substantially all
of its subsidiaries in excess of certain baskets and permitted
amounts, limit its ability and the ability of substantially all
of its subsidiaries to merge, consolidate or amalgamate with
another person. Payments of dividends on the outstanding
preferred shares of NNL and payments under the Proposed
Class Action Settlement are permitted. NNI is required to
prepay the facility in certain circumstances, including in the
event of certain debt or equity offerings or asset dispositions
of collateral by Nortel, NNL or NNI.
Proposed Class Action Settlement
On February 8, 2006, Nortel announced that, as a result of
the previously announced mediation process it entered into with
the lead plaintiffs in two significant class action lawsuits
pending in the U.S. District Court for the Southern
District of New York and based on the recommendation of a senior
Federal Judge, Nortel and the lead plaintiffs had reached an
agreement in principle to settle these lawsuits (the
“Proposed Class Action Settlement”). This
settlement would be part of, and is conditioned on, Nortel
reaching a global settlement encompassing all pending
shareholder class actions and proposed shareholder class actions
commenced against Nortel and certain other defendants following
its announcement of revised financial guidance during 2001 and
its revision of certain of its 2003 financial results and
restatement of other prior periods. The Proposed
Class Action Settlement was also conditioned on Nortel and
the lead plaintiffs reaching agreement on corporate governance
related matters and the resolution of insurance related issues
and the receipt of all required court, securities regulatory and
stock exchange approvals.
On March 17, 2006, Nortel announced that Nortel and the
lead plaintiffs reached an agreement on the related insurance
and corporate governance matters including Nortel’s
insurers agreeing to pay $228.5 in cash towards the settlement
and Nortel and NNL agreeing with their insurers to certain
indemnification obligations. On April 3, 2006, the
insurance proceeds were placed into escrow by the insurers.
Nortel believes that these indemnification obligations would be
unlikely to materially increase its total payment obligations
under the Proposed Class Action Settlement. The insurance
payments would not reduce the amounts payable by Nortel as noted
below. Nortel also agreed to certain corporate governance
enhancements, including the codification or certain of their
current governance practices (such as the annual election by
their directors of a non-executive Board chair) in their
respective Board of Directors written mandates and the inclusion
in Nortel Network’s Corporation respective annual proxy
circular and proxy statement of a report on certain of their
other governance practices (such as the process followed for the
annual evaluation of the Board, committees of the Board and
individual directors). The Proposed Class Action Settlement
would contain no admission of wrongdoing by Nortel or any of the
other defendants.
Under the terms of the proposed global settlement contemplated
by the Proposed Class Action Settlement, Nortel would make
a payment of $575 in cash, issue 628,667,750 Nortel Networks
Corporation common shares (representing 14.5% of Nortel’s
equity as of February 7, 2006), and contribute one-half of
any recovery in its existing litigation against Nortel’s
former president and chief executive officer, former chief
financial officer and former controller, who were terminated for
cause in April 2004, seeking the return of payments made to them
under Nortel’s bonus plan in 2003. In the event of a share
consolidation of Nortel Networks Corporation common shares, the
number of Nortel Networks Corporation common shares to be issued
pursuant to the Proposed Class Action Settlement would be
adjusted accordingly. As a result of the Proposed
Class Action Settlement, Nortel has established a
litigation provision and recorded a charge to its full-
202
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
year 2005 financial results of $2,474, of which $575 relates to
the proposed cash portion of the Proposed Class Action
Settlement, while $1,899 relates to the proposed equity
component and will be adjusted in future quarters based on the
fair value of the Nortel Networks Corporation common shares
issuable until the finalization of the settlement. The cash
amount bears interest commencing March 23, 2006 at a
prescribed rate and is to be held in escrow on June 1, 2006
pending satisfactory completion of all conditions to the
Proposed Class Action Settlement. Any change to the terms
of the Proposed Class Action Settlement as a result of
ongoing discussions with the lead plaintiffs would likely also
result in an adjustment to the litigation provision.
Nortel and the lead plaintiffs are continuing discussions
towards a definitive settlement agreement. At this time, it is
not certain that such an agreement can be reached, that each of
the actions noted above can be brought into, or otherwise bound
by, the proposed settlement, if finalized, or that such an
agreement would receive the required court and other approvals
in all applicable jurisdictions. The timing of any developments
related to these matters is also not certain. The Proposed
Class Action Settlement and the litigation provision charge
taken in connection with the Proposed Class Action
Settlement do not relate to ongoing regulatory and criminal
investigations and do not encompass a related Employment
Retirement Income Security Act (“ERISA”) class action
or the pending application in Canada for leave to commence a
derivative action against certain current and former officers
and directors of Nortel. For additional information see
note 22.
Tasman Networks Acquisition
On February 24, 2006, Nortel acquired Tasman Networks Inc.
(“Tasman Networks”), an established networking company
that provides a portfolio of secure enterprise routers, for
$99.5 in cash and assumed liabilities.
Effective February 28, 2006, Nortel terminated a portion of
an information services outsourcing contract. In connection with
the termination, Nortel agreed to pay $50 to acquire certain
hardware and software assets and the rights under certain
warranty, maintenance, support and other contracts, and to
settle all outstanding claims with the service provider.
Nortel Restatement of previously issued financial
statements
On March 10, 2006, in conjunction with the release of
Nortel’s preliminary unaudited fourth quarter and full year
2005 results, Nortel announced that it and NNL would restate
their financial results for 2003, 2004 and the first nine months
of 2005, and would have adjustments to periods prior to 2003. As
a result of the Third Restatement, Nortel and NNL delayed the
filing of their annual reports on
Form 10-K for the
year ended December 31, 2005 (the “2005 Reports”)
beyond their regulatory filing deadline of March 16, 2006.
Nortel and NNL completed the Third Restatement through the
filing of the 2005 Reports with the SEC and OSC on
April 28, 2006. For additional information on the
restatement adjustments see note 4.
2006 Credit Facility and EDC Support Facility
As a result of the delayed filing of this report with the SEC,
an event of default occurred under the 2006 Credit Facility. As
a result of this and certain other related breaches, lenders
holding greater than 50% of each tranche under the 2006 Credit
Facility have the right to accelerate such tranche, and lenders
holding greater than 50% of all of the secured loans under the
2006 Credit Facility have the right to exercise rights against
certain collateral. The entire $1,300 under the 2006 Credit
Facility is currently outstanding.
In addition, as a result of the delayed filing of this report
with the SEC and other related breaches, EDC has the right to
refuse to issue additional support and terminate its commitments
under the $750 EDC Support Facility or require that NNL cash
collateralize all existing support. As at April 14, 2006,
there was approximately $162 of outstanding support under the
EDC Support Facility.
Nortel is currently in discussions with its lenders under the
2006 Credit Facility and with EDC under the EDC Support Facility
to negotiate waivers related to the Third Restatement and the
delay in filing this report and the anticipated delay in filing
our Quarterly Report on
Form 10-Q for the
period ended March 31, 2006, or the 2006 First Quarter
Report.
203
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Although Nortel expects to reach an agreement with its lenders
and EDC with respect to the terms of an acceptable waiver, there
can be no assurance that Nortel or NNL will receive such waivers.
Debt Securities
As a result of the delayed filing of the 2005 Reports Nortel and
NNL were not in compliance with its obligations to deliver its
SEC filings to the trustees under Nortel’s public debt
indentures. The delay in filing the 2005 Reports did not result,
and the anticipated delay in filing the 2006 First Quarter
Reports (which Nortel is obligated to deliver to the trustees by
May 25, 2006) will not result, in an automatic default and
acceleration of such long-term debt. Neither the trustee under
any such public debt indenture nor the holders of at least 25%
of the outstanding principal amount of any series of debt
securities issued under the indentures have the right to
accelerate the maturity of such debt securities unless Nortel or
NNL, as the case may be, fail to file and deliver its required
SEC filings within 90 days after the above mentioned
holders have given notice of such default to Nortel or NNL.
While such notice could have been given at any time after
March 30, 2006 as a result of the delayed filing of the
2005 Reports, neither Nortel nor NNL has received such a notice
to the date of this report. In addition, any acceleration of the
loans under the 2006 Credit Facility would result in a
cross-default under the public debt indentures that would give
the trustee under any such public debt indenture or the holders
of at least 25% of the outstanding principal amount of any
series of debt securities issued under the indentures the right
to accelerate such series of debt securities. Approximately $500
of debt securities of NNL (or its subsidiaries) and $1,800 of
convertible debt securities of Nortel (guaranteed by NNL) are
currently outstanding under the indentures.
Stock exchanges
As a result of the delay in filing the 2005 Reports, Nortel and
NNL were in breach, and as a result of the anticipated delay in
filing the 2006 First Quarter Reports, Nortel and NNL will be in
breach of the continued listing requirements of the NYSE and the
TSX. The TSX has granted Nortel Networks Corporation and NNL an
extension up to April 30, 2006 by which to file the 2005
Reports. To date, neither the NYSE nor the TSX has commenced any
suspension or delisting procedures in respect of Nortel Networks
Corporation common shares and other of Nortel Networks and
NNL’s listed securities. The commencement of any suspension
or delisting procedures by either exchange remains, at all
times, at the discretion of such exchange.
Stock-based compensation plans
As a result of the Third Restatement, Nortel suspended as of
March 10, 2006, the purchase of Nortel Networks Corporation
common shares under the ESPPs; the exercise of outstanding
options granted under the 2000 Plan or the 1986 Plan, or the
grant of any additional options under those plans, or the
exercise of outstanding options granted under employee stock
option plans previously assumed by Nortel in connection with
mergers and acquisitions; and the purchase of units in a Nortel
stock fund or purchase of Nortel Networks Corporation common
shares under Nortel defined contribution and investments plans,
until such time, at the earliest, that Nortel is in compliance
with U.S. and Canadian securities regulatory filing requirements.
24.
Reconciliation from U.S. GAAP to Canadian GAAP
New Canadian regulations allow issuers that are required to file
reports with the SEC, upon meeting certain conditions, to
satisfy their Canadian continuous disclosure obligations by
using financial statements prepared in accordance with
U.S. GAAP. Accordingly, for fiscal 2005 and 2004, Nortel is
including in the notes to its consolidated financial statements
a reconciliation highlighting the material differences between
its financial statements prepared in accordance with
U.S. GAAP as compared to financial statements prepared in
accordance with accounting principles generally accepted in
Canada (“Canadian GAAP”). Subsequent to 2005, no
further reconciliation or financial statement presentation in
accordance with Canadian GAAP will be required under current
Canadian regulations. Nortel will therefore not present Canadian
GAAP financial statements or a reconciliation from
U.S. GAAP to Canadian GAAP in 2006. Prior to 2004, Nortel
prepared financial statements (with accompanying notes) and
Management’s Discussion and Analysis — Canadian
Supplement in accordance with Canadian GAAP and Canadian
securities regulations, all of which
204
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
were presented as a separate report and filed with the relevant
Canadian securities regulators in compliance with its Canadian
continuous disclosure obligations.
The consolidated financial statements of Nortel have been
prepared in accordance with U.S. GAAP and the accounting
rules and regulations of the SEC which differ in certain
material respects from those principles and practices that
Nortel would have followed had its consolidated financial
statements been prepared in accordance with Canadian GAAP. There
are no significant differences between U.S. and Canadian GAAP
that impact the consolidated statement of cash flows. The
following is a reconciliation of the net earnings (loss) between
U.S. GAAP and Canadian GAAP and accumulated deficit and
earnings per share data under Canadian GAAP for the years ended
December 31, 2005, 2004 and 2003:
2005
2004
2003
As restated*
As restated*
Net earnings (loss)
U.S. GAAP
$
(2,575
)
$
(207
)
$
293
Deferred stock option
compensation(a)
—
—
16
Derivative
accounting(b)((j)(iv))
(14
)
32
(22
)
Financial
instruments(c)
(79
)
(64
)
(79
)
Stock option
expense(f)
(4
)
(8
)
(5
)
Cumulative effect of accounting change — net of
tax((j)(vi))
—
—
12
Other
13
(11
)
(46
)
Canadian GAAP
$
(2,659
)
$
(258
)
$
169
Canadian GAAP:
Accumulated deficit
Deficit at the beginning of the
period(c)((j)(vi))
Notes to Consolidated Financial
Statements — (Continued)
The following details the material differences between
U.S. GAAP and Canadian GAAP for balance sheet information
as of December 31, 2005 and 2004:
2005
2004
As restated*
Canadian
Canadian
U.S. GAAP
Adjustments
GAAP
U.S. GAAP
Adjustments
GAAP
ASSETS
Current
assets(g)
$
8,867
$
5
$
8,872
$
8,850
$
6
$
8,856
Investments(d)(g)
244
(34
)
210
299
(35
)
264
Plant and equipment — net
1,564
—
1,564
1,640
(1
)
1,639
Goodwill(a)
2,592
(895
)
1,697
2,303
(910
)
1,393
Intangible assets —
net(h)
172
(37
)
135
78
(40
)
38
Deferred income taxes — net
(h)
3,629
(197
)
3,432
3,738
(218
)
3,520
Other
assets(b)(h)
1,044
35
1,079
867
(9
)
858
Total assets
$
18,112
$
(1,123
)
$
16,989
$
17,775
$
(1,207
)
$
16,568
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current
liabilities(g)((j)(v))
$
8,068
$
(110
)
$
7,958
$
5,935
$
(40
)
$
5,895
Long-term
debt(b)(c)
2,439
(192
)
2,247
3,852
(277
)
3,575
Deferred income taxes — net
(h)
104
12
116
144
14
158
Other
liabilities(b)(c)(h)
5,935
(1,302
)
4,633
3,578
(1,279
)
2,299
Total liabilities
16,546
(1,592
)
14,954
13,509
(1,582
)
11,927
Minority interests in subsidiary
companies(c)
780
(57
)
723
626
(47
)
579
Total shareholders’ equity
(b)(c)(d)(g)(h)
786
526
1,312
3,640
422
4,062
Total liabilities and shareholders’ equity
$
18,112
$
(1,123
)
$
16,989
$
17,775
$
(1,207
)
$
16,568
*
See notes 4 and 24(i)
The significant differences between U.S. GAAP and Canadian
GAAP that impact the consolidated financial statements of Nortel
include the following:
(a)
Business combinations
All of Nortel’s business combinations have been accounted
for using the purchase method. Until June 30, 2001, under
Canadian GAAP, when common share consideration was involved, the
purchase price of Nortel’s acquisitions was determined
based on the average trading price per Nortel Networks
Corporation common share for a reasonable period before and
after the date the transaction was closed. Under U.S. GAAP,
when common share consideration was involved, the purchase price
of the acquisitions was determined based on the average price
per Nortel Networks Corporation common share for a reasonable
period before and after the date the acquisition was announced
or the date on which the exchange ratio became fixed. After
June 30, 2001, treatment under Canadian GAAP was the same
as under U.S. GAAP for measurement of share consideration.
As a result of the difference between Canadian GAAP and
U.S. GAAP until June 30, 2001, the value of purchase
price consideration assigned to acquisitions may have varied
significantly depending on the length of time between the
announcement date and the closing date of the transaction and
the volatility of Nortel Networks Corporation common share price
within that time frame.
Stock options assumed on acquisitions were recorded at fair
value for acquisitions on or after July 1, 2000 under
U.S. GAAP, and for acquisitions on or after July 1,2001 under Canadian GAAP. Beginning with acquisitions completed
subsequent to July 1, 2000, U.S. GAAP requires an
allocation of a portion of the purchase price to deferred
compensation related to the intrinsic value of unvested options
held by employees of the companies acquired. The deferred
compensation is amortized to net earnings (loss) based on the
remaining vesting period of the option awards. With the adoption
of The Canadian Institute of Chartered Accountants
(“CICA”) Handbook Section 3870, “Stock-based
Compensation and Other Stock-based Payments”, on
January 1, 2002, unearned compensation is recorded on
unvested options held by employees of acquired companies.
Previously, there was no requirement to record deferred
compensation in respect of such unvested options under Canadian
GAAP. The difference in accounting for options issued from the
206
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
value ascribed under U.S. GAAP, as part of acquisitions
discussed above, can result in a different balance being
ascribed to goodwill under U.S. GAAP.
The potential differences in the initial measurement of goodwill
in business combinations under Canadian GAAP and U.S. GAAP
may result in a difference in the amount of any subsequent
goodwill impairment charge. Effective January 1, 2002,
under both U.S. GAAP and Canadian GAAP, the method used in
accounting for goodwill changed from an amortization method to
an impairment only method, thereby eliminating any impact on net
earnings (loss) due to the amortization of different amounts of
goodwill during these periods.
(b)
Derivative accounting
Under U.S. GAAP, effective January 1, 2001, Nortel
adopted SFAS 133, which was subsequently amended by
SFAS No. 138, “Accounting for Certain Derivative
Instruments and Certain Hedging Activities — an
Amendment of SFAS No. 133”, and SFAS 149.
Under Canadian GAAP, gains and losses on derivatives that are
designated as hedges and that manage the underlying risks of
anticipated transactions are not recorded until the underlying
hedged item is recorded in net earnings (loss) and hedge
ineffectiveness is not recorded until settlement. Under
U.S. GAAP, the accounting for changes in the fair value of
a derivative depends on the intended use of the derivative and
the resulting designation. For fair value hedges, changes in the
fair value of the derivative and of the hedged item attributable
to the hedged risk are reported in net earnings (loss) from
continuing operations immediately. For cash flow hedges, the
effective portion of the gains or losses is reported as a
component of other comprehensive income (loss) and the
ineffective portion is reported in net earnings (loss) from
continuing operations immediately. Foreign currency hedges can
be either fair value hedges or cash flow hedges and are
accounted for accordingly.
Under U.S. GAAP, an embedded derivative is accounted for at
fair value separate from the host contract when certain
specified conditions are met. Under Canadian GAAP, embedded
derivatives are not accounted for separately from the host
contract.
(c)
Financial instruments
Under Canadian GAAP, a financial instrument that contains both a
liability and equity component must be allocated to those
components based on fair value. As a result, the $1,800 proceeds
on the 4.25% Convertible Senior Notes issued on
August 15, 2001, convertible at the holders’ option
into Nortel Networks Corporation common shares, were allocated
based on the fair value of the debt component calculated at
$1,325, with the residual of $475 being assigned to the equity
component. Under Canadian GAAP, the debt component is accreted
to the face value of the 4.25% Convertible Senior Notes
over their seven year term, with the resulting charge recorded
in interest expense. Under U.S. GAAP, such instruments are
not broken out into their component parts but rather are
reported as the type of instrument of which they are principally
comprised. Therefore, the 4.25% Convertible Senior Notes
are reported as debt under U.S. GAAP.
In November 2004, the Emerging Issues Committee
(“EIC”) of the Canadian Institute of Chartered
Accountants (“CICA”) issued EIC No. 149,
“Accounting for Retractable or Mandatorily Redeemable
Shares” (“EIC 149”). EIC 149 clarifies
the accounting for certain financial instruments with
characteristics of both liabilities and equity and requires that
those instruments be classified as liabilities and measured at
their redemption value on the balance sheets with retroactive
application unless certain criteria are met.
Nortel consolidates two enterprises with limited lives, which
have mandatory liquidation requirements at the end of their
prescribed lives in 2024. Upon liquidation, the net assets of
these entities will be distributed to the owners based on their
relative interests at that time. As result of the EIC 149
requirement, the mandatorily redeemable non-controlling
interests of the two enterprises are classified as financial
liabilities and recorded at their redemption values, where in
this particular case, redemption value is fair value, under
Canadian GAAP. Changes in the redemption values are reflected in
net earnings. Under US GAAP, the non-controlling interests
remain in minority interest, with note disclosure of their fair
values. The impact of this difference in the years ended
December 31, 2005, 2004 and 2003 is to reclassify $57, $47
and $41 from minority interest to long-term liabilities,
increase or decrease the long-term liability to $91, $71 and
$67, with increases (decreases) of $(10), $2 and $(16),
respectively, to net earnings (loss) and a $10
increase to the 2003 opening accumulated deficit.
207
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
(d)
Investments
Under U.S. GAAP, certain investment securities deemed
available-for-sale by Nortel are remeasured to fair value each
period, with unrealized holding gains (losses) included in other
comprehensive income (loss) until realized. Under Canadian GAAP,
these investments are recorded at historical cost unless a loss
that is considered other than temporary occurs.
(e)
Other financial statement presentation differences
Under Canadian GAAP, global investment tax credits are deducted
from R&D expense while under U.S. GAAP, these amounts
are required to be deducted from the income tax benefit
(expense). The impact of this difference in the years ended
December 31, 2005, 2004 and 2003 of $39, $43 and $41,
respectively, was to increase or decrease net earnings (loss)
from continuing operations before income taxes, non-controlling
interests and equity in net loss of associated companies under
Canadian GAAP, with a corresponding increase or decrease in
income tax benefit (expense).
(f)
Other
Under U.S. GAAP, translation adjustments for
self-sustaining subsidiaries are reported as a component of
other comprehensive income (loss) whereas, under Canadian GAAP,
these translation adjustments are classified as foreign currency
translation adjustment, also a component of shareholders’
equity.
Under both U.S. and Canadian GAAP, compensation expense should
be recognized if an employee is eligible for retirement at the
date of grant or becomes eligible during the vesting period and
is eligible for acceleration of vesting upon retirement. The SEC
has provided relief from this interpretation for awards granted
prior to the adoption of SFAS 123R; however, no such relief
exists under Canadian GAAP. Nortel has made an adjustment of $17
(including $13 related to prior periods) for compensation
expense under Canadian GAAP in the year ended December 31,2005.
(g)
Joint ventures
Nortel has a number of joint ventures with other parties. Under
U.S. GAAP, investments in joint ventures are generally
accounted for under the equity method, whereas, under Canadian
GAAP, the proportionate consolidation method is used. The
difference in accounting does not impact net earnings (loss),
but does impact certain other consolidated financial statement
items.
(h)
Pension and other post-retirement benefits
Under U.S. GAAP, a minimum pension liability adjustment
must be recognized in the amount of the excess of the unfunded
accumulated benefit obligation over the recorded pension benefit
liability. An offsetting intangible pension asset is recorded
equal to the unrecognized prior service costs, with any
difference recorded in accumulated other comprehensive loss. No
such adjustments are required under Canadian GAAP.
(i)
Canadian GAAP Restatement Adjustments
As part of the Third Restatement, Nortel determined that, for
the year ended December 31, 2004, it had incorrectly
applied the requirement in EIC 149 that required it to classify
the mandatorily redeemable non-controlling interests of two
enterprises as financial liabilities at their redemption values.
For details on the difference from U.S. GAAP as a result of
the application of EIC 149, see note 24(c).
(j)
Accounting changes
(i)
Determining whether an arrangement contains a lease
In December 2004, the EIC issued abstract 150, “Determining
Whether an Arrangement Contains a Lease”
(“EIC 150”). EIC 150 provides guidance on
how to determine whether an arrangement contains a lease that is
within the scope of CICA Handbook Section 3065,
“Leases”. The guidance in EIC 150 is based on whether
the arrangement conveys to the purchaser the right to use a
tangible asset, and is effective for Nortel for arrangements
entered into or
208
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
modified after January 1, 2005. Equivalent guidance in
U.S. GAAP has already been adopted by Nortel. The adoption
of EIC 150 did not have any material impact on
Nortel’s results of operations and financial condition.
(ii)
Financial Instruments — disclosure and
presentation
In January 2004, the CICA issued amendments to CICA Handbook
Section 3860, “Financial Instruments —
Disclosure and Presentation”
(“Section 3860”), to require obligations that
must or may be settled at the issuer’s option by a variable
number of the issuer’s own equity instruments to be
presented as liabilities. Thus, securities issued by an
enterprise that give the issuer unrestricted rights to settle
the principal amount in cash or in the equivalent value of its
own equity instruments will no longer be presented as equity.
The amendments to Section 3860 are applicable to Nortel
beginning January 1, 2005 on a retroactive basis. The
adoption of the amendments to Section 3860 did not have any
material impact on Nortel’s results of operations and
financial condition.
(iii)
Accounting by a customer (including a reseller) for certain
consideration received from a vendor
In January 2005, the EIC issued amended abstract 144,
“Accounting by a Customer (including a Reseller) for
Certain Consideration Received from a Vendor”. The
amendment is effective retroactively for periods commencing on
or after February 15, 2005. The amendment requires
companies to recognize the benefit of non-discretionary rebates
for achieving specified cumulative purchasing levels as a
reduction of the cost of purchases over the relevant period,
provided the rebate is probable and reasonably estimable.
Otherwise, the rebates would be recognized as purchasing
milestones are achieved. The adoption of the new amendment did
not have a material impact on Nortel’s results of
operations and financial condition.
(iv)
Derivative accounting
Effective January 1, 2004, Nortel adopted CICA Accounting
Guideline (“AcG”) 13, “Hedging
Relationships”
(“AcG-13”),
which establishes specific criteria for derivatives to qualify
for hedge accounting. Nortel had been previously applying these
criteria under U.S. GAAP. Therefore, there was no impact on
adoption of AcG-13.
Concurrent with the adoption of
AcG-13, Nortel also
adopted the CICA’s EIC 128, “Accounting for
Trading, Speculative or Non-Hedging Derivative Financial
Instruments” (“EIC 128”), which requires
that certain freestanding derivative instruments that give rise
to a financial asset or liability, and do not qualify for hedge
accounting under
AcG-13, be recognized
on the balance sheet and measured at fair value, with changes in
fair value recognized in earnings (loss) in each period. As a
result of the adoption of EIC 128, certain warrants, which
had been previously recorded at cost under Canadian GAAP, are
required to be recorded at fair value consistent with
U.S. GAAP. The impact of this accounting change, which has
been recorded prospectively as at January 1, 2004, was an
increase to investments and other income of $23 during the year
ended December 31, 2004.
(v)
Revenue recognition
In December 2003, the EIC issued abstract 142, “Revenue
Arrangements with Multiple Deliverables”
(“EIC 142”). EIC 142 addresses how to
determine whether an arrangement involving multiple deliverables
contains more than one unit of accounting. EIC 142 also
addresses how arrangement consideration should be measured and
allocated to the separate units of accounting in the
arrangement. EIC 142 was applicable to Nortel beginning
January 1, 2004 and was applied prospectively. The
application of EIC 142 did not have a material impact on
Nortel’s results of operations and financial condition.
In December 2003, the EIC issued abstract 141, “Revenue
Recognition” (“EIC 141”). EIC 141
summarizes the principles set forth in SAB 101, which was
issued by the SEC. Under EIC 141, performance is achieved
in a transaction involving the sale of goods when all of the
following criteria are met: persuasive evidence of an
arrangement exists; delivery has occurred or services have been
rendered; and the seller’s price to the buyer is fixed or
determinable. EIC 141 was applicable to Nortel beginning
January 1, 2004 and was applied prospectively. The
application of EIC 141 did not have a material impact on
Nortel’s results of operations and financial condition.
209
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
(vi) Asset
retirement obligations
Under U.S. GAAP, Nortel adopted SFAS 143
“Accounting for Asset Retirement Obligations”
(“SFAS 143”), effective January 1, 2003, and
recorded a cumulative effect of accounting change, net of tax,
within net earnings (loss) on the date of adoption. Nortel
adopted similar Canadian guidance, CICA Handbook
Section 3110, “Asset Retirement Obligations”,
effective January 1, 2004, with retroactive restatement of
prior periods. Under Canadian GAAP, the cumulative effect of
adoption as of January 1, 2003 was recorded as an
adjustment to opening accumulated deficit, as opposed to an
adjustment within net earnings (loss) under U.S. GAAP,
resulting in a difference of $12. The retroactive adjustment to
net earnings (loss) for the years ended December 31, 2003
and 2002 under Canadian GAAP was not significant. Plant and
equipment — net, other liabilities and accumulated
deficit as of December 31, 2003 have been increased by $4,
$16 and $12, respectively, to reflect the retroactive
restatement.
(vii) Stock-based
compensation
In November 2001, the CICA issued Handbook Section 3870,
“Stock-based Compensation and Other Stock-based
Payments” (“Section 3870”), which was
revised in November 2003. Section 3870 establishes
standards for the recognition, measurement and disclosure of
stock-based compensation and other stock-based payments made in
exchange for goods and services and applies to transactions,
including non-reciprocal transactions, in which an enterprise
grants common shares, stock options or other equity instruments,
or incurs liabilities based on the price of common shares or
other equity instruments. Section 3870 outlines a fair
value based method of accounting required for certain
stock-based transactions, effective January 1, 2002, and
applied to awards granted on or after that date.
Prior to October 1, 2003, as permitted by
Section 3870, Nortel did not adopt the provisions in
respect of the fair value based method of accounting for its
employee stock-based transactions.
On October 1, 2003, Nortel elected to expense employee
stock-based compensation using the fair value based method
prospectively for all awards granted, modified or settled on or
after January 1, 2003, in accordance with the transitional
provisions of Section 3870 and concurrent with the adoption
of expense recognition under the fair value based method for
U.S. GAAP.
(viii) Restructuring
charges
Under U.S. GAAP, effective January 1, 2003, Nortel
adopted SFAS 146. SFAS 146 requires that costs
associated with an exit or disposal activity be recognized when
the liability is incurred. Under Canadian GAAP, EIC 134,
“Accounting for Severance and Termination Benefits”
(“EIC 134”), and EIC 135, “Accounting
for Costs Associated with Exit and Disposal Activities
(Including Costs Incurred in a Restructuring)”
(“EIC 135”), were issued to harmonize Canadian
GAAP requirement with SFAS 146. Effective April 1,2003, Nortel adopted EIC 134 and EIC 135.
(ix) Impairment
and disposal of long-lived assets
In May 2003, the CICA issued an updated Section 3475
“Disposal of Long-Lived Assets and Discontinued
operations” (“Section 3475”). In April 2003,
the CICA issued Handbook Section 3063, “Impairment of
Long-Lived Assets” (“Section 3063”).
Section 3475 provides criteria for classifying long-lived
assets as held for sale and requires the measurement of such
assets at the lower of their carrying amount and their fair
value less costs to sell. It also requires that long-lived
assets that are classified as held for sale are not amortized.
Section 3475 also provides criteria for classifying a
disposal as a discontinued operation and specifies the
presentation and disclosure for discontinued operations and
other disposals of long-lived assets.
Section 3475 requires a long-lived asset which is to be
disposed of other than by sale to be classified as held and used
until it is disposed of. Section 3475 replaces the disposal
provisions in the former Section 3475, “Discontinued
Operations” and Section 3061, “Property, Plant
and Equipment” (“Section 3061”).
Section 3063 requires an impairment loss for a long-lived
asset to be held and used to be recognized when events or
changes in circumstances cause its carrying value to exceed its
total undiscounted cash flows from its use and eventual
210
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
disposition. The impairment loss is calculated by deducting the
fair value of the asset from its carrying value.
Section 3063 replaces the write down provisions in
Section 3061.
Section 3475 is applicable for disposal activities
initiated by a company’s commitment to a plan on or after
May 1, 2003. Section 3063 is applicable for years
beginning on or after April 1, 2003; early adoption was
permitted. Nortel adopted these standards effective
January 1, 2003. The adoption of Sections 3475 and
3063, which are substantially consistent with U.S. GAAP,
did not have a material impact on the results of operations and
financial condition of Nortel.
Prior to the adoption of Section 3063, an impairment loss
was recognized in an amount equal to the excess of the carrying
value of plant and equipment, net of related provisions for
future removal and site restoration costs and future income
taxes, and the anticipated net recoverable amount of the
asset(s). Net recoverable amount is an amount equal to the
anticipated cash flows net of directly attributable general and
administrative costs, carrying costs, future removal and site
restoration costs and future income taxes, plus the expected
residual value, if any.
(x) Guarantees
In February 2003, the CICA issued
AcG-14,
“Disclosure of Guarantees”
(“AcG-14”).
AcG-14 expands on
previously issued accounting guidance and requires additional
disclosure by a guarantor of information about each guarantee,
or each group of similar guarantees, even when the likelihood of
the guarantor having to make any payments under the guarantee is
slight. AcG-14 does not
address the recognition or measurement of a guarantor’s
liability for obligations under a guarantee. Nortel adopted the
requirements of AcG-14
effective January 1, 2003, which are substantially
consistent with the disclosure requirements under U.S. GAAP
for guarantees.
(xi) Consolidation
of variable interest entities
In June 2003, the CICA issued
AcG-15, which is
consistent with FASB Interpretation No. 46,
“Consolidation of Variable Interest Entities”.
AcG-15 clarifies the
application of consolidation guidance to those entities defined
as VIEs (which includes, but is not limited to, special purpose
entities, trusts, partnerships, certain joint ventures and other
legal structures) in which equity investors do not have the
characteristics of a “controlling financial interest”
or there is not sufficient equity at risk for the entity to
finance its activities without additional subordinated financial
support. The requirements of AcG-15 were effective for all
annual and interim periods beginning on or after
November 1, 2004. Earlier application was encouraged and
effective July 1, 2003, Nortel adopted AcG-15 at the same
time as equivalent guidance under U.S. GAAP and
prospectively began consolidating two VIEs for which Nortel was
considered the primary beneficiary.
(k)
Comparative information
The following tables present consolidated statements of
operations and cash flows under Canadian GAAP for the year ended
December 31, 2003. For the years ended December 31,2005 and 2004, in accordance with Canadian securities law
requirements, Nortel quantified the effect of material
differences between Canadian GAAP and U.S. GAAP on its
211
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
consolidated statements of operations and did not publish
consolidated statement of operations and cash flows for those
periods, due to the differences being immaterial.
Consolidated statement of operations for the year ended
December 31:
2003
2003
As
Previously
As
Reported
Restated*
Revenues
$
10,193
$
9,932
Cost of revenues
5,851
5,723
Gross profit
4,342
4,209
Selling, general and administrative expense
1,949
1,979
Research and development expense
1,922
1,931
Amortization of intangibles
101
101
Special charges
288
292
(Gain) loss on sale of businesses and assets
(7
)
(7
)
Operating earnings (loss)
89
(87
)
Other income (expense) — net
412
410
Interest expense
Long-term debt
(244
)
(241
)
Other
(28
)
(28
)
Earnings (loss) from continuing operations before income taxes,
non-controlling interests and equity in net loss of associated
companies
229
54
Income tax benefit (expense)
18
20
247
74
Non-controlling interests — net of tax
(63
)
(52
)
Equity in net loss of associated companies — net of tax
(37
)
(36
)
Net earnings (loss) from continuing operations
147
(14
)
Net earnings (loss) from discontinued operations — net
of tax
184
183
Net earnings (loss)
$
331
$
169
*
The adjustments for Canadian GAAP, due to the restatement, did
not result in any material differences between Canadian and
U.S. GAAP.
212
NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial
Statements — (Continued)
Consolidated statement of cash flows for the year ended
December 31:
2003
2003
As
Previously
As
Reported
Restated*
Cash flows from (used in) operating activities
Net earnings (loss) from continuing operations
$
147
$
(14
)
Adjustments to reconcile net earnings (loss) from continuing
operations to net cash from (used in) operating activities, net
of effects from acquisitions and divestitures of businesses:
Amortization and depreciation
539
544
Non-cash portion of special charges and related asset write downs
87
87
Equity in net loss of associated companies
37
37
Stock option compensation
26
31
Future income taxes
(21
)
(24
)
Other liabilities
106
110
(Gain) loss on repurchases of outstanding debt securities
(4
)
(4
)
(Gain) loss on sale or write down of investments, businesses and
assets
(150
)
(150
)
Other — net
109
115
Change in operating assets and liabilities
(769
)
(850
)
Net cash from (used in) operating activities of continuing
operations
107
(118
)
Cash flows from (used in) investing activities
Expenditures for plant and equipment
(171
)
(168
)
Proceeds on disposals of plant and equipment
38
38
Restricted cash and cash equivalents, net
—
200
Acquisitions of investments and businesses — net of
cash acquired
(58
)
(31
)
Proceeds on sale of investments and businesses
107
107
Net cash from (used in) investing activities of continuing
operations
(84
)
146
Cash flows from (used in) financing activities
Increase in notes payable
80
80
Decrease in notes payable
(125
)
(125
)
Repayments of long-term debt
(270
)
(270
)
Repayments of capital leases payable
(12
)
(12
)
Dividends paid by subsidiaries to non-controlling interests
(35
)
(35
)
Issuance of common shares
3
3
Net cash from (used in) financing activities of continuing
operations
(359
)
(359
)
Effect of foreign exchange rate changes on cash and cash
equivalents
176
176
Net cash from (used in) continuing operations
(160
)
(155
)
Net cash from (used in) operating activities of discontinued
operations
127
127
Net cash from (used in) investing activities of discontinued
operations
241
241
Net increase (decrease) in cash and cash equivalents
208
213
Cash and cash equivalents at beginning of year
3,793
3,793
Cash and cash equivalents at end of year
$
4,001
$
4,006
*
The adjustments for Canadian GAAP, due to the restatement, did
not result in any material differences between Canadian and
U.S. GAAP.
Nortel believes all adjustments necessary for a fair
presentation of the results for the periods presented have been
made. These amounts have been restated to reflect the correction
of errors identified in the Third Restatement.
Earnings (loss) from continuing operations before income taxes,
minority interests and equity in net earnings (loss) of
associated companies
(2,399
)
114
84
Income tax benefit (expense)
102
(3
)
(4
)
(2,297
)
111
80
Minority interests — net of tax
(4
)
(17
)
(17
)
Equity in net earnings (loss) of associated
companies — net of tax
1
2
2
Net earnings (loss) from continuing operations
(2,300
)
96
65
Net earnings from discontinued operations — net of tax
(2
)
37
37
Net earnings (loss)
$
(2,302
)
$
133
$
102
Basic and diluted earnings (loss) per common share
— from continuing operations
$
(0.53
)
$
0.02
$
0.01
— from discontinued operations
(0.00
)
0.01
0.01
Basic and diluted earnings (loss) per common share
$
(0.53
)
$
0.03
$
0.02
(a)
The fourth quarter ended December 31, 2005 had not been
previously reported.
(b)
Previously reported in the Unaudited Quarterly Financial Data
section of the 2004 Annual Report on
Form 10-K.
See notes 3, 7 and 10 to the consolidated financial
statements in this report for the impact of accounting changes,
special charges and acquisitions, divestitures and closures,
respectively, that affect the comparability of the selected
financial data. Additionally, the following significant items
were recorded in the fourth quarters of 2005 and 2004:
•
During the fourth quarter of 2005, Nortel recorded a charge of
$2,474 related to an agreement reached in principle for the
settlement of shareholder class action litigation.
•
During the fourth quarter of 2005, Nortel recorded a tax benefit
of approximately $140 related to the release of a liability
attributed to the retroactive application of the APA.
•
During the fourth quarter of 2004, bad debt recoveries of $80,
which related primarily to customer financing notes receivable
that were restructured and subsequently sold for cash proceeds
in the first quarter of 2005, were recorded as a reduction to
SG&A expense. Other income (expense) included foreign
exchange gains of $43 related to
day-to-day
transactional activities and a gain of $53 related to the
restructured customer financing arrangement for which Nortel
received cash proceeds in the fourth quarter of 2004.
Guarantees, commitments and contingencies (refer to
notes 13, 14 and 22 of this report)
SHAREHOLDERS’ EQUITY
Common shares
33,840
33,840
33,844
33,844
33,932
33,932
Additional paid-in capital
3,301
3,301
3,316
3,316
3,252
3,253
Accumulated deficit
(32,632
)
(33,054
)
(32,587
)
(33,087
)
(32,692
)
(33,223
)
Accumulated other comprehensive loss
(824
)
(613
)
(951
)
(735
)
(699
)
(668
)
Total shareholders’ equity
3,685
3,474
3,622
3,338
3,793
3,294
Total liabilities and shareholders’ equity
$
16,757
$
17,458
$
16,582
$
17,404
$
16,464
$
17,403
220
Condensed Consolidated Statements of Cash Flows
(Unaudited)
2005
Three Months Ended
Six Months Ended
Nine Months Ended
March 31
June 30
September 30
As
As
As
Previously
As
Previously
As
Previously
As
Reported
Restated
Reported
Restated
Reported
Restated
(Millions of U.S. dollars)
Net cash from (used in):
Operating activities of continuing operations
$
(262
)
$
(263
)
$
(159
)
$
(153
)
$
(304
)
$
(297
)
Investing activities of continuing operations
Expenditures for plant and equipment
(54
)
(54
)
(119
)
(124
)
(167
)
(176
)
Proceeds on disposals of plant and equipment
—
—
10
10
10
10
Restricted cash and cash equivalents
—
1
9
9
9
9
Acquisitions of investments and businesses — net
(2
)
(2
)
(448
)
(448
)
(449
)
(449
)
Proceeds on sale of investments and businesses
83
83
167
167
308
308
Investing activities of continuing operations
27
28
(381
)
(386
)
(289
)
(298
)
Financing activities of continuing operations
Dividends paid by subsidiaries to minority interests
(14
)
(14
)
(24
)
(24
)
(33
)
(33
)
Increase in notes payable
20
20
38
38
58
59
Decrease in notes payable
(26
)
(26
)
(46
)
(46
)
(64
)
(64
)
Proceeds from long-term debt
—
—
—
—
—
—
Repayments of long-term debt
—
—
—
—
—
—
Repayments of capital leases payable
(1
)
(1
)
(4
)
(5
)
(8
)
(8
)
Issuance of common shares
—
—
1
1
4
4
Financing activities of continuing operations
(21
)
(21
)
(35
)
(36
)
(43
)
(42
)
Effect of foreign exchange rate changes on cash and cash
equivalents
(35
)
(35
)
(85
)
(85
)
(86
)
(86
)
Net cash from (used in) continuing operations
(291
)
(291
)
(660
)
(660
)
(722
)
(723
)
Net cash from (used in) operating activities of discontinued
operations
36
36
34
34
33
34
Net decrease in cash and cash equivalents
(255
)
(255
)
(626
)
(626
)
(689
)
(689
)
Cash and cash equivalents at beginning of period
3,686
3,685
3,686
3,685
3,686
3,685
Cash and cash equivalents at end of period
$
3,431
$
3,430
$
3,060
$
3,059
$
2,997
$
2,996
221
Condensed Consolidated Statements of Cash Flows
(Unaudited)
2004
Three Months Ended
Six Months Ended
Nine Months Ended
March 31
June 30
September 30
As
As
As
Previously
As
Previously
As
Previously
As
Reported
Restated
Reported
Restated
Reported
Restated
(Millions of U.S. dollars)
Net cash from (used in):
Operating activities of continuing operations
$
(340
)
$
(341
)
$
(257
)
$
(257
)
$
(447
)
$
(448
)
Investing activities of continuing operations
Expenditures for plant and equipment
(43
)
(43
)
(102
)
(102
)
(194
)
(194
)
Proceeds on disposals of plant and equipment
5
5
10
10
10
10
Restricted cash and cash equivalents
—
1
10
10
(14
)
(14
)
Acquisitions of investments and businesses — net
(3
)
(3
)
(6
)
(6
)
(7
)
(7
)
Proceeds on sale of investments and businesses
55
55
132
132
143
143
Investing activities of continuing operations
14
15
44
44
(62
)
(62
)
Financing activities of continuing operations
Dividends paid by subsidiaries to minority interests
(9
)
(9
)
(16
)
(16
)
(24
)
(24
)
Increase in notes payable
10
11
41
52
54
65
Decrease in notes payable
(13
)
(14
)
(26
)
(37
)
(56
)
(67
)
Proceeds from long-term debt
—
—
—
—
—
—
Repayments of long-term debt
(97
)
(97
)
(98
)
(98
)
(107
)
(107
)
Repayments of capital leases payable
(3
)
(3
)
(8
)
(8
)
(5
)
(5
)
Issuance of common shares
30
30
30
30
30
30
Financing activities of continuing operations
(82
)
(82
)
(77
)
(77
)
(108
)
(108
)
Effect of foreign exchange rate changes on cash and cash
equivalents
13
13
(9
)
(9
)
(6
)
(6
)
Net cash from (used in) continuing operations
(395
)
(395
)
(299
)
(299
)
(623
)
(624
)
Net cash from (used in) operating activities of discontinued
operations
(3
)
(3
)
11
11
16
16
Net decrease in cash and cash equivalents
(398
)
(398
)
(288
)
(288
)
(607
)
(608
)
Cash and cash equivalents at beginning of period
3,997
4,002
3,997
4,002
3,997
4,002
Cash and cash equivalents at end of period
$
3,599
$
3,604
$
3,709
$
3,714
$
3,390
$
3,394
222
Supplemental information (Millions of U.S. dollars)
(unaudited)
(a)
Adjustments
The following tables summarize the revenue adjustments and other
adjustments to net earnings (loss) (refer to note 4 of the
accompanying consolidated financial statements for a description
of the nature of the adjustments).
2005
2004
Three
Three
Three
Three
Three
Three
Three
Months
Months
Months
Months
Months
Months
Months
Ended
Ended
Ended
Ended
Ended
Ended
Ended
March 31
June 30
September 30
March 31
June 30
September 30
December 31
Revenues — as previously reported
$
2,536
$
2,855
$
2,655
$
2,444
$
2,590
$
2,179
$
2,615
Adjustments:
Application of SOP 81-1
82
(23
)
(13
)
(22
)
(29
)
(17
)
(16
)
Interaction between multiple revenue recognition accounting
standards
(183
)
(155
)
(70
)
(19
)
(31
)
(49
)
(75
)
Application of SAB 104 and SOP 97-2
(53
)
(45
)
(62
)
(37
)
(54
)
42
11
Other revenue recognition adjustments
7
(13
)
8
—
2
4
(22
)
Revenues — as restated
$
2,389
$
2,619
$
2,518
$
2,366
$
2,478
$
2,159
$
2,513
Net earnings (loss) — as previously reported
$
(49
)
$
45
$
(105
)
$
59
$
16
$
(259
)
$
133
Adjustments:
Application of SOP 81-1
9
(12
)
(6
)
(3
)
(14
)
(3
)
(8
)
Interaction between multiple revenue recognition accounting
standards
(26
)
(12
)
(7
)
(6
)
(7
)
(10
)
(24
)
Application of SAB 104 and SOP 97-2
(26
)
(25
)
(22
)
(23
)
(26
)
2
(5
)
Other revenue recognition adjustments
(3
)
(50
)
6
(9
)
3
2
—
(Gain)/loss on sale of businesses
(21
)
25
—
(1
)
—
—
(6
)
Health and WelfareTrust
—
—
—
—
—
—
(1
)
Foreign
exchange(i)
2
11
(5
)
—
6
(34
)
(10
)
Other
10
(15
)
3
(2
)
(1
)
1
23
Net earnings (loss) — as restated
$
(104
)
$
(33
)
$
(136
)
$
15
$
(23
)
$
(301
)
$
102
2005
2004
Six
Nine
Six
Nine
Months
Months
Months
Months
Ended
Ended
Ended
Ended
June 30
September 30
June 30
September 30
Revenues — as previously reported
$
5,391
$
8,046
$
5,034
$
7,213
Adjustments:
Application of SOP 81-1
59
46
(51
)
(68
)
Interaction between multiple revenue recognition accounting
standards
(338
)
(408
)
(50
)
(99
)
Application of SAB 104 and SOP 97-2
(98
)
(160
)
(91
)
(49
)
Other revenue recognition adjustments
(6
)
2
2
6
Revenues — as restated
$
5,008
$
7,526
$
4,844
$
7,003
Net earnings (loss) — as previously reported
$
(4
)
$
(109
)
$
75
$
(184
)
Adjustments:
Application of SOP 81-1
(3
)
(9
)
(17
)
(20
)
Interaction between multiple revenue recognition accounting
standards
(38
)
(45
)
(13
)
(23
)
Application of SAB 104 and SOP 97-2
(51
)
(73
)
(49
)
(47
)
Other revenue recognition adjustments
(53
)
(47
)
(6
)
(4
)
(Gain)/loss on sale of businesses
4
4
(1
)
(1
)
Foreign
exchange(i)
13
8
6
(28
)
Other
(5
)
(2
)
(3
)
(2
)
Net earnings (loss) — as restated
$
(137
)
$
(273
)
$
(8
)
$
(309
)
(i)
Includes the foreign exchange gains and losses resulting from
the Third Restatement adjustments, and the correction of certain
foreign exchange errors as described in note 4 of the
accompanying consolidated financial statements.
223
Revenue
Recognition Adjustments:
As described in note 4, the impact of the Third Restatement
adjustments that related to revenue recognition errors resulted
in corrections to revenue previously recognized that should have
been deferred to subsequent periods. The timing of the
recognition of revenue is dependent on the satisfaction of
various revenue recognition criteria as described in note 4
and therefore will result in quarterly fluctuations which may
not reflect the annual trends.
In 2004, Nortel identified and corrected certain errors that
related to revenue recognition. The cumulative adjustments were
previously recorded in 2004, rather than restating prior
periods, because they were not material either to 2004, or the
prior period results as originally reported. As part of the
Third Restatement, these adjustments have now been recorded in
the appropriate periods as follows:
•
A cumulative correction previously recorded in the third quarter
of 2004 has now been recorded primarily in 2003, and prior
periods resulting in an increase to revenue of $80 in the third
quarter of 2004. The adjustment was to correct for previously
recognized revenue relating to past sales of Optical Networks
equipment which we determined should have been deferred and
recognized with the delivery of future contractual PCS and other
services over the term of the PCS.
•
A cumulative correction in the fourth quarter of 2004 has now
been recorded in the appropriate prior periods resulting in an
increase to revenue of $40 in the fourth quarter of 2004. The
adjustment was to correct for previously recognized revenue
related to an EMEA contract which should have been deferred
until the delivery of certain undelivered elements such as
services.
Other
Adjustments:
Nortel had previously recorded a foreign exchange gain in the
third quarter of 2004 to correct a cumulative error from prior
periods related to the functional currency designation of an
entity in Brazil. As part of the Third Restatement, the impact
of this adjustment has now been recorded in the appropriate
prior periods, resulting in a decrease to other income in the
third quarter of 2004 of $33.
Nortel had previously recorded a charge of $27 to
(gain) loss on sale of businesses and assets in the second
quarter of 2005 to correct a cumulative error related to
capitalized legal and professional fees, real estate impairment
costs and special termination benefits relating to its
transaction with Flextronics. Nortel determined that these costs
should have been expensed as incurred starting in 2004, and
through the first quarter of 2005. As part of the Third
Restatement, these adjustments have been recorded in the
appropriate prior periods resulting in a decrease to the loss on
sale of businesses and assets in the second quarter of 2005 of
$27 and a corresponding increase of $20 and $7 in the first
quarter of 2005 and fourth quarter of 2006, respectively.
In addition, during the first three quarters of 2005, Nortel
recorded gains related to inventory transferred to Flextronics
as a reduction of cost of revenues. These gains should have been
included in the calculation of the (gain) loss on sale of
businesses and assets and deferred accordingly. The correction
of this error resulted in an increase in cost of revenues of $8,
$21, and $10 for the first, second and third quarters of 2005,
respectively.
224
(b)
Segments
The following tables sets forth information by segment:
2005
Three Months
Three Months
Three Months
Ended
Ended
Ended
March 31
June 30
September 30
As
As
As
Previously
As
Previously
As
Previously
As
Reported
Restated
Reported
Restated
Reported
Restated
Revenues
Carrier Packet Networks
$
664
$
598
$
743
$
724
$
754
$
715
CDMA Networks
535
535
662
625
539
544
GSM and UMTS Networks
788
713
719
566
674
580
Enterprise Networks
547
542
730
703
685
677
Total reportable segments
2,534
2,388
2,854
2,618
2,652
2,516
Other
2
1
1
1
3
2
Total revenues
$
2,536
$
2,389
$
2,855
$
2,619
$
2,655
$
2,518
Management EBT
Carrier Packet Networks
$
(31
)
$
(59
)
$
26
$
7
$
48
$
30
CDMA Networks
168
155
203
172
137
139
GSM and UMTS Networks
53
51
27
(6
)
(67
)
(70
)
Enterprise Networks
23
21
103
82
38
39
Total reportable segments
213
168
359
255
156
138
Other
(224
)
(220
)
(192
)
(191
)
(175
)
(188
)
Total Management EBT
(11
)
(52
)
167
64
(19
)
(50
)
Amortization of intangibles
(2
)
(2
)
(2
)
(2
)
(6
)
(7
)
Special charges
(21
)
(14
)
(90
)
(92
)
(37
)
(39
)
Gain (loss) on sale of businesses and assets
(1
)
(22
)
(36
)
(11
)
(4
)
(3
)
Income tax benefit (expense)
(16
)
(16
)
7
9
(40
)
(39
)
Net earnings (loss) from continuing operations
$
(51
)
$
(106
)
$
46
$
(32
)
$
(106
)
$
(138
)
225
2004
Three Months
Three Months
Three Months
Three Months
Ended
Ended
Ended
Ended
March 31
June 30
September 30
December 31
As
As
As
Previously
As
Previously
As
Previously
As
As
Reported
Restated
Reported
Restated
Reported
Restated
Previously(i)
Restated
Revenues
Carrier Packet Networks
$
683
$
650
$
724
$
698
$
533
$
584
$
685
$
657
CDMA Networks
569
568
567
566
511
493
616
589
GSM and UMTS Networks
656
614
711
641
543
510
665
646
Enterprise Networks
534
532
578
564
591
571
651
622
Total reportable segments
2,442
2,364
2,580
2,469
2,178
2,158
2,617
2,514
Other
2
2
10
9
1
1
(2
)
(1
)
Total revenues
$
2,444
$
2,366
$
2,590
$
2,478
$
2,179
$
2,159
$
2,615
$
2,513
Management EBT
Carrier Packet Networks
$
(59
)
$
(85
)
$
(46
)
$
(61
)
$
(131
)
$
(125
)
$
(1
)
$
(27
)
CDMA Networks
224
212
173
168
140
133
166
175
GSM and UMTS Networks
1
(15
)
(9
)
(33
)
(179
)
(182
)
39
33
Enterprise Networks
17
17
22
15
39
30
92
74
Total reportable segments
183
129
140
89
(131
)
(144
)
296
255
Other
(124
)
(115
)
(197
)
(186
)
(107
)
(135
)
(97
)
(80
)
Total Management EBT
59
14
(57
)
(97
)
(238
)
(279
)
199
175
Amortization of intangibles
(3
)
(2
)
(2
)
(2
)
(2
)
(2
)
(3
)
(3
)
Special charges
(7
)
(7
)
1
1
(93
)
(94
)
(81
)
(81
)
Gain (loss) on sales of businesses and asset
—
(1
)
75
75
39
39
(16
)
(22
)
Income tax benefit (expense)
9
10
(7
)
(6
)
30
30
(3
)
(4
)
Net earnings (loss) from continuing operations
$
58
$
14
$
10
$
(29
)
$
(264
)
$
(306
)
$
96
$
65
(i)
During the first quarter of 2005, Nortel changed its reportable
segments. The first three quarters of 2005 and the related 2004
comparatives had been previously reported under the new
reportable segments. Nortel did not previously report financial
data for the fourth quarter of 2004 reflecting its new
reportable segments. The amounts for the three months ended
December 31, 2004 have been reclassified to conform to the
new reportable segments.
On June 3, 2005, NNI, an indirect subsidiary of Nortel,
indirectly acquired PEC for approximately $449. The consolidated
financial statements of Nortel include PEC’s operating
results from the date of acquisition. The following unaudited
pro-forma information presents a summary of the consolidated
results of operations of Nortel and PEC as if the acquisition
had occurred on January 1, 2004, with pro-forma adjustments
to give effect to amortization of intangible assets and certain
other adjustments:
The following is a reconciliation of the net earnings (loss)
between U.S. GAAP and Canadian GAAP and earnings per share
data under Canadian GAAP for the three months ended:
2005
2004
(As restated)
(As restated)
Three Months Ended
Three Months Ended
March 31
June 30
September 30
March 31
June 30
September 30
Net earnings (loss)
U.S. GAAP
$
(104
)
$
(33
)
$
(136
)
$
15
$
(23
)
$
(301
)
Derivative accounting
(4
)
(7
)
(4
)
22
—
—
Financial instruments
(17
)
(17
)
(17
)
(16
)
(16
)
(17
)
Stock option expense
1
1
(11
)
(8
)
—
—
Other
—
(1
)
5
5
1
10
Canadian GAAP
$
(124
)
$
(57
)
$
(163
)
$
18
$
(38
)
$
(308
)
Canadian GAAP:
Basic and diluted earnings (loss) per common share
— from continuing operations
$
(0.03
)
$
(0.01
)
$
(0.04
)
$
0.00
$
(0.01
)
$
(0.07
)
— from discontinued operations
0.00
(0.00
)
0.00
0.00
0.00
0.00
Basic and diluted earnings (loss) per common share
$
(0.03
)
$
(0.01
)
$
(0.04
)
$
0.00
$
(0.01
)
$
(0.07
)
228
REPORT OF INDEPENDENT REGISTERED CHARTERED ACCOUNTANTS
To the Shareholders and Board of Directors of Nortel Networks
Corporation
We have audited the consolidated financial statements of Nortel
Networks Corporation and its subsidiaries (“Nortel”)
as of December 31, 2005 and 2004 and for each of the three
years in the period ended December 31, 2005,
management’s assessment of the effectiveness of
Nortel’s internal control over financial reporting as of
December 31, 2005, and the effectiveness of Nortel’s
internal control over financial reporting as of
December 31, 2005, and have issued our reports thereon
dated April 28, 2006 (which report on the consolidated
financial statements expressed an unqualified opinion, includes
an explanatory paragraph relating to the restatement of the
consolidated financial statements as of December 31, 2004
and for the years ended December 31, 2004 and 2003, and
includes a separate report titled Comments by Independent
Registered Chartered Accountants on Canadian-U.S. Reporting
Differences referring to changes in accounting principles that
have a material effect on the comparability of the financial
statements; and which report on the effectiveness of
Nortel’s internal control over financial reporting
expressed an unqualified opinion on management’s assessment
of the effectiveness of Nortel’s internal control over
financial reporting and an adverse opinion on the effectiveness
of Nortel’s internal control over financial reporting
because of material weaknesses); such consolidated financial
statements and reports are included elsewhere in this
Form 10-K. Our
audits also included the consolidated financial statement
schedule of Nortel listed in Item 15. This consolidated
financial statement schedule is the responsibility of
Nortel’s management. Our responsibility is to express an
opinion based on our audits. In our opinion, such consolidated
financial statement schedule, when considered in relation to the
basic consolidated financial statements taken as a whole,
presents fairly, in all material respects, the information set
forth therein.
Includes acquisitions and disposals of subsidiaries and
divisions and amounts written off, and foreign exchange
translation adjustments.
(c)
Includes provisions for uncollectibles on long-term accounts
receivable of $33, $65 and $297 as of December 31, 2005,
2004 and 2003, respectively.
230
ITEM 9.
Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure
None.
ITEM 9A.
Controls and Procedures
Management Conclusions Concerning Disclosure Controls and
Procedures
All dollar amounts in this Item 9A are in millions of
United States, or U.S., dollars unless otherwise stated.
We carried out an evaluation under the supervision and with the
participation of management, including the current CEO and
current CFO (Mike S. Zafirovski and Peter W. Currie,
respectively), pursuant to
Rule 13a-15 under
the Securities Exchange Act of 1934, or the Exchange Act, of the
effectiveness of our disclosure controls and procedures as at
December 31, 2005 (the end of the period covered by this
report). The CEO and CFO were appointed to such positions as at
November 15, 2005 and February 14, 2005, respectively.
In making this evaluation, the CEO and CFO considered, among
other matters:
•
our successive restatements of our financial statements,
including the Third Restatement;
•
the findings of the Independent Review summarized in the
“Summary of Findings and of Recommended Remedial Measures
of the Independent Review,” submitted to the Audit
Committee in January 2005 by WilmerHale and Huron Consulting
Services LLC, or the Independent Review Summary, included in
Item 9A of our 2003 Annual Report;
•
the material weaknesses in our internal control over financial
reporting that we and our independent registered chartered
accountants, Deloitte, have identified (as more fully described
below);
•
management’s assessment of our internal control over
financial reporting and conclusion that our internal control
over financial reporting was not effective as at
December 31, 2004 and 2005, and Deloitte’s attestation
report with respect to that assessment and conclusion, each
pursuant to the requirements of Section 404 of the
Sarbanes-Oxley Act of 2002, or SOX 404, included in Item 8
and Item 9A of our 2004 Annual Report and this report;
•
the conclusion of the CEO and CFO that our disclosure controls
and procedures, as at the end of each quarter in 2005, were not
effective, included in each 2005 Quarterly Report;
•
the findings of the Revenue Independent Review included in this
Item 9A;
•
the ongoing Internal Audit Review described more fully
below; and
•
the remedial measures we have identified, developed and begun to
implement to address these issues.
Based on this evaluation, the CEO and CFO have concluded that
our disclosure controls and procedures as at December 31,2005 were not effective to provide reasonable assurance that
information required to be disclosed in the reports we file and
submit under the Exchange Act is recorded, processed, summarized
and reported as and when required and that it is accumulated and
communicated to our management, including the CEO and CFO, as
appropriate, to allow timely decisions regarding required
disclosure.
In light of this conclusion, we have applied compensating
procedures and processes as necessary to ensure the reliability
of our financial reporting. Accordingly, management believes,
based on its knowledge, that (i) this report does not
contain any untrue statement of a material fact or omit to state
a material fact necessary to make the statements made, in light
of the circumstances under which they were made, not misleading
with respect to the period covered by this report and
(ii) the financial statements, and other financial
information included in this report, fairly present in all
material respects our financial condition, results of operations
and cash flows as at, and for, the periods presented in this
report.
Management’s Report on Internal Control Over Financial
Reporting
Management is responsible for establishing and maintaining
adequate internal control over financial reporting as defined in
Rules 13a-15(f)
and 15d-15(f) under the
Exchange Act. Our internal control over financial reporting is
intended to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of
financial statements for
231
external purposes in accordance with applicable GAAP. Our
internal control over financial reporting should include those
policies and procedures that:
•
pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and
dispositions of our assets;
•
provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in
accordance with applicable GAAP, and that receipts and
expenditures are being made only in accordance with
authorizations of management and the Board of Directors; and
•
provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use or disposition of our
assets that could have a material effect on the financial
statements.
Because of its inherent limitations, internal control over
financial reporting may not prevent or detect misstatements.
Also, projections of any evaluation of effectiveness to future
periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree
of compliance with the policies or procedures may deteriorate.
Management, including the current CEO and current CFO, assessed
the effectiveness of our internal control over financial
reporting, and concluded that five material weaknesses in our
internal control over financial reporting existed, as at
December 31, 2005. These material weaknesses, which are the
same material weaknesses that existed as at December 31,2004 and as first reported in our 2003 Annual Report, are:
•
lack of compliance with written Nortel procedures for monitoring
and adjusting balances related to certain accruals and
provisions, including restructuring charges and contract and
customer accruals;
•
lack of compliance with Nortel procedures for appropriately
applying applicable GAAP to the initial recording of certain
liabilities, including those described in SFAS No. 5,
and to foreign currency translation as described in
SFAS No. 52;
•
lack of sufficient personnel with appropriate knowledge,
experience and training in U.S. GAAP and lack of sufficient
analysis and documentation of the application of U.S. GAAP
to transactions, including, but not limited to, revenue
transactions;
•
lack of a clear organization and accountability structure within
the accounting function, including insufficient review and
supervision, combined with financial reporting systems that are
not integrated and which require extensive manual
interventions; and
•
lack of sufficient awareness of, and timely and appropriate
remediation of, internal control issues by Nortel personnel.
For purposes of this Management’s Report on Internal
Control Over Financial Reporting, the term “material
weakness” means a significant deficiency (within the
meaning of Public Company Accounting Oversight Board Auditing
Standard No. 2), or combination of significant
deficiencies, that results in more than a remote likelihood that
a material misstatement of our annual or interim financial
statements will not be prevented or detected.
In making its assessment of internal control over financial
reporting, management used the criteria issued by the Committee
of Sponsoring Organizations of the Treadway Commission
(COSO) in Internal Control-Integrated Framework and PCAOB
Standard No. 4. Because of the material weaknesses
described above, management believes that, as at
December 31, 2005, we did not maintain effective internal
control over financial reporting based on those criteria.
Management has excluded from its assessment the internal control
over financial reporting of both LG-Nortel, a joint venture
formed on November 2, 2005 between Nortel and LG
Electronics, Inc., and PEC, a company acquired by Nortel on
June 3, 2005 (see “Developments in 2005 and
2006 — Significant Developments —
Acquisitions” in the MD&A section of this report).
Our fiscal 2005 consolidated financial statements include the
operating results of PEC for approximately 7 months. During
this period, PEC’s operations generated approximately $142,
or 1%, of our 2005 consolidated revenues and contributed $7 of
income included in our 2005 net loss. Additionally,
PEC’s total assets as of December 31, 2005 were
approximately $515, or 3% of our 2005 consolidated total assets.
Our fiscal 2005 consolidated financial statements also include
the operating results of LG-Nortel for approximately
2 months. During this period, LG-Nortel’s operations
generated approximately $24, or less than 1%, of our 2005
232
consolidated revenues and contributed $12 of our 2005 net
loss. Additionally, LG-Nortel’s total assets as of
December 31, 2005 were approximately $524, or 3% of our
2005 consolidated total assets.
Our independent registered chartered accountants have issued an
attestation report expressing an unqualified opinion on
management’s assessment of the effectiveness of internal
control over financial reporting, and an adverse opinion on the
effectiveness of internal control over financial reporting as at
December 31, 2005, which report appears below.
Report of Independent Registered Chartered Accountants
To the Shareholders and Board of Directors of Nortel
Networks Corporation
We have audited management’s assessment, included in the
accompanying Management’s Report on Internal Control over
Financial Reporting, that Nortel Networks Corporation and its
subsidiaries (“Nortel”) did not maintain effective
internal control over financial reporting as of
December 31, 2005, because of the effect of the material
weaknesses identified in management’s assessment based on
criteria established in Internal Control — Integrated
Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission. As described in Management’s
Report on Internal Control over Financial Reporting, management
excluded from their assessment (1) the internal control
over financial reporting at LG-Nortel Co. Ltd.
(“LG-Nortel”) which was formed on November 2,2005 and whose financial statements reflect total assets and
revenues constituting 3% and less than 1%, respectively, of
Nortel’s consolidated financial statement amounts as of and
for the year ended December 31, 2005 and (2) the
internal control over financial reporting at Nortel Government
Solutions Incorporated (“Nortel Government Solutions”,
formerly PEC Solutions Inc.) which was acquired on June 6,2005 and whose financial statements reflect total assets and
revenues constituting 3% and 1%, respectively, of Nortel’s
consolidated financial statement amounts as of and for the year
ended December 31, 2005. Accordingly, our audit did not
include the internal control over financial reporting at either
LG-Nortel or Nortel Government Solutions. Nortel’s
management is responsible for maintaining effective internal
control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our
responsibility is to express an opinion on management’s
assessment and an opinion on the effectiveness of Nortel’s
internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain
reasonable assurance about whether effective internal control
over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of
internal control over financial reporting, evaluating
management’s assessment, testing and evaluating the design
and operating effectiveness of internal control, and performing
such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable
basis for our opinions.
A company’s internal control over financial reporting is a
process designed by, or under the supervision of, the
company’s principal executive and principal financial
officers, or persons performing similar functions, and effected
by the company’s board of directors, management and other
personnel to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with
generally accepted accounting principles. A company’s
internal control over financial reporting includes those
policies and procedures that (1) pertain to the maintenance
of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the
company; (2) provide reasonable assurance that transactions
are recorded as necessary to permit preparation of financial
statements in accordance with generally accepted accounting
principles, and that receipts and expenditures of the company
are being made only in accordance with authorizations of
management and directors of the company; and (3) provide
reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use, or disposition of the
company’s assets that could have a material effect on the
financial statements.
Because of the inherent limitations of internal control over
financial reporting, including the possibility of collusion or
improper management override of controls, material misstatements
due to error or fraud may not be prevented or detected on a
timely basis. Also, projections of any evaluation of the
effectiveness of the internal control over financial reporting
to future periods are subject to the risk that the controls may
become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may
deteriorate.
233
A material weakness is a significant deficiency, or combination
of significant deficiencies, that results in more than a remote
likelihood that a material misstatement of the annual or interim
financial statements will not be prevented or detected. The
following material weaknesses have been identified and included
in management’s assessment:
•
Lack of compliance with written Nortel procedures for monitoring
and adjusting balances relating to certain accruals and
provisions, including restructuring charges and contract and
customer accruals;
•
Lack of compliance with Nortel procedures for appropriately
applying generally accepted accounting principles
(“GAAP”) to the initial recording of certain
liabilities including those described in Statement of Financial
Accounting Standards (“SFAS”) No. 5,
“Accounting for Contingencies”, and to foreign
currency translation as described in SFAS No. 52,
“Foreign Currency Translation”;
•
Lack of sufficient personnel with appropriate knowledge,
experience and training in U.S. GAAP and lack of sufficient
analysis and documentation of the application of U.S. GAAP
to transactions including, but not limited to, revenue
transactions;
•
Lack of a clear organization and accountability structure within
the accounting function, including insufficient review and
supervision, combined with financial reporting systems that are
not integrated and which require extensive manual
interventions; and
•
Lack of sufficient awareness of, and timely and appropriate
remediation of, internal control issues by Nortel personnel.
These material weaknesses were considered in determining the
nature, timing and extent of audit tests applied in our audit of
the consolidated financial statements and financial statement
schedule of Nortel as of and for the year ended
December 31, 2005 and this report does not affect our
reports on such financial statements and financial statement
schedule.
In our opinion, management’s assessment that Nortel did not
maintain effective internal control over financial reporting as
of December 31, 2005, is fairly stated, in all material
respects, based on the criteria established in Internal
Control — Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission. Also in
our opinion, because of the effect of the material weaknesses
described above on the achievement of the objectives of the
control criteria, Nortel has not maintained effective internal
control over financial reporting as of December 31, 2005,
based on the criteria established in Internal
Control — Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with Canadian generally
accepted auditing standards and the standards of the Public
Company Accounting Oversight Board (United States), the
consolidated financial statements and financial statement
schedule as of and for the year ended December 31, 2005 of
Nortel and our reports dated April 28, 2006 expressed
unqualified opinions on those financial statements (which report
on the consolidated financial statements includes an explanatory
paragraph relating to the restatement of the consolidated
financial statements as of December 31, 2004 and for the
years ended December 31, 2004 and 2003, and includes a
separate report titled Comments by Independent Registered
Chartered Accountants on Canadian-U.S. Reporting
Differences referring to changes in accounting principles that
have a material effect on the comparability of the financial
statements) and on the financial statement schedule.
As part of the remediation efforts discussed below in this
Item 9A and to compensate for the material weaknesses in
our internal control over financial reporting, we undertook
intensive efforts in 2005 to enhance our controls and procedures
relating to the recognition of revenue. These efforts included,
among other measures, extensive documentation and review of
customer contracts for revenue recognized in 2005 and earlier
periods. As a result of the contract review, it became apparent
that certain of the contracts had not been accounted for
properly under U.S. GAAP. Most of these errors related to
contractual arrangements involving multiple deliverables, for
which revenue recognized in prior periods should have been
deferred to later periods, under SAB 104 and
SOP 97-2.
In addition, based on our review of our revenue recognition
policies and discussions with our independent registered
chartered accountants as part of the 2005 audit, we determined
that in our previous application of these policies, we
misinterpreted certain of these policies principally related to
complex contractual arrangements with customers where multiple
deliverables were accounted for using the
percentage-of-completion method of accounting under
SOP 81-1, as described in more detail below:
•
Certain complex arrangements with multiple deliverables were
previously fully accounted for under the
percentage-of-completion method of SOP 81-1, but elements
outside of the scope of SOP 81-1 should have been examined
for separation under the guidance in
EITF 00-21; and
•
Certain complex arrangements accounted for under the
percentage-of-completion method did not meet the criteria for
this treatment in SOP 81-1 and should instead have been
accounted for using completed contract accounting under
SOP 81-1.
In correcting for both application errors, the timing of revenue
recognition was frequently determined to be incorrect, with
revenue having generally been recognized prematurely when it
should have been deferred and recognized in later periods.
Management’s determination that these errors required
correction led to the Audit Committee’s decision on
March 9, 2006, to effect a further restatement of our
consolidated financial statements. We have restated our
consolidated balance sheet as of December 31, 2004, and our
consolidated statements of operations, changes in equity and
comprehensive income (loss) and cash flows for each of the years
ended December 31, 2004 and 2003. The Third Restatement
also corrected other miscellaneous accounting errors, as well as
the classification of certain items within the consolidated
statements of operations and cash flows. The impact of the Third
Restatement to periods prior to 2003 was a net increase of $70
to the opening accumulated deficit as of January 1, 2003.
The Third Restatement process included the maintenance of a
restatement database to track issues and adjustments, the
involvement and oversight by senior finance management and open
and regular dialogue with Deloitte.
Overall in the Third Restatement, as a result of the adjustments
to correct errors related to revenue recognition, we decreased
revenues by an aggregate of $261, $312 and $520 in 2003, 2004
and the first nine months of 2005, respectively. These
adjustments constituted the recognition of revenues that had
previously been improperly recognized in prior periods and
should have been deferred to future periods. This also had the
effect of reducing previously reported revenues in 2001 and 2002
by approximately $67 and $270, respectively.
Principal Adjustments
The following are the main categories of the revenue adjustments
in 2003 and 2004:
Revenues
Cost of revenues
2004
2003
2004
2003
As previously reported
$
9,828
$
10,193
$
5,750
$
5,852
Adjustments:
Application of SOP 81-1
$
(84
)
$
(118
)
$
(55
)
$
(103
)
Interaction between multiple revenue recognition accounting
standards
(174
)
(49
)
(127
)
(26
)
Application of SAB 104 and SOP 97-2
(38
)
(84
)
14
(36
)
Other revenue recognition adjustments
(16
)
(10
)
(12
)
26
Other adjustments
—
—
4
10
As restated
$
9,516
$
9,932
$
5,574
$
5,723
235
The following table summarizes the main categories of the
adjustments for the quarters ended March 31, June 30
and September 30, 2004 and 2005, respectively, and the
quarter ended December 31, 2004:
2005
2004
Three
Three
Three
Three
Three
Three
Three
Months
Months
Months
Months
Months
Months
Months
Ended
Ended
Ended
Ended
Ended
Ended
Ended
March 31
June 30
September 30
March 31
June 30
September 30
December 31
Revenues — as previously reported
$
2,536
$
2,855
$
2,655
$
2,444
$
2,590
$
2,179
$
2,615
Adjustments:
Application of SOP 81-1
82
(23
)
(13
)
(22
)
(29
)
(17
)
(16
)
Interaction between multiple revenue recognition accounting
standards
(183
)
(155
)
(70
)
(19
)
(31
)
(49
)
(75
)
Application of SAB 104 and SOP 97-2
(53
)
(45
)
(62
)
(37
)
(54
)
42
11
Other revenue recognition adjustments
7
(13
)
8
—
2
4
(22
)
Revenues — as restated
$
2,389
$
2,619
$
2,518
$
2,366
$
2,478
$
2,159
$
2,513
Net earnings (loss) — as previously reported
$
(49
)
$
45
$
(105
)
$
59
$
16
$
(259
)
$
133
Adjustments:
Application of SOP 81-1
9
(12
)
(6
)
(3
)
(14
)
(3
)
(8
)
Interaction between multiple revenue recognition accounting
standards
(26
)
(12
)
(7
)
(6
)
(7
)
(10
)
(24
)
Application of SAB 104 and SOP 97-2
(26
)
(25
)
(22
)
(23
)
(26
)
2
(5
)
Other revenue recognition adjustments
(3
)
(50
)
6
(9
)
3
2
—
Gain on sale of businesses
(21
)
25
—
(1
)
—
—
(6
)
Health and WelfareTrust
—
—
—
—
—
—
(1
)
Foreign exchange
2
11
(5
)
—
6
(34
)
(10
)
Other
10
(15
)
3
(2
)
(1
)
1
23
Net earnings (loss) — as restated
$
(104
)
$
(33
)
$
(136
)
$
15
$
(23
)
$
(301
)
$
102
For additional information concerning adjustments made in the
Third Restatement, see note 4 to the accompanying audited
consolidated financial statements and “Restatements: Nortel
Audit Committee Independent Review; Material Weaknesses; Related
Matters — Third Restatement” in the MD&A
section of this report.
Decision Not to Amend Certain Previous Filings
The Third Restatement involved the restatement of our
consolidated financial statements for 2001, 2002, 2003, 2004 and
the first nine months of 2005. Amendments to our prior filings
with the SEC would be required in order for us to be in full
compliance with our reporting obligations under the Securities
Exchange Act of 1934. However, any amendments to our 2003 Annual
Report and 2004 Annual Report and the Quarterly Reports on
Form 10-Q for the quarterly periods ended March 31,
June 30, and September 30, 2005 and 2004,
respectively, would in large part repeat the disclosure
contained in this report. Accordingly, Nortel does not plan to
amend these or any other prior filings. Nortel believes that it
has included in this report all information needed for current
investor understanding.
We have not restated the separate consolidated financial
statements of Nortel’s indirect subsidiary, Nortel Networks
S.A., originally presented in our 2003 Annual Report, or the
supplemental consolidating financial information presented in
our 2003 Annual Report and 2004 Annual Report (as well as in
relevant Quarterly Reports on Form 10-Q during the
applicable periods). As certain guarantee and security
agreements that gave rise to the requirement to present this
information under applicable rules under the Securities and
Exchange Act of 1934 were no longer in effect as at
December 31, 2005, we are not required to present this
information in this report and we believe that the restatement
of this information would not be relevant for current investor
understanding. The previously filed consolidated financial
statements of Nortel Networks S.A. and supplemental
consolidating financial information should no longer be
relied upon.
236
Internal Audit Review of facts and circumstances
surrounding Third Restatement
Following the announcement of the Third Restatement on
March 10, 2006, the Audit Committee directed the Internal
Audit group to conduct a review of the facts and circumstances
surrounding the Third Restatement principally to review the
underlying conduct of the initial recording of the errors and
any overlap of items restated in the Third Restatement and the
Second Restatement. Internal Audit engaged third party forensic
accountants to assist in the review. The work underlying the
review is substantially complete. Internal Audit continues to
review and assess its work and upon completion, will provide its
final findings to the Audit Committee.
Revenue Independent Review
As described in our 2003 Annual Report, management identified
certain accounting practices and errors related to revenue
recognition that it determined required adjustment as part of
the Second Restatement. In light of the resulting corrections to
previously reported revenues totaling approximately $3,400, the
Audit Committee determined to review the facts and circumstances
leading to the restatement of these revenues for specific
transactions identified in the Second Restatement,with a
particular emphasis on the underlying conduct. The Audit
Committee sought a full understanding of the historic events
that required the revenues for these specific transactions to be
restated and intended to consider any appropriate additional
remedial measures, including those involving internal controls
and processes. The Audit Committee engaged WilmerHale to advise
it in connection with this review. Because of the significant
accounting issues involved in the inquiry, WilmerHale retained
Huron Consulting Services LLC, or Huron, to provide expert
accounting assistance, and Huron was involved in all phases of
WilmerHale’s work. The Audit Committee launched the Revenue
Independent Review after the Second Restatement was completed
and did not seek to have WilmerHale and Huron audit or otherwise
review the substantive accuracy of Nortel’s restated
financial statements or review other aspects of Nortel’s
accounting practices not adjusted in the Second Restatement.
The Revenue Independent Review focused principally on
transactions that accounted for approximately $3,000 of the
approximately $3,400 in restated revenue, with a particular
emphasis on transactions that accounted for approximately $2,600
in 2000. That emphasis was appropriate because (1) the size
of the revenue restatement for 2000 ($2,800 of the total
restated revenue of $3,400) and (2) the same types of
errors made in 2000 reoccurred in subsequent years. As more
fully described in Item 9A of the 2003 Annual Report, the
revenue adjustments that were part of the Second Restatement
primarily related to certain categories of transactions, and the
independent review has examined transactions in each of these
categories.
The Revenue Independent Review found that, in an effort to meet
internal and external targets, the senior corporate finance
management team, none of whom are current employees, changed the
accounting policies of the Company several times during 2000,
either to defer revenue out to a subsequent period or pull
revenue in to the current period. After changing internal
accounting policies, senior corporate finance management did not
understand relevant U.S. GAAP, misapplied these
U.S. GAAP requirements, and, in certain circumstances,
turned a blind eye to these U.S. GAAP requirements. As a
result, Nortel recognized revenue for numerous transactions with
disregard for the proper accounting and this conduct was driven
by the need to close revenue and earnings gaps.
The findings of the Revenue Independent Review have been
presented to the Audit Committee and Board of Directors. The
Revenue Independent Review is now complete.
In the Independent Review Summary approved by the Board of
Directors and included in our 2003 Annual Report, the Board of
Directors adopted a framework of governing remedial principles
to prevent recurrence of the inappropriate accounting conduct,
to rebuild a finance environment based on transparency and
integrity, and to ensure sound financial reporting and
comprehensive disclosure. The Board of Directors directed
management to implement those principles, through a series of
remedial measures, across the company, to prevent any repetition
of past misconduct and re-establish a finance organization with
values of transparency, integrity, and sound financial reporting
as its cornerstone. Management’s ongoing implementation
efforts are described below and will continue following the
filing of this report. The Board of Directors has monitored the
implementation efforts to date and will continue to regularly
monitor management’s implementation efforts.
Remedial Measures
We have identified, developed and begun to implement remedial
measures in light of the findings of the Independent Review and
Revenue Independent Review,and of management’s assessment
of the effectiveness of internal control over
237
financial reporting, to strengthen our internal control over
financial reporting and disclosure controls and procedures, and
to address the material weaknesses in our internal control over
financial reporting.
At the recommendation of the Audit Committee, the Board of
Directors adopted all of the recommendations for remedial
measures contained in the Independent Review Summary. Those
governing remedial principles were designed to prevent
recurrence of the inappropriate accounting conduct found in the
Independent Review, to rebuild a finance environment based on
transparency and integrity, and to ensure sound financial
reporting and comprehensive disclosure. The governing remedial
principles included:
•
establishing standards of conduct to be enforced through
appropriate discipline;
•
infusing strong technical skills and experience into the finance
organization;
•
requiring comprehensive, on-going training on increasingly
complex accounting standards;
•
strengthening and improving internal controls and processes;
•
establishing a compliance program throughout the Company which
is appropriately staffed and funded;
•
requiring management to provide clear and concise information,
in a timely manner, to the Board of Directors to facilitate its
decision-making; and
•
implementing an information technology platform that improves
the reliability of financial reporting and reduces the
opportunities for manipulation of results.
See the Independent Review Summary for further information
concerning these governing principles as they relate to three
identified categories — people, processes and
technology.
The Board of Directors recognized that its adoption of these
governing principles was the beginning of a long and vitally
important process. It directed management to develop a detailed
plan and timetable for the implementation of these remedial
measures. Management developed an implementation plan, which was
approved by the Board of Directors, and has begun implementation
of that plan. Certain remedial measures that management has
begun to implement include: the hiring of key senior management
including our CFO, Controller and Vice President Audit and
Compliance Officer; reorganization of the finance organization
to segregate control and planning and forecasting
responsibilities; strengthening of the internal audit function;
and continual review and improvements to controls around the
review and approval of accounting entries. The Board of
Directors continues to monitor the ongoing implementation
efforts.
In February 2005, the Board of Directors approved a program to
transform our finance organization’s structure, processes
and finance systems to create a more effective organization with
segregated functions and clear accountabilities built around
global standard processes based on SAP. SAP is a software
package that will allow us to consolidate many of our numerous
computer systems into an integrated finance system. We expect
that the global phased SAP finance implementation will reduce
the chance of error, including through a significant reduction
in manual journal entries, improve speed of the consolidation
process and increase transparency of journal entries to senior
management.
Management has also identified, developed and begun to implement
a number of measures to strengthen our internal control over
financial reporting and disclosure controls and procedures, and
to address the material weaknesses in our internal control over
financial reporting. These measures include the compensating
procedures and processes that we have applied, in light of our
material weaknesses and ineffective internal control over
financial reporting and disclosure controls and procedures, to
ensure the reliability of our financial reporting, including the
substantive processes described above under “Restatement of
Financial Results”. Management also has taken, and will
continue to take where appropriate, steps to augment the
organization with individuals of requisite skill to address the
material weaknesses. We have taken disciplinary action with
respect to some employees, including employee terminations where
appropriate. Senior management has regularly communicated to our
employees, through education sessions, ‘town hall’
meetings and training, that it will not tolerate accounting
conduct that involves the misapplication of U.S. GAAP and
will hold employees accountable for their actions and decisions.
Management Assessment and Observations
In management’s assessment of its internal control over
financial reporting, the following observations were made:
•
While we have invested significantly in improvements to our
internal control environment, this has been a very difficult
task, as many of the reasons for weak internal control over
financial reporting are pervasive and relate to our
infrastructure and organization.
238
•
Without significant infrastructure changes, including changes to
the information systems and finance organizational structure, we
will be utilizing short-term, time-consuming workaround
solutions to address identified control issues as opposed to
streamlining and building sustainable processes that involve the
effective execution of stronger and more efficient monitoring
and preventative controls.
•
In order to fully remediate the identified material weaknesses,
we will need to put in place a more rigorous management
assessment process while continuing to remedy deficiencies in
the process. In addition, we need to ensure that we have
sufficient resources to make the necessary improvements to
controls as well as further strengthen the training and
competencies of our finance personnel and to invest sufficient
time to design and evaluate the necessary controls so that they
are fully understood, implemented and operate effectively.
•
A number of control design deficiencies, including those at the
entity level, result in a control environment wherein the design
or operation of the internal control components would not reduce
to a relatively low level the risk that material misstatements
caused by error or fraud may occur and may not be detected
within a timely period in the normal course (entity level
controls include those controls that have a pervasive effect on
the organization). Entity level controls will require
significant attention and improvement before a foundation upon
which internal controls could be considered effective will exist
and upon which controls at the transaction process level could
be considered effective and reliable (i.e., result in a
sustainable control environment). In general, we noted many
control deficiencies at the entity level and a high volume of
deficiencies at the transaction process level.
•
At the transaction process level, we need to improve upon the
balance between detective and preventative controls. We continue
to rely heavily on manual and detective controls and experience
a high volume of post-close accounting adjustments, including
out-of-period
adjustments, all in the context of processes that are complex
and fragmented.
Management’s assessment is that, in our control
environment, it would be impractical to categorize each of our
extensive control deficiencies as either inconsequential or
significant, and therefore, virtually all control deficiencies
should be considered as more than inconsequential, and each such
deficiency relates closely to, or is a symptom of, one of the
material weaknesses identified by management and described above
under “Management’s Report on Internal Control Over
Financial Reporting”. The control deficiencies at the
transaction process level generally relate more to preventative
controls than to detective controls. The control deficiencies
directly or indirectly referenced in the material weaknesses or
in the observations set forth above, include, among others,
those that relate to our whistle-blowing, code of ethics and
anti-fraud programs, as well as our segregation of duty
requirements such as control over user access to systems, data
protection controls and controls with outsource providers.
Deloitte has reported to the Audit Committee on their audit of
our internal control over financial reporting, which included
observations on management’s assessment and conclusion that
the internal control over financial reporting was not effective
as at December 31, 2005 because of the effect of our five
material weaknesses. Management’s observations described
above under “Management Assessment and Observation”
are consistent with Deloitte’s reporting to the Audit
Committee.
We expect that full implementation of the remedial measures
contained in the Independent Review Summary and full remediation
of our material weaknesses, our internal control over financial
reporting and our disclosure controls and procedures will
continue to take significant time and effort, due largely to the
complexity and extensive nature of some of the remediation
required and a need to increase the co-ordination of remedial
efforts within the organization in order to implement one
comprehensive remediation plan with a well defined set of
objectives and agreed upon timelines. These initiatives were
impacted in 2005 and in 2006 to date by the substantial efforts
needed to reestablish our current financial reporting in
accordance with U.S. and Canadian securities laws, the
significant turnover in our finance personnel, changes in our
accounting systems and continuing documentation weaknesses.
Management continues to assess the internal and external
resources that will be needed to continue to implement, support,
sustain and monitor the effectiveness of our ongoing and future
remedial efforts.
In addition, in part as a result of the compensating procedures
and processes that we are applying to our financial reporting
process, during the preparation of our financial statements for
recent periods (including 2004, 2005 and interim periods in
2005), we have identified a number of adjustments to correct
accounting errors related to prior periods, including the errors
corrected by the Third Restatement, as more fully described
above. We also recorded in the past adjustments that were
immaterial to the then current period and to the prior periods
in the financial statements for the then current period. As long
as we continue to have material weaknesses in our internal
control over financial reporting,
239
we may in future identify similar adjustments to prior period
financial information. Adjustments that may be identified in the
future could require further restatement of our financial
statements.
Changes in Internal Control Over Financial Reporting
During the fiscal quarter ended December 31, 2005, the
following changes occurred in our internal control over
financial reporting that materially affected, or are reasonably
likely to materially affect, our internal control over financial
reporting:
•
The formation of the LG-Nortel joint venture on November 2,2005, including implementation by the joint venture entity of a
separate Oracle financial software system (including general
ledger, accounts payable and accounts receivable functions) and
an enterprise resource planning system. For more information
about the LG-Nortel joint venture, see “Developments in
2005 and 2006 — Significant Business
Developments — Joint Ventures” in the MD&A
section of this report and note 9 of the accompanying
audited consolidated financial statements.
•
The appointment of a new President and CEO, Chief Legal Officer
and Vice President, Global Supply Chain and Quality.
•
As part of the remediation efforts discussed above and to
compensate for the material weaknesses in our internal control
over financial reporting, we undertook extensive documentation
and review of customer contracts for revenue recognized in 2005
and earlier periods. This contract review was commenced in the
middle of 2005 following the completion of the Second
Restatement and the filing of our delayed periodic reports, but
was conducted substantially in the fourth quarter of 2005 and
the first quarter of 2006.
The information required by this item is incorporated herein by
reference to Nortel’s 2006 proxy circular and proxy
statement to be filed with the Commission pursuant to
Regulation 14A. Such incorporation by reference shall be
deemed not to specifically incorporate by reference the
information referred to in Item 402(a)(8) of
Regulation S-K,
contained under the captions “Report on Executive
Compensation”, “Shareholder Return Performance
Graph” and “Report of the Audit Committee of Nortel
Networks Corporation”.
ITEM 11.
Executive Compensation
The information required by this item is incorporated herein by
reference to Nortel’s 2006 proxy circular and proxy
statement to be filed with the Commission pursuant to
Regulation 14A. Such incorporation by reference shall be
deemed not to specifically incorporate by reference the
information referred to in Item 402(a)(8) of
Regulation S-K,
contained under the captions “Report on Executive
Compensation”, “Shareholder Return Performance
Graph” and “Report of the Audit Committee of Nortel
Networks Corporation”.
ITEM 12.
Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters
The information required by this item is incorporated herein by
reference to Nortel’s 2006 proxy circular and proxy
statement to be filed with the Commission pursuant to
Regulation 14A. Such incorporation by reference shall be
deemed not to specifically incorporate by reference the
information referred to in Item 402(a)(8) of
Regulation S-K,
contained under the captions “Report on Executive
Compensation”, “Shareholder Return Performance
Graph” and “Report of the Audit Committee of Nortel
Networks Corporation”.
ITEM 13.
Certain Relationships and Related Transactions
Indebtedness of management
The Company provides relocation assistance to employees who are
requested to relocate under the Nortel Networks —
International Assignment Relocation program that is designed to
minimize the financial exposure to employees as a result of the
move. In the past, the assistance has included housing loans,
advances on real estate equity, and payments on behalf of
employees of direct costs associated with the move. The
assistance offered is specific to each employee and is
structured to be competitive in the area to which the employee
is relocated, subject to the overall relocation policy.
Effective July 30, 2002, the Company no longer offers its
executive officers housing loans as part of their relocation
assistance and neither the Company nor its subsidiaries have
given any guarantee, support agreement, letter of credit, or
similar arrangement or understanding, to any other entity in
connection with indebtedness of current and former directors or
executive officers since that time.
As at April 21, 2006, approximately $4.2 million of
indebtedness was owed by current and former employees to the
Company and its subsidiaries, of which $1.2 million related
to housing loans and $3.0 million related to miscellaneous
employee receivable such as adjustments to employee
reimbursements and advances. Except for a recently appointed
officer’s indebtedness (set out below), which pre-dates the
United States Sarbanes-Oxley Act of 2002, no current or former
director or executive officer had any loans outstanding during
2005.
Table of Indebtedness of Directors and Executive Officers
A subsidiary of the Company extended a housing loan to
Ms. Lechner in February 2000 in connection with a
relocation. As long as Ms. Lechner remains a Nortel
employee, the loan is due and payable in full in February 2010.
241
ITEM 14.
Principal Accountant Fees and Services
Deloitte & Touche LLP, the member firms of Deloitte
Touche Tohmatsu, and their respective affiliates (or,
collectively, the Deloitte Entities) are the principal
independent registered chartered accountants of the Company and
NNL.
In accordance with applicable laws and the requirements of stock
exchanges and securities regulatory authorities, the audit
committees of the Company and NNL pre-approve all audit and
non-audit services to be provided by the Deloitte Entities. In
addition, in April 2002, the audit committees of the Company and
NNL recommended for approval, and the boards of directors of the
Company and NNL approved, a policy that thereafter the
Company’s and NNL’s auditors would be retained solely
to provide audit and audit-related services and advice with
respect to tax matters, and that the auditors would not be
retained to provide consulting services, such as information
technology services.
Audit Fees
The Company and NNL prepare financial statements in accordance
with United States generally accepted accounting principles (or
US GAAP), with a reconciliation to Canadian generally accepted
accounting principles (or Canadian GAAP). Deloitte Entities
billed the Company and its subsidiaries $59.5 million for
2005, for the following audit services: (i) the audit of
the annual consolidated financial statements of the Company and
NNL for the fiscal year ended December 31, 2005;
(ii) reviews of the financial statements of the Company and
NNL in Forms 10-Q
for the periods ended March 31, June 30 and
September 30, 2005; (iii) audit of internal controls
over financial reporting as required under the United States
Sarbanes-Oxley Act of 2002 for the fiscal year ended
December 31, 2005; (iv) audits of individual
subsidiary and other investments statutory financial statements;
and (v) comfort letters, attest services, statutory and
regulatory audits, consents and other services related to United
States Securities and Exchange Commission matters. Deloitte
Entities billed $49 million for 2004, previously reported
as $46 million, for the following audit services:
(i) audits of the annual consolidated financial statements
of the Company and NNL for the fiscal year ended
December 31, 2004; (ii) reviews of the financial
statements of the Company and NNL in
Forms 10-Q for the
periods ended March 31, June 30 and September 30,2004; (iii) audit of internal controls over financial
reporting as required under the United States Sarbanes-Oxley Act
of 2002 for the fiscal year ended December 31, 2004;
(iv) audits and reviews of the restated financial
statements of the Company and NNL as comparative statements in
their respective
Form 10-K for the
fiscal year ended December 31, 2003; (v) audits of
individual subsidiary statutory financial statements; and
(vi) comfort letters, attest services, statutory and
regulatory audits, consents and other services related to United
States Securities and Exchange Commission matters.
Audit-Related Fees
Deloitte Entities billed the Company and its subsidiaries
$2.9 million and $3.8 million for 2005 and 2004,
respectively, for the following audit-related services:
(i) audit of pension plan financial statements;
(ii) financial accounting and reporting consultations;
(iii) advisory services related to the United States
Sarbanes-Oxley Act of 2002; (iv) accounting consultations
and audits in connection with acquisitions and dispositions;
(v) internal control reviews; and (vi) accounting
consultations regarding financial accounting standards for
various local business-related transactions.
Tax Fees
Deloitte Entities billed the Company and its subsidiaries
$4.9 million and $7.1 million for 2005 and 2004,
respectively, for tax compliance services. Tax compliance
services are services rendered based upon facts already in
existence or transactions that have already occurred to
document, compute and obtain government approval for amounts to
be included in tax filings and consisted of: (i) assistance
in filing tax returns in various jurisdictions; (ii) sales
and use, property and other tax return assistance;
(iii) research and development tax credit documentation and
analysis for purposes of filing amended returns;
(iv) transfer pricing documentation; (v) requests for
technical advice from taxing authorities; (vi) assistance
with tax audits and appeals; and (vii) preparation of
expatriate tax returns.
All Other Fees
Deloitte Entities did not bill the Company and its subsidiaries
for any other services in 2005 and 2004.
242
PART IV
ITEM 15.
Exhibits, Financial Statement Schedules
1.
Financial Statements
The index to the Consolidated Financial Statements appears on
page 122.
2. Financial Statement
Schedules
Page
Quarterly Financial Data (Unaudited)
214
Report of Independent Registered Chartered Accountants
229
II — Valuation and Qualifying Accounts and Reserves,
Provision for Uncollectibles
230
All other schedules are omitted because they are inapplicable or
not required.
3.
Other Documents Filed as a Part of This Report
Management’s Report on Internal Control over Financial
Reporting
231
Report of Independent Registered Chartered Accountants
123
Individual financial statements of entities accounted for by the
equity method have been omitted because no such entity
constitutes a “significant subsidiary” requiring such
disclosure at December 31, 2005.
Pursuant to the rules and regulations of the SEC, Nortel has
filed certain agreements as exhibits to this Annual Report on
Form 10-K/A. These
agreements may contain representations and warranties by the
parties. These representations and warranties have been made
solely for the benefit of the other party or parties to such
agreements and (i) may have been qualified by disclosures
made to such other party or parties, (ii) were made only as
of the date of such agreements or such other date(s) as may be
specified in such agreements and are subject to more recent
developments, which may not be fully reflected in Nortel’s
public disclosure, (iii) may reflect the allocation of risk
among the parties to such agreements and (iv) may apply
materiality standards different from what may be viewed as
material to investors. Accordingly, these representations and
warranties may not describe Nortel’s actual state of
affairs at the date hereof and should not be relied upon.
The items listed as Exhibits 10.2 to 10.8, 10.25 to 10.41,
10.44 to 10.46, 10.52 to 10.62, 10.64 to 10.66 and items 10.68
to 10.76 relate to management contracts or compensatory plans or
arrangements.
Exhibit
No
Description
*2
.
Amended and Restated Arrangement Agreement involving BCE Inc.,
Nortel Networks Corporation, formerly known as New Nortel Inc.,
and Nortel Networks Limited, formerly known as Nortel Networks
Corporation, made as of January 26, 2000, as amended and
restated March 13, 2000 (including Plan of Arrangement
under Section 192 of the Canada Business Corporations
Act) (filed as Exhibit 2.1 to Nortel Networks
Corporation’s Current Report on Form 8-K dated
May 1, 2000).
*3
.1
Restated Certificate and Articles of Incorporation of Nortel
Networks Corporation (filed as Exhibit 3 to Nortel Networks
Corporation’s Current Report on Form 8-K dated
October 18, 2000).
*3
.2
By-Law No. 1 of Nortel Networks Corporation (filed as
Exhibit 3.2 to Nortel Networks Corporation’s Annual
Report on Form 10-K for the year ended December 31,2000).
*4
.1
Shareholders Rights Plan Agreement dated as of March 13,2000 between Nortel Networks Corporation and Montreal Trust
Company of Canada, which includes the Form of Rights Certificate
as Exhibit A thereto, as amended by the Registration
Statement on Form 8-A/ A filed on May 1, 2000, as
further amended and restated by Registration Statement dated
February 14, 2003 (filed as Exhibit 3 to Nortel
Networks Corporation’s Registration Statement on
Form 8-A/ A filed on April 25, 2003).
243
Exhibit
No
Description
*4
.2
Indenture dated as of November 30, 1988, between Nortel
Networks Limited and The Toronto-Dominion Bank Trust Company, as
trustee, related to debt securities authenticated and delivered
thereunder, which comprised the 6% Notes due
September 1, 2003, and the 6.875% Notes due
September 1, 2023 issued by Nortel Networks Limited (filed
as Exhibit 4.1 to Nortel Networks Corporation’s Annual
Report on Form 10-K for the year ended December 31,1999).
*4
.3
Indenture dated as of February 15, 1996, among Nortel
Networks Limited, as issuer and guarantor, Nortel Networks
Capital Corporation, formerly Northern Telecom Capital
Corporation, as issuer, and The Bank of New York, as trustee,
related to debt securities and guarantees authenticated and
delivered thereunder, which comprised the 7.40% Notes due
2006 and the 7.875% Notes due 2026 (filed as
Exhibit 4.1 to Registration Statement on Form S-3
(No. 333-1720) of Nortel Networks Limited and Nortel
Networks Capital Corporation).
*4
.4
Indenture dated as of December 15, 2000 among Nortel
Networks Limited, as issuer and guarantor, Nortel Networks
Capital Corporation, as issuer, and Citibank, N.A., as trustee,
related to debt securities authenticated and delivered
thereunder (filed as Exhibit 4.1 to Registration Statement
on Form S-3 (No. 333-51888) of Nortel Networks Limited
and Nortel Networks Capital Corporation).
*4
.5
First Supplemental Indenture dated as of February 1, 2001
to Indenture dated as of December 15, 2000 among Nortel
Networks Limited, as issuer and guarantor, Nortel Networks
Capital Corporation, as issuer, and Citibank, N.A., as trustee,
related to 6.125% Notes due 2006 (filed as Exhibit 4.1
to Nortel Networks Limited’s Current Report on
Form 8-K dated February 2, 2001).
*4
.6
Instrument of Resignation, Appointment and Acceptance entered
into as of December 19, 2002, effective as of
January 2, 2003, among Nortel Networks Limited, as issuer
and guarantor, Nortel Networks Capital Corporation, as issuer,
Citibank, N.A. and Deutsche Bank Trust Company Americas, with
respect to the Indenture dated as of December 5, 2000, as
supplemented by a First Supplemental Indenture dated as of
February 1, 2001 related to debt securities (filed as
Exhibit 4.6 to Nortel Networks Corporation’s Annual
Report on Form 10-K for the year ended December 31,2002).
*4
.7
Indenture dated as of August 15, 2001 between Nortel
Networks Corporation, Nortel Networks Limited, as guarantor, and
Bankers Trust Company, as trustee, related to convertible debt
securities and guarantees authenticated and delivered
thereunder, which comprised the 4.25% Convertible Senior
Notes due 2008 (filed as Exhibit 4 to Nortel Networks
Corporation’s Quarterly Report on Form 10-Q for the
quarter ended September 30, 2001).
*10
.1
Third Amended and Restated Reciprocal Credit Agreement dated as
of December 19, 2002 between Nortel Networks Corporation,
Nortel Networks Limited and the other parties who have executed
the agreement (filed as Exhibit 10.1 to Nortel Networks
Corporation’s Annual Report on Form 10-K for the year
ended December 31, 2002).
*10
.2
Nortel Networks Supplementary Executive Retirement Plan, as
amended effective October 18, 2001 and October 23,2002 (filed as Exhibit 10.2 to Nortel Networks
Corporation’s Annual Report on Form 10-K for the year
ended December 31, 2002).
*10
.3
Agreement dated April 29, 1997 related to the remuneration
of the Chief Legal Officer (termination agreement filed
September 7, 2005) (filed as Exhibit 10.3 to Nortel
Networks Corporation’s Annual Report on Form 10-K for
the year ended December 31, 2001).
*10
.4
Acknowledgement effective as of June 1, 2000 related to the
remuneration of the Chief Legal Officer (termination agreement
filed September 7, 2005) (filed as Exhibit 10.4 to
Nortel Networks Corporation’s Annual Report on
Form 10-K for the year ended December 31, 2001).
*10
.5
Statement describing the retirement arrangements of the former
President and Chief Executive Officer (filed as
Exhibit 10.5 to Nortel Networks Corporation’s Annual
Report on Form 10-K for the year ended December 31,2001).
*10
.6
Nortel Networks Corporation Executive Retention and Termination
Plan, as amended and restated, effective from June 26, 2002
(filed as Exhibit 10.1 to Nortel Networks
Corporation’s Quarterly Report on Form 10-Q for the
quarter ended September 30, 2002).
*10
.7
Nortel Networks Corporation Special Retention Plan effective
August 1, 2001 and expired on June 30, 2003 (filed as
Exhibit 10.3 to Nortel Networks Corporation’s
Quarterly Report on Form 10-Q for the quarter ended
September 30, 2001).
*10
.8
Purchase Contract and Unit Agreement dated as of June 12,2002 among Nortel Networks Corporation, Computershare Trust
Company of Canada, as purchase contract agent, and Holders (as
defined therein) from time to time (filed as Exhibit 10.1
to Nortel Networks Corporation’s Quarterly Report on
Form 10-Q for the quarter ended June 30, 2002).
244
Exhibit
No
Description
*10
.9
U.S. Guarantee and Security Agreement dated as of the first
day of the “Collateral Period” (as defined therein)
among Nortel Networks Limited, Nortel Networks Inc. and certain
of their subsidiaries and JPMorgan Chase Bank, as Collateral
Agent as terminated by Letter, Termination Agreement and Full
and Final Release and Discharge all dated as of October 24,2005 (filed as Exhibits 99.1, 99.2 and 99.7 respectively to
Nortel Networks Corporation’s Current Report on
Form 8-K dated October 28, 2005).
*10
.10
Amendment No. 1 dated as of December 12, 2002 to the
U.S. Guarantee and Security Agreement dated as of
April 4, 2002 among Nortel Networks Limited, Nortel
Networks Inc., the Subsidiary Lien Grantors party thereto and
JPMorgan Chase Bank, as Collateral Agent, as terminated by
Letter, Termination Agreement and Full and Final Release and
Discharge all dated as of October 24, 2005 (filed as
Exhibits 99.1, 99.2 and 99.7 respectively to Nortel
Networks Corporation’s Current Report on Form 8-K
dated October 28, 2005).
*10
.11
Canadian Guarantee and Security Agreement dated as of the first
day of the “Collateral Period” (as defined therein)
among Nortel Networks Limited and certain of its subsidiaries
and JPMorgan Chase Bank, as Collateral Agent, as terminated by
Letter, Termination Agreement and Full and Final Release and
Discharge all dated as of October 24, 2005 (filed as
Exhibits 99.1, 99.3 and 99.7 respectively to Nortel
Networks Corporation’s Current Report on Form 8-K
dated October 28, 2005).
*10
.12
Amendment No. 1 dated as of December 12, 2002 to the
Canadian Guarantee and Security Agreement dated as of
April 4, 2002 among Nortel Networks Limited, Nortel
Networks Inc., the Subsidiary Guarantors party thereto and
JPMorgan Chase Bank, as Collateral Agent, as terminated by
Letter, Termination Agreement and Full and Final Release and
Discharge all dated as of October 24, 2005 (filed as
Exhibits 99.1, 99.3 and 99.7 respectively to Nortel
Networks Corporation’s Current Report on Form 8-K
dated October 28, 2005).
*10
.13
Form of Nortel Networks Limited Foreign Subsidiary Guarantee
dated as of April 4, 2002 and schedule thereto listing the
specific foreign subsidiary guarantees which are not attached as
exhibits (filed as Exhibit 10.8 to Nortel Networks
Corporation’s Quarterly Report on Form 10-Q for the
quarter ended March 31, 2002).
*10
.14
Amendment No. 1 dated as of December 12, 2002 to
certain Foreign Subsidiary Guarantees dated as of April 4,2002 among Nortel Networks (Ireland) Limited, Nortel Networks UK
Limited, Nortel Networks (Asia) Limited and JPMorgan Chase Bank,
as Collateral Agent, as terminated by Letter, Termination
Agreements and Full and Final Release and Discharge all dated as
of October 24, 2005 (filed as Exhibits 99.1 to 99.7
respectively to Nortel Networks Corporation’s Current
Report on Form 8-K dated October 28, 2005).
*10
.15
Foreign Pledge Agreement dated as of April 4, 2002 among
Nortel Networks Limited, the Subsidiary Guarantors party thereto
and JPMorgan Chase Bank, as Collateral Agent (filed as
Exhibit 10.9 to Nortel Networks Corporation’s
Quarterly Report on Form 10-Q for the quarter ended
March 31, 2002).
*10
.16
Foreign Pledge Agreement dated as of April 4, 2002 among
Nortel Networks Limited, Nortel Networks International
Corporation and JPMorgan Chase Bank, as Collateral Agent (filed
as Exhibit 10.10 to Nortel Networks Corporation’s
Quarterly Report on Form 10-Q for the quarter ended
March 31, 2002).
*10
.17
Foreign Pledge Agreement dated as of April 4, 2002 among
Nortel Networks Inc. and JPMorgan Chase Bank, as Collateral
Agent (filed as Exhibit 10.11 to Nortel Networks
Corporation’s Quarterly Report on Form 10-Q for the
quarter ended March 31, 2002).
*10
.18
Pledge Agreement dated as of April 4, 2002 among Nortel
Networks Limited, Nortel Networks International
Finance & Holding B.V., Nortel Networks S.A., and
JPMorgan Chase Bank, as Collateral Agent (filed as
Exhibit 10.12 to Nortel Networks Corporation’s
Quarterly Report on Form 10-Q for the quarter ended
March 31, 2002).
*10
.19
Foreign Pledge Agreement dated as of April 4, 2002 among
Nortel Networks International Finance & Holding B.V.,
Nortel Communications Holdings (1997) Limited, Nortel
Networks AB and JPMorgan Chase Bank, as Collateral Agent,
together with(a) the Supplementing Pledge Agreement dated
as of April 4, 2002 among Nortel Networks International
Finance & Holding, B.V. and JPMorgan Chase Bank, as
Collateral Agent,(b) the Pledge Agreement Supplement dated
as of April 4, 2002 between Nortel Networks Limited and
JPMorgan Chase Bank, as Collateral Agent, and(c) the Pledge
Agreement Supplement dated as of April 4, 2002 between
Nortel Networks U.K. Limited and JPMorgan Chase Bank, as
Collateral Agent (filed as Exhibit 10.13 to Nortel Networks
Corporation’s Quarterly Report on Form 10-Q for the
quarter ended March 31, 2002).
*10
.20
Foreign Pledge Agreement dated as of April 4, 2002 between
Nortel Networks International Finance & Holding B.V.
and JPMorgan Chase Bank, as Collateral Agent, together
with(a) the Pledge Agreement Supplement, dated as of
April 4, 2002 between Nortel Networks Optical Components
Limited and JPMorgan Chase Bank, as Collateral Agent,
and(b) the Pledge Agreement Supplement dated as of
April 4, 2002 between Nortel Networks International
Finance & Holding B.V., Nortel Networks Optical
Components Limited and JPMorgan Chase Bank, as Collateral Agent
(filed as Exhibit 10.14 to Nortel Networks
Corporation’s Quarterly Report on Form 10-Q for the
quarter ended March 31, 2002).
245
Exhibit
No
Description
*10
.21
Pledge Agreement Supplement dated as of May 20, 2002
between Nortel Networks Mauritius Ltd and JPMorgan Chase Bank,
as Collateral Agent supplementing the Foreign Pledge Agreement
dated as of April 4, 2002 among Nortel Networks
International Finance & Holding B.V., Nortel
Communications Holdings (1997) Limited, Nortel Networks AB
and JPMorgan Chase Bank, as Collateral Agent (filed as
Exhibit 10.5 to Nortel Networks Corporation’s
Quarterly Report on Form 10-Q for the quarter ended
June 30, 2002).
*10
.22
Pledge Agreement Supplement dated as of May 15, 2002
between Nortel Networks International Finance & Holding
B.V. and JPMorgan Chase Bank, as Collateral Agent, supplementing
the Foreign Pledge Agreement dated as of April 4, 2002
among Nortel Networks International Finance & Holding
B.V., Nortel Communications Holdings (1997) Limited, Nortel
Networks AB and JPMorgan Chase Bank, as Collateral Agent (filed
as Exhibit 10.6 to Nortel Networks Corporation’s
Quarterly Report on Form 10-Q for the quarter ended
June 30, 2002).
*10
.23
Pledge Agreement Supplement dated as of June 4, 2002
between Nortel Networks Singapore Pte Ltd, and JPMorgan Chase
Bank, as Collateral Agent, supplementing the Foreign Pledge
Agreement dated as of April 4, 2002 among Nortel Networks
International Finance & Holding B.V., Nortel
Communications Holdings (1997) Limited, Nortel Networks AB
and JPMorgan Chase Bank, as Collateral Agent (filed as
Exhibit 10.7 to Nortel Networks Corporation’s
Quarterly Report on Form 10-Q for the quarter ended
June 30, 2002).
*10
.24
Pledge Agreement Supplement dated as of May 15, 2002
between Nortel Networks Limited and JPMorgan Chase Bank, as
Collateral Agent, supplementing the Foreign Pledge Agreement
dated as of April 4, 2002 among Nortel Networks Limited,
the Subsidiary Guarantors party thereto and JP Morgan Chase
Bank, as Collateral Agent (filed as Exhibit 10.8 to Nortel
Networks Corporation’s Quarterly Report on Form 10-Q
for the quarter ended June 30, 2002).
Supplementary Pension Credits Arrangement (filed as
Exhibit 10.14 to Nortel Networks Corporation’s
Registration Statement on Form S-1 (No. 2-71087)).
*10
.27
Statements describing the right of certain executives in Canada
to defer all or part of their short-term and long-term incentive
awards (filed as Exhibit 10.4 to Nortel Networks
Limited’s Quarterly Report on Form 10-Q for the
quarter ended June 30, 2000).
*10
.28
Statement describing eligibility for the Group Life Insurance
Plan for directors who are not salaried employees of Nortel
Networks Corporation (filed as Exhibit 10.30 to Nortel
Networks Corporation’s Annual Report on Form 10-K for
the year ended December 31, 2002).
*10
.29
Resolutions of the Board of Directors of Nortel Networks Limited
dated December 17, 1993, as amended by resolutions of the
Board of Directors of Nortel Networks Limited dated
February 29, 1996, providing for retirement compensation of
directors who are not salaried employees of Nortel Networks
Limited or its subsidiaries (filed as Exhibit 10.33 to
Nortel Networks Corporation’s Annual Report on
Form 10-K for the year ended December 31, 2002).
*10
.30
Agreement between a director of Nortel Networks Corporation and
Nortel Networks Limited and the respective companies dated
June 22, 2001, setting forth the arrangements with respect
to serving as non-executive chairman of each of the board of
directors of Nortel Networks Corporation and Nortel Networks
Limited (filed as Exhibit 10.1 to Nortel Networks
Corporation’s Quarterly Report on Form 10-Q for the
quarter ended June 30, 2001).
*10
.31
Amended general description of cash bonus for employees and
executives of Nortel Networks Corporation and Nortel Networks
Limited as originally filed as Exhibit 10.5 to Nortel
Networks Corporation’s Quarterly Report on Form 10-Q
for the quarter ended September 30, 2002 (filed as
Exhibit 10.01 to the Nortel Networks Corporation’s
Quarterly Report on Form 10-Q for the quarter ended
June 30, 2003).
Nortel Networks Corporation Directors’ Deferred Share
Compensation Plan effective January 1, 2002 as amended and
restated May 29, 2003, as amended and restated
December 18, 2003 effective January 1, 2004 as amended
June 29, 2005 effective immediately (filed as
Exhibit 10.7 to Nortel Networks Corporation’s
Quarterly Report on Form 10-Q for the quarter ended
June 30, 2005).
246
Exhibit
No
Description
*10
.34
Nortel Networks Limited Directors’ Deferred Share
Compensation Plan effective June 30, 1998 as amended and
restated May 1, 2000, as further amended and restated
effective January 1, 2002, as amended and restated
May 29, 2003, as amended and restated December 18,2003 effective January 1, 2004 as amended June 29,2005 effective immediately (filed as Exhibit 10.8 to Nortel
Networks Corporation’s Quarterly Report on Form 10-Q
for the quarter ended June 30, 2005).
Nortel Networks Corporation 2000 Stock Option Plan as amended
effective May 1, 2000 and January 31, 2002 (filed as
Exhibit 10.2 to Nortel Networks Corporation’s
Quarterly Report on Form 10-Q for the quarter ended
March 31, 2002).
*10
.37
Nortel Networks NA Inc., formerly known as Bay Networks, Inc.,
1994 Stock Option Plan as Amended and Restated, as amended
effective May 1, 2000 (filed as Exhibit 4.3 to
Post-Effective Amendment No. 2 on Form S-8 to Nortel
Networks Corporation’s Registration Statement on
Form S-4 (No. 333-9066)).
*10
.38
Nortel Networks/ BCE 1985 Stock Option Plan (Plan of Arrangement
2000) (filed as Exhibit 10.5 to Nortel Networks
Corporation’s Quarterly Report on Form 10-Q for the
quarter ended March 31, 2000).
*10
.39
Nortel Networks/ BCE 1999 Stock Option Plan (Plan of Arrangement
2000) (filed as Exhibit 10.6 to Nortel Networks
Corporation’s Quarterly Report on Form 10-Q for the
quarter ended March 31, 2000).
*10
.40
Assumption Agreement between Nortel Networks Corporation and
Nortel Networks Limited dated March 5, 2001, regarding the
assumption and agreement by Nortel Networks Corporation to
perform certain covenants and obligations of Nortel Networks
Limited under the Nortel Networks Limited Executive Retention
and Termination Plan (filed as Exhibit 10.25 to Nortel
Networks Corporation’s Annual Report on Form 10-K for
the year ended December 31, 2000).
*10
.41
Nortel Networks U.S. Deferred Compensation Plan (filed as
Exhibit 4.3 to Post-Effective Amendment No. 1 to
Nortel Networks Corporation’s Registration Statement on
Form S-8 (No. 333-11558)).
Master Indemnity Agreement dated as of February 14, 2003
between Nortel Networks Limited and Export Development Canada,
amended and restated as of October 24, 2005 (filed as
Exhibit 10.3 to Nortel Networks Corporation’s Current
Report on Form 8-K dated October 28, 2005).
*10
.44
Letter dated June 23, 2003 from the former President and
Chief Executive Officer of Nortel Networks, to the Joint
Leadership Resources Committee of the Board of Directors of
Nortel Networks Corporation and Nortel Networks Limited
regarding the voluntary return for cancellation of certain stock
options to purchase common shares of Nortel Networks Corporation
(filed as Exhibit 10.4 to the Nortel Networks
Corporation’s Quarterly Report on Form 10-Q for the
quarter ended June 30, 2003).
*10
.45
Notice of Blackout to Nortel Networks Corporation’s Board
of Directors and Executive Officers Regarding Suspension of
Trading dated March 10, 2004 (filed as Exhibit 99.2 to
Nortel Networks Corporation’s Current Report on
Form 8-K dated March 10, 2004).
*10
.46
Summary statement of terms of initial compensation arrangements
related to the president and chief executive officer approved by
the Board of Directors of Nortel Networks Corporation and Nortel
Networks Limited as of April 29, 2004 (filed as
Exhibit 10.1 to Nortel Networks Corporation’s
Quarterly Report on Form 10-Q for the quarter ended
June 30, 2004).
*10
.47
Asset Purchase Agreement dated June 29, 2004 among Nortel
Networks Limited, Flextronics International Ltd. and Flextronics
Telecom Systems, Ltd., amended as of November 1, 2004,
February 7, 2005 and August 22, 2005 (filed as
Exhibit 99.1 to Nortel Network Corporation’s Current
Report on Form 8-K dated August 26, 2005).
**10
.48
Amended and Restated Master Contract Manufacturing Services
Agreement dated June 29, 2004 between Nortel Networks
Limited and Flextronics Telecom Systems, Ltd., amended as of
November 1, 2004 (filed as Exhibit 10.59 to Nortel
Networks Corporation’s Annual Report on Form 10-K for
the year ended December 31, 2004).
247
Exhibit
No
Description
**10
.49
Master Repair Services Agreement dated June 29, 2004
between Nortel Networks Limited and Flextronics Telecom Systems
Limited, amended as of February 8, 2005 (filed as
Exhibit 10.4 to Nortel Networks Corporation’s
Quarterly Report on Form 10-Q for the quarter ended
March 31, 2005).
**10
.50
Master Contract Logistics Services Agreement dated June 29,2004 between Nortel Networks Limited and Flextronics Telecom
Systems, Ltd., amended as of February 8, 2005 (filed as
Exhibit 10.5 to Nortel Networks Corporation’s
Quarterly Report on Form 10-Q for the quarter ended
March 31, 2005).
**10
.51
Letter Agreement dated June 29, 2004 among Nortel Networks
Limited, Flextronics International Ltd. and Flextronics Telecom
Systems, Ltd. (filed as Exhibit 10.7 to Nortel Networks
Corporation’s Quarterly Report on Form 10-Q for the
quarter ended June 30, 2004).
*10
.52
William A. Owens, President and Chief Executive Officer
Employment Letter dated as at August 31, 2004 (filed as
Exhibit 10.2 to Nortel Networks Corporation’s
Quarterly Report on Form 10-Q for the quarter ended
September 30, 2004).
*10
.53
Letter, dated January 10, 2005, to Mr. Lynton (Red)
Wilson, the Chairman of the Board of Nortel Networks
Corporation, and modified March 1, 2005 and delivered on
August 11, 2005 from certain officers of Nortel Networks
Corporation (filed as Exhibit 10.1 to Nortel Networks
Corporation’s Current Report on Form 8-K dated
August 18, 2005).
*10
.54
Peter Currie, Executive Vice-President and Chief Financial
Officer Employment Letter dated January 20, 2005 (filed as
Exhibit 10.2 to Nortel Networks Corporation’s
Quarterly Report on Form 10-Q for the quarter ended
March 31, 2005).
*10
.55
Gary Daichendt, President and Chief Operating Officer Employment
Letter dated March 2, 2005 (filed as Exhibit 10.6 to
Nortel Networks Corporation’s Quarterly Report on
Form 10-Q for the quarter ended March 31, 2005).
*10
.56
Summary statement of terms of the additional special pension
benefits for the Vice-Chairman and Chief Executive Officer
approved by the Joint Leadership Resources Committee of the
Board of Directors of Nortel Networks Corporation and Nortel
Networks Limited and the Independent members of the Board of
Directors of Nortel Networks Corporation and Nortel Networks
Limited on March 22, 2005 (filed as Exhibit 10.8 to
Nortel Networks Corporation’s Quarterly Report on
Form 10-Q for the quarter ended March 31, 2005).
*10
.57
The Nortel 2005 Stock Incentive Plan (as filed with the 2005
Proxy Statement) (filed as Exhibit 10.1 to Nortel Networks
Corporation’s Quarterly Report on Form 10-Q for the
quarter ended June 30, 2005).
*10
.58
Summary statement of the interest payable on the special pension
benefits for the Vice-Chairman and Chief Executive Officer of
Nortel Networks Corporation and Nortel Networks Limited approved
by the Joint Leadership Resources Committee of the Board of
Directors of Nortel Networks Corporation and Nortel Networks
Limited and the independent members of the Board of Directors of
Nortel Networks Corporation and Nortel Networks Limited on
May 27, 2005 (filed as Exhibit 10.2 to Nortel Networks
Corporation’s Quarterly Report on Form 10-Q for the
quarter ended June 30, 2005).
*10
.59
Form of Indemnity Agreement effective on or as of June 29,2005 entered into between Nortel Networks Corporation and each
of the following Directors: Harry J. Pearce, Ronald W. Osborne,
Richard D. McCormick, John A. MacNaughton, James B.
Hunt, Jr. and Jalynn H. Bennett (filed as Exhibit 10.4
to Nortel Networks Corporation’s Quarterly Report on
Form 10-Q for the quarter ended June 30, 2005).
*10
.60
Summary of remuneration, retirement compensation and group life
insurance of the Chairman of the Board, Directors and Chairman
of Committees of Nortel Networks Corporation effective
June 29, 2005 (filed as Exhibit 10.5 to Nortel
Networks Corporation’s Quarterly Report on Form 10-Q
for the quarter ended June 30, 2005).
*10
.61
Summary of remuneration, retirement compensation and group life
insurance of the Chairman of the Board, Directors and Chairman
of Committees of Nortel Networks Limited effective June 29,2005 (filed as Exhibit 10.6 to Nortel Networks
Corporation’s Quarterly Report on Form 10-Q for the
quarter ended June 30, 2005).
*10
.62
Forms of Instruments of Grant generally provided to optionees
granted options under the Nortel Networks Corporation 1986 Stock
Option Plan, as Amended and Restated or the Nortel Networks
Corporation 2000 Stock Option Plan (filed as Exhibit 10.9
to Nortel Networks Corporation’s Quarterly Report on
Form 10-Q for the quarter ended June 30, 2005).
*10
.63
Proxy Agreement effective as of July 29, 2005 with respect
to Capital Stock of Nortel Government Solutions Inc. by and
among Nortel Networks Corporation, Nortel Networks Limited,
Nortel Networks Inc., Nortel Government Solutions Inc., James
Frey, Thomas McInerney, Gregory Newbold, and the United States
Department of Defense (filed as Exhibit 10.1 to Nortel
Networks Corporation’s Quarterly Report on Form 10-Q
for the quarter ended September 30, 2005).
248
Exhibit
No
Description
*10
.64
Escrow Agreement dated as of March 1, 2005 and as entered
into on August 11, 2005 between Nortel Networks
Corporation, Computershare Trust Company of Canada and certain
officers of Nortel Networks Corporation (filed as
Exhibit 10.3 to Nortel Networks Corporation’s
Quarterly Report on Form 10-Q for the quarter ended
September 30, 2005).
*10
.65
Form of Instrument of Award in connection with the award of
restricted stock units under the Nortel 2005 Stock Incentive
Plan (filed as Exhibit 10.1 to Nortel Network
Corporation’s Current Report on Form 8-K dated
September 12, 2005).
*10
.66
Termination Agreement dated September 7, 2005 between
Nicholas DeRoma, Chief Legal Officer and Nortel Networks
Corporation (filed as Exhibit 10.6 to Nortel Networks
Corporation’s Quarterly Report on Form 10-Q for the
quarter ended September 30, 2005).
*10
.67
Agreement and Plan of Merger dated as of April 25, 2005, by
and among Nortel Networks Inc., PS Merger Sub, Inc. and PEC
Solutions, Inc. (filed as Exhibit 99(d)(1) to Nortel
Networks Inc. Current Report on Form SC TO-T dated
May 3, 2005 and filed as Exhibit 10.9 to Nortel
Networks Corporation’s Quarterly Report on Form 10-Q
for the quarter ended March 31, 2005).
10
.68
William A. Owens letter agreement entered into on
December 1, 2005, concerning the cessation of
Mr. Owens’ responsibilities as Vice-Chairman and Chief
Executive Officer of Nortel Networks Corporation and Nortel
Networks Limited effective November 15, 2005.
10
.69
Nicholas DeRoma, former Chief Legal Officer, Letter Agreement
dated December 20, 2005 amending the Termination Agreement
dated September 7, 2005.
10
.70
Steve Pusey, Executive Vice-President and President, Eurasia,
Letter Agreement dated September 29, 2005 concerning a
retention bonus.
10
.71
Summary statement of employment terms and conditions for Mike
Zafirovski, President and Chief Executive Officer effective
November 15, 2005, as approved by the Joint Leadership
Resources Committee of the Board of Directors of Nortel Networks
Corporation and Nortel Networks Limited and the Independent
members of the Board of Directors of Nortel Networks Corporation
and Nortel Networks Limited on October 16, 2005.
10
.72
Mike Zafirovski, President and Chief Executive Officer,
Indemnity Agreement dated January 18, 2006 with effect from
October 31, 2005.
10
.73
Nortel Networks Corporation Directors’ Deferred Share
Compensation Plan as amended December 7, 2005 and restated
on June 29, 2005.
10
.74
Nortel Networks Limited Directors’ Deferred Share
Compensation Plan as amended December 7, 2005 and restated
on June 29, 2005.
10
.75
Pascal Debon letter agreement dated February 21, 2006,
concerning the cessation of Mr. Debon’s
responsibilities as Senior Advisor of Nortel Networks
Corporation and Nortel Networks Limited effective
December 23, 2005.
10
.76
Brain McFadden letter agreement dated February 21, 2006,
concerning the cessation of Mr. McFadden’s
responsibilities as Chief Research Officer of Nortel Networks
Corporation and Nortel Networks Limited effective
December 23, 2005.
10
.77
Notice of Blackout to Nortel Networks Corporation’s Board
of Directors and Executive Officers Regarding Suspension of
Trading dated March 10, 2006 (filed as Exhibit 99.2 to
Nortel Networks Corporation’s Current Report on
Form 8-K dated March 10, 2006).
Rule 13a — 14(a)/15d — 14(a)
Certification of the Vice-Chairman and Chief Executive Officer.
31
.2
Rule 13a — 14(a)/15d — 14(a)
Certification of the Chief Financial Officer.
32
.
Certification of the Vice-Chairman and Chief Executive Officer
and Chief Financial Officer pursuant to 18 U.S.C.
Section 1350 as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
Certain portions of this Exhibit have been omitted based upon a
request for confidential treatment. These portions have been
filed separately with the United States Securities and Exchange
Commission
249
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned,
thereunto duly authorized, in the City of Brampton, Ontario,
Canada on the 1st day of May, 2006.
Pursuant to the requirements of the Securities Exchange Act of
1934, this report has been signed below by the following persons
on behalf of the registrant and in the capacities indicated on
the 1st day of May, 2006.
