DBRS Confirms Nortel at B (low), Assigns Recovery Ratings and Changes Trend to Positive

DBRS has today confirmed its B (low) rating of the short- and long-term debt of Nortel Networks Corporation, Nortel Networks Limited and Nortel Networks Capital Corporation (collectively, Nortel or the Company). Additionally, consistent with its recently released Leveraged Finance methodology, DBRS has established an issuer rating for Nortel at B (low), which underpins the recovery rating process outlined in the methodology. The trend has been changed to Positive from Stable.

The Positive trend is supported by Nortel’s progress with its revitalization efforts and its improved business model. The foundation for growth at Nortel has been developed by a largely new management team over the past two-and-a-half years and, as DBRS has noted previously, the management team, under the direction of CEO Mike Zafirovski, has made significant progress in stabilizing the Company. DBRS now believes the Company has in place a foundation upon which management can begin to profitably grow its businesses.

Nortel has recently communicated its targets to achieve sufficient growth in its Enterprise and Metro Ethernet segments to replace declining wireless sales and achieve and sustain double-digit operating margins. DBRS notes that Nortel’s CDMA (Code Division Multiple Access) wireless business accounts for the bulk of profitability in the Company’s Carrier Networks segment. The market for CDMA equipment is anticipated to decline at a rate of approximately 4% annually for the foreseeable future, which could lead Nortel’s wireless segment operating margins to compress by up to ten percentage points over the next four years.

The decline in Nortel’s wireless business is expected to continue until its wireless customers begin to migrate their current CDMA and GSM (Global System for Mobile communications) networks to the fourth generation (4G) network technology LTE (Long Term Evolution), which DBRS believes will commence in 2012. In order to offset this decline in its main cash generating engine, Nortel has rebuilt the other segments in its portfolio and will rely on them to achieve its objectives of (1) double-digit operating margins, (2) strong cash generation, and (3) revenue growth greater than the market.

DBRS believes that Nortel is now well positioned to make material advances toward the broad corporate goals identified above, and has reflected that belief in the change in trend in the rating. However, DBRS also believes that the Company’s plan is very aggressive and may underestimate the broad business risks facing the communications-solutions industry and Nortel’s relative position within it. These are important drivers of the overall credit rating DBRS has established for the Company; therefore, significant evidence of the plan’s success is required before the rating can be materially improved. Such evidence would be observed in continued revenue growth in line with the industry, gross margins maintained above 40% and twelve-month trailing operating margins of at least 8%, at which threshold DBRS would consider upgrading the rating.

In terms of the Enterprise segment, Nortel intends to address what it describes as a convergence of IT and telecommunications, with a commitment to aggressively develop into a more relevant Enterprise solutions provider through its Unified Communications platform, which emphasizes software and applications solutions. DBRS notes that this emphasis, as the business scales, should result in expanded profit margins for the segment. Additionally, within the Metro Ethernet segment, Nortel has experienced initial success with its next generation 40G transport solution. Here the Company should also experience margin expansion over time, attributable to cost reduction achieved from its migration to a single platform OME 6500 product, used for metro, long haul and ultra-long haul optical applications. Nortel intends for the profitability improvement contributed by these two segments combined to more than offset the margin erosion to be experienced in the wireless business – a position DBRS has become inclined to believe.

DBRS’s recovery ratings and instrument ratings are based on three key factors set forth in the recently published DBRS Leveraged Finance Methodology (see press release dated June 9, 2008). The B (low) issuer rating on Nortel speaks to the probability of default for the Company. Following the establishment of the issuer rating, DBRS conducts a recovery analysis for each specific debt issue and formulates an opinion on the issues’ recovery prospects at the point of default. The instrument rating considers both the issuer rating and the recovery rating, taking into account the specific rank of each security outstanding.

DBRS’s B (low) issuer rating on Nortel is driven by the overall credit profile of the primary operating businesses of Nortel Networks Limited and its subsidiaries. DBRS notes that despite the significant business risks inherent in the telecommunications solutions industry, the business risk and financial risk profiles of Nortel are expected to improve in the short term, thereby prompting the trend change to Positive.

Some of Nortel’s debt carries a guarantee from its U.S. subsidiary Nortel Networks Inc. (NNI), which DBRS believes gives these notes superior recovery prospects versus the notes that do not carry such a guarantee. However, the notes that mature in 2023 and 2026 that do not carry a guarantee from the U.S. operating subsidiary NNI have default recovery prospects that are not sufficiently inferior to cause them to be rated differently. All of these notes have an expected recovery in default that DBRS considers average and consistent with a recovery rating of RR4 and an instrument rating of B (low).

The Nortel Networks Limited preferred shares are estimated to have zero recovery under the base case default/recovery scenario. As such, DBRS has assigned these securities a recovery rating of RR6 and an instrument rating of Pfd-5 (low), consistent with a long-term rating of CCC, which is two notches below the Nortel issuer rating of B (low).

Note:
All figures are in U.S. dollars unless otherwise noted.

DBRS will publish a full report shortly that will provide additional analytical detail on this rating action. If you are interested in receiving this report, contact us at info@dbrs.com.

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