Date of Release: 2005-08-25

Nortel Networks

Confirms Nortel Networks, Removes From Under Review - Negative, Trends Stable

Dominion Bond Rating Service (“DBRS”) has today confirmed Nortel Networks Corporation’s (“NNC”) and Nortel Networks Limited’s (“NNL”) (together, “Nortel” or the “Company”) long-term ratings at B and the preferred share ratings at Pfd-5 (low), all with Stable trends. This completes the “Under Review-Negative” that Nortel’s ratings were under since April 28, 2004.

At this time, DBRS believes the main credit issues pertain to the risks in realigning Nortel’s core businesses given current market conditions, as well as the overhang from pending regulatory investigations and outstanding lawsuits. While the Company’s accounting restatements, due to improper oversight, are concerning, the size of the numerical changes were within expectations. Going forward, DBRS believes the key issue for Nortel is its revenue growth, as it has remained near US$10 billion, and is down significantly from 2000. Current revenue is now at levels seen in the mid-1990s (albeit with similar gross margins). However, there are several important differences, including higher leverage.

DBRS notes one clear difference is Nortel’s dependence on sales to the wireless industry (US$4.8 billion), which made up almost 50% of 2004 sales, compared with only 17% in the mid-1990s. Even as wireless sales improved over the past few years, profitability has been pressured. In an effort to spur wireless growth, the Company has entered new markets, such as India where it discounted pricing to secure contracts. Another difference includes the large selling, general, and administrative (SG&A) costs and research and development (R&D) costs that were over 41% of sales last year, compared to only 33% in the mid-1990s. More recently, this ratio has started to decline and the Company plans to exit the year at approximately 35%. Most of the extra expense (about US$600 million) is going to R&D. In the past, Nortel’s extensive R&D programs have led to impressive new products that have provided the Company with a competitive advantage. At present, however, it remains to be seen whether these high R&D costs should be continued as Nortel faces numerous competitors, many with excellent products, that are backed up by excellent R&D facilities. Without significant new product breakthroughs, Nortel may be approaching a time when its competitive advantage will mostly pertain to sales and marketing, product reliability, price, ongoing service, and the ability to team with other vendors to complete projects.

DBRS believes that Nortel’s strategy regarding these issues still seems in flux, as the Company has been preoccupied with internal investigations. DBRS believes the industry is shifting its emphasis to competitive pricing, facilitated by declining cost bases (a major manufacturer based in China is pursuing this aggressively). In addition, there have been indications that some competitors are using their balance sheets for vendor financing, especially to emerging market customers, an area where Nortel has a limited appetite to compete. DBRS believes that going forward the Company’s new directors and senior management need to provide more clarity concerning future strategies. Otherwise, without meaningful growth, the Company’s SG&A and R&D costs will likely need to be reduced.

Regarding liquidity, DBRS acknowledges that Nortel has maintained reasonable levels over the past few years, with approximately US$3.1 billion in cash on hand as at June 30, 2005, and support from Export Development Canada (“EDC”). Also, the Company is near free cash flow break-even on a normalized basis. However, DBRS is concerned that significant cash could be required for settlements with regulators and others. Also, debt levels are high and cash may be used to settle the US$1.275 billion note that is coming due in February 2006. As a result, DBRS believes the Company should be planning to reopen access to the banks and capital markets this year. Otherwise, a large portion of the Company’s cash on hand would be needed to refinance its near-term maturing debt, as well as any cash settlements relating to contingencies, which could significantly deplete the Company’s current liquidity. A material reduction in liquidity could again place pressure on the Company’s ratings.

Notes:
n – This security is non-cumulative.
DBRS notes that its ratings on Nortel’s long-term debt reflect obligations that are currently secured. If the security agreements were to be removed, the collateral related to these long-term debt obligations would fall away, and the debt would then revert back to being unsecured. If this were to occur, DBRS does not expect Nortel’s long-term debt ratings to change, as long as all other debt outstanding at Nortel Networks Limited and Nortel Networks Corporation rank pari passu.

The full report providing additional analytical detail is available by clicking on the link below or by contacting us at info@dbrs.com.

Related Research

• Nortel Networks Corporation & Nortel Networks Limited