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Nortel Networks 10-Q 2007
e10vq
Table of Contents

 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
 
 
     
          þ     QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)      
       OF THE SECURITIES EXCHANGE ACT OF 1934
     
 
For the Quarterly Period Ended March 31, 2007
OR
     
     
    o     TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
       OF THE SECURITIES EXCHANGE ACT OF 1934
     
 
 
          For the Transition Period From            to           
 
Commission file number: 001-07260
 
 
 
 
     
Canada
  Not Applicable
(State or Other Jurisdiction of
Incorporation or Organization)
  (I.R.S. Employer
Identification No.)
 
 
     
195 The West Mall   M9C 5K1
Toronto, Ontario, Canada
(Address of Principal Executive Offices)
  (Zip Code)
 
 
Registrant’s Telephone Number Including Area Code (905) 863-7000
 
 
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 such filing requirements for the past 90 days.
 
Yes þ     No 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     No þ
 
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of April 20, 2007.
 
436,577,565 shares of common stock without nominal or par value
 


 

 
             
        PAGE
 
PART I
FINANCIAL INFORMATION
  Condensed Consolidated Financial Statements (unaudited)     1  
  Management’s Discussion and Analysis of Financial Condition and Results of Operations     35  
  Quantitative and Qualitative Disclosures About Market Risk     69  
  Controls and Procedures     70  
 
PART II
OTHER INFORMATION
  Legal Proceedings     74  
  Risk Factors     75  
  Unregistered Sales of Equity Securities and Use of Proceeds     76  
  Exhibits     77  
    79  
 EX-4.2
 EX-10.4
 EX-10.5
 EX-10.6
 EX10.7
 EX-10.8
 EX-10.9
 EX-12
 EX-31.1
 EX-31.2
 EX-32
 
All dollar amounts in this document are in United States dollars unless otherwise stated.
 
NORTEL, NORTEL (Logo), NORTEL NETWORKS, The GLOBEMARK, NT, and NORTEL > BUSINESS MADE SIMPLE are trademarks of Nortel Networks.
 
MOODY’S is a trademark of Moody’s Investor Services, Inc.
 
NYSE is a trademark of the New York Stock Exchange, Inc.
 
SAP is a trademark of SAP AG.
 
S&P and STANDARD & POOR’S are trademarks of The McGraw-Hill Companies, Inc.
 
All other trademarks are the property of the respective owners.


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ITEM 1.   CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
NORTEL NETWORKS CORPORATION
 
Condensed Consolidated Statements of Operations (unaudited)
(Millions of U.S. dollars, except per share amounts)
 
                 
    Three Months Ended March 31,  
    2007     2006  
          As restated*  
 
Revenues:
               
Products
  $ 2,169     $ 2,088  
Services
    314       302  
                 
Total revenues
    2,483       2,390  
                 
Cost of revenues:
               
Products
    1,303       1,296  
Services
    178       169  
                 
Total cost of revenues
    1,481       1,465  
                 
Gross profit
    1,002       925  
Selling, general and administrative expense
    604       610  
Research and development expense
    409       479  
Amortization of intangibles
    12       5  
Special charges
    80       5  
Gain on sale of businesses and assets
    (1 )     (39 )
Shareholder litigation settlement expense (recovery) (note 17)
    (54 )     19  
                 
Operating loss
    (48 )     (154 )
Other income — net
    76       56  
Interest expense
               
Long-term debt
    (85 )     (45 )
Other
    (11 )     (16 )
                 
Loss from operations before income taxes, minority interests and equity in net loss of associated companies
    (68 )     (159 )
Income tax expense
    (13 )     (25 )
                 
      (81 )     (184 )
Minority interests — net of tax
    (22 )     6  
Equity in net loss of associated companies — net of tax
          (2 )
                 
Net loss before cumulative effect of accounting change
    (103 )     (180 )
Cumulative effect of accounting change — net of tax (note 2)
          9  
                 
Net loss
  $ (103 )   $ (171 )
                 
Basic and diluted loss per common share
  $ (0.23 )   $ (0.39 )
                 
 
 
See note 3
 
The accompanying notes are an integral part of these condensed consolidated financial statements


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NORTEL NETWORKS CORPORATION
 
Condensed Consolidated Balance Sheets (unaudited)
(Millions of U.S. dollars, except for share amounts)
 
                 
    March 31,
    December 31,
 
    2007     2006  
 
ASSETS
Current assets
               
Cash and cash equivalents
  $ 4,555     $ 3,492  
Restricted cash and cash equivalents
    44       639  
Accounts receivable — net
    2,359       2,785  
Inventories — net
    2,048       1,989  
Deferred income taxes — net
    367       276  
Other current assets
    490       742  
                 
Total current assets
    9,863       9,923  
Investments
    201       204  
Plant and equipment — net
    1,515       1,530  
Goodwill
    2,530       2,529  
Intangible assets — net
    229       241  
Deferred income taxes — net
    3,785       3,863  
Other assets
    599       689  
                 
Total assets
  $ 18,722     $ 18,979  
                 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
                 
Current liabilities
               
Trade and other accounts payable
  $ 1,051     $ 1,125  
Payroll and benefit-related liabilities
    524       640  
Contractual liabilities
    227       243  
Restructuring liabilities
    135       97  
Other accrued liabilities
    3,795       4,603  
Long-term debt due within one year
    21       18  
                 
Total current liabilities
    5,753       6,726  
Long-term debt
    5,591       4,446  
Deferred income taxes — net
    48       97  
Other liabilities
    3,836       5,810  
                 
Total liabilities
    15,228       17,079  
                 
Minority interests in subsidiary companies
    790       779  
Guarantees, commitments and contingencies (notes 11, 12 and 17)
               
 
SHAREHOLDERS’ EQUITY
                 
Common shares, without par value — Authorized shares: unlimited; Issued and outstanding shares: 436,874,114 as of March 31, 2007 and 433,934,747 as of December 31, 2006
    34,015       33,938  
Additional paid-in capital
    4,957       3,378  
Accumulated deficit
    (35,678 )     (35,574 )
Accumulated other comprehensive loss
    (590 )     (621 )
                 
Total shareholders’ equity
    2,704       1,121  
                 
Total liabilities and shareholders’ equity
  $ 18,722     $ 18,979  
                 
 
The accompanying notes are an integral part of these condensed consolidated financial statements


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NORTEL NETWORKS CORPORATION
 
Condensed Consolidated Statements of Cash Flows (unaudited)
(Millions of U.S. dollars)
 
                 
    Three Months Ended March 31,  
    2007     2006  
          As restated*  
 
Cash flows from (used in) operating activities
               
Net loss
  $ (103 )   $ (171 )
Adjustments to reconcile net loss to net cash from (used in) operating activities, net of effects from acquisitions and divestitures of businesses:
               
Amortization and depreciation
    79       50  
Non-cash portion of shareholder litigation settlement expense (recovery)
    (54 )     19  
Non-cash portion of special charges and related asset write downs
          (11 )
Equity in net loss of associated companies
          2  
Share based compensation expense
    25       25  
Deferred income taxes
    5       15  
Cumulative effect of accounting change — net of tax
          (9 )
Pension and other accruals
    92       101  
Gain on sale or write down of investments, businesses and assets — net
    (1 )     (38 )
Minority interests
    22       (6 )
Other — net
    18       46  
Change in operating assets and liabilities:
               
Other
    (59 )     (197 )
Global Class Action Settlement — net
    (585 )      
                 
Net cash from (used in) operating activities
    (561 )     (174 )
                 
Cash flows from (used in) investing activities
               
Expenditures for plant and equipment
    (56 )     (99 )
Proceeds on disposals of plant and equipment
    14       87  
Change in restricted cash and cash equivalents
    595       3  
Acquisitions of investments and businesses — net of cash acquired
    (14 )     (121 )
Proceeds from the sale of investments and businesses
    (39 )     30  
                 
Net cash from (used in) investing activities
    500       (100 )
                 
Cash flows from (used in) financing activities
               
Dividends paid by subsidiaries to minority interests
    (10 )     (18 )
Increase in notes payable
    10       4  
Decrease in notes payable
    (12 )     (3 )
Proceeds from issuance of long-term debt
    1,150       1,300  
Repayments of long-term debt
          (1,275 )
Debt issuance costs
    (22 )      
Decrease in capital leases payable
    (5 )     (5 )
Issuance of common shares
    7       1  
                 
Net cash from (used in) financing activities
    1,118       4  
                 
Effect of foreign exchange rate changes on cash and cash equivalents
    6       14  
                 
Net increase (decrease) in cash and cash equivalents
    1,063       (256 )
Cash and cash equivalents at beginning of period
    3,492       2,951  
                 
Cash and cash equivalents at end of period
  $ 4,555     $ 2,695  
                 
 
 
See note 3
 
The accompanying notes are an integral part of these condensed consolidated financial statements


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited)
(Millions of U.S. dollars, except per share amounts, unless otherwise stated)
 
1.   Significant accounting policies
 
 
The unaudited condensed consolidated financial statements of Nortel Networks Corporation (“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 interim financial information. They do not include all information and notes required by U.S. GAAP in the preparation of annual consolidated financial statements. The accounting policies used in the preparation of the unaudited condensed consolidated financial statements are the same as those described in Nortel’s audited consolidated financial statements prepared in accordance with U.S. GAAP for the year ended December 31, 2006 except as discussed in note 2. The condensed consolidated balance sheet as of December 31, 2006 is derived from the December 31, 2006 audited financial statements. Although Nortel is headquartered in Canada, the unaudited condensed 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.
 
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 unaudited condensed 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, research and development provisions, restructuring and other provisions, stock-based compensation and contingencies.
 
Nortel believes all adjustments necessary for a fair statement of the results for the periods presented have been made and all such adjustments were of a normal recurring nature unless otherwise disclosed. The financial results for the three months ended March 31, 2007 are not necessarily indicative of financial results for the full year. The unaudited condensed consolidated financial statements should be read in conjunction with Nortel’s Annual Report on Form 10-K for the year ended December 31, 2006 filed with the SEC and Canadian securities regulatory authorities (the “2006 Annual Report”).
 
On November 6, 2006, Nortel’s Board of Directors approved a consolidation of Nortel’s outstanding common shares at a ratio of 1 consolidated share for 10 pre-consolidated shares in accordance with the authority given to the Board by Nortel’s shareholders at its annual and special meeting of shareholders held on June 29, 2006. Nortel’s common shares began trading on the Toronto Stock Exchange and New York Stock Exchange on a consolidated basis on December 1, 2006. All references to share and per share data for all periods presented in the consolidated financial statements have been adjusted to give effect to the 1 for 10 common share consolidation.
 
 
Certain 2006 figures in the unaudited condensed consolidated financial statements have been reclassified to conform to the 2007 presentation and certain 2006 figures have been restated as set out in note 3.
 
 
In February 2007, the United States Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statements No. 115” (“SFAS 159”). SFAS 159 allows the irrevocable election of fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities and other items on an instrument-by-instrument basis. Changes in fair value would be reflected in earnings as they occur. The objective of SFAS 159 is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS 159 is effective as of the beginning of the first fiscal year beginning after November 15, 2007. Nortel is currently evaluating if it will elect the fair value option for any of its eligible financial instruments and other items.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
On May 2, 2007 the FASB issued FASB Interpretation FIN No. 48-1, “Definition of Settlement in FASB Interpretation 48” (“FIN 48-1”). FIN 48-1 amends FIN 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109”, to provide guidance on how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. The guidance in FIN 48-1 shall be applied upon the initial adoption of FIN 48. Accordingly, Nortel has applied the provisions of FIN 48-1 effective January 1, 2007. The adoption of FIN 48-1 did not have a material impact on Nortel’s results of operations and financial condition.
 
2.   Accounting changes
 
 
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments — an amendment to FASB Statements No. 133 and 140” (“SFAS 155”). SFAS 155 simplifies the accounting for certain hybrid financial instruments containing embedded derivatives. SFAS 155 allows fair value measurement, at the option of the company, for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation under SFAS 133. In addition, it amends SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”, to eliminate certain restrictions on passive derivative financial instruments that a qualifying special-purpose entity can hold. SFAS 155 is effective for all financial instruments acquired, issued or subject to a re-measurement event occurring after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Pursuant to SFAS 155, Nortel has not elected to measure its hybrid instruments at fair value.
 
 
In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140” (“SFAS 156”). SFAS 156 simplifies the accounting for assets and liabilities arising from loan servicing contracts. SFAS 156 requires that servicing rights be valued initially at fair value and subsequently either (i) accounted for at fair value or (ii) amortized over the period of estimated net servicing income (loss), with an assessment for impairment or increased obligation each reporting period. The adoption of SFAS 156 has not had a material impact on Nortel’s results of operations and financial condition.
 
 
In June 2006, the FASB issued FIN 48. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”). The interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides accounting guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The evaluation of tax positions under FIN 48 is a two-step process, whereby (1) Nortel determines whether it is more likely than not that the tax positions will be sustained based on the technical merits of the position and (2) for those tax positions that meet the more-likely-than-not recognition threshold, Nortel would recognize the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement with the related tax authority. The adoption of FIN 48 resulted in an increase of $1 to opening accumulated deficit as at January 1, 2007. For additional information, see note 7.
 
 
In June 2006, the FASB Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 06-2 “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43, Accounting for Compensated Absences” (“EITF 06-2”). EITF 06-2 provides clarification surrounding the accounting for benefits in the form of compensated absences, whereby an employee is entitled to paid time off after working for a specified period of time. EITF 06-2 is effective for fiscal years beginning after December 15, 2006. The adoption of EITF 06-2 has not had a material impact on Nortel’s results of operations and financial condition.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
(e)   How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement
 
In June 2006, the EITF reached a consensus on EITF Issue No. 06-3 “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross Versus Net Presentation)” (“EITF 06-3”). EITF 06-3 provides guidance on how taxes directly imposed on revenue producing transactions between a seller and customer that are remitted to governmental authorities should be presented in the income statement (i.e. gross versus net presentation). Nortel elected to follow its existing policy of net presentation, allowed by EITF 06-3 and therefore its adoption of EITF 06-3 had no impact on Nortel’s results of operations and financial condition.
 
 
On January 1, 2006, Nortel adopted SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123R”). Nortel previously elected to account for 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 No. 148, “Accounting for Stock Based Compensation — Transition and Disclosure”. Staff Accounting Bulletin No. 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. As a result of the adoption of SFAS 123R in the first quarter of 2006, Nortel recorded a gain of $9 or $0.02 per common share on a basic and diluted basis as a cumulative effect of an accounting change. There were no other material impacts on Nortel’s results of operations and financial condition as a result of the adoption of SFAS 123R. For additional disclosure related to SFAS 123R, see note 15.
 
3.   Restatement of previously issued financial statements
 
In the course of the preparation of Nortel’s 2006 annual financial statements, management identified certain errors primarily through discussions with Nortel’s North American pension and post-retirement actuaries and through its ongoing remediation efforts with respect to its material weakness related to revenue recognition and its other previously reported material weaknesses and other internal control deficiencies. As a result, Nortel restated its consolidated balance sheet as of December 31, 2005 and consolidated statements of operations, changes in equity and comprehensive income (loss) and cash flows for each of the years ended December 31, 2005 and 2004 and the first three quarters of 2006. The adjustments relate to:
 
  •  Pension and post-retirement benefits errors;
  •  Revenue recognition errors;
  •  A prior year tax error; and
  •  Other errors.
 
The following tables present the impact of the adjustments on Nortel’s previously reported unaudited condensed consolidated statements of operations and a summary of the adjustments for the three months ended March 31, 2006. Restated amounts presented herein are consistent with the unaudited quarterly financial data disclosed in Nortel’s 2006 Annual Report.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
Condensed Consolidated Statement of Operations for the three months ended March 31, 2006
 
                         
    As Previously
             
    Reported(a)     Adjustments     As Restated  
 
Revenues:
                       
Products
  $ 2,080     $ 8     $ 2,088  
Services
    302             302  
                         
Total revenues
    2,382       8       2,390  
                         
Cost of revenues:
                       
Products
    1,305       (9 )     1,296  
Services
    169             169  
                         
Total cost of revenues
    1,474       (9 )     1,465  
                         
Gross profit
    908       17       925  
                         
Selling, general and administrative expense
    595       15       610  
Research and development expense
    478       1       479  
Amortization of intangibles
    5             5  
Special charges
    5             5  
Gain on sale of businesses and assets
    (35 )     (4 )     (39 )
Shareholder litigation settlement expense
    19             19  
                         
Operating loss
    (159 )     5       (154 )
                         
Other income — net
    69       (13 )     56  
Interest expense
                       
Long-term debt
    (46 )     1       (45 )
Other
    (24 )     8       (16 )
                         
Loss before income taxes, minority interests and equity in net loss of associated companies
    (160 )     1       (159 )
Income tax expense
    (23 )     (2 )     (25 )
                         
      (183 )     (1 )     (184 )
                         
Minority interests — net of tax
    9       (3 )     6  
Equity in net loss of associated companies — net of tax
    (2 )           (2 )
                         
Net loss before cumulative effect of accounting change
    (176 )     (4 )     (180 )
Cumulative effect of accounting change — net of tax
    9             9  
                         
Net loss
  $ (167 )   $ (4 )   $ (171 )
                         
Basic and diluted loss per common share
  $ (0.39 )   $ 0.00     $ (0.39 )
                         
 
 
(a) In the third quarter of 2006, Nortel began disclosing revenues and cost of revenues from both its products and services. Previous quarters have been updated to reflect this presentation change. Additionally, earnings per share amounts have been adjusted to reflect Nortel’s 1 for 10 share consolidation of its common shares effected on December 1, 2006.
 
 
The following table summarizes the restatement adjustments to revenues, cost of revenues, and net loss.
 
                         
    Three Months Ended March 31, 2006  
    Revenues     Cost of Revenues     Net Loss  
 
As previously reported
  $ 2,382     $ 1,474     $ (167 )
Adjustments:
                       
Pension and post-retirement benefits errors
          3       (8 )
Revenue recognition errors
    8       (15 )     19  
Other errors
          3       (15 )
                         
As restated
  $ 2,390     $ 1,465     $ (171 )
                         


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
As a result of the previously announced pension plan changes, third party actuarial firms retained by Nortel performed re-measurements of the U.S. and Canadian pension and post-retirement benefit plans in the third quarter of 2006, at which time one of the firms discovered potential errors (generally originating in the late 1990s) in the historical actuarial calculations they had originally performed for the U.S. pension plan assets. Throughout the fourth quarter of 2006 and into 2007, Nortel investigated these potential errors, including initiating a comprehensive review by Nortel and its third party actuaries of each of its significant pension and post-retirement benefit plans.
 
As a result, Nortel determined that the accounting for the U.S. pension plan contained a historical adjustment that overstated the actuarial calculation of the market-related value of assets, resulting in an increased pension and post-retirement benefit expense of $5 for the first quarter of 2006. In addition, Nortel discovered an error in the Canadian pension plan accounting related to the amortization of unrealized gains within the actuarial calculation of the market-related value of assets over a longer period than permitted under SFAS No. 87, “Employers’ Accounting for Pensions”. This error resulted in a $3 increase in pension and post-retirement benefit expense for the first quarter of 2006.
 
The correction of the pension and post-retirement benefit errors, in aggregate, resulted in a net increase in pension and post-retirement benefit expense of $8 for the first quarter of 2006. The $8 increase in pension and post-retirement benefit expense increased cost of revenues, selling, general and administrative (“SG&A”), and research and development (“R&D”) by $3, $3 and $2, respectively, for the first quarter of 2006. As a result of the pension and post-retirement errors, Nortel recorded a cumulative $74 decrease to other comprehensive loss as of March 31, 2006.
 
 
As a result of the significant ongoing remedial efforts to address Nortel’s internal control material weaknesses and other deficiencies, throughout 2006, Nortel identified a number of individually immaterial revenue recognition errors it corrected as a result of this restatement, the more individually significant of which are discussed below.
 
Revenue recognition errors related principally to complex arrangements with multiple deliverables in which the timing of revenue recognition was determined to be incorrect. For certain of Nortel’s multiple element arrangements where certain elements such as post-contract customer support (“PCS”) specified upgrade rights and/or non-essential hardware or software products or services remained undelivered, Nortel determined that the undelivered element could not be treated as a separate unit of accounting because fair value could not be established. Accordingly, Nortel should have deferred revenue, and related costs, until the earlier of the point in time that fair value of the undelivered element could be established or all the remaining elements have been delivered. These corrections resulted in decreases in revenue and cost of revenue of $1 and $13, respectively, in the first quarter of 2006.
 
In the third quarter of 2006, Nortel recognized $40 of revenue that had been previously deferred by LG-Nortel due to the fact that it believed that LG-Nortel had a practice of providing implicit PCS for which they did not have fair value. A subsequent detailed review of the enterprise products sold by LG-Nortel led to the conclusion in the third quarter of 2006 that LG-Nortel did not have a practice of providing implicit PCS for certain enterprise products. As a result, revenue should have been recognized upon delivery of such products. Nortel had previously recorded a cumulative correction of this error in the third quarter of 2006 and, as a result of the restatement, recorded it in the appropriate periods. The correction of this error resulted in a $14 increase in revenue and a $5 increase in cost of revenue in the first quarter of 2006. Included in “other errors” are reductions to minority interest to reflect the non-controlling interest’s share of the impact of these restatement adjustments.
 
The previous misapplication of American Institute of Certified Public Accountants Statement of Position (“SOP”) 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts”, resulted in errors on revenues recognized in an arrangement between 2003 and the first quarter of 2006. The misapplication related to the calculation of liquidated damages estimated to be incurred as a result of contractual commitments related to network outages. Prior to the second quarter of 2006, Nortel estimated its liquidated damages based on a quarterly network outage estimate. In the second quarter of 2006, Nortel determined that it should have been recognizing product credits based on an estimate of the total expected outages for the arrangement. Nortel had previously corrected the resulting revenue errors in the second quarter of 2006 and, as a result of the restatement, has recorded the correction in the appropriate periods. The corrections resulted in an increase in revenue and gross profit of $5 in the first quarter of 2006.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
In 2004, Nortel entered into a software arrangement where the customer had the right to suspend payments until delivery of certain future products; therefore, the arrangement fee was not fixed or determinable. Pursuant to SOP 97-2, “Software Revenue Recognition”, if at the outset of the arrangement the fee is not fixed or determinable, once all other revenue recognition criteria have been satisfied, revenue should be recognized as payments become due. Previously, the fee was recognized ratably over the term. Due to the lack of a fixed or determinable fee, the amount recognized ratably should have been limited to the amount that was due and payable from the customer. The correction of this error resulted in an increase in both revenue and gross profit of $1 in the first quarter of 2006.
 
 
The restatement had no impact on the condensed consolidated statement of cash flows for the first quarter of 2006, other than conforming changes to the components of the reconciliation to net cash used in operating activities.
 
4.   Consolidated financial statement details
 
The following tables provide details of selected items presented in the condensed consolidated statements of operations and cash flows, and the condensed consolidated balance sheets.
 
Consolidated statements of operations
 
                 
    Three Months Ended March 31,  
    2007     2006  
 
Interest and dividend income
  $ 53     $ 29  
Loss on sale or write down of investments
          (1 )
Currency exchange gains
          2  
Other — net
    23       26  
                 
Other income — net
  $ 76     $ 56  
                 
 
Hedge ineffectiveness and the discontinuance of cash flow hedges and fair value hedges that were accounted for in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, had no material impact on net loss for the three months ended March 31, 2007 or 2006, and were reported within other income — net in the consolidated statements of operations.
 
During the three months ended March 31, 2007 and 2006, net customer financing bad debt expense (recovery) recorded by Nortel as a result of settlements and adjustments to other existing provisions was insignificant. The recoveries and expenses were included in the consolidated statements of operations within SG&A.
 
Consolidated balance sheets
 
 
                 
    March 31,
    December 31,
 
    2007     2006  
 
Trade receivables
  $ 2,041     $ 2,464  
Notes receivable
    9       7  
Contracts in process
    398       402  
                 
      2,448       2,873  
Less: provision for doubtful accounts
    (89 )     (88 )
                 
Accounts receivable — net
  $ 2,359     $ 2,785  
                 


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
                 
    March 31,
    December 31,
 
    2007     2006  
 
Raw materials
  $ 660     $ 725  
Work in process
    10       11  
Finished goods
    688       727  
Deferred costs
    1,921       1,952  
                 
      3,279       3,415  
Less: provision for inventory
    (911 )     (1,007 )
                 
Inventories — net
    2,368       2,408  
Less: long-term deferred costs(a)
    (320 )     (419 )
                 
Current inventories — net
  $ 2,048     $ 1,989  
                 
 
 
(a) Long-term portion of deferred costs is included in other assets.
 
 
                 
Prepaid expenses
  $ 190     $ 175  
Income taxes recoverable
    60       64  
Other
    240       503  
                 
Other current assets
  $   490     $   742  
                 
 
 
                 
Cost:
               
Land
  $ 35     $ 35  
Buildings
    1,187       1,185  
Machinery and equipment
    2,009       2,048  
Capital lease assets
    215       215  
Sale lease-back assets
    92       92  
                 
      3,538       3,575  
                 
Less accumulated depreciation:
               
Buildings
    (451 )     (444 )
Machinery and equipment
    (1,456 )     (1,488 )
Capital lease assets
    (99 )     (96 )
Sale lease-back assets
    (17 )     (17 )
                 
      (2,023 )     (2,045 )
                 
Plant and equipment — net(a)
  $ 1,515     $ 1,530  
                 
 
 
(a) Includes assets held for sale with a carrying value of $53 and $52 as of March 31, 2007 and December 31, 2006, respectively, related to owned facilities that were being actively marketed for sale. These assets were written down in previous periods to their estimated fair values less estimated costs to sell. The write downs were included in special charges. Nortel expects to dispose of all these assets held for sale during 2007.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
                                                 
                Metro
                   
    Enterprise
    Carrier
    Ethernet
    Global
             
    Solutions     Networks     Networks     Services     Other     Total  
 
Balance — as of December 31, 2006(a)
  $ 488     $ 146     $ 661     $ 1,063     $ 171     $ 2,529  
Change:
                                               
Additions
                                   
Disposals
                                   
Foreign exchange
                      1             1  
Other
                                   
                                                 
Balance — as of March 31, 2007
  $ 488     $ 146     $ 661     $ 1,064     $ 171     $ 2,530  
                                                 
 
 
(a) Opening balances for Enterprise Solutions, Carrier Networks, and Metro Ethernet Networks have been decreased by $20, $19 and $107, respectively, and Global Services has been increased by $146, to reflect the reclassification of Nortel’s network implementation services to Global Services, as described in note 5.
 
 
                 
    March 31,
    December 31,
 
    2007     2006  
 
Cost:
               
Other intangible assets
  $ 307     $ 307  
Less accumulated amortization:
               
Other intangible assets
    (78 )     (66 )
                 
Intangible assets — net
  $ 229     $ 241  
                 
 
 
                 
Outsourcing and selling, general and administrative related provisions
  $ 276     $ 400  
Customer deposits
    99       78  
Product related provisions
    85       93  
Warranty provisions (note 11)
    205       217  
Deferred revenue
    1,435       1,127  
Advance billings in excess of revenues recognized to date on contracts(a)
    1,326       1,352  
Miscellaneous taxes
    54       75  
Income taxes payable
    39       72  
Tax uncertainties (note 7)
    10        
Interest payable
    62       114  
Global Class Action Settlement provision (note 17)
          814  
Other
    204       261  
                 
Other accrued liabilities
  $ 3,795     $ 4,603  
                 
 
 
(a) Includes amounts which may be recognized beyond one year due to the duration of certain contracts.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
                 
    March 31,
    December 31,
 
    2007     2006  
 
Pension benefit liabilities
  $ 1,853     $ 1,965  
Post-employment and post-retirement benefit liabilities
    801       794  
Restructuring liabilities (note 6)
    182       177  
Deferred revenue
    669       919  
Global Class Action Settlement provision (note 17)
          1,680  
Tax uncertainties (note 7)
    68        
Other long-term provisions
    263       275  
                 
Other liabilities
  $ 3,836     $ 5,810  
                 
 
Consolidated statements of cash flows
 
 
                 
    Three Months Ended March 31,  
    2007     2006  
 
Accounts receivable — net
  $ 427     $ 258  
Inventories — net
    9       (63 )
Deferred costs
    31       (102 )
Income taxes
    (11 )     (27 )
Accounts payable
    (74 )     (112 )
Payroll, accrued and contractual liabilities
    (595 )     (266 )
Deferred revenue
    42       64  
Advance billings in excess of revenues recognized to date on contracts
    (13 )     78  
Restructuring liabilities
    38       (19 )
Other
    87       (8 )
                 
Change in operating assets and liabilities, excluding Global Class Action Settlement — net
  $ (59 )   $ (197 )
                 
 
 
                 
Cash interest paid
  $ 136     $ 105  
Cash taxes paid
  $ 18     $ 27  
 
 
                 
Extinguishment of Global Class Action Settlement provision through increase in common shares and additional paid-in capital (note 17)
  $ 1,626     $  —  
 
5.   Segment information
 
 
In the first quarter of 2007, Nortel changed the name of its Mobility and Converged Core Networks segment to Carrier Networks (“CN”). Additionally, revenues from network implementation services consisting of engineering, installation and project management services bundled in customer contracts and previously included with sales in each of CN, Enterprise Solutions (“ES”) and Metro Ethernet Networks (“MEN”) have now been reallocated to its Global Services (“GS”) segment for management reporting purposes. The segments are discussed below. The amount reallocated to the GS segment was based primarily on the stated value of the services in the respective bundled customer arrangements. Prior period segment information has been recast to conform to current segment presentation.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
  •  CN provides mobility networking solutions using (i) CDMA solutions and GSM and UMTS solutions and (ii) carrier circuit and packet voice solutions. 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, laptops and other computing and communications devices. 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 and to roam globally. In addition, Nortel’s carrier circuit and packet voice solutions provide a broad range of voice solutions to its service provider customers for business and residential subscribers, traditional, full featured voice services as well as internet based voice and multimedia communications services using either circuit or packet-based switching technologies. These service provider customers include local and long distance telephone companies, wireless service providers, cable operators and other communication service providers. Increasingly, CN addresses customers who want to provide service across both wireless as well as wired devices.
 
  •  ES provides solutions to enterprise customers using (i) enterprise circuit and packet voice solutions, (ii) data networking and security solutions, which supply data, voice and multi-media communications solutions to Nortel’s enterprise customers, and (iii) software solutions for multi-media messaging, conferencing and call centers. Nortel’s solutions for enterprises are used to build new networks and transform their existing communications networks, into packet-based networks supporting data, voice and multi-media communications. Nortel’s ES customers consist of a broad range of enterprises around the world, including large businesses at their headquarters, data centers, call centers and their branch offices, small businesses and home offices, as well as government agencies, educational and other institutions and utility organizations.
 
  •  GS provides a broad range of services to address the requirements of Nortel’s carrier and enterprise customers throughout the entire lifecycle of their networks. The GS portfolio is organized into four main service product groups: (i) network implementation services, including network integration, planning, installation, optimization and security services, (ii) network support services, including technical support, hardware maintenance, equipment spares logistics and on-site engineers, (iii) network managed services, including services related to the monitoring and management of customer networks and providing a range of network managed service options and (iv) network application services, including applications development, integration and web services. Nortel’s GS market mirrors that of its carrier and enterprise markets along with a broad range of customers in all geographic regions where Nortel conducts business, including small and medium-sized businesses, to large global enterprises and all levels of government.
 
  •  MEN combines Nortel’s optical networking solutions and the carrier portion of its data networking solutions, to transform its carrier and large enterprise customers’ networks to be more scalable and reliable for the high speed delivery of diverse multi-media communications services. By combining Nortel’s optical expertise and data knowledge, Nortel creates solutions that help service providers and enterprises better manage increasing bandwidth demands. Nortel believes that ethernet technology is particularly suited to these solutions and is integrating ethernet with Nortel’s optical technology. In addition to increased capacity and lower cost per bit, Nortel differentiates its MEN products on the basis of being able to deliver carrier-grade reliability. The metropolitan, or metro, network is a key focus area as bandwidth demands are increasing as a result of the growth of network based broadcast and on-demand video delivery, wireless “backhaul” for a variety of data services including video as well as traditional business, internet, private line and voice services. MEN serves the long haul optical market using common products and technologies from the metro optical market. MEN also serves high performance, mission critical enterprise networks.
 
Other miscellaneous business activities and corporate functions, including the operating results of Nortel Government Solutions, acquired on June 3, 2005, by Nortel Networks Inc. (“NNI”), do not meet the quantitative criteria to be disclosed separately as reportable segments and have been reported in “Other”. Costs associated with shared services and other corporate costs are allocated to Nortel’s reportable segments based on usage determined generally by headcount. Costs not allocated to the segments are primarily related to Nortel’s corporate compliance, interest attributable to its long-term debt 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 segment performance and in deciding how to allocate resources to the segments. The primary financial measures


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

used by the CEO in assessing performance and allocating resources to the segments are management earnings (loss) before income taxes (“Management EBT”) and operating margin. 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 is not allocated to a reportable segment and is included in “Other”. Management believes that Management EBT is determined in accordance with the measurement principles most consistent with those used by Nortel in measuring the corresponding amounts in its consolidated financial statements. The accounting policies of the reportable segments are the same as those applied to the consolidated financial statements. The CEO does not review asset information on a segmented basis in order to assess performance and allocate resources.
 
Segments
 
The following tables set forth information by segment for the following periods:
 
                 
    Three Months Ended March 31,  
    2007     2006  
 
Revenues
               
Carrier Networks
  $ 1,009     $ 1,071  
Enterprise Solutions
    597       455  
Global Services
    448       506  
Metro Ethernet Networks
    373       293  
                 
Total reportable segments
    2,427       2,325  
Other
    56       65  
                 
Total revenues
  $ 2,483     $ 2,390  
                 
Management EBT
               
Carrier Networks
  $ 136     $ 56  
Enterprise Solutions
    2       (30 )
Global Services
    77       93  
Metro Ethernet Networks
    (17 )     (18 )
                 
Total reportable segments
    198       101  
Other
    (251 )     (266 )
                 
Total Management EBT
    (53 )     (165 )
Amortization of intangibles
    (12 )     (5 )
Special charges
    (80 )     (5 )
Gain on sale of businesses and assets
    1       39  
Shareholder litigation settlement (expense) recovery
    54       (19 )
Income tax expense
    (13 )     (25 )
                 
Net loss before cumulative effect of accounting change
  $ (103 )   $ (180 )
                 
 
During the three months ended March 31, 2007 and 2006, Nortel had one customer that generated revenues of approximately $309 and $275 or 12.5% and 11.5% of total consolidated revenues, respectively. The revenues were generated throughout all of Nortel’s reportable segments.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
6.   Special charges
 
During the first quarter of 2007, in continuing efforts to increase competitiveness by improving profitability and overall business performance, Nortel announced a restructuring plan that includes workforce reductions of approximately 2,900 employees and shifting of an additional 1,000 positions from higher-cost locations to lower-cost locations. In addition to the workforce reductions, Nortel announced steps to achieve additional cost savings by efficiently managing its various business locations and consolidating real estate requirements. Collectively, these efforts are referred to as the “2007 Restructuring Plan”. Nortel estimates the total charges to earnings and cash outlays associated with the 2007 Restructuring Plan will be approximately $390 and $370, respectively, to be incurred over fiscal 2007 and 2008, of which $75 was expensed in the first three months of 2007. Nortel expects that workforce reductions and shifting of positions will account for $300 of the estimated expense, and $90 will relate to real estate consolidation.
 
During the second quarter of 2006, in an effort to increase competitiveness by improving profitability and overall business performance, Nortel announced a restructuring plan that includes workforce reductions of approximately 1,900 employees (the “2006 Restructuring Plan”). The workforce reductions are expected to include approximately 350 middle management positions throughout the company, with the balance of the workforce reductions to primarily occur in the U.S. and Canada and span all of Nortel’s segments. Nortel estimates the total charges to earnings and cash outlays associated with the 2006 Restructuring Plan will be approximately $100, to be incurred over fiscal 2006 and 2007. Approximately $73 of the total charges relating to the 2006 Restructuring Plan have been incurred as of March 31, 2007.
 
During 2004, Nortel announced a strategic work plan involving a focused workforce reduction of approximately 3,250 employees, real estate optimization and other cost containment actions across all segments (the “2004 Restructuring Plan”). Nortel estimates that total charges to earnings associated with the 2004 Restructuring Plan will be approximately $410, comprised of approximately $240 with respect to the workforce reductions and approximately $170 with respect to the real estate actions. Approximately $365 of the total charges relating to the 2004 Restructuring Plan have been incurred as of March 31, 2007. Substantially all of the charges with respect to the workforce reductions have been incurred, and the remainder of the charges relating to ongoing lease costs, related to the impacted real estate facilities related to the 2004 Restructuring Plan is to be substantially incurred by the end of 2018.
 
During 2001, Nortel implemented a work plan to streamline operations and activities around core markets and leadership strategies (the “2001 Restructuring Plan”). Substantially all of the charges with respect to the workforce reductions have been incurred, and the remainder of the charges for ongoing lease costs, related to impacted real estate facilities as part of the 2001 Restructuring Plan are to be substantially incurred by the end of 2013.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
During the three months ended March 31, 2007, Nortel continued to implement these restructuring work plans. Special charges for the three months ended March 31, 2007 were as follows:
 
                                 
          Contract
             
          Settlement
    Plant and
       
    Workforce
    and Lease
    Equipment
       
    Reduction     Costs     Write Downs     Total  
 
2007 Restructuring Plan
                               
Provision balance as of December 31, 2006
  $     $     $     $  
Other special charges
    57       18             75  
Revisions to prior accruals
                       
Cash drawdowns
    (6 )                 (6 )
Non-cash drawdowns
    (2 )                 (2 )
                                 
Provision balance as of March 31, 2007
  $ 49     $ 18     $     $ 67  
                                 
2006 Restructuring Plan
                               
Provision balance as of December 31, 2006
  $ 38     $     $     $ 38  
Other special charges
    11                   11  
Revisions to prior accruals
    (6 )                 (6 )
Cash drawdowns
    (15 )                 (15 )
Non-cash drawdowns
                       
                                 
Provision balance as of March 31, 2007
  $ 28     $     $     $ 28  
                                 
2004 Restructuring Plan
                               
Provision balance as of December 31, 2006
  $ 3     $ 53     $     $ 56  
Other special charges
                       
Revisions to prior accruals
                       
Cash drawdowns
    (1 )     (3 )           (4 )
Non-cash drawdowns
                       
                                 
Provision balance as of March 31, 2007
  $ 2     $ 50     $     $ 52  
                                 
2001 Restructuring Plan
                               
Provision balance as of December 31, 2006
  $ 2     $ 178     $     $ 180  
Other special charges
                       
Revisions to prior accruals
    (1 )     1              
Cash drawdowns
          (10 )           (10 )
Non-cash drawdowns
                       
                                 
Provision balance as of March 31, 2007
  $ 1     $ 169     $     $ 170  
                                 
Total provision balance as of March 31, 2007(a)
  $ 80     $ 237     $     $ 317  
                                 
 
 
(a) As of March 31, 2007 and December 31, 2006, the short-term provision balances were $135 and $97, respectively, and the long-term provision balances were $182 and $177, respectively.
 
2007 Restructuring Plan
 
Three months ended March 31, 2007
 
For the three months ended March 31, 2007, Nortel recorded special charges of $57 related to severance and benefit costs associated with a workforce reduction of approximately 730 employees, of which 550 were notified of termination during the three months ended March 31, 2007, and $18 related to the real estate initiative. The workforce reduction was primarily in the U.S. and Canada. Approximately 75% of the total restructuring expense related to the 2007 Restructuring Plan is expected to be incurred by the end of 2007.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
2006 Restructuring Plan
 
Three months ended March 31, 2007
 
For the three months ended March 31, 2007, Nortel recorded special charges of $5, including revisions of $(6), related to severance and benefit costs associated with a cumulative workforce reduction of approximately 943 employees, of which 265 were notified of termination during the three months ended March 31, 2007. The workforce reduction was primarily in the U.S. and Canada. The remaining provision is expected to be substantially drawn down by the end of 2007.
 
2004 Restructuring Plan
 
Three months ended March 31, 2007
 
During the three months ended March 31, 2007, the provision balance for workforce reduction and contract settlement and lease costs was drawn down by cash payments of $1 and $3, respectively. The remaining provision, net of approximately $33 in estimated sublease income, is expected to be substantially drawn down by the end of 2018.
 
2001 Restructuring Plan
 
Three months ended March 31, 2007
 
During the three months ended March 31, 2007, Nortel recorded revisions of $(1) for workforce reduction and $1 for contract settlements and lease costs. The remaining provision, net of approximately $142 in estimated sublease income, is expected to be substantially drawn down by the end of 2013.
 
Segments
 
The following table summarizes the total special charges incurred for each of Nortel’s restructuring plans by segment during the three months ended March 31, 2007 and 2006:
 
                                                 
                Metro
                   
    Enterprise
    Carrier
    Ethernet
    Global
             
    Solutions     Networks     Networks     Services     Other     Total  
 
2007 Restructuring Plan
  $ 11     $ 45     $ 15     $ 4     $     $ 75  
2006 Restructuring Plan
    1       3       1                   5  
2004 Restructuring Plan
                                   
2001 Restructuring Plan
                                   
                                                 
Total special charges for the three months ended
March 31, 2007
  $ 12     $ 48     $ 16     $ 4     $     $ 80  
                                                 
2006 Restructuring Plan
  $     $     $     $     $     $  
2004 Restructuring Plan
    1       1       1                   3  
2001 Restructuring Plan
          2                         2  
                                                 
Total special charges for the three months ended
March 31, 2006
  $ 1     $ 3     $ 1     $     $     $ 5  
                                                 
 
As described in note 5, 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.
 
7.   Income taxes
 
During the three months ended March 31, 2007, Nortel recorded a tax expense of $13 on a loss from operations before income taxes, minority interests and equity in net loss of associated companies of $68. The tax expense of $13 is primarily related to the reduction of Nortel’s deferred tax assets as well as current tax provisions in certain taxable jurisdictions which have been partially offset by the recognition of R&D related incentives.


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Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
During the three months ended March 31, 2006, Nortel recorded a tax expense of $25 on a loss from operations before income taxes, minority interests and equity in net loss of associated companies of $159. The tax expense of $25 is primarily related to the reduction of Nortel’s deferred tax assets as well as current tax provisions in certain taxable jurisdictions and various corporate minimum and other taxes partially offset by the recognition of R&D related incentives.
 
As of March 31, 2007, Nortel’s net deferred tax assets were $4,104 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.
 
As a result of having adopted FIN 48, Nortel recognized approximately a $1 increase to reserves for uncertain tax positions. This increase was accounted for as a $1 increase to the January 1, 2007 accumulated deficit. Additionally, Nortel reduced its gross deferred tax asset by approximately $1,533, including a reduction of $758 related to the future tax benefit of the Global Class Action Settlement (as defined in note 17), and $620 related to capital losses.
 
Nortel has approximately $1,750 of total gross unrecognized tax benefits as of the adoption of FIN 48 at January 1, 2007. Of this total, $75 represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in future periods.
 
Nortel recognizes interest and penalties accrued related to unrecognized tax benefits in income tax expense. During the first quarter of 2007, Nortel recognized approximately $1 in interest and penalties. Nortel had approximately $26 and $27 accrued for the payment of interest and penalties as of January 1, 2007 and March 31, 2007, respectively.
 
Nortel believes it is reasonably possible that $18 of its unrecognized tax benefit will decrease during 2007 as the result of the statute of limitations expiring related to an uncertain tax benefit associated with transfer pricing. This potential decrease in unrecognized tax benefit would impact the effective tax rate in 2007.
 
Nortel is subject to tax examinations in all major taxing jurisdictions in which it operates and currently has examinations open in Canada, the U.S., France, Australia, Germany and Brazil. Nortel’s tax years 2000 through 2006 remain open in most of these jurisdictions primarily as a result of ongoing negotiations regarding Advance Pricing Arrangements (“APAs”) affecting these periods.
 
In accordance with 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 significant tax jurisdictions (namely Canada, the U.S., the U.K. and France), Nortel’s cumulative profits or losses in recent years, and Nortel’s projections of earnings in its significant jurisdictions. On a jurisdictional basis, Nortel is in a cumulative loss position in certain of its significant 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. Specifically, the tax authorities in Brazil have completed an examination of prior taxation years and have issued assessments in the amount of $74 for the taxation years of 1999 and 2000. In addition, the tax authorities in France have commenced negotiations to settle the proposed assessments in respect of the 2001, 2002 and 2003 taxation years. These assessments collectively propose adjustments to taxable income of approximately $1,119, additional income tax liabilities of $44 inclusive of interest as well as certain adjustments to withholding and other taxes of approximately $74 plus applicable interest and penalties. In 2006, Nortel discussed settling the audit adjustment without prejudice at the field agent level for the purpose of accelerating the process to either the courts or competent authority proceedings under the Canada-France tax treaty. Nortel withdrew from the discussions during the first quarter of 2007 and is in the process of entering into competent authority proceedings. Nortel believes that it has adequately provided for tax adjustments that are more likely than not to be realized as a result of any ongoing or future examinations.
 
Nortel had previously entered into 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 U.K. that applied to the taxation years beginning in 2001. The APA requests are currently under consideration and the tax


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Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

authorities are in the process of negotiating the terms of the arrangements. Nortel continues to monitor the progress of these negotiations; however Nortel is not a party to these negotiations. Nortel has applied the transfer pricing methodology proposed in the APA requests in preparing its tax returns and accounts beginning in 2001.
 
Nortel has requested that the APAs apply to the 2001 through 2005 taxation years. Nortel is also in the initial stages of preparing a new APA request which Nortel anticipates will be filed in 2007 to include tax years 2006 through at least 2008. Nortel continues to apply the transfer pricing methodology proposed in the APAs to its current year financial statements and intends to file its 2006 corporate income tax returns consistent with the methodology described in its APA requests.
 
The outcome of the APA application request 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 more likely than not 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.
 
8.   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 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.
 
In the second quarter of 2006, Nortel announced changes to its North American pension and post-retirement plans effective January 1, 2008. Nortel will reallocate employees currently enrolled in its defined benefit pension plans to defined contribution plans. In addition, Nortel will eliminate post-retirement healthcare benefits for employees who were not yet age 50 with five years of service as of July 1, 2006.
 
The following details the net pension expense for the defined benefit plans for the following periods:
 
                 
    Three Months Ended March 31,  
    2007     2006  
 
Pension expense:
               
Service cost
  $ 30     $ 35  
Interest cost
    115       113  
Expected return on plan assets
    (121 )     (109 )
Amortization of prior service cost
    1       1  
Amortization of net losses
    26       34  
Curtailment, contractual and special termination losses
    2       1  
                 
Net pension expense
  $ 53     $ 75  
                 


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Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

The following details the net cost components of post-retirement benefits other than pensions for the following periods:
 
                 
    Three Months Ended March 31,  
    2007     2006  
 
Post-retirement benefit cost:
               
Service cost
  $ 1     $ 2  
Interest cost
    8       11  
Amortization of prior service cost
    (2 )     (1 )
Amortization of net losses
          1  
                 
Net post-retirement benefit cost
  $ 7     $ 13  
                 
 
During the three months ended March 31, 2007, contributions of $136 were made to the defined benefit plans and $9 to the post-retirement benefit plans. Nortel expects to contribute an additional $189 in 2007 to the defined benefit pension plans for a total contribution of $325, and an additional $28 in 2007 to the post-retirement benefit plans for a total contribution of $37.
 
9.   Acquisitions, divestitures and closures
 
Acquisitions
 
 
On November 3, 2005, Nortel entered into a business venture with LG Electronics Inc. (“LGE”), named LG-Nortel. Certain assets of Nortel’s South Korean distribution and services business were combined with the service business and certain assets of LGE’s telecommunications infrastructure business. In exchange for a cash contribution of $155 paid to LGE, Nortel received 50% plus one share and LGE received 50% less one share of the equity in LG-Nortel. Separately, LGE will be entitled to payments from Nortel over a two-year period based on the achievement by LG-Nortel of certain business goals in the 2006 and 2007 fiscal years, of up to a maximum of $80. During the first quarter of 2007, Nortel and LGE agreed that the payment related to the 2006 fiscal year was $29 and this amount is recognized in these financial statements.
 
Divestitures
 
 
In 2004, Nortel entered into an agreement with Flextronics Telecom Systems, Ltd. (“Flextronics”) for 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. As of March 31, 2007, Nortel had transferred approximately $404 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, Chateaudun and Calgary. As Flextronics has the ability to exercise rights to sell 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 March 31, 2007. Nortel does not expect that rights will be exercised with respect to any significant amount of inventory and/or equipment. Nortel has recorded a deferred gain of $14 on this transaction as of March 31, 2007.
 
10.   Long-term debt
 
 
On March 28, 2007, Nortel completed an offering of $1,150 aggregate principal amount of unsecured convertible senior notes (the “Convertible Notes”) to qualified institutional buyers pursuant to Rule 144A under the U.S. Securities Act of 1933, as amended (the “Securities Act”), and in Canada to qualified institutional buyers that are also accredited investors pursuant to applicable Canadian private placement exemptions. The Convertible Notes consist of $575 principal amount of Senior Convertible Notes due 2012 (the “2012 Convertible Notes”) and $575 of Senior Convertible Notes due 2014 (the


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

“2014 Convertible Notes”), in each case, including $75 principal amount of Notes issued pursuant to the exercise in full of the over-allotment options granted to the initial purchasers. The 2012 Notes pay interest semi-annually at a rate per annum of 1.75% and the 2014 Notes pay interest semi-annually at a rate per annum of 2.125%.
 
The 2012 Notes and 2014 Notes are each convertible into common shares of Nortel at any time based on an initial conversion rate of 31.25 common shares per $1,000.00 principal amount of Notes (which is equal to an initial conversion price of $32.00 per common share), which rate is not a beneficial conversion option, in each case subject to adjustment in certain events, including a change of control. Holders of Notes who convert their Notes in connection with certain events resulting in a change in control may be entitled to a “make-whole” premium in the form of an increase in the conversion rate.
 
Upon a change of control, Nortel will be required to offer to repurchase the Notes for cash at 100% of the principal amount thereof plus accrued and unpaid interest and additional interest, if any, up to but not including the date of repurchase.
 
Nortel may redeem each series of Notes at any time in cash at a repurchase price equal to 100% of the aggregate principal amount, together with accrued and unpaid interest and any additional interest to the redemption date in the event of certain changes in applicable Canadian withholding taxes. Nortel may redeem in cash the 2012 Notes and the 2014 Notes at any time on or after April 15, 2011 and April 15, 2013, respectively, at repurchase prices equal to 100.35% and 100.30% of their respective principal amounts, plus accrued and unpaid interest and any additional interest up to but excluding the applicable redemption date.
 
The Notes are fully and unconditionally guaranteed by Nortel Networks Limited (“NNL”) and initially guaranteed by NNI. The Notes are senior unsecured obligations of Nortel and rank pari passu with all other senior obligations of Nortel. Each guarantee is the senior unsecured obligation of the respective guarantor and ranks pari passu with all other senior obligations of that guarantor.
 
In connection with the issuance of the Notes, Nortel, NNL and NNI entered into a registration rights agreement obligating Nortel to file with the U.S. Securities and Exchange Commission prior to or on the 191st day after the issuance of the Notes and to use its reasonable best efforts to cause to become effective prior to or on the 283rd day after the issuance of the Notes, a resale shelf registration statement covering the Notes, the related guarantees and the common shares issuable upon conversion of the Notes. Holders of the Notes will be entitled to the payment of certain additional interest if any of the conditions above, and certain other conditions, are not met.
 
The net proceeds from the sale of the Notes will be $1,127, after deducting commissions payable to the initial purchasers and other offering expenses. Nortel plans to use these net proceeds to redeem at par value on or about September 1, 2007, a corresponding amount of its $1,800 outstanding principal amount of 4.25% convertible senior notes due 2008. Pending this redemption, Nortel plans to invest the net proceeds in short term liquid instruments.
 
 
On February 14, 2003, 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”). NNL obtained a waiver from EDC as of March 9, 2007 of certain defaults and events of defaults arising under the EDC Support Facility as a result of the previously announced need to restate and make adjustments to NNL’s financial results for prior periods. Absent such a waiver, EDC would have had the right to refuse to issue additional support under the EDC Support Facility and to terminate its commitments under the EDC Support Facility, subject to a 30 day cure period with respect to certain provisions. NNL became compliant with its obligations under the EDC Support Facility by obtaining the waiver.
 
As of March 31, 2007, there was approximately $135 of outstanding support utilized under the EDC Support Facility, approximately $97 of which was outstanding under the revolving small bond sub-facility.
 
11.   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 applicable to Nortel as a contract that contingently requires Nortel to make payments (either in cash, financial instruments, other assets, common shares of Nortel or through the provision of services) to a third party


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Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

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 March 31, 2007, is provided below:
 
 
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 losses 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.
 
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 sales 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 March 31, 2007 is $10. A liability of $8 has been accrued in the consolidated financial statements as of March 31, 2007 with respect to the obligation associated with this guarantee.
 
 
Nortel has periodically entered into agreements with customers and suppliers which 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 March 31, 2007, no liability has been accrued in the consolidated financial statements with respect to Nortel’s intellectual property indemnification obligations.
 
 
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 $37 as of March 31, 2007. 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.


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Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
 
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, Nortel’s guarantee is secured, usually by the assets being purchased or financed. As of March 31, 2007, Nortel had no third party debt agreements that would require it to make any debt payments for its customers.
 
 
Nortel has agreed to indemnify the banks and their 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 their agents related to the use of loan proceeds. Nortel has also 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.
 
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 March 31, 2007, Nortel had approximately $206 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 2007, 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 under such agreements and no significant liability has been accrued in the consolidated financial statements with respect to the obligations associated with these guarantees.
 
 
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.


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Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
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.
 
Nortel has included specified price trade-in rights in certain customer arrangements that qualify as guarantees. As of March 31, 2007, Nortel had accrued $18 with respect to these indemnification obligations.
 
On March 17, 2006, in connection with the Global Class Action Settlement (as defined in note 17), Nortel announced that it had reached an agreement with the lead plaintiffs on the related insurance and corporate governance matters including Nortel’s insurers agreeing to pay $229 in cash towards the settlement and Nortel agreeing with their insurers to certain indemnification obligations. Nortel believes that these indemnification obligations would be unlikely to materially increase its total cash payment obligations under the Global Class Action Settlement. Nortel is aware of one claim made to the insurers by a former officer, but information is not available at this time to make a reasonable estimate of the amount for which Nortel may be liable. As a result, Nortel has not recorded a contingent liability as at March 31, 2007. The insurers’ payments would not reduce the amounts payable by Nortel as disclosed in note 17.
 
 
The following summarizes the accrual for product warranties that was recorded as part of other accrued liabilities in the consolidated balance sheet as of March 31, 2007:
 
         
Balance as of December 31, 2006
  $ 217  
Payments
    (38 )
Warranties issued
    52  
Revisions
    (26 )
         
Balance as of March 31, 2007
  $ 205  
         
 
12.   Commitments
 
 
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:
 
                 
    March 31,
    December 31,
 
    2007     2006  
 
Bid and performance related bonds(a)
  $ 201     $ 231  
Other bonds(b)
    19       30  
                 
Total bid, performance related and other bonds
  $ 220     $ 261  
                 
 
 
(a) Net of restricted cash and cash equivalent amounts of $3 and $7 as of March 31, 2007 and December 31, 2006, respectively.
(b) Net of restricted cash and cash equivalent amounts of $41 and $628 as of March 31, 2007 and December 31, 2006, respectively.


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Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
 
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 $28 as of March 31, 2007. These commitments expire at various dates through to 2016.
 
 
In the third quarter of 2006, Nortel and Microsoft Corporation (“Microsoft”) entered into a four-year agreement, with provisions for extension, to form a strategic alliance to jointly develop, market and sell communications solutions. Under the agreement, Nortel and Microsoft agreed to form joint teams to collaborate on product development spanning enterprise, mobile and wireline carrier solutions. The agreement engages the companies at the technology, marketing and business levels and includes joint product development, solutions and systems integration, and go-to-market initiatives. Both companies will invest resources in marketing, business development and delivery.
 
Microsoft will make available to Nortel up to $52 in marketing and telephony systems integration funds to be offset against marketing costs incurred by Nortel, and $40 in research and development funds over the initial four year term of the agreement. Microsoft will recoup its payment of research and development funds by receiving payments from Nortel of five percent of revenue over a mutually agreed upon enterprise voice and application business base plan. Any research and development funds that have not been recouped must be repaid in full by Nortel to Microsoft by March 31, 2012. As of March 31, 2007, Nortel had not received any of the research and development funds from Microsoft.
 
13.   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 loss per common share for the following periods:
 
                 
    Three Months Ended March 31,  
    2007(a) & (b)     2006(a)  
(Number of common shares in millions)            
 
Basic weighted-average shares outstanding:
               
Issued and outstanding
    442       434  
                 
Basic weighted-average shares outstanding
    442       434  
                 
Weighted-average shares dilution adjustments:
               
Dilutive stock options
           
             
                 
Diluted weighted-average shares outstanding
    442       434  
                 
Weighted-average shares dilution adjustments — exclusions:
               
Stock options
    32       29  
4.25% Convertible Senior Notes(a)
    18       18  
1.75% Convertible Senior Notes(a)
    18        
2.125% Convertible Senior Notes(a)
    18        
 
 
(a)  As a result of the net loss from operations for the three months ended March 31, 2007 and 2006, all potential dilutive securities were considered anti-dilutive.
(b)  Shares issuable as a result of the Global Class Action Settlement have been included in the calculation of weighted average number of shares outstanding with effect from March 20, 2007. For additional information, see note 17.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
14.   Shareholders’ equity
 
The following are the changes in shareholders’ equity during the three months ended March 31, 2007:
 
                                         
                      Accumulated
       
          Additional
          Other
       
    Common
    Paid-in
    Accumulated
    Comprehensive
       
    Stock     Capital     Deficit     Loss     Total  
 
Balance — as of December 31, 2006
  $ 33,938     $ 3,378     $ (35,574 )   $ (621 )   $ 1,121  
Net loss
                (103 )           (103 )
Foreign currency translation adjustment
                      12       12  
Unrealized loss on investments — net
                      (2 )     (2 )
Pension liability adjustment — net
                      15       15  
Unrealized derivative gain on cash flow hedges — net
                      6       6  
Stock-based compensation
    12       20                   32  
Global Class Action Settlement (note 17)
    68       1,558                   1,626  
Adoption of FIN 48 (notes 2 and 7)
                (1 )           (1 )
Other
    (3 )     1                   (2 )
                                         
Balance — as of March 31, 2007
  $ 34,015     $ 4,957     $ (35,678 )   $ (590 )   $ 2,704  
                                         
 
The following are the components of comprehensive loss, net of tax, for the following periods:
 
                 
    Three Months Ended March 31,  
    2007     2006  
 
Net loss
  $ (103 )   $ (171 )
Other comprehensive income (loss) adjustments:
               
Change in foreign currency translation adjustment
    12       24  
Unrealized gain (loss) on investments — net(a)
    (2 )     14  
Pension liability adjustment — net
    15       (1 )
Unrealized derivative gain (loss) on cash flow hedges — net(b)
    6       (6 )
                 
Comprehensive loss
  $ (72 )   $ (140 )
                 
 
 
(a)  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 loss and were included in accumulated other comprehensive loss until realized. Unrealized gain (loss) on investments was net of tax of nil and nil for the three months ended March 31, 2007 and 2006, respectively.
(b)  During the three months ended March 31, 2007 and 2006, $5 and $5 of net derivative gains (losses) were reclassified to other income — net, respectively. Nortel estimates that $4 of net derivative losses included in accumulated other comprehensive loss will be reclassified into net earnings (loss) within the next 12 months.
 
15.   Common shares and stock-based compensation plans
 
 
Nortel is authorized to issue an unlimited number of common shares without nominal or par value. The outstanding number of common shares included in shareholders’ equity consisted of the following as of the following periods:
 
                 
    Number
       
    (Thousands)     $  
 
Common shares:
               
Balance as at December 31, 2006
    433,935     $ 33,938  
Shares issued pursuant to:
               
Stock option plans
    312       12  
Global Class Action Settlement
    2,623       68  
Other
    4       (3 )
                 
Balance as at March 31, 2007
    436,874     $ 34,015  
                 


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
Prior to 2006, Nortel granted options to employees to purchase Nortel common shares under two existing stock option plans, the Nortel Networks Corporation 2000 Stock Option Plan (the “2000 Plan”) and the Nortel Networks Corporation 1986 Stock Option Plan As Amended and Restated (the “1986 Plan”). Under these two plans, options to purchase Nortel common shares could be granted to employees and, under the 2000 Plan, options could be also 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% 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. Options granted prior to 2003 generally vest 331/3% on the anniversary date of the grant for three years. Commencing in 2003, options granted generally vest 25% each year over a four-year period on the anniversary of the date of grant. The Compensation and Human Resources Committee of the Boards of Directors of Nortel and NNL (the “CHRC”) 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 common shares. Common shares remaining available for grant after December 31, 2005 under the 2000 Plan and the 1986 Plan (and including common shares that become available upon expiration or termination of options granted under such plans) have been rolled over and are available for grant under the Nortel 2005 Stock Incentive Plan (the “SIP”) effective January 1, 2006.
 
During 2005, the shareholders of Nortel approved the SIP, a stock-based compensation plan, which permits grants of stock options, including incentive stock options, stock appreciation rights (“SARs”), performance stock units (“PSUs”) and restricted stock units (“RSUs”) to employees of Nortel and its subsidiaries. On November 6, 2006, the SIP was amended and restated effective as of December 1, 2006, to adjust the number of common shares available for grant thereunder to reflect the 1 for 10 consolidation of Nortel’s issued and outstanding common shares. The subscription price for each share subject to an option shall not be less than 100% of the market value of common shares of Nortel on the 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. Options granted under the SIP generally vest 25% each year over a four-year period on the anniversary of the date of grant. The CHRC, which administers the SIP, generally has the discretion to accelerate or waive any condition to the vesting of options, but in no case shall options granted become exercisable within the first year (except in the event of death), and in no case shall the exercise period exceed ten years. Nortel meets its obligations under the SIP by issuing Nortel common shares. All stock options granted have been classified as equity instruments based on the settlement provisions of the stock-based compensation plans.
 
Stand-alone SARs or SARs in tandem with options may be granted under the SIP. Upon the exercise of a vested SAR, a holder will be entitled to receive payment of an amount equal to the excess of the market value of a common share of Nortel on the date of exercise over the subscription or base price under the SAR. On the exercise of a tandem SAR, the related option shall be cancelled. As of March 31, 2007 and 2006, there were no SARs outstanding.
 
In January 1995, a key contributor stock option program (the “Key Contributor Program”) was established and options have been granted under the 1986 Plan and the 2000 Plan in connection with this program. 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 a common share of Nortel on the date of grant and the replacement options have an exercise price equal to the market value of a common share of Nortel 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 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 periods ended March 31, 2007 and 2006.
 
Nortel also assumed stock option plans in connection with the acquisition of various companies. Common shares of Nortel 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


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

differ from the SIP, 2000 Plan and 1986 Plan, but are not considered 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 as of the following dates:
 
                                         
                Weighted
             
                Average
             
          Weighted-
    Remaining
             
    Outstanding
    Average
    Contractual
    Aggregate
    Available
 
    Options
    Exercise
    Life
    Intrinsic
    for Grant
 
    (Thousands)     Price     (In years)     Value     (Thousands)  
 
Balance at December 31, 2006
    29,782     $ 81.72       5.7     $ 36,952       15,703  
Granted options under all stock option plans
    4,185       25.82                     (6,570 )(a)
Options exercised
    (312 )     23.72               1,583        
Options forfeited
    (223 )     36.84                       233 (a)
Options expired
    (1,241 )     113.93                       1,205 (a)
                                         
Balance at March 31, 2007
    32,191     $ 74.20       6.2     $ 14,570       10,571  
                                         
 
(a)  Amount is inclusive of RSUs and PSUs granted or cancelled. RSUs and PSUs reduce shares available for grant under the SIP.
 
 
RSUs and PSUs can be issued under the SIP.  RSUs generally become vested based on continued employment and PSUs generally become vested subject to the attainment of performance criteria. Each RSU or PSU granted under the SIP generally represents one common share of Nortel. Vested units will generally be settled upon vesting by delivery of a common share of Nortel for each vested unit or payment of a cash amount equal to the market value of a common share of Nortel at the time of settlement, or a combination thereof, as determined at the discretion of the CHRC.
 
The number of RSUs granted during the three months ended March 31, 2007 was 1,884,085. Generally, RSUs awarded to executive officers in 2005 and going forward vest in equal installments on the first three anniversary dates of the date of the award. The RSUs awarded under the SIP will be settled in shares at the time of vesting. All RSUs granted have been classified as equity instruments based on the settlement provisions of the stock-based compensation plans.
 
The number of PSUs granted during the three months ended March 31, 2007 was 500,950. Vesting and settlement of PSUs at the end of the three year performance period will depend upon the level of achievement of certain performance criteria based on the relative total shareholder return on the common shares of Nortel compared to the total shareholder return on the common shares of a comparative group of companies included in the Dow Jones Technology Titans 30 Index (the “Technology Index”). The number of common shares to be issued for the vested PSUs are determined based on Nortel’s ranking within the Technology Index and can range from 0% to 200%. All PSUs granted have been classified as equity instruments based on the settlement provisions of the stock-based compensation plans.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
The following is a summary of the total number of outstanding RSU and PSU awards granted as of the following dates:
 
                                                 
    RSU     PSU  
                Weighted
                Weighted
 
                Average
                Average
 
    Outstanding
    Weighted-
    Remaining
    Outstanding
    Weighted-
    Remaining
 
    RSU Awards
    Average
    Contractual
    PSU Awards
    Average
    Contractual
 
    Granted
    Grant Date
    Life
    Granted
    Grant Date
    Life
 
    (Thousands)     Fair Value(a)     (In years)     (Thousands)     Fair Value(a)     (In years)  
 
Balance at December 31, 2006
    1,240     $ 24.83       2.5       447     $ 22.63       2.5  
Granted awards
    1,884       25.82               501       21.69          
Awards exercised
                                       
Awards forfeited
    (11 )     22.43                              
Awards expired
                                       
                                                 
Balance at March 31, 2007
    3,113     $ 25.44       2.7       948     $ 22.13       2.6  
                                                 
 
 
(a) RSU and PSU awards do not have an exercise price therefore, grant date weighted-average fair value has been calculated using the stock price on the date of grant and a Monte Carlo simulation model, respectively.
 
 
The following table provides the stock-based compensation recorded for the following periods:
 
                 
    Three Months Ended March 31,  
    2007     2006(a)  
 
Stock-based compensation:
               
Stock option expense
  $ 20     $ 14  
RSU expense
    4       2  
PSU expense
    1        
                 
Total stock-based compensation reported
  $ 25     $ 16  
                 
 
 
(a) Includes a reduction of stock-based compensation expense of approximately $9 recognized in the first quarter of 2006 to align Nortel’s recognition of stock option forfeitures with the adoption of SFAS 123R.
 
Nortel estimates the fair value of stock options using the Black-Scholes-Merton option-pricing model, consistent with the provisions of SFAS 123R and SAB 107. The key input assumptions used to estimate the fair value of stock options include the grant price of the award, the expected term of the options, the volatility of Nortel’s stock, the risk-free rate and Nortel’s dividend yield. Nortel believes that the Black-Scholes-Merton option-pricing model utilized to develop the underlying assumptions is appropriate in calculating the fair values of Nortel’s stock options.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (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:
 
                 
    Three Months Ended March 31,  
    2007     2006(d)  
 
Black-Scholes weighted-average assumptions
               
Expected dividend yield
    0.00 %      
Expected volatility(a)
    53.56 %      
Risk-free interest rate(b)
    4.43 %      
Expected option life in years(c)
    4        
Weighted-average stock option fair value per option granted
  $ 11.86        
 
 
(a) The expected volatility of Nortel’s stock is estimated using the daily historical stock prices over a period equal to the expected term.
 
(b) Nortel used the five year government treasury bill rate to approximate the four year risk free rate.
 
(c) The expected term of the stock options is estimated based on historical grants with similar vesting periods.
 
(d) Due to the restatement effected in the second quarter of 2006 and the suspension of trading under the plans, no awards were granted in the first quarter of 2006.
 
The fair value of RSU awards is the stock price on the date of grant. Nortel estimates the fair value of PSU awards using a Monte Carlo simulation model, consistent with the provisions of SFAS 123R. Certain assumptions used in the model include (but are not limited to) the following:
 
                 
    Three Months Ended March 31,  
    2007     2006(b)  
 
Monte Carlo assumptions
               
Beta
    1.9        
Risk-free interest rate(a)
    4.46 %      
 
 
(a) The risk-free rate used was the three year government treasury bill rate.
 
(b) Due to the restatement effected in the second quarter of 2006 and the suspension of trading under the plans, no awards were granted in the first quarter of 2006.
 
As of March 31, 2007, the annual forfeiture rates applied to Nortel’s stock option plans, RSU and PSU awards were 16%, 13% and 7%, respectively.
 
Cash received from exercises under all share-based payment arrangements were $7 and $1 for the three months ended March 31, 2007 and 2006, respectively. Tax benefits realized by Nortel related to these exercises were nil and nil, for the three months ended March 31, 2007 and 2006, respectively.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
16.   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 business ventures of Nortel. These transactions are sales and purchases of goods and services under usual trade terms and are measured at their exchange amounts.
 
Transactions with related parties are summarized for the following periods:
 
                 
    Three Months Ended March 31,  
    2007     2006  
 
Revenues:
               
LG Electronics Inc.(a)
  $ 7     $ 1  
Vertical Communications Systems Inc.(b)
    4        
Other
    2        
                 
Total
  $ 13     $ 1  
                 
Purchases:
               
LG Electronics Inc.(a)
    79       53  
Sasken Communications Technology Ltd. (“Sasken”)(c)
    5       8  
GNTEL Co., Ltd (“GNTEL”)(d)
    15       9  
Other
    2       3  
                 
Total
  $ 101     $ 73  
                 
 
 
(a) LGE holds a minority interest in LG-Nortel. Nortel’s sales and purchases relate primarily to certain inventory related items. As of March 31, 2007, accounts payable to LGE was $89, compared to $76 as at December 31, 2006.
 
(b) LG-Nortel currently owns a minority interest in Vertical Communications Ltd. (“Vertical”), which on December 1, 2006 acquired Vodavi. Vertical supports LG-Nortel’s efforts to distribute Nortel’s products to the North American market.
 
(c) Nortel currently owns a minority interest in Sasken. Nortel’s purchases from Sasken relate primarily to software and other software development related purchases. As of March 31, 2007, accounts payable to Sasken was $2, compared to $2 as at December 31, 2006.
 
(d) Nortel holds a minority interest in GNTEL through its business venture LG-Nortel. Nortel’s purchases from GNTEL relate primarily to installation and warranty services. As of March 31, 2007, accounts payable to GNTEL was $15, compared to $17 as at December 31, 2006.
 
As of March 31, 2007 and December 31, 2006, accounts receivable from related parties were $16 and $13, respectively. As of March 31, 2007 and December 31, 2006, accounts payable to related parties were $106 and $97, respectively.
 
17.   Contingencies
 
Subsequent to Nortel’s announcement on February 15, 2001, in which it provided revised guidance for its 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 several purported class action lawsuits in the U.S. and Canada (collectively, the “Nortel I Class Actions”). These lawsuits in the U.S. District Court for the Southern District of New York, where all the U.S. lawsuits were consolidated, the Ontario Superior Court of Justice, the Supreme Court of British Columbia and the Quebec Superior Court were filed on behalf of shareholders who acquired securities of Nortel during certain periods between October 24, 2000 and February 15, 2001. The lawsuits 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.
 
Subsequent to Nortel’s announcement on March 10, 2004, in which it indicated it was likely that Nortel 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 in 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 several purported class action lawsuits in the U.S. and Canada (collectively, the “Nortel II Class Actions”). These lawsuits in the U.S. District


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

Court for the Southern District of New York, the Ontario Superior Court of Justice and the Quebec Superior Court were filed on behalf of shareholders who acquired securities of Nortel during certain periods between February 16, 2001 and July 28, 2004. The lawsuits allege, among other things, violations of U.S. federal and Canadian provincial securities laws, negligence, misrepresentations, oppressive conduct, insider trading and violations of Canadian corporation and competition laws in connection with certain of Nortel’s financial results. These matters are also the subject of investigations by Canadian and U.S. securities regulatory and criminal investigative authorities.
 
During 2006, Nortel entered into agreements to settle all of the Nortel I Class Actions and Nortel II Class Actions (the “Global Class Action Settlement”) concurrently, except one related Canadian action described below. In December 2006 and January 2007, the Global Class Action Settlement was approved by the courts in New York, Ontario, British Columbia and Quebec, and became effective on March 20, 2007.
 
Under the terms of the Global Class Action Settlement, Nortel will pay $575 in cash and issue approximately 62,866,775 common shares of Nortel (representing approximately 14.5% of Nortel’s common shares outstanding as of February 7, 2006, the date an agreement in principle was reached with the plaintiffs in the U.S. class action lawsuits), reflecting Nortel’s 1 for 10 common share consolidation on December 1, 2006 to the plaintiffs. Nortel will also contribute to the plaintiffs one-half of any recovery from its ongoing litigation against certain of its former senior officers who were terminated for cause in 2004, which seeks the return of payments made to them in 2003 under Nortel’s bonus plan. The total settlement amount will include all plaintiffs’ court-approved attorneys’ fees. On June 1, 2006, Nortel placed $575 plus accrued interest of $5 into escrow and has classified this amount as restricted cash. As a result of the Global Class Action Settlement, Nortel established a litigation reserve and recorded a charge in the amount of $2,474 to its full-year 2005 financial results, $575 of which related to the cash portion of the Global Class Action Settlement, while $1,899 related to the equity component. The equity component of the litigation reserve has been adjusted each quarter since February 2006 to reflect the fair value of the common shares issuable.
 
The effective date of the Global Class Action Settlement was March 20, 2007, on which date the number of shares issuable in connection with the equity component was fixed. As such, a final measurement date occurred for the equity component of the settlement and the value of the shares issuable was fixed at their fair value of $1,626 on the effective date. No further fair value adjustments will be made beyond March 20, 2007.
 
Nortel recorded a shareholder litigation settlement recovery of $54 during the first quarter of 2007 as a result of a final fair value adjustment for the equity component of the Global Class Action Settlement made on March 20, 2007. In addition, the litigation reserve related to the equity component was reclassified to additional paid-in capital within shareholders’ equity on March 20, 2007 as the number of issuable shares was fixed on that date. The reclassified amount will be further reclassified to common shares as the shares are issued. At the effective date of March 20, 2007, Nortel also removed the restricted cash and corresponding litigation reserve related to the cash portion of the settlement as the funds are controlled by the escrow agents and Nortel’s obligation has been extinguished. The administration of the settlement will be a complex and lengthy process. The claims administrator will submit lists of approved claims to the appropriate courts for approval. Once all the courts have approved the claims, the process of distributing cash and share certificates to claimants will begin. It is not possible to predict how long the process will take, although it is expected to take many months.
 
Nortel’s insurers have agreed to pay $229 in cash toward the settlement and Nortel has agreed to certain indemnification obligations with its insurers. Nortel believes that it is unlikely that these indemnification obligations will materially increase its total cash payment obligations under the Global Class Action Settlement.
 
Under the terms of the Global Class Action Settlement, Nortel also agreed to certain corporate governance enhancements. These enhancements include the codification of certain of Nortel’s current governance practices in the written mandate for its Board of Directors and the inclusion in its Statement of Corporate Governance Practices contained in Nortel’s annual proxy circular and proxy statement of disclosure regarding certain other governance practices.
 
In August 2006, Nortel reached a separate agreement in principle to settle a class action lawsuit in the Ontario Superior Court of Justice that is not covered by the Global Class Action Settlement, subject to court approval (the “Ontario Settlement”). In February 2007, the court approved the Ontario Settlement. The settlement did not have a material impact on Nortel’s financial condition and an accrued liability was recorded in the third quarter of 2006.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
In April 2004, Nortel announced that it was under investigation by each of the SEC and the Ontario Securities Commission in connection with the restatements of its financial statements in 2003 and 2004. These investigations are ongoing.
 
In May 2004, Nortel 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. In August 2005, Nortel received an additional federal grand jury subpoena seeking additional documents, including documents relating to the Nortel Retirement Income Plan and the Nortel Long-Term Investment Plan. This investigation is ongoing. A criminal investigation into Nortel’s financial accounting situation by the Integrated Market Enforcement Team of the Royal Canadian Mounted Police is also ongoing.
 
Beginning in December 2001, Nortel, together with certain of its then-current and former directors, officers and employees, was named as a defendant in several purported class action lawsuits pursuant to the United States Employee Retirement Income Security Act. These lawsuits have been consolidated into a single proceeding in the U.S. District Court for the Middle District of Tennessee. This lawsuit is on behalf of participants and beneficiaries of the Nortel Long-Term Investment Plan, who held shares of the Nortel Networks Stock Fund during the period from March 7, 2000, through November 28, 2006. The lawsuit alleges, among other things, material misrepresentations and omissions to induce participants and beneficiaries to continue to invest in and maintain investments in Nortel’s common shares through the investment plan. A class of plaintiffs in this action has not yet been certified.
 
In January 2005, Nortel and NNL filed a Statement of Claim in the Ontario Superior Court of Justice against Messrs. Frank Dunn, Douglas Beatty and Michael Gollogly, their 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 April 2006, Mr. Dunn filed a Notice of Action and Statement of Claim 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-judgment interest and costs.
 
In May and October 2006, respectively, Messrs. Gollogly and Beatty filed Statements of Claim in the Ontario Superior Court of Justice against Nortel and NNL asserting claims for, among other things, wrongful dismissal and seeking compensatory, aggravated and punitive damages, and pre-and post-judgment interest and costs.
 
In June 2005, Ipernica Limited (formerly known as QSPX Development 5 Pty Ltd), an Australian patent holding firm, filed a lawsuit against Nortel in the U.S. District Court for the Eastern District of Texas alleging patent infringement. In April 2007, the jury reached a verdict to award damages to the plaintiff in the amount of $28. Following post-trial motions, the trial judge will enter a judgment that could range from increasing the damages award against Nortel to a reversal of the jury’s verdict.
 
Except as otherwise described herein, 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 and the related fair value adjustments, which Nortel has recorded in its first quarter of 2007 and 2006 financial results as a result of the Global Class Action Settlement and the accrued liability for the Ontario 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. Except for the Global Class Action Settlement, Nortel cannot determine whether these actions, suits, claims and proceedings will, individually or collectively, have a material adverse effect on its business, results of operations, financial condition or liquidity. Except for matters encompassed by the Global Class Action Settlement and the Ontario Settlement, 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.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)

 
Nortel is also a defendant in various other suits, claims, proceedings and investigations which arise in the normal course of business.
 
 
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 and will be subject to various product content laws and product take-back and recycling requirements that will require full compliance in the coming years. 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 continues to evolve compliance plans and risk mitigation strategies relating to the new laws and requirements. Nortel intends to design and 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 generation, management and disposal of hazardous substances and wastes. As of March 31, 2007, the accruals on the consolidated balance sheet for environmental matters were $27. Based on information available as of March 31, 2007, 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 three 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.


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ITEM 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
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The following Management’s Discussion and Analysis, or MD&A, is intended to help the reader understand the results of operations and financial condition of Nortel. The MD&A should be read in combination with our unaudited condensed consolidated financial statements and the accompanying notes. All dollar amounts in this MD&A are in millions of United States, or U.S., dollars except per share amounts or unless otherwise stated.
 
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 which we believe are reasonable but which are subject to important assumptions, risks and uncertainties and may prove to be inaccurate. Consequently our actual results could differ materially from our expectations set out in this MD&A. In particular, see the Risk Factors section of this report and our Annual Report on Form 10-K for the year ended December 31, 2006, or 2006 Annual Report, for factors that 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.
 
Executive Overview
 
 
We are a global supplier of networking solutions serving both service provider and enterprise customers. Our networking solutions include hardware and software products and services designed to reduce complexity, improve efficiency, increase productivity, and drive customer value. 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 business activities include the design, development, engineering, marketing, sale, supply, licensing, installation, servicing and support of these networking solutions.
 
The telecommunications industry has evolved over the past two decades by developing new technologies and using those technologies to build smarter and faster networks. We believe that the telecommunications industry today stands at the threshold of a new era to be fueled by increasing demand for pervasive personal broadband capabilities that provide high-bandwidth access to any application from any device and any location. We believe that innovation in this era will be driven by three emerging trends: hyperconnectivity, true broadband, and the emergence of communications-enabled applications. Hyperconnectivity refers to the expected dramatic increase in demand for network connections as more devices such as portable gaming and entertainment devices, digital cameras, appliances, motor vehicles, and other devices are added to the network. True broadband refers to the ability of an internet user to access the network from any location


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using any access device without losing quality, connectivity, content or clarity. We believe that the increasing use of video, high definition television, video on demand, peer-to-peer connectivity, and other applications requiring the use of significant bandwidth will result in increased demand for true broadband. To deliver a true broadband experience to users, wired and wireless access bandwidth will need to be substantially increased and fixed and mobile communications will need to continue to converge. Communications-enabled applications refers to the trend towards web-based, network-aware applications and services which will be made possible by middleware based on emerging technologies like Service-Oriented Architecture and IP Multimedia Subsystem, or IMS. Our strategy is to capitalize on these trends by transforming enterprises to support a hyperconnected world, delivering next-generation mobility and convergence to enable a true broadband experience, and providing networking solutions that integrate networks and applications into a seamless framework.
 
Our short-term focus has been on: (i) the transformation of our businesses and processes, (ii) integrity renewal and (iii) growth imperatives. We believe we are well positioned to deliver wireless and wireline infrastructure, applications and services to carrier and enterprise customers.
 
Our plan for business transformation is expected to address our most significant operational challenges. It is focused on simplifying our organizational structure and maintaining a strong focus on revenue generation and improved operating margins as well as quality improvements and cost reductions through a program known as Six Sigma. Our plan contemplates the transformation of our business in six key areas: services, procurement effectiveness, revenue stimulation (including sales and pricing), research and development, or 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. Other initiatives include the continued progress of our finance transformation project, which will implement, among other things, a new information technology platform to provide an integrated global financial system.
 
We remain focused on integrity renewal and ethical conduct through a commitment to effective corporate governance practices and the remediation of the material weakness in our internal controls. We have an enhanced compliance function that places greater emphasis on compliance with applicable laws and company policies, and we have increased employee awareness of ethics issues through an online ethics training program and a new code of business conduct.
 
Our long-term growth imperatives are motivated by a desire to generate profitable growth and focus on areas where we can attain a leadership position and a minimum market share of twenty percent in key technologies, with a specific focus on mobility and convergence, enterprise transformation, and services and solutions. We anticipate that industry demand for wireless networking solutions will increase due to continued subscriber and network traffic growth to support applications such as mobile video. As a result, we plan to increase our investment in metro ethernet, particularly to support video delivery over wired as well as wireless access, and in products compliant with the Worldwide Interoperability for Microwave Access, or WiMAX, standard, and the IMS service creation and control architecture, and other 4G products as the market determines, such as LTE.
 
We believe we are well-positioned in many enterprise voice networks today, but continue to face competitive challenges in integrating our voice and data portfolios to capitalize on the trend towards internet protocol, or IP, converged networks. We have taken steps to strengthen our end-to-end convergence solutions and focus on the enterprise market, including through the acquisition of Tasman Networks Inc. in 2006, which has strengthened our data portfolio. In the third quarter of 2006, we entered into a strategic alliance with Microsoft Corporation to facilitate the ongoing transition of a key component of our business from traditional voice technology to software.
 
Our four reportable segments are: Mobility and Converged Core Networks, or MCCN, Enterprise Solutions, or ES, Global Services, or GS, and Metro Ethernet Networks, or MEN. In the first quarter of 2007, we changed the name of the MCCN segment to Carrier Networks, or CN. The CN segment provides wireless networking solutions that enable service providers and cable operators to supply mobile voice, data and multimedia communications services to individuals and enterprises using mobile telephones, personal digital assistants, and other wireless computing and communications devices and also offers circuit- and packet-based voice switching products that provide traditional, full featured voice services as well as internet-based voice and multimedia communication services to telephone companies, wireless service providers, cable operators and other service providers. Increasingly, CN addresses customers who want to provide service across both wireless and wired devices. The ES segment provides communication solutions for our enterprise customers that are used to build new networks and to transform existing communications networks into more cost effective, packet-based networks supporting data, voice and multimedia communications. The GS segment provides a broad range of services to address the requirements of our carrier and enterprise customers throughout the entire lifecycle of their networks. The MEN segment provides optical


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networking and carrier grade Ethernet data networking solutions to make our carrier and large enterprise customers’ networks more scalable and reliable for the high speed delivery of diverse multimedia communications services.
 
In the first quarter of 2007, we further refined our segments. Revenues from network implementation services consisting of network planning, engineering, installation and project management services bundled in customer contracts and previously included with sales in each of CN, ES and MEN have now been reallocated to our GS segment for management reporting purposes. The segments are discussed below. The amount reallocated to the GS segment was based primarily on the stated value of the services in the respective bundled customer arrangements. We have recast our first quarter 2006 segment information to reflect these changes in our reportable segments.
 
 
Our president and chief executive officer, or CEO, has been identified as our chief operating decision maker in assessing the performance and allocating resources to our operating segments. The primary financial measures used by the CEO are operating margin and management earnings (loss) before income taxes, or Management EBT. Operating Margin is a non-GAAP measure defined as Gross Profit less SG&A and R&D expenses. Operating Margin percentage is a non-GAAP measure defined as Operating Margin divided by Revenue. Consolidated Management EBT is a non-GAAP measure defined as Operating Margin less 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”. Our management believes that these measures are meaningful measurements of operating performance and provide greater transparency to investors with respect to our performance and supplemental information used by management in its financial and operational decision making. These non-GAAP measures may also facilitate comparisons to our historical performance and our competitors’ operating results.
 
These non-GAAP measures should be considered in addition to, but not as a substitute for, the information contained in our financial statements prepared in accordance with GAAP. These measures may not be synonymous to similar measurement terms used by other companies.
 
 
The following is a summary of our first quarter financial highlights:
 
                                 
    For the Three Months Ended  
    March 31,
    March 31,
             
    2007     2006     $ Change     % Change  
 
Revenues
  $ 2,483     $ 2,390     $ 93       4  
Gross Profit
    1,002       925       77       8  
Gross Margin %
    40.4 %     38.7 %             1.7 pts  
Selling, General and Administrative Expense
    604       610       (6 )     (1 )
Research and Development Expense
    409       479       (70 )     (15 )
                                 
Operating Margin
    (11 )     (164 )     153          
Operating Margin %
    −0.4 %     −6.9 %             6.5 pts  
Interest Expense
    (96 )     (61 )     (35 )        
Other Income — Net
    76       56       20       36  
Minority Interest
    (22 )     6       (28 )     (467 )
Equity in Net Loss of Associated Companies — net of tax
          (2 )     2          
                                 
Management EBT
    (53 )     (165 )     112          
Amortization of Intangibles
    12       5       7       140  
Special Charges
    80       5       75       1,400  
Gain on Sale of Businesses and Assets
    (1 )     (39 )     38          
Shareholder Litigation Settlement Expense (Recovery)
    (54 )     19       (73 )     (384 )
Income Tax Expense
    (13 )     (25 )     12          
                                 
Net Loss Before Cumulative Effect of Accounting Change
    (103 )     (180 )     77          
                                 


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As discussed below under “Restatements; Remedial Measures and the Elimination of Material Weaknesses; Related Matters”, we have restated our consolidated financial statements for the first, second and third quarters of 2006. For additional information see note 3, “Restatement of previously issued financial statements” to the accompanying unaudited condensed consolidated financial statements and the 2006 Annual Report.
 
  •  Revenues increased 4% to $2,483:  Revenues increased in the first quarter of 2007 compared to the first quarter of 2006 in the ES and MEN segments, partially offset by declines in the CN and GS segments. From a geographic perspective, the increase was driven by the Asia and U.S. regions, partially offset by declines in the Caribbean and Latin America, or CALA, and Europe, Middle East and Africa, or EMEA, regions. The revenue growth is primarily attributable to deferred revenues recognized in the first quarter of 2007 due to our ongoing completion or elimination of customer deliverable obligations and CDMA growth, partially offset by declines in the CN and GS segments related to the divestiture of certain assets and liabilities related to our UMTS Access business.
 
  •  Gross margin increased 1.7 percentage points to 40.4%:  The increase was predominantly due to the shift in product mix in the first quarter of 2007 as compared to the first quarter of 2006, most significantly in the CN and GS segments primarily due to the UMTS Access divestiture.
 
  •  Operating margin increased by $153 to a loss of $11:  The increase was predominately due to increased gross profit as a result of the increase in revenues and gross margins, and decreased R&D expenses in the first quarter of 2007 compared to the first quarter of 2006 as a result of continued momentum related to our business transformation initiatives and the UMTS Access divestiture.
 
  •  Management EBT increased by $112 to a loss of $53:  The increase in Management EBT was driven primarily by increases in the CN and ES segments. The CN and GS segments continued to be significantly more profitable than ES and MEN.
 
  •  Net loss decreased $77 to a net loss of $103 from a net loss of $180:  The decrease in net loss was driven primarily by changes in the fair value of the equity component of our Global Class Action Settlement and an increase in operating margin, offset by an increase in special charges of $75.
 
  •  Cash and cash equivalents increased $1,063 from December 31, 2006 to $4,555 at March 31, 2007:  The increase in cash was primarily driven by net cash from financing activities of $1,118, primarily related to our offering of convertible senior notes, net cash from investing activities of $500 primarily due to a reduction in restricted cash related to the Global Class Action Settlement, and net positive impacts from foreign exchange of $6, partially offset by net cash used in operating activities of $561. We intend to use the net proceeds of the offering of convertible senior notes to redeem on or about September 1, 2007 at par a corresponding amount of our 4.25% convertible senior notes due 2008.
 
 
 
On March 28, 2007, we completed an offering of convertible senior notes, or the Convertible Notes, in an aggregate principal amount of $1,150. We plan to use the net proceeds to redeem at par value on or about September 1, 2007, a corresponding amount of our $1,800 outstanding principal amount of 4.25% convertible notes, which mature in September 2008. Pending this redemption, we plan to invest the $1,127 net proceeds of the Convertible Notes offering in short term liquid investments.
 
 
On February 7, 2007, we outlined the next steps of our Business Transformation plan with the announcement of a work plan to implement a net reduction in our global workforce of approximately 2,900 positions, or the 2007 Restructuring Plan. As part of this plan we will also shift approximately 1,000 positions from higher-cost to lower-cost locations. The 2007 Restructuring Plan also includes initiatives to more efficiently manage our various business locations and reduce our global real estate portfolio. Upon completion, the 2007 Restructuring Plan is expected to result in annual savings of approximately $400.
 
 
In February 2006, we announced an agreement to settle two significant class action lawsuits pending in the U.S. District Court for the Southern District of New York, or the Global Class Action Settlement. Subsequently, we entered into


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agreements to settle all related Canadian actions. In December of 2006 and January of 2007, the Global Class Action Settlement was approved by the courts in New York, Ontario, Quebec and British Columbia. The Global Class Action Settlement became effective on March 20, 2007.
 
 
On May 2, 2007, the appointment of KPMG LLP as our principal independent public accountants beginning with fiscal 2007 was approved by our shareholders at our Annual and Special Meeting of Shareholders. KPMG LLP was also appointed as NNL’s principal independent public accountants on the same date.
 
Restatements; Remedial Measures and the Elimination of Material Weaknesses; Related Matters
 
 
We have effected successive restatements of prior period financial results. In December 2003, we restated 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. Following an independent review of the facts and circumstances leading to the First Restatement, or the Independent Review, we restated 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.
 
Please see the Independent Review Summary in the Controls and Procedures section of our 2003 Annual Report on Form 10-K for further information concerning these governing principles as they relate to three identified categories — people, processes and technology.
 
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. As a result, we effected a further restatement of our consolidated financial statements, or the Third Restatement, for the years ended December 31, 2004 and 2005, and for the fiscal quarters ended March 31, June 30 and September 30, 2006, in May 2006. For information relating to these prior restatements and control deficiencies that resulted in previously reported material weaknesses, please see the Controls and Procedures section of our 2003, 2004 and 2005 Annual Reports on Form 10-K.
 
During 2006, we continued to build on the remedial actions in 2004 and 2005 and implemented significant changes to our internal control over financial reporting and continued to develop and implement remedial measures to address unremedied material weaknesses, as well as to implement the recommendations for remedial measures in the Independent Review Summary. As at December 31, 2006, we concluded that these measures resulted in the elimination of the five material weaknesses, with the exception of the deficiencies that comprise the following revenue related material weakness as at December 31, 2006, which is further described in the Controls and Procedures section of this report:
 
  •  lack of sufficient cross-functional communication and coordination, including further definition of roles and responsibilities, with respect to the scope and timing of customer arrangements, insufficient segregation of duties in certain areas, delayed implementation of Nortel review processes and personnel for our business venture with LG Electronics, Inc., or LG-Nortel, and insufficient controls over certain end user computing applications, all of which impact upon the appropriate application of U.S. GAAP to revenue generating transactions.
 
In the course of the preparation of our 2006 annual financial statements, we identified certain errors primarily through discussions with our North American pension and post-retirement actuaries and through our ongoing remediation efforts with respect to our material weakness related to revenue recognition and our previously reported material weaknesses and other internal control deficiencies. As a result, we restated our consolidated balance sheet as of December 31, 2005 and consolidated statement of operations, changes in equity and comprehensive income (loss) and statement of cash flows for the years ended December 31, 2005 and 2004, as well as the quarters ended March 31, June 30 and September 30, 2006. The adjustments related to: (i) pension and post-retirement benefits errors, (ii) revenue recognition errors, (iii) a prior year tax error, and (iv) other errors.


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The following table summarizes the adjustments from the most recent restatement for the three months ended March 31, 2006:
 
                         
    Three Months Ended March 31, 2006  
          Cost of
    Net Earnings
 
    Revenues     Revenues     (Loss)  
 
As previously reported
  $ 2,382     $ 1,474     $ (167 )
Adjustments:
                       
Pension and post-retirement errors
          3       (8 )
Revenue recognition errors
    8       (15 )     19  
Other errors
          3       (15 )
                         
As restated
  $ 2,390     $ 1,465     $ (171 )
                         
 
 
We are under investigation by the United States Securities and Exchange Commission, or SEC, and the Ontario Securities Commission, or OSC, Enforcement Staff. In addition, we 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, a criminal investigation into our financial accounting situation by the Integrated Market Enforcement Team of the Royal Canadian Mounted Police is ongoing. Regulatory sanctions may potentially require us to agree to remedial undertakings that may involve our or an independent adviser to report on the review, assessment and monitoring of 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.
 
Results of Operations
 
 
The following table sets forth our revenue by geographic location of the customer:
 
                                 
    For the Three Months Ended March 31,  
    2007     2006     $ Change     % Change  
 
United States
  $ 1,216     $ 1,128     $ 88       8  
EMEA
    578       633       (55 )     (9 )
Canada
    173       162       11       7  
Asia
    382       305       77       25  
CALA
    134       162       (28 )     (17 )
                                 
Consolidated
  $ 2,483     $ 2,390     $ 93       4  
                                 
 
Revenues increased to $2,483 in the first quarter of 2007 from $2,390 in the first quarter of 2006, an increase of $93, or 4%. Revenues increased in Canada, the U.S. and Asia due to increased volumes and the recognition of previously deferred revenue. These revenue increases were partially offset by the UMTS Access divestiture in the fourth quarter of 2006, which resulted in decreased revenues in the first quarter of 2007, with the most significant impact in EMEA. The first quarter of 2007 revenues also benefited from favorable foreign currency exchange impacts, resulting in an estimated increase of approximately 1%, driven by the strengthening of the British Pound and Euro against the U.S. dollar.
 
Revenues in Canada and the U.S. increased by $99 in the first quarter of 2007 compared to the first quarter of 2006, driven primarily by increases in our CN and ES segments. CDMA solutions increased by $96 in the U.S. and $33 in Canada, partially offset by a decrease in GSM and UMTS solutions of $41 in the U.S. due to revenues associated with the completion of major projects in 2006 that were not repeated in the first quarter of 2007. CN circuit and packet voice solutions decreased by $27 in the U.S. and $8 in Canada as a result of a decline in demand for traditional Time Division Multiplexing, or TDM, based solutions and the completion of major projects in 2006 that were not repeated in the first quarter of 2007. The ES segment increased by $44 in the U.S., primarily due to market growth and the recognition of previously deferred revenue due to our ongoing completion or elimination of customer deliverable obligations for certain products in our enterprise data networking and security solutions business. The MEN segment increased by $29 in Canada and the U.S., primarily due to the recognition of previously deferred revenue as a result of the


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completion of certain customer contract deliverables resulting from the termination of a supplier agreement, partially offset by volume decreases and a declining market for maturing products.
 
Revenues increased by $77 in Asia in the first quarter of 2007 compared to the first quarter of 2006, driven primarily by increases in our CN and ES segments. GSM and UMTS solutions revenue in Asia increased by $35 as a result of increases in revenue for LG-Nortel, partially offset by certain other volume decreases. CDMA solutions increased by $14 and CN circuit and packet voice solutions increased by $16 due to increases in revenue for LG-Nortel. Enterprise circuit and packet solutions increased by $13 in Asia, driven primarily by LG-Nortel.
 
Revenues decreased by $55 in EMEA in the first quarter of 2007 compared to the first quarter of 2006, driven primarily by decreases in our CN and GS segments attributable to the UMTS Access divestiture. Enterprise circuit and packet solutions increased by $36 in EMEA and enterprise data networking and security solutions increased by $44 mainly due to market growth and the recognition of previously deferred revenue due to our ongoing completion or elimination of customer deliverable obligations for certain products. MEN optical networking solutions in EMEA increased by $53 and were positively impacted by the recognition of previously deferred revenue as a result of the completion of certain customer contract deliverables.
 
Revenues decreased by $28 in CALA in the first quarter of 2007 compared to the first quarter of 2006, driven primarily by decreases in our CN segment, partially offset by increases in our MEN and ES segments. GSM and UMTS solutions revenue in CALA decreased by $27 due to revenues associated with the completion of major projects in 2006 that were not repeated in the first quarter of 2007.
 
 
                                 
    For the Three Months Ended March 31,  
    2007     2006     $ Change     % Change  
 
Gross Profit
  $ 1,002     $ 925     $ 77       8  
Gross Margin
    40.4 %     38.7 %             1.7 pts  
                                 
 
Gross margin increased to 40.4% in the first quarter of 2007 compared to 38.7% in the first quarter of 2006, an increase of 1.7 percentage points. Historically, our gross margins have been lower in the Asia and EMEA regions than in the Canada and U.S. regions, primarily due to competitive pressures and product and customer mix. In the first quarter of 2007 we experienced a geographical mix change resulting in a greater proportion of our revenues from the North America and Asia regions while the EMEA region saw a decline as a result of the divestiture of our UMTS Access business. In the first quarter of 2007, improved product mix within the CN segment, primarily related to the divestiture of our UMTS Access business, resulted in an increase in gross margin of 2.4 percentage points, which was partially offset by the recognition of previously deferred revenue in our MEN portfolio that negatively impacted gross margins by approximately 0.7 percentage points.
 
 
                                 
    For the Three Months Ended March 31,  
    2007     2006     $ Change     % Change  
 
Operating Margin
  $ (11 )   $ (164 )   $ 153       93  
Operating Margin as a Percentage of Revenue
    −0.4 %     −6.9 %             6.5 pts  
                                 
 
Operating margin increased from a loss of $164 in the first quarter of 2006 to a loss of $11 in the first quarter of 2007, an increase of $153, or 93%. Operating margin as a percentage of revenue increased by 6.5 percentage points in the first quarter of 2007 compared to the first quarter of 2006. The increase in operating margin was primarily the result of decreases in both SG&A and R&D. Cost savings of approximately $70 resulted from the UMTS Access divestiture accompanied with costs savings as a result of decreases in employee related expenses and savings of $12 in relation to our internal control remediation plans. These cost savings were partially offset by increased costs due to unfavorable foreign exchange impacts resulting from the strengthening of the Euro and British pound against the U.S. dollar and increased costs in our employee bonus plans of $9.


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The following table sets forth special charges by restructuring plan:
 
                                 
    For the Three Months Ended March 31,  
    2007     2006     $ Change     % Change  
 
2007 Restructuring Plan
  $ 75     $     $ 75        
2006 Restructuring Plan
    5             5        
2004 Restructuring Plan
          3       (3 )     (100 )
2001 Restructuring Plan
          2       (2 )     (100 )
                                 
Total Special Charges
  $ 80     $ 5     $ 75       1,500  
                                 
 
 
In the first quarter of 2007, we outlined the next steps of our Business Transformation plan with the announcement of the 2007 Restructuring Plan. The plan includes a net reduction in our global workforce of approximately 2,900 employees plus a shift of approximately 1,000 positions from higher-cost to lower-cost locations. The 2007 Restructuring Plan also includes initiatives to more efficiently manage our various business locations and reduce our global real estate portfolio by approximately 500,000 square feet by the end of 2007. We expect to incur charges of approximately $390, with
approximately $300 related to the workforce reductions and approximately $90 related to the real estate actions. We recorded special charges of $75, $57 related to workforce reductions and $18 related to the real estate initiatives, in the first quarter of 2007. Cash expenditures are currently estimated to be approximately $370, of which $6 were incurred in the first quarter of 2007. Cash expenditures are expected to be incurred generally in the same timeframe as the charges are incurred. Upon completion, these actions are expected to deliver approximately $400 in annual savings, with approximately half of these annual savings expected to be realized in 2007.
 
 
During the second quarter of 2006, in an effort to increase competitiveness by improving operating margins and overall business performance, we announced the 2006 Restructuring Plan, which includes workforce reductions of approximately 1,900 employees, as well as the creation of approximately 800 new positions in our Operations Centers of Excellence. The workforce reductions span all of our segments and are expected to include approximately 350 middle management positions throughout Nortel, with the balance of workforce reductions to primarily occur in the U.S. and Canada. We estimate total charges to earnings and cash associated with the 2006 Restructuring Plan will be approximately $100, of which $73 in charges were incurred through the first quarter of 2007, with the remainder expected to be incurred in the remainder of 2007. Through the first quarter of 2007, we incurred total cash costs related to the 2006 Restructuring Plan of approximately $43 with the remaining cash costs expected to be incurred primarily in the remainder of 2007. Annual savings from these actions were targeted to be approximately $100 in 2007 and approximately $175 by 2008 and we continue to expect to meet these targeted savings.
 
 
In the third quarter of 2004, we announced a strategic plan involving focused workforce reductions of approximately 3,250 employees, real estate optimization and other cost containment actions, or the 2004 Restructuring Plan. 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, of which $365 have been incurred. Substantially all of the charges with respect to the workforce reductions have been incurred with the remainder of the charges related to ongoing lease costs for impacted real estate facilities to be substantially incurred by the end of 2018. We expect to incur total cash costs related to the 2004 Restructuring Plan of approximately $360, which are split approximately $230 for workforce reductions and $130 for real estate actions. Through the first quarter of 2007, we incurred total cash costs related to the 2004 Restructuring Plan of approximately $264, with the remaining cash costs expected to be substantially incurred by the end of 2018.
 
 
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. Substantially all of the charges with respect to the workforce reductions have been incurred, with the remainder of the charges related


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to ongoing lease costs for impacted real estate facilities to be substantially incurred, by the end of 2024. We incurred cash costs related to the 2001 Restructuring Plan of $10 in the first quarter of 2007. Remaining cash costs relating to the 2001 Restructuring Plan of approximately $185 are expected to be incurred into 2024 for ongoing lease costs related to impacted real estate facilities.
 
The following table sets forth special charges by segment for the three months ended March 31:
 
                                                                         
    2007
                         
    Restructuring
                         
    Plan     2006 Restructuring Plan     2004 Restructuring Plan     2001 Restructuring Plan     Total Special Charges  
    2007     2007     2006     2007     2006     2007     2006     2007     2006  
 
Special charges by segment:
                                                                       
Carrier Networks
  $ 45     $ 3     $     $       1     $     $ 2     $ 48     $ 3  
Enterprise Solutions
    11       1                   1                   12       1  
Metro Ethernet Networks
    15       1                   1                   16       1  
Global Services
    4                                           4        
Other
                                                     
                                                                         
Total special charges
  $ 75     $ 5     $     $       3     $     $ 2     $ 80     $ 5  
                                                                         
 
 
We did not have any material asset or business dispositions in the first quarter of 2007. In the first quarter of 2006, gain on sale of businesses and assets was $39, primarily due to a gain of $19 on the sale of certain assets and a gain of $18 on the sale of our Brampton facility.
 
 
Under the terms of the Global Class Action Settlement, we will pay $575 in cash and issue approximately 62,866,775 of our common shares, and we will contribute to the plaintiffs one-half of any recovery resulting from our ongoing litigation against certain former officers of Nortel.
 
As a result of the Global Class Action Settlement, we established a litigation settlement provision and recorded a charge to our full-year 2005 financial results of $2,474 (net of insurance proceeds of $229, which were placed in escrow in April 2006). Of this amount, $575 related to the cash portion, which we placed in escrow on June 1, 2006, along with $5 in accrued interest, and $1,899 related to the equity component. We have adjusted the equity component in each quarter since February 2006 to reflect the fair value of the equity component. The final adjustment to the fair value of the equity component occurred on March 20, 2007, the date the settlement became effective. As of March 20, 2007, the fair value of the equity component had decreased to $1,626, including a recovery of $54 for the first quarter of 2007. Additionally, as of March 20, 2007, the litigation settlement provision related to the equity component was reclassified to additional paid-in-capital within shareholders’ equity as the number of shares was fixed at such date. The restricted cash and corresponding litigation reserve related to the cash portion of the settlement are under the direction of the escrow agents and our obligation has been satisfied and as a result the balances have been released. Approximately 4% of the settlement shares have been issued, with the balance of settlement shares expected to be issued in the second half of 2007. For additional information, see “Significant Business Developments — Global Class Action Settlement”.
 
 
The components of other income — net were as follows:
 
                 
    For the Three Months Ended March 31,  
    2007     2006  
 
Interest and dividend income(a)
  $ 53     $ 29  
Loss on sale or write down of investments
          (1 )
Currency exchange gains(b)
          2  
Other — net
    23       26  
                 
Other income — net
  $ 76     $ 56  
                 
 
 
(a)  Interest and dividend income on our short-term investments.
(b)  Currency exchange gains and losses were primarily related to day-to-day transactional activities.


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In the first quarter of 2007, other income — net was $76, which included interest and dividend income on our short term investments of $53 and other net income of $23, which was primarily driven by $9 in royalties from patented technology, $6 from the sub-lease of certain facilities and $3 of mark-to-market gains on certain warrants and swaps not qualified for hedge accounting.
 
In the first quarter of 2006, other income — net was $56, which included interest and dividend income on our short-term investments of $29 and a net currency exchange gain of $2. Other net income of $26 was primarily driven by a gain of $26 related to the sale of a note receivable from Bookham, Inc.
 
 
Interest expense increased by $35 in the first quarter of 2007 compared to the first quarter of 2006. The increase was primarily due to higher debt levels, interest rates and borrowing costs on NNL’s debt as a result of the issuance by NNL of the $2,000 principal amount of high-yield notes in July 2006.
 
 
During the three months ended March 31, 2007, we recorded an income tax expense of $13 on pre-tax loss from operations of $68 before minority interests and equity in net earnings (loss) of associated companies. The income tax expense of $13 was primarily related to the reduction of our deferred tax assets, 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.
 
During the three months ended March 31, 2006, we recorded an income tax expense of $25 on a pre-tax loss from operations of $159 before minority interests and equity in net earnings (loss) of associated companies. We recorded a tax expense against the earnings of certain taxable entities, partially offset by the tax benefit of certain R&D related incentives and favorable audit settlements, and we recorded additional valuation allowances against the tax benefit of current period losses of other entities.
 
As of March 31, 2007, we have substantial loss carryforwards and valuation allowances in our significant tax jurisdictions (namely Canada, the U.S., the U.K., and France). 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
 
 
The following table sets forth revenues and Management EBT for the CN segment:
 
                                 
    For the Three Months Ended March 31,  
    2007     2006     $ Change     % Change  
 
Revenue
                               
CDMA solutions
  $ 568     $ 439     $ 129       29  
GSM and UMTS solutions
    271       436       (165 )     (38 )
Circuit and packet voice solutions
    170       196       (26 )     (13 )
                                 
Total Revenue
  $ 1,009     $ 1,071     $ (62 )     (6 )
                                 
Management EBT
  $ 136     $ 56     $ 80       143  
                                 
 
CN revenues decreased to $1,009 in the first quarter of 2007 from $1,071 in the first quarter of 2006, a decrease of $62 or 6%. The decrease in 2007 was driven primarily by the UMTS Access divestiture in the fourth quarter of 2006 and by declines in the demand for our traditional technologies such as GSM and TDM. These decreases were partially offset by volume increases in CDMA solutions.


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CDMA solutions revenues increased $96 and $33 in the U.S. and Canada, respectively, primarily as a result of increased investments by certain of our customers in their infrastructure in order to enhance their service offerings, higher revenues associated with the continuing rollout of our EV-DO Rev A technology, and the first quarter of 2006 negatively impacted by delays in spending by one of our major customers.
 
The decline in GSM and UMTS solutions was primarily due to declines in EMEA of $131, the U.S. of $41, and CALA of $27. The decline in EMEA is primarily due to a $109 decrease in UMTS solutions as a result of the UMTS Access divestiture in the fourth quarter of 2006. In the U.S. and CALA, revenues associated with the completion of major projects in 2006 were not repeated in the first quarter of 2007. The declines in EMEA, the U.S. and CALA were partially offset by an increase in Asia of $35, driven by increases in revenue for LG-Nortel, which were partially offset by other volume decreases.
 
The decrease in circuit and packet voice solutions was driven primarily by declines in revenues from traditional product solutions in the first quarter of 2007, partially offset by increase in revenue for LG-Nortel.
 
Management EBT for the CN segment increased to $136 in the first quarter of 2007 from $56 in the first quarter of 2006, an increase of $80 or 143%. The $80 increase was the result of an increase in gross profit of $13 and decreases in SG&A and R&D expenses of $7 and $79, respectively. These increases to Management EBT were partially offset by an increase in minority interest expense of $14.
 
CN gross profit increased by $13 due to increased sales volumes in CDMA solutions and gross margin increased by 4.1 percentage points as a result of product mix related to higher revenues related to CDMA solutions, and lower revenues related to UMTS Access solutions as a result of the UMTS Access divestiture in the fourth quarter of 2006 and other traditionally lower margin products. The decrease in SG&A of $7 was primarily due to decreased headcount costs as a result of the UMTS Access divestiture. R&D expense decreased by $79 primarily due to the UMTS Access divestiture, as well as headcount reductions, low-cost outsourcing and reduced investment in maturing technologies consistent with our cost reduction initiatives. These decreases were partially offset by focused increases in R&D related to opportunities we believe have the greatest potential for growth.
 
 
The following table sets forth revenues and Management EBT for the ES segment:
 
                                 
    For the Three Months Ended March 31,  
    2007     2006     $ Change     % Change  
 
Revenue
                               
Circuit and packet voice solutions
  $ 375     $ 327     $ 48       15  
Data networking and security solutions
    222       128       94       73  
                                 
Total Revenue
  $ 597     $ 455     $ 142       31  
                                 
Management EBT
  $ 2     $ (30 )   $ 32        
                                 
 
ES revenues increased to $597 in the first quarter of 2007 from $455 in the first quarter of 2006, an increase of $142 or 31%. The increase in 2007 was driven primarily by market growth, volume increases, and the recognition of previously deferred revenue as a result of the elimination of our previously established practice of providing PCS for certain products.
 
The enterprise market is in the process of transitioning from traditional communications systems to next-generation IP networks. The change in the product mix of our ES revenues in 2006 and 2007 is consistent with this trend. We continue to see growth in our packet-based voice solutions which support the next-generation technology, while seeing continued decline in our traditional circuit-based voice solutions.
 
Revenues from enterprise circuit and packet voice solutions increased by $36 in EMEA due to volume increases and $13 in Asia due to strong performance from LG-Nortel.
 
The increase in enterprise data networking and security solutions was primarily the result of increases of $44 in each of the U.S. and EMEA primarily due to volume increases and the recognition of previously deferred revenue as a result of the elimination of our previously established practice of providing PCS for certain products.
 
Management EBT for the ES segment increased to $2 in the first quarter of 2007 from a loss of $30 in first quarter of 2006, an increase of $32. This increase in Management EBT was primarily driven by an increase in gross profit of $65,


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partially offset by increases in SG&A and R&D expenses of $28 and $9, respectively. Gross margin remained essentially flat and gross profit increased by $65 primarily due to higher sales volumes and recognition of previously deferred revenue. The increase in SG&A expense of $28 was due to investments across all regions to drive growth and also due to unfavorable foreign exchange impacts. Increased investment in the development of our packet-based voice, data and security solutions portfolios resulted in an increase in R&D expense of $9.
 
 
The following table sets forth revenues and Management EBT for the Global Services segment:
 
                                 
    For the Three Months Ended March 31,  
    2007     2006     $ Change     % Change  
 
Revenue
  $ 448     $ 506     $ (58 )     (11 )
                                 
Management EBT
  $ 77     $ 93     $ (16 )     (17 )
                                 
 
GS revenues decreased to $448 in the first quarter of 2007 from $506 in the first quarter of 2006, a decrease of $58, or 11%. The decrease is primarily related to the UMTS Access divestiture in the fourth quarter of 2006.
 
The decrease in GS revenue was primarily due to the $76 decrease in network implementation services, primarily related to the UMTS Access divestiture, and lower sales volumes in the U.S. These decreases were partially offset by growth of $15 in network support services, primarily due to growth in EMEA in businesses other than UMTS of $7 and an increase of $8 in Asia due to increased volume. In the first quarter of 2007, the majority of GS revenue continued to be generated by network support services. Decreases in GS revenues in the U.S. and EMEA of $13 and $46, respectively, were partially offset by an increase in Asia of $3.
 
Management EBT in the GS segment decreased to $77 in the first quarter of 2007 from $93 in the first quarter of 2006, a decrease of $16. Gross margin increased by 4.0 percentage points while gross profit increased by $2 as the impact of gross margin increase more than offset lower sales volumes. The increase in gross margin was primarily attributable to a favorable services mix and favorable foreign exchange impacts. An increase in SG&A and R&D of $9 and $3, respectively, and an increase in minority interest expense from our joint ventures in EMEA and Asia of $5 primarily drove the decrease in Management EBT. The increases in SG&A and R&D resulted from investments in resources and capabilities in the areas within the GS segment we believe have the greatest potential for growth.
 
 
The following table sets forth revenues and Management EBT for the MEN segment:
 
                                 
    For the Three Months Ended March 31,  
    2007     2006     $ Change     % Change  
 
Revenue
                               
Optical Networking Solutions
  $ 263     $ 212     $ 51