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Corporate Profile

Who we are

A New Era of Networking

www.nortelnetworks.com

annual.report.98

65097.11/03-99www.nortelnetworks.com


www.nortelnetworks.com

annual.report.98

Nortel Networks is a global supplier of

communications networks and services for

data and telephony, bringing together a

broad range of complementary networking

technologies, skills, distributor channels,

and integrated networking capabilities.

Nortel Networks works with carrier and

enterprise customers worldwide to design,

build, and deliver Unified Network

solutions. Unified Networks create greater

value for customers worldwide through

integrated network solutions spanning

data and telephony. Unified Networks

blend routing, optical, wireline, wireless,

switching, and Internet Protocol tech-

nologies in a seamless manner to deliver

service predictability and security.

Customers include public and private

enterprises and institutions; Internet service

providers; local and long-distance, cellular,

and PCS communications companies; cable

television carriers; and public utilities.

Nortel Networks’ common shares are

listed on the New York, Toronto, Montréal,

Vancouver, and London stock exchanges.

Nortel Networks had 1998 revenues

of $17.6 billion and has approximately

75,000 employees in over 150 countries

and territories.

Annual.report.98

The Web is changing everything

1 Letter to Shareholders

5 Year in Review

9 Financial Section

10 Financial Review

30 Consolidated Financial Statements

36 Notes to Consolidated Financial Statements

68 Directors and Officers

Corporate Information

The Web is changing everything, including

our annual report.

Last year, we defined our webtone

vision of making the World Wide Web the

foundation for a dramatically different

kind of service to society. We set out to use

our experience and networking expertise

to build the Web into a reliable, secure,

commercial-grade system that could support

a wide array of business transactions.

We’re leading the way by using the Web

to maintain closer relationships with

customers, employees, suppliers, analysts,

and – starting with this year’s annual

report – our investors.

In the new era of Web-based communi-

cations, the traditional annual report is a

relic from the past. Therefore, as part of

evolving into a more Web-centric company,

we are providing a less elaborate report in

printed form and a Web-based interactive

version in the Investor Relations section

of our website.

The benefits include shareholder-ready

access to information about the com-

pany, as well as savings in design, paper,

production, and distribution costs.

The document in hand provides you with

detailed information about the company’s

financial performance in 1998, in line

with meeting our requirements to deliver

an annual report to shareholders.

For comprehensive information about our

business and integrated network solutions,

visit www.nortelnetworks.com.

All dollar amounts in this annual report are in U.S. dollars

unless otherwise stated.

Annual.report.98

Letter to Shareholders

2 NORTEL NETWORKS 1998 ANNUAL REPORT

The global communications industry hasexperienced more than two decades of rev-olutionary ferment. As we approach the endof the twentieth century, the pace of changehas never been more rapid nor the changesmore profound.

The marketplace is being dramaticallyreshaped by deregulation, technology, andmobility, compounded by the explosivegrowth of the Internet, as both a communi-cations medium and a business phenomenon.Powerful drivers of change are transformingnetwork economics, creating new customerrelationships, and generating massive invest-ment in network infrastructure, services,

and applications. These are the characteris-tics of a new era of networking that willdefine the global economy and society ofthe next century.

The new era of networking excites theimagination in many ways. Sometimes it’sthe little things that capture our attention,such as getting a better deal on a new carafter comparison shopping on the Web, oreffortlessly reaching the office through awireless laptop connection.

But the new era of networking is aboutbig things, too. It offers a panoramic vision of a networked society that allows our ideasand aspirations to soar around the globe and into cyberspace.

At the Heart of the Revolution

Telecommunications is the “killer app” driv-ing the Internet revolution. This is goodnews for a company like Nortel Networksthat understands both telecommunicationsand the Internet. It puts your company atthe heart of the revolution the comingtogether of public and private networks withthe Internet. High-performance optical

technology is powering the Internet revolu-tion that’s changing the way the world com-municates. Seventy-five percent of Internettraffic in North America is carried on NortelNetworks high-performance optical networks.

After just a few short years, the Internetis becoming part of everyday life. It elimi-nates the constraints of time and distanceand gives us global access to information,not only in online libraries, but in businessesand in people’s minds.

Together, the Internet and the WorldWide Web are having a major impact on thevolume and kinds of traffic carried on theworld’s networks. They’re helping to change

the way we think about networks and thevery nature of what networks do.

Until recently, “the network” referred tothe worldwide telecommunications infra-structure of local and long-distance networkswhose primary service was voice telephony.Not any more. Today, “the network” is anexpanding web of interconnected voice anddata networks, private and public networks,and wireline and wireless networks.

The traditional telecom and data net-working industries have changed fundamen-tally. The market is volatile and customersare uncertain about the demands end-users will put on their networks and howthose networks will evolve. The boundariesbetween enterprise and carrier networks andbetween wireless and wireline are blurring.

New and traditional customers are movinginto a world of networks designed for data.Increasingly, these data networks use theInternet Protocol (IP), the language of theInternet and the standard for the networksof the future. But the thousands of circuit-switched networks built for voice commu-nication worldwide during the past century

will be with us for many years to come. Customers today require networks capa-

ble of handling both voice and data traffic,unifying circuit and packet systems.Leading-edge networks blend switching,routing, IP networking, fiber optics, wireless,and other technologies. These are the funda-mental building blocks for networks capableof carrying huge volumes of Internet trafficefficiently, quickly, and most important ascommerce moves onto the Web reliably.

Nortel Networks brings to the market a unique ability to integrate and combinedisparate technologies in reliable, secureUnified Networks that span data and tele-phony. With our competence and strength inall major networking technologies, we canreach into our portfolio of technologies andservices and put together solutions that meetdiverse needs. We are one of the few com-panies capable of guiding customers to thefuture, no matter how their networks evolve.

Our mission is to deliver greater value tocustomers worldwide through integratednetwork solutions. We’re bringing togetherand unifying many diverse networks andbuilding a more reliable Internet to enablenew ways for people to share ideas, do business, and improve the quality of life forthemselves and their communities.

Our Financial Performance

Our strong position was gained during ayear of dramatic change in the industry andthe global economy, as well as in NortelNetworks, which experienced more funda-mental change in 1998 than at any othertime in its history. But your companyentered 1999 in better shape than ever, lay-ing new foundations for growth by workingwith customers and partners to create a newera of networking.

By any measure, 1998 was a year of ac-complishment for your company. Thanks tothe support of our customers and investors,and the commitment of 75,000 employeesaround the world, Nortel Networks set newrecords for financial performance:

Annual.report.98

Letter to Shareholders

Nortel Networks is at the heart of the Internet

revolution and the opportunities it offers for creating a

new era of networking.


• Revenues rose 14 percent to an all-timehigh of $17.6 billion.

• Net earnings applicable to commonshares of $1.07 billion (before acquisition-related costs, one-time gains, and charges),or $1.86 per share, were up 32 percent and21 percent, respectively, over 1997.

• Record order input of $18.5 billion fromongoing operations represented an increaseof 16 percent over 1997.

Nortel Networks is a well-balanced com-pany, supported by a broad customer baseand the broadest portfolio of technologiesand network solutions in the industry.Revenues from carrier customers grew 14 percent globally, with a dramatic increasein sales of our broadband network offerings.Enterprise revenues were up 26 percentover 1997, reflecting the comprehensive datanetworking portfolio we can offer sinceacquiring Bay Networks.

Nortel Networks is well-balanced geo-graphically, and revenues from NorthAmerica, Europe, Asia Pacific, and CALA(Caribbean and Latin America) all showedstrong growth during the year. As the Yearin Review following this letter highlights,we had major wins in markets around theworld and in all market segments.

Expenses relating to sales, marketing,and general administration were $3.09 bil-lion, or 17.6 percent of revenues, reflectingour investments to support global market-ing programs and streamline our businessprocesses. We continue to focus on mak-ing every dollar of expense go further inresearch and development (R&D) andother activities. R&D expenses increased to$2.45 billion, or 14 percent of revenues,from $2.15 billion, or 13.9 percent of rev-enues, in 1997, a level consistent withplanned and ongoing investments across allbusiness units.

Our strong financial performance in1998 demonstrated the effectiveness of ourstrategy of increasing value for our share-holders by building on our core strengthsand by working hard to increase the satis-

faction and loyalty of our customers.Customer satisfaction and loyalty ratingsboth increased two percentage points over1997. With our solid fourth quarter andrecord order input for the year, we began1999 with strong momentum and confi-dence in the future.

A More Powerful Company

Our customers are seeing a more powerfulcompany building even greater strength bybringing together new technologies, skills,

channels to the market, and integrated networking capabilities designed to meettheir needs.

This demonstrates the major progress inbuilding Nortel Networks into an IP data-networking powerhouse ready to capitalizeon new market opportunities and satisfychanging customer demands. During 1998,we brought together the portfolio of tech-nologies, products, and solutions to establishNortel Networks as a new class of company,and equipped our people to build next-generation wireless and wireline networks.

To help expand the portfolio andstrengthen our position, we invested in a hostof companies developing innovative tech-nologies in high-growth market segmentsand sold minority investments in othersthat no longer served our strategic needs.With internally generated innovations, ourlarge portfolio of patents is growing at a rateof three patent filings per day.

We made selective acquisitions to bringnew technology, skills, and capabilities into the company. With the purchase of Broadband Networks Inc., we could offerinnovative technology for high-quality wire-less voice, video, data, and Internet services.The purchase of Aptis Communications, Inc.

brought us expertise in next-generationremote-access data networking and virtualprivate networks. With Cambrian SystemsCorporation, we added metropolitan areasto our world-leading position in optical networking.

The acquisition of Bay Networks, com-pleted smoothly and in record time,brought us leading-edge customers andenterprise sales channel partners, a strongportfolio, and 7,000 talented people skilledin routing and IP technologies. By the end

of the year, we were recognized by NetworkWorld magazine as one of the five most powerful companies in the global network-ing industry.

We made organizational changes to con-centrate our efforts on new opportunities inboth the carrier and enterprise segments.We merged Bay Networks with our enter-prise data networks unit and consolidatedour packet technologies, products, andskills within a new and formidable businesscapable of offering carriers an impressivearray of Unified Network solutions.

We continued retooling the Corporationfor greater speed and responsiveness. Wecompleted the reengineering of the R&Dorganization to bring customers and design-ers closer together, initiated the consoli-dation of manufacturing, and eliminatedbusiness practices no longer appropriate forour future.

During the coming year, we’ll continueleveraging our unique breadth of people,skills, and technologies to generate new revenues, gain market share, and delivergreater value to our customers and share-holders. We’ll continue building the portfo-lio, streamlining our procedures, and movingmore of our business processes to the Web.

NORTEL NETWORKS 1998 ANNUAL REPORT 3

Nortel Networks brings to the market a unique ability to

integrate and combine disparate technologies in reliable,

secure Unified Networks that span data and telephony.

The Network is our Business

As this annual report demonstrates, we’reincreasingly using the Web to communicatewith our employees, partners, suppliers, andinvestors, as well as build closer relation-ships with our customers. We’re leading theway in leveraging networking technologyfor critical business applications. Our inter-nal network is much more than a collectionof technologies linking people at corpo-rate sites worldwide. At Nortel Networks, as at other companies today, the network isour business.

That’s why we’re building a Web reliableenough to handle our business 24 hours a day. We operate one of the largest corpo-rate networks in the world, managing voice, data, and video traffic between employees,management teams, R&D labs, manufac-turing operations, and many customers,suppliers, and partners. The network is aliving lab that gives us tremendous insightsinto the architecture, the components, and the expertise required to build next-generation networks with the capacity, reli-ability, and quality of service that can makebusinesses more competitive and meetfuture growth needs.

Nortel Networks is already a leader inimplementing “network commerce,” a termencompassing all forms of e-commerce/telephony commerce, including electronicdata interchange (EDI), electronic fundstransfer, and various forms of telephonycommerce, such as 1-800 services, call cen-ters, and interactive voice response systems.

Our ServiceWeb customer service andsupport tool lets customers receive productinformation, download software patches,and resolve issues via the Internet. With1,700 users and 130 user sessions a day atthe end of 1998, volume is expected toreach 10,000 users and 1,000 sessions a dayby 2000.

Our network has already had a majorimpact on the way we do business, movingus closer to customers and making us more

effective, efficient, and flexible in respond-ing to market needs. Doing more businesselectronically will have a positive impact onrevenues, profitability, and value for ourcustomers and shareholders.

Capitalizing on Change

Your company has always succeeded by taking a leadership position, embracing discontinuities and capitalizing on changeto fuel new growth and improve competi-tiveness. Nortel Networks rose to the chal-lenges of leadership with digital, wireless,and fiber-optic systems. Now we are leadingthe way by providing enterprises and serviceproviders with high-value, Unified Networksolutions spanning data and telephony,wireless and wireline, and circuit-switchedand packet technologies.

As we take up the challenge of creating anew era of networking, we’re continuingour efforts to help our customers succeed ina highly competitive world. We’re providingintegrated network solutions to a diverseand growing base of customers in morethan 150 countries and territories, buildingsome of the fastest, most reliable, and cost-effective networks in the world today.

We’re laying the foundation for newgrowth, guided by the vision of makingNortel Networks the most valued companyin the industry. We will be valued by ouremployees by continuing to provide a greatplace to work, with multiple career pathsand challenging opportunities. We will bevalued by the communities where our peoplelive and work by continuing our tradition of community support, with an emphasison expanding educational opportunities inevery region where we operate.

Nortel Networks will be valued by cus-tomers by providing the network solutions,applications, services, and skills that helpthem make the transition to the new era ofnetworking. And that will help us continuegenerating the strong returns that buildlong-term value for our shareholders.

As we come to the end of the century,we’re pursuing several of the biggest growthopportunities in the history of our industryand our company. We’re determined to seizethese opportunities. In the process, we’llplay a role in reshaping economic life andhow the world shares ideas, overcoming oldbarriers and boundaries that have limitedthe possibilities for interaction, coopera-tion, and growth. In these efforts, thanks tothe support of our customers, employees,and shareholders, we’re strongly positionedfor success.

We also wish to thank Paul Oreffice forthe contributions he made during his yearsof distinguished service as a director of the Corporation. Mr. Oreffice retired as a director on April 23, 1998. At the sametime, we welcome to the board of directorsSir Antony Pilkington, retired chairman,Pilkington plc; Richard J. Currie, presidentof George Weston Limited; and David L.House, who joined the board as president of Northern Telecom Limited in August,following the acquisition of Bay Networks,where he was chairman, president, and chiefexecutive officer.

Donald J. SchuenkeChairman of the Board

John A. RothVice-Chairman and Chief Executive Officer

February 25, 1999


Donald J. Schuenke

John A. Roth

Annual.report.98

Year in Review


Acquisitions

■■ Bay Networks, Inc., a California-based leader in the world-wide data networking market. Northern Telecom acquired BayNetworks, which more than doubled the number of registered andbeneficial shareholders of Nortel Networks stock, and announcedthe new corporate brand name of the merged business NortelNetworks. This new brand communicates and reinforces our lead-ership in providing high-value, unified network solutions to adiverse and growing base of telephony and data customers world-wide. Nortel Networks’ $6.9 billion acquisition of Bay Networksexpanded significantly its base of high-speed packet and IP-optimized network solutions. As a result of the acquisition, Nortel Networks became the largest company in Canada and BCE Inc. reduced its ownership to approximately 41 percent. ■■ AptisCommunications, Inc., a Massachusetts-based, data network-ing start-up company, with leadership in the remote-access area.■■ Broadband Networks Inc., a Manitoba-based start-up com-pany and a leader in the design and manufacture of fixed broad-band wireless communications networks. ■■ Cambrian SystemsCorporation, an Ontario-based developer of an innovative tech-nology to speed the flow of network traffic between metropolitanareas and optical Internet backbone networks. ■■ Minorityinterests in companies such as Avici Systems, Inc. and interWAVECommunications International Ltd.

Achievements

■■ Internet Backbones: 75 percent of backbone Internet trafficin North America is carried on optical equipment supplied by Nortel Networks, which also supplies six out of seven pan-EuropeanInternet backbones. ■■ Qwest, United States: Augmenting its1997 purchase of Nortel Networks advanced fiber-optic transmissionequipment for its 16,000-mile coast-to-coast telecommunicationsnetwork, Qwest Communications International, Inc., a multimediacommunications company, has chosen Nortel Networks backboneswitching hubs Nortel Networks DMS-250 SuperNode tandemswitching systems and ServiceBuilder Intelligent Network (IN)service creation platform to address its expanding networkneeds. ■■ Level 3 Communications, Inc., United States: Tocomplete Level 3 Communications’ global end-to-end network bythe year 2001, using IP-based technology, Nortel Networks andCorning Incorporated worked together on delivering the best fiber solution, using Siecor’s cable design and Corning’s fiber.■■ Colombia: In April 1998, Nortel Networks announced that more than 80 percent of Colombia’s 1.2 million cellular sub-scribers were being served by Nortel Networks wireless solutions.■■ Cellcom Israel: Nortel Networks helped Cellcom Israel buildthe world’s first all-digital TDMA wireless network to reach onemillion subscribers. ■■ Bouygues Telecom, France: Superiorquality of service is available to subscribers in the Paris, Bordeaux,Aquitaine Poitou, and Southwestern regions, as Bouygues Telecomcontinues to use Nortel Networks’ radio equipment and installa-tion services to expand its GSM 1800 digital wireless network.■■ JazzTel, Spain: Jazz Telecom S.A., Spain’s first competitivelocal exchange carrier, is building a new national network withSpain’s SAINCO and Nortel Networks. The new network will offerbusiness customers a broader range of advanced, high-quality, cost-

effective services, including access to the Internet. ■■ IomegaCorporation, United States: To save time and increase produc-tivity, the manufacturer of the award-winning Zip and Jaz drivesand disks has implemented Nortel Networks Symposium CallCenter Server, a leading-edge software solution utilizing MicrosoftWindows NT. Hewlett-Packard and Bell Canada are amongother customers who have installed the system. ■■ Reuters,London: The world’s leading financial and news informationorganization wanted to build a network with new architecture andnetwork infrastructure capable of scaling well beyond anythingpredictable today. Reuters chose a next generation high-performanceWAN backbone based on a Nortel Networks Passport infrastruc-ture. Nortel Networks’ architecture will carry all Reuters’ legacyproducts on one network, together with its IP and frame relaytraffic, as well as saving money by using asynchronous transfermode (ATM) backbones. Nortel Networks dominates the infor-mation provider market, which includes Reuters, Telerate,Bloombergs, and Bridge Information Systems. ■■ Primus,Australia: Primus Telecommunications, one of Australia’s leadingcarriers, selected Nortel Networks to provide a turnkey solution forits new Internet service, internetPrimus, which will cover all thecapital cities in Australia and an additional twenty-seven majorregional centers. ■■ Cable & Wireless Communications,London: Corporate and business customers will have increasedspeed, capacity, and reliability in voice and data services throughCable & Wireless Communications’ $650 million network upgradeand expansion, which will be created through a three-year workingrelationship with Nortel Networks and will produce substantialoperating efficiencies for Cable & Wireless Communications.■■ Federa, The Netherlands: A new GSM 1800 radio networkis now available in The Netherlands, as Nortel Networks suppliedseveral hundred cell sites for the network to Federa, the new Dutchtelecom operator owned by France Télécom Mobiles International,ABN Amro Bank, and Rabobank. ■■ Hebei PTA, The People’sRepublic of China: By mid-year 1999, a major expansion of theprovince’s GSM digital cellular network will create the capacity for651,000 new subscribers. The Hebei Post and TelecommunicationsAdministration’s Phase Five expansion project represents the largestcontract for a single project that Nortel Networks has ever signedin China. ■■ State Postal Bureau, The People’s Republicof China: China’s State Postal Bureau is constructing computernetworks to connect central offices and branches in ministries,provinces, and post areas. Nortel Networks will supply all of the routing equipment, which includes 237 different router products, for the integrated service network router backbone.■■ SUNDAY, Hong Kong SAR: Hong Kong’s new generationGSM operator awarded Nortel Networks a series of projects tostrengthen and expand its mobile phone network, which will enableSUNDAY to become one of the most comprehensive networks in Hong Kong. ■■ Telstra, Australia: Australia’s principal tele-communications company and largest mobile telecommunicationscompany has selected Nortel Networks to build a national turn-key cdmaOne (IS-95 CDMA) mobile telephone network withservice beginning in the third quarter of 1999. ■■ Net2000Communications, United States: To support Net2000’s goal tobe the leading super-regional integrated communications provider,Nortel Networks will provide the foundation for this emergingcompetitive local exchange carrier’s state-of-the-art voice and data

Annual.report.98

Year in Review


network serving the eastern United States. ■■ Liz ClaiborneInc., United States: One of the largest manufacturers of women’sapparel and accessories in the United States will help maximize itscompetitive position with a Nortel Networks high-speed network that features a multi-service ATM and Ethernet-switched backbone.■■ City of Philadelphia, United States: Philadelphia deployedNortel Networks Accelar 1200 routing switches in two new five-story city administration buildings to provide high-speed, Layer 3IP-forwarding for citywide applications. ■■ BT, its Europeanpartners Albacom (Italy), BT Belgium, Cegetel (France),Sunrise (Switzerland), Telfort (The Netherlands), and ViagInterkom (Germany) and Nortel Networks are building a newpan-European network to meet the explosive growth in theInternet and demand for bandwidth-hungry, high-speed data ser-vices. ■■ Formus Communications, United States: This global competitive carrier will provide data and Internet services to busi-nesses in selected markets around the world with Nortel NetworksUnified Network solutions for high-speed, broadband wirelessservices. The deal is expected to be worth as much as $500 millionand will include Nortel Networks Reunion broadband wirelessaccess equipment, Passport ATM switching, and system integra-tion services. ■■ MetroNet Communications Corp., Canada:Business customers of Canada’s first and largest facilities-basednational competitive provider of local telecommunications ser-vices will have access to one of the most advanced networks inCanada, through access, high-capacity and local transport opticalequipment, and switching systems from Nortel Networks. ■■AT&T, United States: To support its thrust into local telephony, AT&T has selected the Cornerstone cable telephony communi-cations system from ANTEC and Arris Interactive, a NortelNetworks/ANTEC joint venture, to serve up to two million homes.The initial order for Cornerstone product represents the first stepin an agreement that could result in sales of up to $900 million.More cable operators have deployed Cornerstone than any othercable telephony product worldwide, including Cox, TCI,Cablevision Lightpath, Time Warner, Titus Communications(Japan), VTR Telefonica (Chile), Jupiter Telecommunications(Japan), and Priority Telecom (Austria). ■■ Telgua, Guatemala:Several key regions in Guatemala will benefit from more readilyavailable voice, data, and enhanced calling services. GuatemalaCity was the first to have Nortel Networks’ infrastructure installedfor a 150,000-subscriber expansion of the Telecomunicaciones deGuatemala network. This agreement with Telgua for a CDMA-based network makes Nortel Networks the only supplier to have allmajor wireless technologies (AMPS, GSM, TDMA, and CDMA)in implementation in Latin America. ■■ Cybercare Inc.,United States: Cybercare selected Nortel Networks to provide acomplete home health/remote health system known as CybercareElectronic House Call system, which incorporates technologydeveloped by Medical College of Georgia and Georgia Institute ofTechnology. Health care providers will be able to see and talk withpatients in their homes and assess key health indicators such as heart rate, blood pressure, blood-oxygen and blood-sugar levels, thanks to this system which enhances the accessibility and delivery of medical care at a lower overall cost. ■■ IXCCommunications, Inc., United States: This provider of inte-grated network solutions is using Nortel Networks optical net-working equipment for a coast-to-coast network linking San

Francisco, Los Angeles, Fort Worth, Texas, and New York and asoutheastern route connecting New York, Washington, D.C.,Atlanta, and Houston, Texas. Using 10 Gbps product and Multi-wavelength Optical Repeater (MOR) Systems, these networks willenable the transmission of up to 80 Gbps of multimedia, data, and voice traffic. ■■ Focal Communications Corporation,United States: This competitive local exchange carrier has selected DMS-500 local and long-distance switching systems and full-service AccessNode Express platforms to extend its exist-ing facilities-based telecommunications services into a nation-wide presence. ■■ Kaiser Permanente, United States: The largestnot-for-profit health maintenance organization (HMO) in theUnited States is implementing a nationwide high-performancedata network with more than 350 Nortel Networks Passport 6400enterprise network switches, which will enable it to enhance andincrease support to almost nine million health care customers and medical centers, data centers, and satellite offices. ■■ SBCCommunications Inc., United States: SBC Communications has selected Nortel Networks industry-leading network products DMS-100 digital switching equipment, hardware and softwareupgrades, and product conversion services for the company’sseven-state region, in a five-year contract expected to exceed $1.5 billion. ■■ Electric Lightwave, United States: ElectricLightwave, one of this nation’s leading integrated communicationsproviders, will deploy a high-capacity optical networking solutionin a 3,000-mile western SONET ring. As part of a five-year agreement, the network will carry traffic over a high-capacity net-work scalable up to 320 Gbps, using Nortel Networks’ 10 Gbps four-fiber ring architecture with Dense-Wavelength DivisionMultiplexing (D-WDM). ■■ Omnipoint Communications,United States: Omnipoint has selected Nortel Networks to buildGSM 1900 digital networks in Indianapolis, Detroit, and severalother basic trading areas (BTAs) under terms of a three-year supply agreement. ■■ Bell Atlantic, United States: BellAtlantic is modernizing its advanced telecommunications networkto better meet customer needs for new products and advancedservices, through DMS SuperNode processor upgrades, DMSEnhanced Networks, and Primary Rate ISDN hardware and software. ■■ United States Cellular, United States: Needingto rapidly address competitive challenges with new digital wirelessservice in Milwaukee and other markets in Wisconsin and Illinois,United States Cellular selected Nortel Networks to build newCDMA and TDMA digital wireless networks under a con-tract potentially worth more than $400 million over four years.■■ Société Européenne des Satellites, Luxembourg: SES has signed a contract with Nortel Networks for the provision of a turnkey interactive satellite system, which will consist of the Ground Network as well as Satellite Interactive Terminals to provide interactive broadband and bandwidth-on-demand multimedia services on upcoming ASTRA satellites. ■■ TurkTelekom, Turkey: Turk Telekom is using Nortel Networks’Proximity I fixed wireless access solution to provide domestic tele-phone service with wireline-equivalent digital voice, fax, high-speed data, Internet access, and other services for residential and small business customers. ■■ Copesa ComunicacionesPersonales S.A., Paraguay: Copesa selected Nortel Networks tosupply a complete GSM 1900 digital PCS network, includingswitching, radio base stations, and services for a nationwide


network expected to serve up to 100,000 subscribers. ■■ BellCanada: Bell Canada is using the 1-Meg Modem in Canada’slargest deployment of high-speed data access services. NortelNetworks’ revolutionary plug-and-play 1-Meg Modem was declared“the easiest, least expensive, and most practical” high-speedmodem to use in the industry by Computer Reseller News. Test engineers for Computer Reseller News noted the 1-MegModem solution “is the only one that can be rolled out to servicemore than 70 million subscribers today.” Just eight months afterlaunching the 1-Meg Modem, Nortel Networks had received morethan $1 billion in orders from public institutions, Internet ServiceProviders, and service providers throughout the United States.Major contracts include Transwire Communications Inc. of New York, MegsINet of Chicago, and AGIS Communicationsof Detroit. ■■ Global One: Global One, the worldwide jointventure of Deutsche Telekom, France Télécom, and Sprint, ispreparing to provide its customers with an advanced array of integrated telecommunications services spanning the globe. Athree-year supply and resale agreement covers the purchase of Nortel Networks Multimedia Carrier Switch (MMCS), DMS-Global Services Platform (DMS-GSP) switching systems,and NetWORKS network supervision systems, as well as the purchase and resale of Nortel Networks Passport and the resale of Nortel Networks Vector multimedia ATM switching systems.■■ GST Telecom, Inc., United States: GST and NortelNetworks are jointly building a “converged network,” integratingdata, voice, and video on a single network using a combination of packet, frame, and cell technologies. GST will deploy the nextgeneration Virtual Integrated Transport and Access (VITA) net-work using Nortel Networks Passport and Concorde ATM switches complementing its existing network of Nortel Networks voice, access, and optical network equipment. ■■ TelemigCelular S.A., Brazil: Telemig has selected Nortel Networks toexpand its statewide cellular network over the next three yearsthrough the manufacture, deployment, and integration of NortelNetworks DualMode Radios, DMS-MTX SuperNode digitalswitching systems, and other equipment and services. In additionto the Telemig project, Nortel Networks is deploying TDMA IS-136 digital wireless networks for operators in the city of Sao Paulo, in the capital city of Brasilia, and in the western and northeastern regions of Brazil. ■■ Walgreen Company,United States: The ten-millionth Norstar telephone system wassold to this national drugstore chain. Norstar IntegratedCommunications System is a leader in the global key system mar-ket. The Norstar system has received the Editor’s Choice Awardfrom CTI Magazine and Teleconnect. ■■ Université Laval,Canada: When a greater demand for bandwidth, resulting from anincreased number of users and increasingly demanding engineer-ing applications, made necessary an upgrade to the networkinginfrastructure of its new sciences and engineering faculty building,Université Laval selected Nortel Networks Accelar 1200 routingswitches and Gigabit Ethernet technology to deliver high-speedswitching and routing. ■■ Rite Aid, United States: Rite Aid,one of this nation’s largest drug store chains, wanted a highly scalable, resilient network to serve customers quickly and effi-ciently and is installing equipment such as Nortel NetworksAccelar routing switches for Gigabit Ethernet switching and Layer 3 connectivity into the company’s state-of-the-art distri-bution centers. ■■ Nielsen Media Research, United States:

Nortel Networks is supplying this leader in television ratings and audience estimates with reliable, high-performance Accelar1200 routing switches to improve the performance of its existingmission-critical network infrastructure and provide GigabitEthernet connectivity to link customers to the company’s analyti-cal databases and products. ■■ AirTouch Communications,United States: To lower costs, meet future demands of wirelesscustomers, and achieve a better balance among its mix of infra-structure suppliers, the world’s largest cellular phone service providersigned a letter of intent with Nortel Networks for the multi-yearpurchase of state-of-the-art network switches, base stations, and con-trollers. AirTouch will purchase analog and cdmaOne (IS-95 CDMA)digital network infrastructure in a contract which could reach $500 million. ■■ U S West, United States: U S West is enhancingits advanced payphone system by installing more than 5,000 NortelNetworks Millennium MultiPay MultiApplication payphones,capable of evolving with the dynamic needs of the public accessand electronic commerce marketplace. ■■ MCI WorldCom,United States: At the second annual InfoVision Exhibit onOctober 5, 1998, MCI WorldCom received a product recognitionaward for the deployment of the world’s first 80 Gbps route usingNortel Networks’ industry-leading S/DMS TransportNode OC-192(10 Gbps) system with Dense-Wavelength Division Multiplexing.In December of 1997, MCI WorldCom turned up live customertraffic on the 80 Gbps network span extending 170 miles from LosAngeles to Rialto, California. MCI WorldCom is also deploying aninterexchange carrier market beta trial of Nortel Networks DMS-Spectrum Peripheral Module. The DMS-SPM is a new peripheralservices platform for public network service providers deliveringhigh-speed, direct optical network connectivity. ■■ Sprint PCS,United States: In early 1999, Nortel Networks cdmaOne equip-ment will provide Sprint PCS service across the southern and midwestern United States as a result of an intensive, thirty-monthrollout involving more than 4,700 base stations and an infrastructureinvestment of $1.3 billion. ■■ Defense Advanced ResearchProjects Agency (DARPA), United States: In an effort to jumpstartthe development and deployment of the high-speed, high-band-width networks needed to maintain United States competitivenessin the global markets of the 21st century, DARPA has collectivelyawarded Nortel Networks; GST Telecommunications, Inc.; Sprintand Lawrence Livermore National Laboratory a $10 million, three-year contract to build the West Coast leg of its Next GenerationInternet (NGI) research network, an ultra high-speed, high-band-width network linking Seattle to San Diego with major nodes inthe Portland, San Francisco, and Los Angeles areas. ■■ AbileneNetwork, United States: Set to launch formally in February 1999,Abilene is a high-speed data network managed by the UniversityCorporation for Advanced Internet Development linking sixty uni-versities together for the development of new applications and otherexperiments. Its aim is to improve quality and performance whiledeveloping pioneering new uses for the global computer network.Nortel Networks has donated leading-edge optical networkingequipment to assist Qwest in the deployment of a 10,000-mile fiber-optic backbone linking all members of the Abilene consortium.Nortel Networks’ market-leading optical networking systems willinitially send data at the speed of 2.5 Gbps on the Abilene network,before rising to full capacity of 10 Gbps. The network being pro-vided to Abilene by Qwest, Nortel Networks, and Cisco SystemsInc. will represent an investment worth $500 million.

Annual.report.98

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The following provides additional analysis as to Nortel Networks’ operations and current financial situation. Thiscommentary is supplementary to and should be read in conjunction with the Consolidated Financial Statementswhich begin on page 30. Unless the context indicates otherwise, Northern Telecom Limited (the Corporation) andits subsidiaries are collectively referred to as Nortel Networks.

Overview

On August 31, 1998, the Corporation acquired Bay Networks, Inc. (Bay Networks), a Delaware corporation and aleading provider of data networking products and services (the Bay Networks Merger). The aggregate purchase pricewas approximately $6.9 billion, which was based on the closing market price of the Corporation’s common shares onthe closing day of the acquisition, the value of the assumed Bay Networks stock options, and merger-related costs. Forthe purpose of United States generally accepted accounting principles (GAAP), the aggregate purchase price wasapproximately $9.0 billion. The Bay Networks Merger added to Nortel Networks’ expertise and product portfolios indata and Internet Protocol (IP), increased Nortel Networks’ intellectual capital, provided new distribution channels tomarket, and broadened Nortel Networks’ customer base.

The rapid change of communications systems technology, based on current and future customer needs, is drivingthe convergence of data, telephony and video, and wireless and wireline technologies. The communications networks ofthe future are expected to combine packet and circuit technologies in a unified manner, allowing the smooth operationof applications using the best technology for each kind of traffic. These future networks are expected to create oppor-tunities for businesses to benefit from electronic commerce and the digital economy being created by the Internet,making it possible for the electronic business world to have high-performance networks using diverse IP and telephonytechnologies. Nortel Networks’ ability to develop products and services to meet these new market opportunities andcustomer needs is critical to its future success.

Acquisitions and dispositions

In pursuing its vision of Unified Networks (integrated networks blending routing, optical, wireless, wireline, switch-ing, and IP technologies in a seamless manner) and in strengthening its core business, Nortel Networks has completedthe following acquisitions and dispositions during the three years ended December 31:

December 22, 1998 Acquisition of all the remaining common and preferred shares of Nortel TechnologyLimited (formerly Bell-Northern Research Ltd.) from Bell Canada, increasing its owner-ship to 100 percent.

December 15, 1998 Acquisition of Cambrian Systems Corporation (Cambrian), a producer of metropolitan optical networking technology.

September 25, 1998 Sale of Advanced Power Systems business to Astec (BSR) plc (the Advanced Power Transaction).

August 31, 1998 Acquisition of Bay Networks, a leading provider of data networking products and services.

July 24, 1998 Sale of assembling and testing frames and cabinets facility in Creedmoor, North Carolina, to C-MAC Industries Inc. (the Creedmoor Facility Transaction).

June 25, 1998 Agreements by Matra Nortel Communications S.A.S. (MNC), formerly Matra Communi-cation S.A.S., to sell the Research and Development Centre of its GSM Terminals business to Finland Nokia Group (the GSM Terminals Transaction).

April 22, 1998 Acquisition of Aptis Communications, Inc. (Aptis), a remote-access data networkingstart-up company.

January 9, 1998 Acquisition of Broadband Networks Inc. (BNI), a designer and manufacturer of fixedbroadband wireless communications networks.

April 1, 1997 Sales of TTS Meridian Systems Inc. and Nortel Communications Systems Inc. distributionchannels to WilTel Communications, LLC (the WilTel Transaction).

June 21 1996 Acquisition of MICOM Communications Corp. (MICOM), a manufacturer and dis-tributor of integrated networking solutions.

February 2, 1996 Sale of structured wiring and copper wire and cable business to Cable Design Technologies(CDT) Canada Inc., since renamed NORDX/CDT, Inc.

Annual.report.98

Financial Review


Streamlining of business processes

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

A key element of the Corporation’s strategy is the transition from vertical integration (making and assemblingmost of its products and systems) to virtual integration (acting as a systems house linking customers, design centers,internal production centers, contract manufacturers, and other resources). This transition better aligns Nortel Networksto focus on customers’ changing requirements for software technology and higher value-added integrated systemsand networks.

The operations strategy will involve plant divestitures, manufacturing rationalization, greater reliance on out-sourcing, and redeployment of employees. Approximately 10 percent of the Nortel Networks workforce will be affectedby the program. Divestitures, retraining, and attrition will minimize employee impact. As the program evolves overthe next eighteen to thirty-six months, the Corporation expects to realize savings in the range of $250 to $300 milliona year. The efficiencies generated by the program are not expected to significantly impact 1999 results from continuingoperations, but will position the Corporation for future growth. Over the coming years, the impact of the operationsstrategy is intended to contribute to Nortel Networks’ presence in the marketplace, growth in market share, higher revenue growth, and, ultimately, higher earnings growth.

The era of mega-telecom projects with long product-development cycles is coming to an end as the new economicsof networking take hold. The explosive growth of the Internet and data networking is shifting Nortel Networks’ pro-duct mix from hardware to software. In conjunction with these changes, speed-to-market is a critical factor in meetingcustomers’ demands for fast delivery, testing, and implementation of their unified telephony and data networks. Useof the World Wide Web, EDI (Electronic Document Interchange), and 800 numbers for order entry and fulfillmentwill provide faster and more responsive choices for Nortel Networks and its customers.

Results of operations

Consolidated represents Nortel Networks’ consolidated results.Carrier segment Nortel Networks’ operating segment delivering network solutions to carrier customers comprisedof products included in broadband networks, public carrier networks, and wireless networks.Enterprise segment Nortel Networks’ operating segment delivering network solutions to enterprise customerscomprised of products included in enterprise networks and Bay Networks.Corporate and Other segment (Other) Nortel Networks’ non-operating segment which includes revenues fromdivested businesses (restated annually to reflect in-year divestitures) and the components business, which provideshigh-performance semi-conductors, microwave modules, and other sub-assemblies and services. Other also includesexpenses for internal functions of the Corporation which are charged to the operating segments. Costs not chargedto the operating segments remain within the Corporate and Other segment.

(millions of U.S. dollars, except per share figures) 1998 1997 § 1996 §

Consolidated revenues $17,575 $15,449 $12,847Carrier segment revenues 12,374 10,879 8,269Enterprise segment revenues 4,877 3,879 3,672

Net earnings (loss) applicable to common shares* $ (569) $ 812 $ 619Earnings (loss) per common share (.99) 1.56 1.20

Supplementary measure of net earnings† $ 1,065 $ 804 $ 619Supplementary measure of net earnings per common share† 1.86 1.54 1.20

Earnings before income taxes $ 64 $ 1,267 $ 944Earnings before income taxes, interest expense,

depreciation, and amortization (EBITDA)‡ 2,555 1,982 1,644

*Net earnings (loss) applicable to common shares for 1998 include the impact of amortization of Bay Networks intangible assets and purchased in-process research and development (R&D) from other acquisitions, and one-time gains and charges. Net earnings (loss) applicable to common sharesfor 1998, 1997, and 1996 were calculated after dividends on preferred shares of $32 million, $17 million, and $4 million, respectively.†As a measure to assess financial performance, management utilizes supplementary measures of net earnings and net earnings per common share whichexclude the impact of amortization of the Bay Networks intangible assets and purchased in-process R&D from other acquisitions, and one-time gainsand charges.‡EBITDA should not be considered as an alternative to net earnings (loss) from operations, net earnings (loss), or cash flows from operating activities(all as determined in accordance with GAAP). EBITDA is presented because it is a widely used financial indicator of a company’s ability to serviceindebtedness and other factors.§References to per share amounts have been restated to reflect the two-for-one stock split which was effective January 7, 1998.

Financial Review


Net earnings (loss) applicable to common shares

The net loss applicable to common shares for 1998 was primarily the result of the amortization of the Bay Networksintangible assets ($1,056 million), amortization of purchased in-process R&D from other acquisitions ($574 mil-lion), and pre-tax special charges of $447 million related primarily to the rationalization of certain Nortel Networks’operations, partially offset by one-time gains of $441 million, which included: $230 million from the AdvancedPower Transaction; $70 million from the sale of Lagardère SAS (Lagardère) shares; $89 million relating to EntrustTechnologies Inc. (Entrust Technologies); $30 million from the Creedmoor Facility Transaction; $24 million fromthe sale of Netspeed Inc. shares; $16 million loss from the GSM Terminals Transaction; and $14 million from the dis-position, in the second quarter of 1998, by MNC, of its 50 percent ownership in Matra Ericsson Telecommunications(MET Transaction). As a measure to assess financial performance, management utilizes supplementary measures ofnet earnings and net earnings per common share as discussed below.

Net earnings applicable to common shares in 1997, compared to 1996, reflected improved operating earnings,lower investment and other income (expense) net, and lower interest expense. Net earnings applicable to commonshares for 1997 included a pre-tax gain of $102 million related to the WilTel Transaction and pre-tax special chargesof $95 million related to the write-down of certain investments and the rationalization and/or relocation of certainmanufacturing facilities.

Supplementary measure of net earnings

The supplementary measure of net earnings, which excludes the amortization of the Bay Networks intangible assetsand purchased in-process R&D from other acquisitions, and one-time gains and charges, for the year ended Decem-ber 31, 1998, represents year-over-year growth in net earnings per common share of 21 percent for 1998 compared to1997, and of 28 percent for 1997 compared to 1996. The increase in the supplementary measure of net earnings for1998 primarily reflected a substantial increase in operating earnings, partially offset by a substantial increase in interestexpense. Net earnings were also impacted by substantial increases in investment and other income (expense) net.Excluding the impact of amortization of the Bay Networks intangible assets and in-process R&D from other acquisi-tions, and one-time gains and charges, Nortel Networks’ net earnings per common share would have been $1.86,$1.54, and $1.20 respectively, for 1998, 1997, and 1996.

Earnings before income taxes

The substantial decrease in 1998 earnings before income taxes is primarily the result of the significant acquisition-related costs that were incurred in 1998. These costs totalled $1.63 billion for the year. The 1998 acquisition-relatedcosts will continue to negatively impact Nortel Networks’ earnings before income taxes over the next years. On asegmented basis, earnings before income taxes from operations for Nortel Networks’ carrier segment was $1.58 bil-lion, an increase of $411 million over 1997 results, which were $354 million greater than 1996. The earnings beforeincome taxes from operations for Nortel Networks’ enterprise segment was $639 million for 1998, an increase of$184 million over 1997 results, which were $51 million lower than 1996. The earnings before income taxes fromoperations for Other was a loss of $515 million in 1998 compared to a loss of $360 million in 1997 and a loss of$373 million in 1996. The increase in the loss before income taxes in 1998 for Other is a result of higher interestexpense and goodwill amortization, and a loss on equity investments.

Revenues for the year ended December 31, 1998, compared to December 31, 1997

% of % of % change(millions of U.S. dollars) 1998 total 1997* total from 1997

Carrier segmentPublic carrier networks $ 4,118 23 $ 4,054 26 2Wireless networks 3,743 21 3,454 22 8Broadband networks 4,513 26 3,371 22 34

12,374 70 10,879 70 14Enterprise segment

Enterprise networks 4,877 28 3,879 25 26Other 324 2 691 5 (53)Total $17,575 100 $15,449 100 14

*Annual revenues by product line have been restated to reflect the repositioning of certain businesses, primarily divested businesses, within the man-agement structure. The primary effect of this reclassification was to move revenues from the enterprise segment to Other as a result of the WilTelTransaction and the MET Transaction.

Financial Review


The 14 percent increase in consolidated revenues in 1998 was attributable to an increase in sales volume of approxi-mately 19 percent, partially offset by price reductions (approximately 3 percent) and divestitures (approximately 2 percent.) Consolidated revenues in 1998 increased by 16 percent over the same period in 1997 after adjustment forthe impact of divested businesses (primarily the MET Transaction, the GSM Terminals Transaction, the WilTelTransaction, and the Advanced Power Transaction).

Carrier segment revenue growth of 14 percent in 1998 was largely driven by the growth in revenues of NortelNetworks’ optical networking solutions and also reflected growth in all carrier lines of business. This revenue growthwas attributable to a volume increase of approximately 17 percent, partially offset by price reductions of approxi-mately 3 percent. The 34 percent increase in broadband networks revenues in 1998 was driven by considerablegrowth across all regions. Wireless networks revenues increased 8 percent over 1997 levels as a result of considerablegrowth in sales in the Caribbean and Latin America region (CALA), significantly increased sales in the United States,and substantially increased sales in Asia Pacific. This increase was partially offset by a significant decline in European revenues and substantially lower Canadian sales. Public carrier networks revenues increased 2 percent in 1998 as aresult of higher sales in the United States and strong growth in Europe, offset by considerably lower sales in Asia Pacificand CALA, and significant decreases in Canada. North American revenues from traditional public carrier products areexpected to continue to be negatively affected by the shift in capital spending from public carrier products to highbandwidth broadband products.

Enterprise segment revenues in 1998 increased 26 percent over the same period in 1997. This increase was due togrowth across all major products and was primarily driven by the Bay Networks Merger. The increase in enterprisesegment revenues was attributable to a volume increase of approximately 27 percent, partially offset by price reductionsof approximately 1 percent. Enterprise networks revenue growth was a result of a considerable increase in revenuesfrom the United States (primarily as the result of the Bay Networks Merger) and strong revenue increases in all otherregions, except Canada, which had moderately lower revenues.

Other segment revenues in 1998 decreased 53 percent from the same period in 1997. The decrease was due pri-marily to the impact of lower revenues from divested businesses year-over-year.

Geographic revenues (1998 versus 1997)(Based on the location of the customer rather than the location of the selling organization)

% of % of % change(millions of U.S. dollars) 1998 total 1997 total from 1997

United States $ 9,841 56 $ 8,298 54 19Canada 1,360 8 1,374 9 (1)All other countries

Europe 3,718 21 3,476 22 7Other 2,656 15 2,301 15 15

6,374 36 5,777 37 10Total $17,575 100 $15,449 100 14

United States

The increase of 19 percent in revenues from the United States was primarily theresult of substantially increased revenues in enterprise networks, reflecting the BayNetworks Merger, and substantially increased revenues in broadband networks.Revenues increased in public carrier networks, significantly increased in wirelessnetworks, and declined substantially in Other (primarily the result of the WilTelTransaction). The increase in revenues from the United States over 1997 was theresult of substantially higher sales to interexchange carriers (IECs), independenttelephone operating companies (IOCs), and other United States customers anddistributors (the latter two increases were primarily as a result of the Bay NetworksMerger). Excluding the contribution of Bay Networks, revenues in the UnitedStates increased significantly.

Canada

Revenues in Canada decreased one percent compared to 1997 due to considerablylower sales in wireless networks and significantly lower sales in public carrier net-works, partially offset by substantially higher sales in broadband networks. Sales toBell Canada and other subsidiaries and related companies of BCE Inc. (the BCEgroup) declined from their 1997 level, and sales to other Canadian customersshowed a modest increase for the year.

Financial Review

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Revenues in Europe, Africa, and the Middle East (including the Commonwealth of Independent States) increased 7 percent from 1997 due to significantly increased revenues in enterprise networks and considerably increased revenues in broadband networks, partially offset by substantially lower revenues in Other (primarily the result of theMET Transaction and the GSM Terminals Transaction) and significantly lower revenues in wireless networks. Publiccarrier networks revenues increased from 1997.

Revenues in other markets, comprising CALA and Asia Pacific, increased 15 percent in 1998 when compared to1997. In CALA, sales in wireless networks increased substantially and both enterprise networks and broadband net-works sales rose significantly from 1997. Public carrier networks sales fell considerably compared to 1997. Revenues inAsia Pacific increased significantly in 1998 when compared to 1997, primarily driven by considerable increases inwireless networks revenues, partially offset by a sharp decrease in public carrier networks revenues. Sales in 1998 whencompared to 1997 were considerably higher in broadband networks and significantly higher in enterprise networks.

The recent devaluation of the Brazilian real is expected to slow economic growth in 1999 for the CALA region.Although demand for the Corporation’s products is expected to be impacted in the short term, the Corporation antic-ipates that the long-term growth prospects for the region remain strong.

The Asia Pacific region has been, and is expected to continue to be, affected for the foreseeable future by unstableeconomies caused in part by the volatility of certain currencies. Revenues from Asia Pacific (excluding China) were lessthan 3 percent and 4 percent, respectively, of the consolidated revenues for the years ended December 31, 1998, and1997. The current economic crisis in the affected Asia Pacific countries resulted in lower than anticipated demand forthe Corporation’s products in the second half of 1998 and it is expected that demand will continue to be impacted bythe crisis. In addition, the current economic crisis has spread to other countries, including countries in CALA, and this,together with global financial market uncertainty, may also impact demand generally for the Corporation’s products.

Revenues for the year ended December 31, 1997, compared to December 31, 1996

% of % of % change(millions of U.S. dollars) 1997* total 1996* total from 1996

Carrier segmentPublic carrier networks $ 4,054 26 $ 3,441 26 18Wireless networks 3,454 22 2,281 18 51Broadband networks 3,371 22 2,547 20 32

10,879 70 8,269 64 32Enterprise segment

Enterprise networks 3,879 25 3,672 29 6Other segment 691 5 906 7 (24)Total $15,449 100 $12,847 100 20

*Annual revenues by product line have been restated to reflect the repositioning of certain businesses, primarily divested businesses, within the man-agement structure. The primary effect of this reclassification was to move revenues from the enterprise segment to Other as a result of the WilTelTransaction and the MET Transaction.

The 20 percent increase in consolidated revenues in 1997 was attributable to an increase in sales volume of approxi-mately 24 percent, partially offset by divestitures (approximately 3 percent) and by price reductions (approximately 1 percent). Consolidated revenues in 1997 increased by 24 percent over the same period in 1996 when adjusted forthe impact of divested businesses.

Carrier segment revenue growth of 32 percent in 1997 was primarily due to higher revenues for wireless networks,broadband networks, and public carrier networks when compared to 1996. The revenue growth was attributable to avolume increase of approximately 33 percent partially offset by price reductions of approximately 1 percent. Publiccarrier networks revenues increased 18 percent in 1997 compared to 1996, primarily due to substantially increasedsales in the United States. Sales in 1997 when compared to 1996 were substantially lower in Asia Pacific, significantlyhigher in Europe, substantially higher in CALA, and higher in Canada. Wireless networks revenues increased by 51 percent in 1997 compared to 1996 due to substantially increased sales across all geographic regions. Broadbandnetworks revenues were up 32 percent in 1997 compared to 1996, primarily due to substantially increased sales inthe United States. When compared to 1996, broadband networks 1997 revenues were significantly higher in Europe,substantially higher in Canada, lower in CALA, and essentially flat in Asia Pacific.

Enterprise segment revenues increased in 1997 compared to 1996. Enterprise networks 1997 revenues increasedin the United States, increased substantially in CALA, increased in Asia Pacific, were essentially flat in Europe, andwere down slightly in Canada compared to 1996. The higher enterprise segment revenues in 1997 were attributableto an increase in sales volume.

Financial Review


Other revenues, comprising revenues from divested businesses and miscellaneous other revenues, decreased from 1996, primarily due to the WilTel Transaction.

Geographic revenues (1997 versus 1996)(Based on the location of the customer rather than the location of the selling organization)

% of % of % change(millions of U.S. dollars) 1997 total 1996 total from 1996

United States $ 8,298 54 $ 6,858 53 21Canada 1,374 9 1,233 10 11All other countries

Europe 3,476 22 3,029 24 15Other 2,301 15 1,727 13 33

5,777 37 4,756 37 21Total $15,449 100 $12,847 100 20

United States

The 21 percent increase in revenues in the United States in 1997 was due to higher revenues across all product linescompared to 1996. The increased revenues were due primarily to substantially higher sales to IECs, regional Bell oper-ating companies (RBOCs), other customers, and wireless operators, partially offset by lower sales to distributors.

Canada

Revenues in Canada in 1997 increased by 11 percent compared to 1996. The increased revenues were primarily dueto higher sales to wireless operators and increased sales to the BCE group.

Other countries

Revenues in Europe, Africa and the Middle East (including the Commonwealth of Independent States) in 1997,increased by 15 percent compared to 1996. The increase was due primarily to substantially increased sales in wirelessnetworks. Revenues in 1997 compared to 1996 were significantly higher in public carrier networks, broadband net-works, and other revenues, with enterprise networks sales essentially flat.

Revenues for 1997 in other markets, comprising Asia Pacific and CALA, increased by 33 percent compared with1996. Revenues in Asia Pacific increased significantly in 1997 compared to 1996, primarily due to substantiallyincreased sales in wireless networks. Sales in 1997 compared to 1996 were substantially lower in public carrier networks,higher in enterprise networks, substantially higher in other revenues, and essentially flat in broadband networks.Revenues in CALA increased substantially in 1997 compared to 1996, primarily due to substantially higher sales inwireless networks. Sales in 1997 when compared to 1996 were substantially higher in public carrier networks andenterprise networks, partially offset by lower sales in broadband networks and other revenues.

Gross profit

(billions of U.S. dollars) 1998 1997 1996Gross profit $7.53 $6.34 $5.13Gross margin 42.8% 41.0% 40.0%

The 1998 increase in gross profit over 1997 was primarily the result of increased sales volume in both the carrier andenterprise segments, partially offset by lower sales volume in Other, primarily due to the 1998 dispositions. Withinthe carrier segment, sales volume increased in broadband networks, wireless networks, and public carrier networks.Improvements due to product mix offset price reductions in both segments. When compared to 1996, the 1997increase in gross profit was primarily the result of increased sales in all segments, except Other, and improved marginsin both the enterprise and carrier segments. Gross profit in Other declined primarily due to the WilTel Transaction.

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

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

Financial Review


Selling, general and administrative (SG&A) expense

(billions of U.S. dollars) 1998 1997 1996SG&A expense $3.09 $2.71 $2.20As a percentage of revenues 17.6% 17.6% 17.1%

In 1998, SG&A expense increased by 14 percent over 1997, which increased by 24 percent over 1996. The 1998increase in absolute dollars reflected the funding of North American and international market investments acrossboth operating segments, as well as increased investments supporting Nortel Networks’ global marketing programsand operations systems to simplify and streamline Nortel Networks’ business processes, ongoing investment in com-puter systems infrastructure related to the global supply chain management system, and the preparation for the Year 2000 (see “Impact of the Year 2000 issue”). The lower SG&A expenses in Other are the result of divestitures,primarily resulting from the WilTel Transaction. SG&A was also impacted by the provision for customer financingrisk. Prior to January 1, 1997, customer financing risks were reflected as a reduction in revenues.

Research and development (R&D) expense

(billions of U.S. dollars) 1998 1997 1996R&D expense* $2.45 $2.15 $1.81As a percentage of revenues 14.0% 13.9% 14.1%

*Net of global investment tax credits of $125 million, $123 million, and $118 million for 1998, 1997, and 1996 respectively.

The increased level of investment in absolute dollars in 1998 and 1997 reflects ongoing programs across the carrierand enterprise segments for new products, process development, advanced capabilities, and services for a broad arrayof applications. As a percentage of revenues, R&D expense has remained essentially flat since 1996.

Amortization of intangibles

Although Nortel Networks reported its first, second, and third quarter results of 1998 in accordance with establishedaccounting practice and valuations of purchased in-process R&D provided by independent valuators, these valuations have been reconsidered in light of guidance provided by the United States Securities and ExchangeCommission regarding valuation methodology. Based on this new valuation methodology, the value of the purchasedin-process R&D related to the Bay Networks Merger was reduced to $1.0 billion and goodwill was increased by $440 million. With respect to the Aptis acquisition, the value of the purchased in-process R&D was reduced to$203 million and goodwill was increased by $75 million. Similarly, the amount of purchased in-process R&D relatedto the BNI acquisition was reduced to $329 million and goodwill was increased by $64 million.

(millions of U.S. dollars) 1998 1997 1996In-process R&D $1,241 $ - $ -Acquired technology 228 - -Goodwill 240 48 45

The amortization of purchased in-process R&D for 1998 primarily reflects the charges relatedto the acquisitions of Bay Networks, BNI, Aptis, and Cambrian. The capitalized amount ofpurchased in-process R&D as at December 31, 1998, was $509 million.

The amortization of acquired technology for 1998 reflects the charge related to the BayNetworks Merger. The capitalized amount of acquired technology as at December 31, 1998,was $1.82 billion.

Goodwill for 1998 primarily reflects charges related to the Bay Networks Merger and toinvestments in STC plc, MNC, and MICOM. The capitalized amount of goodwill as atDecember 31, 1998, was $3.29 billion.

Special charges

Special charges, aggregating $447 million, were included in the results for the period endedDecember 31, 1998.

As part of the special charges, a provision of $377 million related to steps taken to stream-line management layers, gain operational efficiencies, and realign resources and investments wasrecorded. Included in the provision was $261 million representing the cost of severance andrelated benefits for approximately 4,100 employees worldwide, which includes $70 million for

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1996

1997

1998

0

500

1,500

1,000

2,000

3,000

2,500

Research and

development

($ millions)


individuals in R&D activities. The majority of Nortel Networks’ business functions, job classes, and geographic areaswere impacted, with a majority of the reductions taking place in the United States and Canada. Also included in thisprovision was $93 million in non-cash expenses for plant and equipment and other write-downs, and $23 million infacilities and other costs, primarily related to wireless networks and enterprise networks. The anticipated benefits ofthese activities began to materialize in the Corporation’s consolidated results of operations during the fourth quarter of1998. All of these activities are expected to be substantially completed by September 30, 1999. As at December 31,1998, $119 million of severance, benefits, and other personnel-related costs, and $23 million in facilities and other costshad been paid. As well, $60 million in non-cash expenses for fixed asset and other write-downs had been recognized.

Included in the special charges for 1998 was a write-down in connection with MNC, primarily related to thereductions in the carrying value of certain assets. Nortel Networks’ proportionate share of this reduction was 50 per-cent of approximately $22 million, resulting in a write-down of approximately $11 million.

Also included in the special charges for 1998 was a provision of $59 million, which comprised a write-down of$32 million related to certain assets and investments held by the Corporation, severance payments of $16 million, andplant rearrangement and relocation costs of $11 million. The majority of the severance and plant rearrangement andrelocation costs related to a charge taken by Nortel plc to downsize a portion of its Fixed Wireless Access manufacturingoperations in Paignton, United Kingdom. The activities are expected to be substantially completed by June 30, 1999.

In 1997, the Corporation announced special charges aggregating $95 million, which comprised a write-down of$51 million related to certain investments held by the Corporation and a provision of $44 million for the rationaliza-tion and/or relocation of certain of the Corporation’s manufacturing facilities. These activities were substantiallycompleted by September 30, 1998.

Investment and other income – net and interest expense

(millions of U.S. dollars) 1998 1997 1996Equity in net earnings (loss) of associated companies $ (19) $ 14 $ (8)Investment and other income (expense) net 234 (14) 47

$215 $ - $ 39

Interest expense $232 $169 $175

The increase in investment and other income net in 1998 as compared to 1997, including equity in net earnings ofassociated companies, was primarily the result of the following items: a pre-tax gain of $70 million from the sale ofLagardère shares; a pre-tax gain of $77 million relating to Entrust Technologies’ initial public offering concurrent witha secondary offering of Entrust Technologies common shares by the Corporation; a pre-tax gain of $24 million onthe sale of Nortel Networks’ equity interest in Netspeed Inc.; and a pre-tax dilution gain of $12 million resulting fromEntrust Technologies’ acquisition of r3 Security Engineering AG (r3). Also contributing to the increase in investmentand other income net in 1998 was an increase of $29 million in interest income, primarily resulting from highercash balances following the Bay Networks Merger and higher levels of short-term investments due to increased cashflows from United States operations. In addition, minority interest has moved from an expense to an income, primari-ly due to the loss recorded by Entrust Technologies as a result of its acquisition of r3. These increases were partiallyoffset by the Corporation’s loss of $19 million from its equity in net earnings (loss) of associated companies, and byincreased foreign exchange losses (see below).

The decrease in investment and other income net in 1997 as compared to 1996 was primarily a result of sub-stantially higher net customer financing expenses, partially offset by significantly higher equity earnings. Investmentand other income net was also impacted by lower interest income earned in 1997 due to, among other things,reductions in short-term interest rates as compared to 1996. Significantly higher foreign exchange losses and higherminority interest compared to 1996 also impacted investment and other income net.

The higher interest expense in 1998 compared to 1997 is primarily due to the increased use of short-term debt,primarily in Colombia and Brazil, increased use of commercial paper, and an increase in short-term interest rates,which was partially offset by lower interest on long-term debt as the result of the settlement at maturity in the firstquarter of 1998 of a C$300 million debt which had been swapped to sterling. The decreased interest expense for1997, when compared to 1996, was primarily due to the reduced use of commercial paper as a result of higher cashbalances, partially offset by increased long-term debt in Colombia.

Nortel Networks continues to expand its business globally and, as such, an increasing proportion of its businesswill be denominated in currencies other than United States dollars. As a result, fluctuations in foreign currencies mayhave an impact on Nortel Networks’ business and financial results. Nortel Networks endeavours to minimize theimpact of such currency fluctuations through its ongoing commercial practices and by attempting to hedge its expo-sures to major currencies. In attempting to manage this foreign exchange risk, Nortel Networks identifies operationsand transactions that may have foreign exchange exposure, based upon, among other factors, the excess or deficiency of

Financial Review


foreign currency receipts over foreign currency expenditures in each of Nortel Networks’ significant foreign currencies.Nortel Networks’ significant currency flows for the year ended December 31, 1998, were in United States dollars,Canadian dollars, United Kingdom pounds, and French francs. For the year ended December 31, 1998, the net impactof foreign exchange fluctuations was a loss of $74 million compared to losses of $50 million and $44 million, respec-tively, for 1997 and 1996. Given the devaluation of the Brazilian real and its continued volatility and Nortel Networks’exposure to this market and other international markets, Nortel Networks continuously monitors all its foreign currency exposures. As the Corporation cannot predict whether foreign exchange losses in Brazil and other countrieswill continue to increase in the future, significant foreign exchange fluctuations may have an adverse impact on theCorporation’s results from operations. The introduction of the euro on January 1, 1999 may reduce the Corporation’sEuropean foreign exchange exposure in the future (see “European monetary union and the euro”).

Income taxes

(millions of U.S. dollars) 1998 1997 1996Income taxes $601 $438 $321As a percentage of pre-tax earnings* 35.5% 34.5% 34.0%

*Excludes the amortization of the Bay Networks’ intangible assets and purchased in-process R&D from other acquisitions.

The increases in the 1998 and 1997 tax rates were due primarily to changes in geographic earnings mix. NortelNetworks’ earnings are subject to differing effective tax rates in each of the countries in which it operates. An increasein the Corporation’s tax rate can result when the proportions of revenues earned in high tax rate countries increasesover the prior year.

Liquidity and capital resourcesChange

(millions of U.S. dollars) 1998 1997 from 1997

Cash and cash equivalents $2,281 $1,371 $ 910Cash flows from operating activities* 1,586 800 786Cash flows from investing activities (105) (153) 48Cash flows from financing activities (531) 5 (536)

*The Consolidated Statements of Cash Flows have been modified to conform with the new Canadian pronouncement. Comparative numbers havebeen restated to reflect this change.

Cash and cash equivalents at December 31, 1998 were $910 million higher than the balance a year earlier. Cashprovided by operating activities in 1998 increased by $786 million when compared to 1997. Nortel Networks con-tinues to focus on working capital as a key component of cash management.

Cash flows from investing activities in 1998 increased by $48 million when compared to 1997. Capital expendituresamounted to $642 million for 1998, an increase of $67 million from 1997 capital expenditures of $575 million.Nortel Networks expects its consolidated capital expenditures for 1999 to be substantially above 1998 levels. The netincrease in long-term receivables of $356 million in 1998 was primarily the result of a higher balance of customerfinancing at year end.

Acquisitions in 1998 generated $115 million, compared to outflows of $167 million in 1997. The improved cashflows from acquisitions primarily resulted from the Bay Networks Merger and were partially offset by other acquisitionsduring the year, primarily Cambrian and BNI. Proceeds from the sales of businesses were $751 million in 1998, anincrease of $361 million over 1997, primarily due to the Advanced Power Transaction, which generated proceeds of$325 million, the initial public and secondary offerings of Entrust Technologies, which generated proceeds of $118 million, and the sale of Nortel Networks’ holdings in ICL plc for proceeds of $93 million.

The total debt to total capitalization ratio was 14 percent at December 31, 1998, compared to 26 percent at Decem-ber 31, 1997, and 26 percent at December 31, 1996. The decrease in the total debt to total capitalization ratio was pri-marily due to the issuance of approximately 135 million common shares in connection with the Bay Networks Merger.

The Corporation and Northern Telecom Capital Corporation (NTCC), an indirect wholly owned subsidiary ofthe Corporation, have $200 million of debt securities and warrants to purchase debt securities, to be offered by eitherthe Corporation or NTCC, with the payment of any debt securities offered by NTCC guaranteed by the Corporation,filed with the United States Securities and Exchange Commission pursuant to a shelf registration program. This registration statement is in addition to the $500 million of debt securities and warrants to purchase debt securitiesremaining available to the Corporation under a separate United States registration statement. The Corporation has alsofiled, in each of the provinces of Canada, a short form shelf prospectus to issue up to C$500 million of debt securities

Financial Review

and warrants to purchase debt securities of the Corporation under a Canadian shelf program. On April 17, 1998, Nortel Networks amended its five-year and 364-day syndicated credit agreements which permit borrowings in an aggregate amount not to exceed $1.5 billion, of which $1.0 billion relates to the five-year agreements and $500 million relates to the 364-day agreements, to, among other things, extend the agreements for an additional oneyear and 364 days, respectively. The entire amount of these committed facilities remains available. Nortel Networksexpects to meet its cash requirements from operations and conventional sources of external financing.

At December 31, 1998, a subsidiary of Bay Networks had $92 million of convertible redeemable subordinateddebentures outstanding. The debentures mature on May 15, 2003, and are convertible at the option of the holder intothe Corporation’s common shares. The debentures are redeemable at the option of the issuer, initially at approximately103.7 percent of the face value and at decreasing premium prices thereafter to 100 percent at maturity.

In January 1997, the Corporation commenced a program (the 1997 program) to acquire common shares of theCorporation for cancellation. The Board of Directors of the Corporation authorized the repurchase for cancellation ofup to 16 million of its common shares, on a post-split basis, in the period from January 30, 1997, to January 29, 1998,through the facilities of the Toronto, Montréal, and New York stock exchanges. At the expiration of the 1997 program,the Corporation had purchased and cancelled 10,182,400 common shares. On February 2, 1998, the Corporationannounced the commencement of a program (the 1998 program) to repurchase for cancellation up to 6.4 million ofthe Corporation’s common shares in the period from February 4, 1998, to February 3, 1999. At the expiration of the1998 program, the Corporation had purchased and cancelled 4,347,400 common shares. On February 22, 1999, theCorporation announced the commencement of a new program (the 1999 program) to repurchase for cancellation upto 10 million of the Corporation’s common shares in the period from February 26, 1999, to February 25, 2000.

The competitive environment requires Nortel Networks and many of its principal competitors to provide signifi-cant amounts of medium-term and long-term customer financing in connection with the sale of products and services.While Nortel Networks has generally been able to place its customer financings with third-party lenders, NortelNetworks anticipates that, due to the amount of financing it expects to provide and the higher risks typically associ-ated with such financings (particularly when provided to start-up operations or to customers in developing countries),the amount of such financings required to be supported directly by Nortel Networks for at least the initial portion oftheir term is expected to increase significantly in the future. At December 31, 1998, Nortel Networks had enteredinto certain financing agreements for the future provision of up to approximately $754 million of customer financingand had outstanding offers or commitments in connection with awarded supply contracts, subject to fulfilment ofcertain conditions, to provide up to approximately $1.46 billion of additional customer financings (not all of theseoffers or commitments are expected to be drawn upon). Nortel Networks expects to continue to arrange for third-party lenders to assume customer financing obligations agreed to by Nortel Networks and to fund other customerfinancings directly supported by Nortel Networks from working capital and conventional sources of external financingin the normal course. In light of recent economic uncertainty and reduced demand for financings in capital andbank markets, Nortel Networks may be required to continue to hold certain customer financing obligations forlonger periods prior to placement with third-party lenders.

As a result of the maturity of Nortel Networks’ internal customer financing processes and Nortel Networks’increased experience in the area of medium-term and long-term customer financing, effective April 1, 1997, theCorporation began to maintain an allowance to absorb credit-related losses in its portfolioof on-balance sheet and off-balance sheet financing assets and liabilities (the FinancingPortfolio). The Financing Portfolio is primarily medium-term and long-term customer-financed receivables and guarantees. The allowance is part of the provision for uncol-lectibles. The allowance is reviewed quarterly for adequacy of impairment coverage and, inmanagement’s opinion, the allowance is considered adequate to absorb credit-related lossesin the Financing Portfolio. Prior to January 1, 1997, the Corporation reflected customerfinancing risk related to PCS contracts as a reduction in revenues. All customer financingrisk is now reflected through SG&A.

Nortel Networks has entered into supply contracts with customers for products andservices, which in some cases involve new technologies currently being developed orwhich have not yet been commercially deployed by Nortel Networks or require NortelNetworks to build and operate networks on a turnkey basis. These supply contracts maycontain delivery and installation timetables and performance criteria which, if not met,could result in the payment of substantial penalties or liquidated damages by NortelNetworks, the termination of the related supply contract, and/or the reduction of sharedrevenues under a turnkey arrangement.

On May 13, 1998, Nortel Networks and Lagardère entered into an amended and restatedparticipation agreement to realign MNC, a joint venture in which Nortel Networks and


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1996

1997

1998

0

5

15

10

20

30

25

Debt to

capitalization

(percent)


Lagardère each hold a 50 percent ownership interest. The agreements relating to this realignment provided for,among other things: (i) Matra Communication S.A.S. to change its name to Matra Nortel Communications S.A.S.,(ii) Nortel Networks to transfer the assets of its distribution business in France to MNC, (iii) MNC to sell its 50 per-cent ownership in Matra Ericsson Telecommunications, and (iv) Nortel Networks to lend $120 million to MNC. The $120 million loan by Nortel Networks to MNC matures on January 2, 2003, bears interest at three percent perannum and is payable by MNC to Nortel Networks either in cash or by way of transfer of MNC’s 34 percent equityinterest in Nortel Matra Cellular SCA (NMC). Nortel Networks has the option, at its sole discretion, to require therepayment of the loan by way of transfer of the NMC shares and, as a result, Nortel Networks is accounting forNMC as if it was a wholly owned subsidiary. After July 1, 1999, Lagardère may, under specific circumstances, requireNortel Networks to purchase all of its equity participation in MNC at a price to be based partly on a formula andpartly on the fair market price as determined at that time.

Market risk

Market risk represents the risk of loss that may impact the Consolidated Financial Statements of the Corporation dueto adverse changes in financial market prices and rates. Nortel Networks’ market risk exposure is primarily a result offluctuations in interest rates and foreign exchange rates. To manage the risk from these fluctuations, NortelNetworks enters into various derivative-hedging transactions that have been authorized pursuant to NortelNetworks’ policies and procedures. Risk management control systems are maintained by the Corporation to monitormarket risks and counter-party risks. These systems rely on analytical techniques including both sensitivity analysisand value-at-risk estimations. Nortel Networks does not hold or issue financial instruments for trading purposes.

A discussion of the Corporation’s accounting policies for derivative financial instruments is included in the Signi-ficant accounting policies note to the Consolidated Financial Statements. Additional disclosure of Nortel Networks’financial instruments is included in the Financial instruments and hedging activities note to the ConsolidatedFinancial Statements.

Foreign exchange exposures are managed using forward, cross currency swap, and option contracts to hedge net for-eign investments and firm sale and purchase commitments. The most significant foreign exchange exposures for NortelNetworks relate to the Canadian dollar, the United Kingdom pound, and the French franc. The hedge of net foreigninvestments is accomplished through the use of forward and cross currency swap contracts, whereby any gain or loss onthe derivative is recorded in the currency translation adjustment (CTA) in shareholders’ equity and is used to offset thegain or loss on the net assets of a foreign subsidiary, which is also recorded in CTA during translation. Nortel Networksenters into United States to Canadian dollar forward, option, and cross currency coupon swap contracts intended tohedge the United States to Canadian dollar exposure on future revenue, expenditure, and preferential cash dividendstreams. The gains and losses on these contracts are recognized in income when the hedged transaction occurs.

Interest rate exposures are managed using a diversified portfolio of fixed and floating rate instruments denominatedin several major currencies, the largest exposure being in United States dollars. These exposures are managed usinginterest rate swaps and cross currency swaps. These derivative instruments reduce Nortel Networks’ cost of financingand reduce the fluctuations in the aggregate interest expense. Net settlements on these swap instruments are bookedas an adjustment to interest expense.

Sensitivity analysis is used to measure Nortel Networks’ foreign currency risk by computing the potential decreasein cash flows that may result from adverse changes in foreign exchange rates. The sensitivity analysis includes cash,short-term and long-term debt, and derivative instruments held at December 31, 1998. The underlying cash flowsthat relate to the hedge of firm commitments are not included in the analysis. As at December 31, 1998, based on aone-year time horizon, a 10 percent adverse change in the exchange rates results in a potential decrease in after-taxcash flows of approximately $82 million. This potential decrease results primarily from Nortel Networks’ exposureto the Canadian dollar, the United Kingdom pound, and the French franc.

Sensitivity analysis is used to measure Nortel Networks’ interest rate risk. As at December 31, 1998, a 100 basispoint adverse change in interest rates would not have a material effect on the consolidated financial position, earn-ings, or cash flows of the Corporation.

Legal proceedings

On October 14, 1998, a class action complaint was filed in the United States District Court for the Southern Districtof New York purportedly on behalf of all persons whose Bay Networks common shares or stock options were exchangedfor the Corporation’s common shares in the Bay Networks Merger. The complaint alleged that the Corporation andcertain named officers violated the Securities Act of 1933 and the Securities Exchange Act of 1934 because the proxystatement/prospectus and registration statement for the Bay Networks Merger and the related issuance of commonshares of the Corporation (the Bay Networks Proxy Statement), as well as certain public statements made by theCorporation, contained materially false and misleading statements and omissions concerning the Corporation’s

Financial Review


financial condition. Two additional class action complaints were filed in the same court on November 16, 1998, andDecember 11, 1998, alleging substantially similar claims. The complaints sought relief in the form of compensatorydamages and rescission rights. The court granted the plaintiffs’ motion to consolidate all three actions on February 1,1999. It is anticipated that the plaintiffs will file a consolidated complaint. The Corporation has not yet responded toany of these complaints.

In June 1998, four class actions were filed in the Delaware Court of Chancery, New Castle County, purportedlyon behalf of all common shareholders of Bay Networks in connection with the announcement of the Bay NetworksMerger. The complaints named the directors and officers of Bay Networks individually, as well as Bay Networks andthe Corporation, as defendants. The complaints essentially alleged that the Bay Networks directors breached fiduciaryduties owed to the Bay Networks shareholders by, among other things, failing to undertake an appropriate evaluationof Bay Networks’ net worth as a merger candidate and by failing in the Bay Networks Merger to obtain for the BayNetworks shareholders adequate value for their Bay Networks common shares. The complaints further alleged thatthe Corporation aided and abetted these alleged breaches of fiduciary duty. The complaints sought relief including apreliminary and permanent injunction enjoining the Bay Networks Merger under the terms then proposed, rescission rights or rescissory damages, and other compensatory damages. On July 23, 1998, Bay Networks, theCorporation, and counsel for the plaintiff class entered into an agreement in principle (the Settlement Agreement)under which these actions will be dismissed, subject to confirmation by the parties, notice to the class, and approvalby the Delaware Court of Chancery. The Settlement Agreement provided that the Bay Networks Proxy Statementinclude certain additional information not included in the document filed with the United States Securities andExchange Commission (the SEC) on July 2, 1998. It also provided that counsel for the plaintiff class may apply tothe Delaware Court of Chancery for an award of legal fees up to $450 thousand and expenses up to $25 thousand.On August 26, 1998, an action was filed in the same court by a shareholder of Bay Networks allegedly on behalf ofall common shareholders of Bay Networks. The complaint alleged that the Bay Networks Proxy Statement wasmaterially misleading and violated applicable securities laws because Bay Networks failed to disclose the existence oflitigation pending in Massachusetts State Court in which Bay Networks was suing six former employees for viola-tions by such employees of their non-competition and non-solicitation agreements with Bay Networks. As part ofthis action, the plaintiff sought a temporary restraining order preventing the closing of the Bay Networks Merger.The court refused to hear the plaintiff ’s application for a temporary restraining order. This action may also be dismissed if the court approves the Settlement Agreement.

On March 4, 1997, Bay Networks announced that shareholders had filed two separate lawsuits against Bay Networks and ten of Bay Networks current and former officers and directors. One lawsuit was filed in theUnited States District Court for the Northern District of California (the Federal Court) and alleges violations of thefederal securities laws (the Federal Action). The other lawsuit was filed in California Superior Court, County ofSanta Clara (the California Court), and alleges violations of the California Corporations Code (the First StateAction). Both lawsuits purported to seek damages on behalf of a class of shareholders who purchased Bay Networks’common shares during the period of May 1, 1995, through October 14, 1996. On April 18, 1997, a shareholder (represented by some of the same plaintiffs’ law firms as in the aforementioned cases) filed a second lawsuit in the California Court, alleging violations of the federal securities laws and California Corporations Code by Bay Networks and nine of its current and former officers and directors (the Second State Action). The Second StateAction purported to seek damages on behalf of a class of shareholders who acquired Bay Networks’ common sharespursuant to the registration statement and prospectus that became effective on November 15, 1995. In April 1998,the California Court granted the plaintiffs’ motion to consolidate the First State Action and the Second State Action(the Consolidated State Action), but denied the plaintiffs’ motion for class certification. The plaintiffs in theConsolidated State Action have appealed this decision. No date for oral arguments in this appeal has been set. InSeptember 1998, the Federal Court dismissed the plaintiffs’ complaint in the Federal Action, granting leave for theplaintiffs to amend the complaint. In November 1998, the Corporation and the plaintiffs in the Federal Actionagreed to stay the proceedings until a decision regarding pleading standards in securities litigation has been renderedby the United States Ninth Circuit Court of Appeal in an unrelated case involving Silicon Graphics, Inc., and theFederal Court has accordingly entered an order staying the Federal Action.

In June 1993, certain holders of the Corporation’s securities commenced three class actions in the United StatesDistrict Court for the Southern District of New York alleging that the Corporation and certain of its officers violatedthe Securities Exchange Act of 1934 and common law by making material misstatements of, or omitting to state,material facts relating to the business operations and prospects and financial condition of the Corporation. Compen-satory and punitive damages were sought in each of the class actions. All three actions were subsequently consolidatedand the plaintiffs were permitted to file a Second Consolidated Amended Complaint after the first ConsolidatedAmended Complaint had been dismissed without prejudice. A defense motion challenging the sufficiency of theSecond Consolidated Amended Complaint was denied in part and granted in part on August 19, 1994. An Answer

Financial Review


to this Complaint was filed on September 22, 1994. On February 24, 1995, the consolidated action was certified as aclass action and on April 10, 1996, a Stipulation and Order of Dismissal was granted permitting one of the namedofficers to be dismissed from the suit. On May 2, 1996, the plaintiffs filed a motion to file a Third ConsolidatedAmended Complaint. The Corporation and the named officers filed an opposition to this and also filed a motion todismiss the remaining allegations in the Second Consolidated Amended Complaint for insufficiency. On May 6, 1998,a magistrate judge of the court issued a report and recommendation denying the motion to dismiss and permitting,in part, the filing of the Third Consolidated Amended Complaint. The Corporation and the named officers havefiled an objection to this report and a judge of the court has not yet ruled on that objection.

Nortel Networks is also a defendant in various other suits, claims, and investigations which arise in the normalcourse of business.

Northern Telecom, Inc. (NTI), the Corporation’s principal United States subsidiary, received a statutory notice ofproposed assessment from the Internal Revenue Service (IRS) dated November 6, 1996 with respect to its 1980through 1985 federal income tax returns. The notice proposes an additional tax liability of approximately $524 million,excluding interest at the applicable statutory rates. The notice states that appropriate adjustments have not beenmade which would reduce the proposed additional tax liability. On February 3, 1997, NTI filed a petition with theUnited States Tax Court opposing such proposed additional tax. If the IRS were to prevail, NTI would be entitled to arefund for later taxable years. Recently, NTI and the IRS have agreed on a basis for resolving the most significantissues involved in this matter, subject only to review and approval by the Joint Committee on Taxation as required bythe Internal Revenue Code. After consultation with outside tax counsel and the Corporation’s independent account-ants, it is management’s opinion that additional tax liability, if any, resulting from the proposed income tax adjustments,relating to either the issues which have been agreed upon or the remaining unresolved issues, will not have a materialadverse impact on the consolidated financial position or results of operations of the Corporation.

Except where noted above, the Corporation is unable to ascertain the ultimate aggregate amount of monetary lia-bility or financial impact of these matters and therefore cannot determine whether these proceedings will, individuallyor collectively, have a material adverse impact on the consolidated financial position or results of operations of theCorporation. Unless otherwise noted, the Corporation and any named officers intend to vigorously defend these actions.

Environmental matters

Nortel Networks, primarily as a result of its manufacturing operations, is subject to numerous environmental lawsand regulations and is exposed to liabilities and compliance costs arising from its past and current generation, man-agement, and disposition of hazardous substances and wastes.

At December 31, 1998, the accruals on the Corporation’s consolidated balance sheet for environmental matters,including those referred to below, were $32 million. It is anticipated that a majority of the accruals will be spent overthe next five years. Based on information presently available, management believes that the existing accruals are suf-ficient to satisfy probable and reasonably estimable environmental liabilities related to known environmental matters.Any additional liability that may result from these matters, and any additional liabilities that may result in connectionwith other locations currently under investigation, are not expected to have a material adverse impact on the consoli-dated financial position or results of operations of the Corporation.

Nortel Networks has remedial activities under way at eight of its facilities and seven previously occupied sites. An estimate of Nortel Networks’ anticipated remediation costs associated with all such sites, to the extent probableand reasonably estimable, is included in the environmental accruals referred to above in an approximate amount of$30 million.

Nortel Networks is also listed as a potentially responsible party (PRP) under the U.S. Comprehensive Environ-mental Response, Compensation and Liability Act (CERCLA) at six Superfund sites in the United States and is listedas a de minimis PRP at three of these Superfund sites. An estimate of Nortel Networks’ share of the anticipated reme-diation costs associated with such Superfund sites is included in the environmental accruals referred to above.

Liability under CERCLA may be imposed on a joint and several basis, without regard to the extent of NortelNetworks’ involvement. In addition, the accuracy of Nortel Networks’ estimate of environmental liability is affectedby several uncertainties such as additional requirements which may be identified in connection with remedial activi-ties, the complexity and evolution of environmental laws and regulations, and the identification of presentlyunknown remediation sites. Consequently, Nortel Networks’ liability could be greater than its current estimate.

Pensions

Nortel Networks has non-contributory defined benefit pension plans covering substantially all of its employees, themajority of whom are in Canada and the United States. Pension benefits are based on length of service and rates ofcompensation. In determining its pension obligations and expense, Nortel Networks’ weighted average discount rateused for 1998 pension calculations was 7.2 percent, which reflects the impact of economies with higher long-termdiscount rates than would typically be found in the United States. The Corporation believes that a downward adjust-ment of the discount rate may have a material effect on consolidated earnings.

Financial Review


Impact of the Year 2000 issue

The Year 2000 issue is the result of computer programs being written using two digits rather than four to define theapplicable year. Computer systems and products that have date-sensitive software may recognize a date using “00” asthe year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptionsof operations, including, among other things, a temporary inability to process transactions, send invoices, or engagein similar normal business activities. Nortel Networks’ business operations, including, for example, its finance,human resources, manufacturing, and customer order management functions, make extensive use of informationtechnology (IT) and, as such, are exposed to significant risk from the Year 2000 issue.

In 1994, Nortel Networks began a long-term program to deploy an enterprise backbone architecture to establisha common suite of business applications throughout the Corporation and its subsidiaries. The new applications arebeing deployed as Year 2000 ready, and for those business units relying on replacement of certain legacy applications aspart of their Year 2000 strategy, they are expected to replace a number of legacy applications by the end of the secondquarter of 1999. All business system applications not addressed by the enterprise backbone deployment, including ven-dor supplied applications, are expected to be made Year 2000 ready through Nortel Networks’ Year 2000 Program.

In 1996, Nortel Networks initiated its Year 2000 Program and subsequently determined that it would be necessaryto modify or replace significant portions of software so that business applications, computing environments andproducts would properly utilize Year 2000 dates before and beyond December 31, 1999. Nortel Networks’ Year 2000Program consists of a product program (the Product Program), an information services program (the IS Program),and a facilities program (the Facilities Program).

In September 1998, following the acquisition of Bay Networks, Nortel Networks commenced integration of BayNetworks’ Year 2000 Program into Nortel Networks’ overall Year 2000 Program.

The Product Program focuses on identifying and resolving Year 2000 issues relating to the Corporation’s productsand deploying solutions to customers. Through this program the Corporation has made or will make its currentproduct offerings Year 2000 ready. In addition, the Corporation is providing an upgrade or migration path and otherinformation to customers and distributors who have non-Year 2000 ready products. The Product Program consists of the following three major phases: Phase I (analysis, remediation, and verification), Phase II (deployment), andPhase III (business continuity planning).

The Corporation estimates that Phase I of the Product Program was approximately 98 percent complete as at December 31, 1998 and the remaining activities are expected to be completed by the end of March 1999. Nortel Networks is also working with outside agencies, such as Bellcore, the United States government (GSA), theTelco Year 2000 Forum in the United States, Alliance for Telecommunications Industry Solutions, and the CanadianYear 2000 Telecom Industry Forum, to support independent verification and interoperability testing of selected products.Phase II, deployment of product and product upgrades, has commenced and is expected to continue throughout 1999at the request of Nortel Networks product users. The Corporation estimates that this phase will be substantially com-plete by mid-1999. Nortel Networks has initiated formal communications with its customers (except where NortelNetworks sells its products through distributors, in which case formal communications have been initiated primarilywith such distributors). Customers and/or distributors are being notified of known risk areas and proposed remediationplans. Customers are being encouraged to arrange for deployment of Year 2000 ready products promptly to ensure theproducts will be deployed prior to the year 2000. Increased orders of Year 2000 ready products and product upgradesat the end of 1999 may overburden available installation resources. Phase III, business continuity planning, began for the Product Program in the third quarter of 1998 and is expected to be completed by the end of the second quarterof 1999. Thereafter, business continuity planning will be monitored and updated on an ongoing basis into the year2000. Joint implementation of business continuity planning will be undertaken with customers as appropriate.

The IS Program addresses business applications and includes third-party/supplier assessment and joint ventureactivities related to Year 2000 readiness. The IS Program consists of the following three major phases: Phase I (assess-ment and validation inventory of Year 2000 affected items, assessment of Year 2000 readiness, and prioritizationof items determined to be material to the Corporation); Phase II (implementation and deployment repair and/orreplacement of items determined not to be Year 2000 ready, testing of all items that have been repaired or replacedor have been identified as Year 2000 ready but are considered to be material to the Corporation, and re-deploymentof tested items into Year 2000 ready operating environments); and Phase III (business continuity planning planningto reduce the risk of business interruption to the Corporation resulting from potential Year 2000 issues).

Business applications are undergoing an assessment and are being remedied, retired, or replaced, as appropriate.Third-party supplied software is similarly being assessed, and has been or will be upgraded or replaced. The Cor-poration estimates that in respect of its business applications, Phases I and II activities were approximately 85 percentcomplete at December 31, 1998, and the remaining Phases I and II activities are on schedule to be completed by theend of the second quarter of 1999. Most of the Phase I and II activities carried over into 1999 are related to thedeployment of applications which have been determined to be Year 2000 ready, and were not deployed in 1998 for

Financial Review


various business reasons. These activities are scheduled to be completed by the end of the second quarter of 1999.Phase III, business continuity planning, began for the IS Program in the fourth quarter of 1998 and plans are expectedto be in place by end of the third quarter of 1999, at which point monitoring and execution of business continuityplans will be undertaken, as appropriate.

None of the Corporation’s IT projects have been delayed due to the implementation of the Year 2000 Program.Third-party supplier relationships are being assessed to determine the potential for Year 2000 impact. These

relationships include third-party suppliers that provide manufacturing materials, software applications, tools, out-sourced services, telecommunications, and other infrastructure-related products and services required by theCorporation. Assessment activities include the identification and prioritization of critical suppliers, direct commu-nications with suppliers regarding their plans and progress in addressing the Year 2000 issue relating to products and services supplied to the Corporation and/or their own internal operations, and specific assessment of direct interfacesbetween the third-party supplier and Nortel Networks. Formal communications between Nortel Networks andsignificant third-party suppliers are focused to determine the extent to which Nortel Networks is vulnerable to thesethird parties’ potential failure to remedy their own Year 2000 issue. Where appropriate, the Corporation has or plansto execute Year 2000 compliance agreements with such parties. Detailed evaluations of the most critical third partiesand their products or services have been initiated. Where appropriate, the results of such evaluations will initiate thedevelopment of business continuity plans. Business continuity planning commenced in the fourth quarter of 1998and plans are expected to be in place by the end of the third quarter of 1999, at which point monitoring and execu-tion of business continuity plans will be undertaken, as appropriate.

The Facilities Program encompasses the building infrastructure including environmental controls, security systems,fire systems, and associated embedded systems that are used in the control or operation of all facilities operated bythe Corporation. Also addressed under the Facilities Program are factory-based embedded systems used in the man-ufacture and testing of Nortel Networks products. The Facilities Program is on schedule, and it is expected that therepair and testing of equipment will be substantially completed by the end of the second quarter of 1999. Businesscontinuity planning for the Facilities Program commenced in the third quarter of 1998 and plans are expected to bein place by the end of the third quarter of 1999, at which point monitoring and execution of such plans will beundertaken, as appropriate.

Business continuity planning, which commenced in the Product Program, IS Program, and Facilities Program during the third and fourth quarters of 1998, has recently been coordinated under a central corporate BusinessContinuity Planning Program (the BCP Program). The governing objective of the BCP Program is to protect corporate resources in the face of a potential Year 2000 event, to continue the delivery of essential services to bothinternal and external customers, and to minimize the effects of the disruption on the operations of the NortelNetworks’ business. The planning process is based on an industry-accepted, process-focused approach, and the overallBCP Program has a scheduled completion date of the end of the third quarter, 1999, with implementation monitor-ing and execution of business continuity plans occurring during the fourth quarter. Interim planning milestoneshave been established and the progress of the BCP Program is monitored on a regular basis. Some business continuityplanning activities will be completed prior to the end of the third quarter in order to prepare for potential Year 2000-related events that could occur prior to such time.

Nortel Networks is utilizing both internal and external resources to reprogram, or replace, and test for Year 2000modifications. The total cost associated with Nortel Networks’ Year 2000 Program is being funded through operatingcash flows and is not expected to be material to the Corporation’s financial position. The estimated total cost of theYear 2000 Program is approximately $155 million. This amount does not include costs to upgrade products or prod-uct software as these costs have been absorbed indirectly through normal product upgrades. As well, this amountdoes not include Nortel Networks’ potential share of Year 2000 costs that may be incurred by partnerships and jointventures in which the Corporation participates but is not the operator. The total amount expended on the Programthrough December 31, 1998, was $125 million. The estimated future cost of completing the Year 2000 Program isapproximately $30 million.

The costs of the Year 2000 Program and the date on which Nortel Networks plans to complete the Year 2000Program are based on management’s best estimates, which were derived utilizing numerous assumptions of futureevents including the continued availability of certain resources, third-party year 2000 programs, and other factors.However, there can be no assurance that these estimates will be achieved and actual results could differ materiallyfrom those plans. Specific factors that might cause such material differences include, but are not limited to, the avail-ability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, thetimely completion of third-party remediation plans, and similar uncertainties.

Nortel Networks presently believes that with the replacement of certain legacy applications, modifications to existing software, and conversions to new software, the Year 2000 issue can be mitigated. However, if such replace-ment, modifications, and conversions are not made, or are not completed on a timely basis and if Nortel Networks’

Financial Review


business continuity plans are ineffective, the Year 2000 issue could have a material adverse effect on the business,results of operations, and financial condition of the Corporation. Although Nortel Networks expects that a number oflegacy applications used by certain lines of business will be replaced by the end of the second quarter of 1999 throughthe enterprise backbone program, failure to replace such applications by the beginning of the year 2000 could have amaterial adverse effect on the business, results of operations, and financial condition of the Corporation. NortelNetworks’ total Year 2000 Program cost and estimates of remaining costs include the estimated costs and time associated with the impact of third parties’ Year 2000 issue on Nortel Networks’ internal systems, and are based onpresently available information. However, there can be no assurance that the systems of other companies on whichNortel Networks’ systems rely will be converted in a timely manner, or that a failure to convert by another corpora-tion, or a conversion that is incompatible with Nortel Networks’ systems, would not have a material adverse effect on Nortel Networks. Nortel Networks’ Year 2000 Program should limit its exposure to contingencies related to theYear 2000 issue for the products it has sold.

In planning for the most reasonably likely worst-case scenarios, Nortel Networks has addressed all three programswhich comprise its Year 2000 Program. Nortel Networks expects that its products will be ready for the Year 2000,and that its exposure lies with customers who are not aware or not willing to complete the required upgrades tomake their Nortel Networks products Year 2000 ready. Nortel Networks’ Product Program includes plans to placeadvertisements in trade journals, conduct seminars, and dedicate a website to contact all possible customers that maypossess non-Year 2000 ready products. Nortel Networks expects that its IT systems will be ready for the Year 2000,but that it may experience isolated incidences of non-compliance and potential outages with respect to IT infra-structure. Nortel Networks plans to allocate internal resources and retain dedicated consultants and vendor representa-tives to be ready to take action should these events occur. Business continuity planning for facilities is currently inprocess, and Nortel Networks is simultaneously putting the required resources in place to carry out those plans forkey facilities. Critical business partners are being contacted to assess their readiness and appropriate business con-tinuity plans will be developed by the end of the second quarter of 1999 to address potential business interruptionsthat may be experienced by such parties. It is a reasonably likely worst-case scenario that some of Nortel Networks’suppliers will experience business interruptions due to the Year 2000 issue. Business continuity planning to addresskey supplier relationships is currently underway. Although Nortel Networks values its established relationships withkey suppliers, alternative products and/or services will be considered in situations where timely confirmation of Year 2000 readiness of products/services or suppliers cannot be established. If certain suppliers are unable to deliverproducts and/or services on a timely basis, due to their own Year 2000 issues, business continuity plans should assurea timely transition to an alternate supplier to provide the required products and/or services. Nortel Networks alsorecognizes the risks to its business if other key suppliers in utilities, communications, transportation, banking, andgovernment are not ready for the Year 2000, and is developing business continuity plans to minimize the potentialadverse impacts of these risks.

European monetary union and the euro

On January 1, 1999, eleven of the fifteen member states of the European Union (EU) adopted the euro as their com-mon legal currency and established fixed, irrevocable exchange rates between their legacy currencies and the euro.Monetary policy for the eleven states (Euroland), including money supply and official interest rates for the euro, isnow the responsibility of the European Central Bank. During a three-year transition period, parties may freely decideto conduct business in either a legacy currency or the cash-less euro under the EU principle of “no prohibition, nocompulsion.” Euro notes and coins will be introduced on January 1, 2002, and legacy currencies will cease to be legaltender by July 1, 2002.

Nortel Networks commenced preparation for the introduction of the euro in 1997 and all affected IT systems havebeen modified to ensure that Nortel Networks can conduct business with both suppliers and customers in eitherlegacy currencies or the euro. The costs of this activity were minimal and are fully reflected in Nortel Networks’ 1998results of operations. Internal transactions which were previously effected in legacy currencies in Euroland wereswitched to the euro on January 1, 1999. Where necessary, existing contracts will be amended to ensure that theintroduction of the euro will not lead to the performance of the contract becoming impossible or frustrated. Directand indirect taxation within Euroland is still the responsibility of each member state and hence no immediatechanges are anticipated as a result of the introduction of the euro; however, further developments of the Economicand Monetary Union (EMU) may include harmonization of some taxes and Nortel Networks will closely monitor anyresulting impact on its business operations. The creation of the euro is expected to have a minor but positive impacton Nortel Networks’ currency risk and risk management programs.

The development of EMU may lead to increased price transparency within EU markets. Nortel Networks willcontinue to review its pricing and marketing strategy to ensure that it remains competitive in all EU markets.Similarly, opportunities to reduce or optimize costs will also be pursued.

Financial Review


Not later than January 1, 2002, all corporate entities in Euroland will have to switch their accounting base fromlegacy currencies to the euro. Nortel Networks is currently assessing the incremental cost of this activity, includingrelated business functions (particularly IT). This one-time expenditure will be incurred primarily in the year 2000,and is not expected to have any material impact on Nortel Networks’ 1999 or 2000 financial results.

Based on information currently available and Nortel Networks’ own analysis, EMU and the introduction of the euroare not expected to have a material adverse effect on its future business, results of operations, or financial condition.

Forward-looking statements

Certain information and statements contained in this Financial Review and other sections of this report, including state-ments containing words such as “could,” “expects,” “may,” “anticipates,” “believes,” “intends,” “estimates,” “plans,” andsimilar expressions constitute forward-looking statements with respect to the financial condition, results of operations,and business of Nortel Networks, including statements that are based on current expectations, estimates, forecasts,and projections about the markets in which Nortel Networks operates and management’s beliefs and assumptionsregarding these markets. In addition, other written or oral statements which constitute forward-looking statementsmay be made by or on behalf of the Corporation. This information and such statements are subject to important risks,uncertainties, and assumptions which are difficult to predict. The results or events predicted in these statements maydiffer materially from actual results or events. Factors which could cause results or events to differ from currentexpectations are discussed below. The Corporation disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

Rapid technological change and voice and data convergence

Nortel Networks expects that data communications traffic will grow substantially in the future compared to the mod-est growth expected for voice traffic. The growth of data traffic is expected to have a significant impact on traditionalvoice networks and create market discontinuities which will drive the convergence of data and telephony and give riseto the demand for IP-optimized networks. Many of Nortel Networks’ traditional customers have already begun toinvest in data networking. Given the dynamic and evolving nature of the communications business and the technologyinvolved, there can be no assurance as to the rate of such convergence. Consequently, there is no assurance that themarket discontinuities and the resulting demand for IP-optimized network equipment will continue to develop.Certain events (including the evolution of other technologies) may occur which would increase the demand for prod-ucts based on other technologies and reduce the demand for IP-optimized network equipment. A lack of demand forIP-optimized network equipment in the future could have a material adverse effect on the business, results of operations,and financial condition of the Corporation.

In order to position Nortel Networks to take advantage of the anticipated growth in demand for IP-optimizednetwork equipment, Nortel Networks has made a number of strategic acquisitions, including the acquisition of BayNetworks. Acquisitions, particularly an acquisition the size of the Bay Networks acquisition, involve significant risksand uncertainties. These risks and uncertainties include the risk that the industry does not evolve as anticipated andthat the technologies acquired do not prove to be those needed to be successful in the industry, the difficulty in inte-grating new businesses and operations in an efficient and effective manner, the risks of customers of Nortel Networks orthe acquired businesses deferring purchase decisions as they evaluate the impact of the acquisition on Nortel Networks’future product strategy, the potential loss of key employees of the acquired businesses, the risk of diverting the attentionof senior management from the operation of the business, and the risks of entering new markets in which NortelNetworks has limited experience. The inability to successfully integrate acquisitions made by Nortel Networks couldhave a material adverse effect on the business, results of operations, and financial condition of the Corporation.

The markets for Nortel Networks’ products are characterized by rapidly changing technologies, evolving industrystandards, frequent new product introductions, and short product life cycles. Nortel Networks’ success is expected todepend, in substantial part, on the timely and successful introduction of new products and upgrades of current prod-ucts to comply with emerging industry standards and to address competing technological and product developmentscarried out by others. The development of new, technologically advanced products, including IP-optimized networkproducts, is a complex and uncertain process requiring high levels of innovation, as well as the accurate anticipationof technological and market trends. The success of new or enhanced products, including IP-optimized networkproducts, is dependent on a number of other factors including the timely introduction of such products, marketacceptance of new technologies and industry standards, and the pricing and marketing of such products. An unan-ticipated change in one or more of the technologies affecting telecommunications and data networking, or in marketdemand for products based on a specific technology, particularly lower than anticipated demand for IP-optimizednetwork products, could have a material adverse effect on the business, results of operations, and financial conditionof the Corporation if it fails to respond in a timely and effective manner to such changes.

Financial Review


Competition

Nortel Networks’ principal competitors are large telecommunications equipment suppliers, such as Lucent Tech-nologies Inc. (Lucent), Siemens AG, and L.M. Ericsson, and data networking companies such as Cisco Systems, Inc.and 3Com Corporation. Since the markets in which Nortel Networks competes are characterized by rapid growthand, in certain cases, low barriers to entry and rapid technological changes, smaller niche market companies andstart-up ventures may become principal competitors in the future. The acquisition of Bay Networks by NortelNetworks was followed by Lucent’s agreement to acquire Ascend Communications Inc. These acquisitions may havethe effect of inducing certain of Nortel Networks’ other competitors to enter into additional business combinations,to accelerate product development, or to engage in aggressive price reductions or other competitive practices, therebycreating even more powerful or aggressive competitors.

Nortel Networks expects that it will face additional competition from existing competitors and from a number ofcompanies that may enter Nortel Networks’ existing and future markets. Some of Nortel Networks’ current andpotential competitors have greater financial (which includes the ability to provide customer financing in connectionwith the sale of its products), marketing, and technical resources. Many of Nortel Networks’ current and potentialcompetitors have also established relationships with Nortel Networks’ current and potential customers. Increasedcompetition could result in price reductions, reduced profit margins, and loss of market share, each of which couldhave a material adverse effect on the business, results of operations, and financial condition of the Corporation.

International growth, foreign exchange, and interest rates

Nortel Networks intends to continue to pursue growth opportunities in international markets. In many internationalmarkets, long-standing relationships between Nortel Networks’ potential customers and their local providers, and pro-tective regulations, including local content requirements and type approvals, create barriers to entry. In addition, pursuitof such international growth opportunities may require significant investments for an extended period before returns onsuch investments, if any, are realized. Such projects and investments could be adversely affected by reversals or delaysin the opening of foreign markets to new competitors, exchange controls, currency fluctuations, investment policies,repatriation of cash, nationalization, social and political risks, taxation, and other factors, depending on the country inwhich such opportunity arises. Difficulties in foreign financial markets and economies, and of foreign financial institu-tions, could adversely affect demand from customers in the affected countries. For a description of these matters as theyrelate to the Asia Pacific and CALA regions and their expected impact on the Corporation, see “Geographic revenues.”

In order to successfully grow in international markets, it is expected that Nortel Networks will be required toprovide significant amounts of customer financing in connection with the sale of products and services. For adescription of this requirement and the risks associated with such financings, see “Liquidity and capital resources.”

General industry and market conditions and growth rates

Nortel Networks’ future operating results may be affected by various trends and factors which must be managed inorder to achieve favourable operating results. In addition, there are trends and factors beyond Nortel Networks’ con-trol which affect its operations. Such trends and factors include adverse changes in the conditions in the specific marketsfor Nortel Networks’ products, the conditions in the broader market for communications, including data networking,computerized information access equipment and services, and the conditions in the domestic or global economygenerally; governmental regulation or intervention affecting communications or data networking; and other factors.

Nortel Networks participates in a highly volatile and rapidly growing industry which is characterized by vigorouscompetition for market share and rapid technological development carried out amidst uncertainty over adoption ofindustry standards and protection of intellectual property rights. These factors could result in aggressive pricingpractices and growing competition both from start-up companies and from well-capitalized computer systems andcommunications companies.

Year 2000 compliance

Many computer systems experience problems handling dates beyond the year 1999. Nortel Networks has a programto assess the readiness of its computer systems and products and believes it is taking the necessary actions to modifyor replace software as required. Nortel Networks expects to implement successfully the systems and programmingchanges necessary to address Year 2000 issues, and does not believe that the cost of such actions will have a materialeffect on Nortel Networks’ business, results of operations, or financial condition. There can be no assurance, how-ever, that there will not be a delay in, or increased costs associated with, the implementation of such changes. NortelNetworks’ inability to implement such changes, or failure to meet customer or competitive requirements on a timelybasis, could have a material adverse effect on future results of operations or financial condition. In addition, manyenterprises are expected to devote a substantial portion of their information systems spending and resources to

Financial Review


resolving the Year 2000 problem. This may result in reduced spending to acquire new networking solutions particularlyin the last quarter of 1999 and could have a material adverse effect on the business, results of operations, and financialcondition of the Corporation. For a description of Nortel Networks’ Year 2000 Program and other risks associatedwith the Year 2000 issue, see “Impact of the Year 2000 issue.”

Consolidations in telecommunications industry

The telecommunications industry has experienced the consolidation of industry participants and this trend is expectedto continue. Nortel Networks and one or more of its competitors may each supply products to the corporations thathave merged or will merge. This consolidation could result in delays in purchasing decisions by the merged corporationsand/or Nortel Networks playing a lesser role in the supply of communications products to the merged corporations,and could have a material adverse effect on the Corporation’s business, results of operations, and financial condition.

United States GAAP reconciliation

For a discussion of the material differences between the Corporation’s accounting policies and United States GAAP,see note 11 of the notes to the Consolidated Financial Statements.

Recent pronouncements

In March 1998, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 98-1,“Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” This SOP revised theaccounting for software development costs and will require the capitalization of certain costs which the Corporationhas historically expensed. The Corporation is currently analyzing the impacts of this SOP, which is required to beadopted for fiscal year 1999.

In June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial AccountingStandards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS No. 133), which estab-lished accounting and reporting standards for derivative instruments and hedging activities. It requires an entity tomeasure all derivatives at fair value and to recognize them in the balance sheet as an asset or liability, depending onthe entity’s rights or obligations under the applicable derivative contract. Management has not yet evaluated theeffects of this statement on its results of operations. As required, the Corporation will adopt SFAS No. 133 in thefirst quarter of 2000.

In December 1997, the Canadian Institute of Chartered Accountants issued Handbook Section 3465,“Accounting for Income Taxes.” These standards require the use of the asset and liability method (which method iscurrently required under United States GAAP). The Corporation is currently analyzing the impacts of this new section, which is required to be adopted for fiscal year 2000.

Financial Review


Dividends

The Corporation declared a cash dividend in each quarter of $.075 per common share, for a total dividend of $.30per common share for the year. Total dividends paid on common shares were $178 million in 1998 and $150 millionin 1997. The Corporation intends to continue paying quarterly dividends on its common shares. The board of direc-tors determines dividend payments based on such considerations as earnings from operations, capital requirements,and Nortel Networks’ financial condition.

Dividends paid to owners of the Corporation’s common shares who are not residents of Canada are subject gener-ally to a 25 percent withholding tax, unless reduced by treaty. Under income tax conventions between Canada andboth the United States and the United Kingdom, a withholding tax of 15 percent generally applies to residents of theUnited States and United Kingdom who do not have a “permanent establishment” or “fixed base” in Canada withwhich the dividends are effectively connected. Persons subject to either United States or United Kingdom incometax on dividends generally will be entitled, subject to certain limitations, to either a credit or deduction with respectto the Canadian taxes withheld.

Gains on disposals of common shares of the Corporation by owners who are not residents of Canada are generallynot subject to Canadian income tax, unless shares are used or held by a non-resident who is carrying on a business in Canada.

Stock prices

The following table shows the high, low, and last (closing) prices of the Corporation’s common shares on The TorontoStock Exchange (TSE) and as reported on the New York Stock Exchange (NYSE) composite tape for each quarter of 1998 and 1997. On January 29, 1999, the last price on the TSE was C$95.700 and on the NYSE was $63.125.

TSE (C$) NYSE composite tape (US$)

High Low Close High Low Close

19981st quarter 92.500 57.500 91.750 65.438 39.688 64.6252nd quarter 100.250 75.500 83.400 69.250 51.375 56.7503rd quarter 94.900 46.250 49.100 63.688 30.438 32.0634th quarter 80.200 41.650 76.600 51.688 26.813 50.000

19971st quarter 52.250 41.703 45.175 38.500 30.250 32.6872nd quarter 62.500 43.500 62.125 45.500 31.063 45.0003rd quarter 74.703 63.875 72.125 53.875 45.125 51.9684th quarter 77.750 56.797 63.575 56.938 40.533 44.375

On December 31, 1998, BCE Inc. owned 40.72 percent of the outstanding common shares of the Corporation, with approximately 12,352 other regis-tered shareholders owning the remaining 59.28 percent.

Total taxes paid

In 1998, Nortel Networks made the following total net cash tax payments:

(millions of U.S. dollars) 1998Income taxes $ 493Payroll, sales, property, and other taxes 555Total $1,048

Total taxes by geographic area:Canada $ 166United States and other 882Total $1,048

Financial Review


The accompanying consolidated financial statements of Northern Telecom Limited and all information in this annu-al report are the responsibility of management and have been approved by the board of directors.

The financial statements have been prepared by management in conformity with generally accepted accountingprinciples in Canada. The financial statements include some amounts that are based on best estimates and judg-ments. Financial information used elsewhere in the annual report is consistent with that in the financial statements.

Management of the Corporation, in furtherance of the integrity and objectivity of the financial statements, hasdeveloped and maintains a system of internal controls and supports an extensive program of internal audits.Management believes the internal controls provide reasonable assurance that financial records are reliable and form aproper basis for the preparation of financial statements, and that assets are properly accounted for and safeguarded.The internal control process includes management’s communication to employees of policies which govern ethicalbusiness conduct.

The board of directors carries out its responsibility for the financial statements in this annual report principallythrough its audit committee, consisting solely of outside directors. The audit committee reviews the Corporation’sannual consolidated financial statements and recommends their approval by the board of directors. The shareholders’auditors have full access to the audit committee, with and without management’s being present.

These financial statements have been examined by the shareholders’ auditors, Deloitte & Touche LLP, CharteredAccountants, and their report follows.

John A. Roth Frank A. DunnVice-Chairman Senior Vice-Presidentand Chief Executive Officer and Chief Financial Officer

To the ShareholdersNorthern Telecom LimitedWe have audited the consolidated balance sheets of Northern Telecom Limited as at December 31, 1998 and 1997and the consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in theperiod ended December 31, 1998. These financial statements are the responsibility of the Corporation’s management.Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in Canada. Those standardsrequire that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosuresin the financial statements. An audit also includes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statement presentation.

In our opinion, these consolidated financial statements present fairly, in all material respects, the financial positionof the Corporation as at December 31, 1998 and 1997 and the results of its operations and its cash flows for each ofthe three years in the period ended December 31, 1998 in accordance with accounting principles generally acceptedin Canada.

Deloitte & Touche LLPChartered AccountantsToronto, CanadaFebruary 1, 1999

Annual.report.98

Independent Auditors’ Report

Annual.report.98

Management’s Report

John A. Roth Frank A. Dunn

Deloitte & Touche LLP


1998 1997 1996

Revenues (note 2) $17,575 $15,449 $12,847Cost of revenues 10,050 9,111 7,714Gross profit 7,525 6,338 5,133

Selling, general and administrative expense 3,093 2,714 2,195Research and development expense (note 5) 2,453 2,147 1,813Amortization of intangibles

Purchased in-process research and development (note 4) 1,241 - -Acquired technology (note 4) 228 - -Goodwill (note 6) 240 48 45

Special charges (note 7) 447 95 -Operating earnings (loss) (177) 1,334 1,080

Equity in net earnings (loss) of associated companies (19) 14 (8)Investment and other income (expense) net (note 8) 234 (14) 47Interest expense

Long-term debt (117) (131) (122)Other (115) (38) (53)

Gain on sales of businesses (note 9) 258 102 -Earnings before income taxes 64 1,267 944

Income tax provision (note 10) 601 438 321Net earnings (loss) (537) 829 623

Dividends on preferred shares 32 17 4Net earnings (loss) applicable to common shares $ (569) $ 812 $ 619

Earnings (loss) per common share (note 3) $ (.99) $ 1.56 $ 1.20

Dividends declared per common share $ .30 $ .29 $ .25

Weighted average number of common shares outstanding (millions) 572 522 516

Annual.report.98

Consolidated Statements of Operations

NORTHERN TELECOM LIMITED YEAR ENDED DECEMBER 31 (MILLIONS OF U.S. DOLLARS EXCEPT PER SHARE FIGURES)


1998 1997

Assets

Current assets

Cash and cash equivalents $ 2,281 $ 1,371Accounts receivable

Related parties (note 22) 248 214Trade (less provision for uncollectibles

$260 for 1998, $223 for 1997) 5,214 4,666Inventories (note 12) 1,687 1,765Prepaid expenses 223 155Deferred income taxes 664 376

10,317 8,547

Long-term receivables

(less provision for uncollectibles $115 for 1998, $25 for 1997) 573 334

Investments

Associated companies at equity 103 118Other 418 167

521 285

Plant and equipment – net (note 13) 2,263 2,040

Intangible assets

Purchased in-process research and development net (note 4) 509 -Acquired technology net (note 4) 1,822 -Goodwill net 3,289 853

5,620 853

Other assets 438 495

Total assets $ 19,732 $12,554

Annual.report.98

Consolidated Balance Sheets

NORTHERN TELECOM LIMITED AS AT DECEMBER 31 (MILLIONS OF U.S. DOLLARS)


1998 1997

Liabilities and shareholders’ equity

Current liabilities

Notes payable $ 186 $ 180Accounts payable and accrued liabilities

Trade and other payables 1,555 1,405Related parties (note 22) 11 4Payroll 172 323Other accrued liabilities 3,697 2,591

Income taxes payable 253 157Long-term debt due within one year (note 15) 19 223

5,893 4,883Long-term liabilities

Deferred income 77 28Long-term debt (note 15) 1,648 1,565Deferred income taxes 94 169Other liabilities 366 367

8,078 7,012Minority interest in subsidiary companies 89 132Commitments and contingencies (notes 16 and 17)

Shareholders’ equity

Preferred shares, without par value Authorized shares: unlimited; Issued and outstanding shares: 30,000,200 for 1998 and 1997 (note 18) 609 609

Common shares, without par value Authorized shares: unlimited; Issued and outstanding shares: 663,104,481 for 1998 and 518,880,270 for 1997 (note 18) 8,553 1,609

Retained earnings 2,568 3,514Additional paid-in capital 199 -Foreign currency translation adjustment (364) (322)

11,565 5,410Total liabilities and shareholders’ equity $19,732 $12,554

On behalf of the Board of Directors

Donald J. Schuenke Ralph M. BarfordDirector Director

Donald J. Schuenke Ralph M. Barford


1998 1997 1996

Preferred shares (note 18)

Balance at beginning of year $ 609 $ 367 $ 73New issues - 242 294

Balance at end of year $ 609 $ 609 $ 367

Common shares (note 18)

Balance at beginning of year $1,609 $1,461 $1,273Shareholder dividend reinvestment and stock purchase plan 4 4 3Stock option plan 121 172 185Shares issued relating to acquisitions 6,844 - -Shares purchased for cancellation (25) (28) -

Balance at end of year $8,553 $1,609 $1,461

Retained earnings

Balance at beginning of year $3,514 $3,290 $2,800Net earnings (loss) (537) 829 623Dividends

Preferred shares (32) (17) (4)Common shares (178) (150) (129)

Excess of cost over carrying amount on common shares purchased for cancellation (199) (438) -

Balance at end of year $2,568 $3,514 $3,290

Additional paid-in capital

Balance at beginning of year $ - $ - $ -Assumed common share options related

to acquisitions (note 20) 215 - -Common shares issued (16) - -

Balance at end of year $ 199 $ - $ -

Foreign currency translation adjustment

Balance at beginning of year $ (322) $ (242) $ (275)Translation of self-sustaining operations (23) (151) 107Impact of foreign currency hedges (19) 71 (74)

Balance at end of year $ (364) $ (322) $ (242)

Annual.report.98

Consolidated Statements of Shareholders’ Equity

NORTHERN TELECOM LIMITED YEAR ENDED DECEMBER 31 (MILLIONS OF U.S. DOLLARS)


1998 1997 1996

Cash and cash equivalents at beginning of year – net $1,371 $ 730 $ 202

Cash flows from operating activities

Net earnings (loss) (537) 829 623Items not involving cash and cash equivalents

Amortization 2,259 546 525Equity in net (earnings) loss of associated companies

in excess of dividends received 24 (6) 8Increase (decrease) in deferred income taxes 59 71 (50)Increase (decrease) in other liabilities 37 5 (8)Gain on sales of businesses net of income taxes (177) (93) -Other (192) (33) (62)

Increase (decrease) in non-cash working capital components (note 20) 113 (519) (102)

Total 1,586 800 934

Cash flows from investing activities

Expenditures for plant and equipment (642) (575) (601)Disposals of plant and equipment 27 5 38Increase in long-term receivables (651) (376) (238)Decrease in long-term receivables 295 570 106Acquisitions and other investments (note 20) 115 (167) (197)Proceeds on sales of businesses (note 9) 751 390 113Total (105) (153) (779)

Cash flows from financing activities

Dividends on common and preferred shares (210) (167) (133)Increase (decrease) in notes payable 6 95 (83)Additions to long-term debt 56 164 457Reductions of long-term debt (281) (38) (347)Reductions of capital leases (3) (1) (7)Issue of preferred shares (note 18) - 242 294Issue of common shares 125 176 188Common shares purchased for cancellation (224) (466) -Total (531) 5 369

Foreign exchange gain (loss) on cash held in foreign currency (40) (11) 4

Cash and cash equivalents at end of year – net $2,281 $1,371 $ 730

Increase in cash and cash equivalents – net $ 910 $ 641 $ 528

Annual.report.98

Consolidated Statements of Cash Flows

NORTHERN TELECOM LIMITED YEAR ENDED DECEMBER 31 (MILLIONS OF U.S. DOLLARS)


1. Significant accounting policies

The consolidated financial statements have been prepared in accordance with accounting principles generally acceptedin Canada. With respect to the consolidated financial statements of Northern Telecom Limited (the Corporation)and its subsidiary companies (collectively, Nortel Networks), there are no material differences between Canadianand United States generally accepted accounting principles (GAAP) except as described in notes 11 and 21. NortelNetworks’ operations domiciled in Canada measure their operations in Canadian dollars and translate to U.S. dollarsfor reporting purposes using the current rate method.

(a) Principles of consolidation

The financial statements of entities which are controlled by the Corporation, referred to as subsidiaries, are consoli-dated; entities which are jointly controlled, referred to as joint ventures, are proportionately consolidated; entitieswhich are not controlled but over which the Corporation has the ability to exercise significant influence, referred toas associated companies, are accounted for using the equity method; and investments in other entities are accountedfor using the cost method.

(b) Translation of foreign currencies

The consolidated financial statements are expressed in U.S. dollars as the greater part of the earnings and net assetsof Nortel Networks are denominated in U.S. dollars.

Self-sustaining operations, which comprise the most significant of the Corporation’s subsidiaries and joint ventures,are those whose economic activities are largely independent of those of the Corporation as a parent company. Assetsand liabilities are translated at the exchange rates in effect at the balance sheet date. Revenues and expenses, includinggains and losses on foreign exchange transactions other than long-term intercompany advances, are translated ataverage rates for the period. The unrealized translation gains and losses on the Corporation’s net investment, includinglong-term intercompany advances, in these operations are accumulated in a separate component of shareholders’equity, described in the consolidated balance sheets as currency translation adjustment (CTA). Exchange gains or losseson certain debt and foreign exchange contracts designated as partial hedges of foreign self-sustaining operations are alsoincluded in CTA. These gains and losses may be realized on the payment of dividends by, or a change in the equitycapital of, a self-sustaining operation, in which event an appropriate portion of CTA is recognized in net earnings.

Integrated subsidiaries and joint ventures are financially or operationally dependent on the Corporation as a parentcompany. Monetary assets and liabilities are translated at the exchange rates in effect at the balance sheet date. Non-monetary assets and liabilities are translated at historical rates. Revenues and expenses are translated at average ratesfor the period, except for amortization which is translated on the same basis as the related assets. Translation exchangegains or losses of integrated subsidiaries, joint ventures, and those subsidiaries operating in hyperinflationary economicenvironments are reflected in net earnings. Unrealized gains and losses on long-term monetary assets and liabilitiesare amortized to income over the remaining lives of the related items.

(c) Revenue recognition

Revenues are generally recognized, net of trade discounts and allowances, upon shipment and when all significantcontractual obligations have been satisfied and collection is reasonably assured. Software revenues are recognized whendelivered in accordance with all terms and conditions of the customer contracts and upon acceptance from the cus-tomer. Revenues on long-term contracts are recognized using the percentage-of-completion method. Profit estimateson long-term contracts are revised periodically based on changes in circumstances, and losses on contracts are recog-nized immediately. Service revenues are recognized at the time of performance or proportionately over the term ofthe contract, as appropriate.

(d) Amortization of plant and equipment

Amortization of plant and equipment is calculated generally on a straight-line basis over their expected useful lives.The expected useful lives of buildings are twenty to forty years, and of machinery and equipment are five to ten years.

(e) Research and development

Research and development (R&D) costs are charged to earnings in the periods in which they are incurred, exceptfor costs incurred pursuant to specific contracts with third parties, which are charged to earnings in the same periodas the related revenue is recognized. Related investment tax credits reduce R&D expense in the same period in whichthe related expenditures are charged to earnings, provided there is reasonable assurance the benefits will be realized.

Annual.report.98

Notes to Consolidated Financial Statements

NORTHERN TELECOM LIMITED (MILLIONS OF U.S. DOLLARS EXCEPT PER SHARE FIGURES AND UNLESS OTHERWISE STATED)


(f) Income taxes

Nortel Networks provides for income taxes based on accounting income using the deferral method. Under thismethod, taxes are computed using current tax rates regardless of when such income is subject to taxes under the taxlaws. The deferred tax balances which result are not adjusted for any subsequent changes in tax rates and includeaccrued investment tax credit benefits.

(g) Cash equivalents

All highly liquid investments with original maturities of three months or less are classified as cash and cash equivalents.The fair value of cash and cash equivalents approximates the amounts shown in the financial statements.

(h) Inventories

Inventories are valued at the lower of cost (calculated generally on a first-in, first-out basis) and net realizable value.The cost of finished goods and work in process comprises material, labor, and manufacturing overhead.

(i) Intangible assets

Purchased in-process R&D represents the value of the acquired R&D which was not technologically feasible as ofthe acquisition date and has no alternative future use, and is charged to earnings using an accelerated amortizationmethod over its estimated useful life of six to nine months.

Acquired technology represents the value of the proprietary “know-how” which was technologically feasible as of the acquisition date, and is charged to earnings on a straight-line basis over its estimated useful life of three years.

Goodwill represents the excess at the dates of acquisition of the costs over the fair values of the net identifiableassets of subsidiary companies, joint ventures, and associated companies, and is amortized on a straight-line basis overits estimated useful life, up to a period of forty years.

The Corporation evaluates on an ongoing basis the carrying value of purchased in-process R&D, acquired tech-nology, and goodwill for potential permanent impairment. In order to determine if such a permanent impairmentexists, Nortel Networks’ management compares the carrying value of these intangible assets to the financial conditionand the present value of the expected future earnings before tax, of the related operations. A permanent impairmentin these intangible assets is written off against earnings in the year that such impairment becomes evident.

( j) Earnings per common share

Earnings per common share are calculated after deducting dividends on preferred shares from net earnings, and arebased on the weighted average number of common shares outstanding during the period.

(k) Derivative financial instruments

Nortel Networks enters into forward, swap, and option contracts to manage its exposure to fluctuations in interestrates and foreign exchange rates. These derivative financial instruments are effective in meeting the risk reductionobjectives of the Corporation by generating cash flows which offset the cash flows related to the underlying position in respect of amount and timing. Nortel Networks does not hold or issue derivative financial instrumentsfor trading purposes.

Forward and cross currency swap contracts are used to hedge certain net foreign investments. Gains and losses onthese instruments are deferred and reported as part of CTA, as outlined in note 1(b). Forward, option, and cross cur-rency coupon swap contracts are used to hedge firm sale and purchase commitments which are denominated in foreign currencies. The unrecognized gains and losses on these contracts are not carried on the balance sheet but arerecognized in income when the hedged transaction occurs. Amounts that are receivable or payable under interestrate swaps are accrued and recorded as adjustments to interest expense. Any premiums paid with respect to deriva-tive financial instrument contracts are deferred and charged to earnings over the contract period.

(l) Use of estimates

The preparation of Nortel Networks’ financial statements in conformity with GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assetsand liabilities at the date of the financial statements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates. Estimates are used when accounting for items andmatters such as long-term contracts, allowance for uncollectible accounts receivable, inventory obsolescence, productwarranty, amortization, employee benefits, taxes, provisions, and contingencies.




(m) Allowance for credit losses

Nortel Networks maintains an allowance to absorb credit-related losses in its portfolio of on-balance sheet and off-balance sheet financing assets and liabilities (the Financing Portfolio). The Financing Portfolio is primarily composedof medium-term and long-term customer-financed receivables and guarantees. This allowance is part of the provisionfor uncollectibles. The allowance is reviewed quarterly for adequacy of impairment coverage and, in management’sopinion, is considered adequate to absorb any credit-related losses in the Financing Portfolio.

(n) Postemployment benefits

Pension expense, based on management’s assumptions, consists of the actuarially computed costs of the pensionbenefits in respect of the current year’s service; imputed interest on plan assets and pension obligations; and straight-line amortization of experience gains and losses, assumption changes, and plan amendments over the expected averageremaining service life of the employee group. The costs of postemployment health care and life insurance benefits areexpensed as incurred.

2. Information on operating segments

General description

Nortel Networks’ operations include two reportable operating segments: carrier and enterprise. The carrier segmentincludes: products which are used by telecommunications operating companies to interconnect access lines and trans-mission facilities to provide local or long-distance services, products to address wireless communications, and productswhich transport voice, data, image, and video communications between locations within a city or between cities,countries, or continents. The enterprise segment products are primarily private digital switching systems, usuallylocated on the customer’s premises, which permit voice, data, or multimedia terminals to communicate with eachother, with or without the use of wide-area public telephone networks.

The Corporation’s reportable segments also represent those product classes that provide unified networking solutionsto two specific customer groups. These segments provide network solutions that integrate data, voice, and video on asingle network using a combination of packet frame and cell technologies. The network solutions involve the conver-gence of traditionally disparate networks for seamless end-user connectivity, reduced costs, and flexible bandwidthmanagement. The solutions address corporate intranet (enterprise) and Internet access, as well as high-speed networktransport (carrier).

The accounting policies of the segments are the same as those described in note 1. The Corporation evaluatesfinancial performance based on measures of profit or loss from operations before income taxes, excluding the impactof the amortization of the Bay Networks, Inc. (Bay Networks) intangible assets and purchased in-process R&D fromother acquisitions, and one-time gains and charges (see notes 4, 7, 8, and 9). Inter-segment revenues were immaterialfor the years ended December 31, 1998, 1997, and 1996.




Operating segments

The Corporation does not allocate income taxes or unusual items to the operating segments. In addition, the operatingsegments do not have significant non-cash items other than amortization on plant and equipment. The followingtables set forth information by operating segment for the year ended December 31:

Carrier Enterprise Corporate1998 Segment Segment & Other Total

Customer revenues $12,374 $ 4,877 $ 324(a) $17,575Earnings before income taxes from operations 1,576 639 (515)(b) 1,700(c)

Earnings per share from operations 1.78 .72 (.64) 1.86(d)

Interest income 26 3 92 121Amortization 194 74 282 550Interest expense 29 1 202 232Total assets 6,692 2,678 10,362(e) 19,732Capital expenditures 309 104 229 642


Customer revenues $10,879 $ 3,879 $ 691(a) $15,449Earnings before income taxes from operations 1,165 455 (360)(b) 1,260(c)




Customer revenues (f ) $ 8,269 $ 3,672 $ 906(a) $12,847Earnings before income taxes from operations 811 506 (373)(b) 944(c)



(a) Represents revenues from business units below the quantitative thresholds, primarily divested businesses and com-ponents businesses which provide high-performance semi-conductors, microwave modules, and other sub-assembliesand services.

(b) Includes corporate services, the organization that manages the centralized internal functions of the Corporation.Corporate services is managed on a “fee for service” basis. The corporate services expenses are charged to the operatingsegments either on a direct basis or through a matrix allocation. Direct charges are based on actual usage of serviceswhile matrix allocation is based on revenue, headcount, or some other appropriate driver. Costs not charged to theoperating segments remain within Corporate & Other. Excludes the impact of the amortization of the Bay Networksintangible assets and purchased in-process R&D from other acquisitions and one-time gains and charges.




(c) Earnings before income taxes1998 1997 1996

Total earnings before income taxes from operationsfor reportable segments $1,700 $1,260 $ 944

Amortization of intangibles:Purchased in-process R&D (1,241) - -Acquired technology (228) - -Bay Networks goodwill (161) - -

One-time gains 441 102 -One-time charges (447) (95) -Total $ 64 $1,267 $ 944

(d) See note 3 Supplementary measures of net earnings and earnings per share.

(e) Includes corporate assets of $3,773, $2,224, and $1,763, and intangible assets of $5,620, $853, and $942 in theyears ended December 31, 1998, 1997, and 1996, respectively.

(f ) Only customer revenues have been restated to reflect the current year’s presentation, as it was impracticable torestate other line items.

Product revenues

Enterprise Networks includes Bay Networks revenues since August 31, 1998. Comparative amounts have been restatedto conform to the current year’s presentation. The following table sets forth information by product line for the yearended December 31:

PublicCustomer Carrier Broadband Wireless EnterpriseRevenues Networks Networks Networks Networks Other Total

1998 $ 4,118 $ 4,513 $ 3,743 $ 4,877 $ 324 $17,5751997 4,054 3,371 3,454 3,879 691 15,4491996 3,441 2,547 2,281 3,672 906 12,847

Geographic areas

The point of origin (the location of the selling organization) of revenues and the location of the assets determine thegeographic areas. The following table sets forth information about geographic areas for the year ended December 31:

1998 1997 1996Total revenues:United States

Customers $10,942 $ 9,105 $ 7,401Transfers between geographic areas 887 934 1,067

11,829 10,039 8,468Canada

Customers 1,802 1,858 1,489Transfers between geographic areas 3,611 3,443 2,777

5,413 5,301 4,266All other countries

Customers 4,831 4,486 3,957Transfers between geographic areas 504 697 605

5,335 5,183 4,562Elimination of transfers between geographic areas (5,002) (5,074) (4,449)Total customer revenues $17,575 $15,449 $12,847




1998 1997 1996Contribution to operating earnings:United States $ 1,747 $ 2,148 $ 1,900Canada 520 957 712Other 505 754 708

2,772 3,859 3,320R&D expense (2,453) (2,147) (1,813)General corporate expenses (496) (378) (427)Operating earnings (177) 1,334 1,080Other income less non-operating expenses (17) (169) (136)Gain on sales of businesses 258 102 -Earnings before income taxes $ 64 $ 1,267 $ 944

Identifiable assets:United States $ 9,927 $ 5,055 $ 4,213Canada 2,916 2,632 2,274Other 4,360 4,697 3,610Adjustments and eliminations (1,244) (2,054) (957)Identifiable assets 15,959 10,330 9,140Corporate assets 3,773 2,224 1,763Total assets $19,732 $12,554 $10,903

Plant and equipment and goodwill:United States $ 3,154 $ 620 $ 639Canada 911 734 769Other 1,487 1,539 1,569Total $ 5,552 $ 2,893 $ 2,977

Transfers between geographic areas are made at prices based on total cost of the product to the supplying segment.

Customer revenues by destination for the year ended December 31 were:1998 1997 1996

United States $ 9,841 $ 8,298 $ 6,858Canada 1,360 1,374 1,233Other 6,374 5,777 4,756Total $17,575 $15,449 $12,847

Export sales, defined as revenues from Canada to customers outside Canada, and intercompany transfers out ofCanada, amounted to $4,053, $3,927, and $3,033 for the years ended December 31, 1998, 1997, and 1996, respectively.

Operating earnings represent total revenues less operating expenses. In computing segmented operating earnings,the following items have been excluded: equity in net earnings (loss) of associated companies, investment and otherincome (expense) – net, interest expense, gain on sales of businesses, general corporate expenses, R&D expense, andincome tax provision.

Identifiable assets are those assets of Nortel Networks that are identified with the operations in the geographicarea. Corporate assets are principally cash and cash equivalents and corporate plant and equipment.




3. Supplementary measures of net earnings and earnings per share

As a measure to assess financial performance, management utilizes supplementary measures of net earnings and earningsper common share which exclude the impact of amortization of the Bay Networks intangible assets and purchased in-process R&D from other acquisitions, and one-time gains and charges. The supplementary measures of net earningsand earnings per share are as follows:

1998 1997 1996Net earnings (loss) applicable to common shares $ (569) $ 812 $ 619Add back:

Acquisition-related amortizationPurchased in-process R&D 1,241 - -Acquired technology 228 - -Bay Networks goodwill 161 - -

One-time gains (notes 8 and 9) (441) (102) -One-time charges (note 7) 447 95 -Net tax impact (2) (1) -

Supplementary measure of net earnings $1,065 $ 804 $ 619

Supplementary measure of earnings per common share 1.86 1.54 1.20Weighted average number of common shares

outstanding (millions) 572 522 516

4. Business combinations

Nortel Technology Limited

On December 22, 1998, the Corporation acquired all of the common and preferred shares of Nortel TechnologyLimited (Nortel Technology), formerly known as Bell-Northern Research Ltd., owned by Bell Canada for approxi-mately $18 in cash, which approximated the fair value of such shares. The transaction increased the Corporation’sownership of Nortel Technology from 70 percent to 100 percent. This transaction was recorded at the exchange amount.

Cambrian Systems Corporation

On December 15, 1998, the Corporation acquired all the issued and outstanding common shares of CambrianSystems Corporation (Cambrian), a company engaged in the production of metropolitan optical networking technology.The aggregate purchase price was approximately $248, consisting of $231 in cash and $17 of additional liabilities. Inaddition, approximately $60 in cash is contingent upon the achievement of certain milestones in 1999. The acquisi-tion was accounted for using the purchase method. The allocation of the purchase price was to assumed liabilitiesnet of tangible assets of $4, purchased in-process R&D assets of $204, and goodwill of $48. This allocation is subjectto refinement. The purchased in-process R&D assets are being charged to earnings over a six-month period, usingan accelerated amortization method. Goodwill is being amortized on a straight-line basis over five years. As atDecember 31, 1998, none of the milestone events had been achieved.

Bay Networks, Inc.

On August 31, 1998, the Corporation acquired Bay Networks, a Delaware corporation which provides network-ing products and services. The acquisition was consummated by way of a merger of Bay Networks with and into awholly owned subsidiary of the Corporation (the Bay Networks Merger). The aggregate purchase price was approxi-mately $6.9 billion, which was based on the closing market price of the Corporation’s common shares on the closingday of the Bay Networks Merger, the value of the assumed Bay Networks stock options, and the merger-relatedcosts. At closing, the Corporation issued approximately 135 million common shares and assumed 39.4 millionoptions to purchase Bay Networks common stock, which were equivalent to 23.6 million options to purchase com-mon shares of the Corporation (note 19). The intrinsic value attributable to these options was $189.

The acquisition was accounted for using the purchase method. The allocation of the purchase price was to tangibleassets of $1,881, assumed liabilities of $475, acquired technology assets of $2,050, purchased in-process R&D assetsof $1,000, and goodwill of $2,417. This allocation is subject to refinement. The acquired technology assets are beingcharged to earnings on a straight-line basis over thirty-six months and the purchased in-process R&D assets arebeing charged to earnings over a nine-month period using an accelerated amortization method. Goodwill is beingamortized on a straight-line basis over five years.




r3 Security Engineering AG

On June 8, 1998, Entrust Technologies Inc. (Entrust Technologies), a Nortel Networks subsidiary, completed theacquisition of r3 Security Engineering AG (r3), a company based in Zurich, Switzerland, which provides consulting,applied research, and product development services related to commercial security and encryption solutions. Theaggregate purchase price was approximately $24, comprising approximately 1.1 million common shares of EntrustTechnologies and cash consideration of approximately $4. The acquisition has been accounted for by EntrustTechnologies using the purchase method. The allocation of the purchase price was to purchased in-process R&D assetsof $20 and goodwill of $4. The purchased in-process R&D assets are being charged to earnings over a nine-monthperiod using an accelerated amortization method. Goodwill is being amortized on a straight-line basis over five years.

Matra Nortel Communications S.A.S. and Nortel Matra Cellular SCA

On May 13, 1998, Nortel Networks and Lagardère SCA (Lagardère) entered into an amended and restated participa-tion agreement to realign Matra Nortel Communications S.A.S., a joint venture in which Nortel Networks andLagardère each hold a 50 percent ownership interest. The agreements relating to this realignment provided for, amongother things: (i) Matra Communication S.A.S. to change its name to Matra Nortel Communications S.A.S. (MNC),(ii) Nortel Networks to transfer at their exchange amounts the assets and liabilities of its distribution business inFrance to MNC, (iii) MNC to sell its 50 percent ownership in Matra Ericsson Telecommunications (MET) to LM Ericsson (note 9), and (iv) Nortel Networks to lend $120 to MNC. This loan matures on January 2, 2003, bearsinterest at 3 percent per annum, and is payable by MNC to Nortel Networks either in cash or by way of transfer ofMNC’s 34 percent equity interest in Nortel Matra Cellular SCA (NMC). Nortel Networks has the option, at its solediscretion, to require the repayment of the loan by way of transfer of the NMC shares, and as a result, NortelNetworks is accounting for NMC as if it were a wholly owned subsidiary. After July 1, 1999, Lagardère may, underspecific circumstances, require Nortel Networks to purchase all of its equity participation in MNC at a price to bebased partly on a formula and partly on the fair market price as determined at that time.

Aptis Communications, Inc.

On April 22, 1998, the Corporation acquired Aptis Communications, Inc. (Aptis), a Massachusetts-based, remote-access data networking start-up company. The acquisition was consummated by way of a merger of Aptis with andinto a wholly owned subsidiary of the Corporation. The aggregate purchase price was approximately $286 includingcontingent consideration. At closing, the Corporation issued approximately 2.5 million common shares and paidapproximately $5 in cash to the Aptis security holders. Subject to the fulfillment of certain conditions, approximately$37 in cash and common shares of the Corporation will be paid to the Aptis security holders over the next three years,of which $3 was paid during 1998. The remainder of the purchase price (approximately $71) has been contingent uponthe achievement of certain milestone events scheduled to occur subsequent to closing and has been payable, at theCorporation’s option, in common shares of the Corporation and/or cash, of which $61 had been paid at year end.The acquisition has been accounted for using the purchase method. The allocation of the purchase price was to nettangible assets of $8, purchased in-process R&D assets of $203, and goodwill of $75. This allocation is subject torefinement. The purchased in-process R&D assets are being charged to earnings over a nine-month period using anaccelerated amortization method. Goodwill is being amortized on a straight-line basis over five years.

Broadband Networks Inc.

On January 9, 1998, the Corporation acquired all the issued and outstanding common shares of Broadband NetworksInc. (BNI), a company engaged in the design and manufacture of fixed broadband wireless communications networks. The aggregate purchase price was approximately $433, comprising approximately $149 in cash and approxi-mately 5.6 million of the Corporation’s common shares. The acquisition was accounted for using the purchase method.The allocation of the purchase price was to net tangible assets of $29, purchased in-process R&D assets of $329, andgoodwill of $75. The purchased in-process R&D assets are being charged to earnings over a nine-month period usingan accelerated amortization method. Goodwill is being amortized on a straight-line basis over five years.

MICOM Communications Corp.

In June 1996, the Corporation acquired all of the outstanding common shares of MICOM Communications Corp.(MICOM), a manufacturer and distributor of integrated networking solutions, for an aggregate purchase price ofapproximately $150. The acquisition was accounted for using the purchase method. The allocation of the purchaseprice was to net tangible assets of $35 and goodwill of $115. Goodwill is being amortized on a straight-line basis over ten years.




Purchased in-process R&D

Although Nortel Networks reported its first, second, and third quarter results of 1998 in accordance with establishedaccounting practice and valuations of acquired in-process R&D provided by independent valuators, these valuationshave been reconsidered in light of guidance provided by the United States Securities and Exchange Commissionregarding valuation methodology.

Based on this new valuation methodology, the value of the purchased in-process R&D related to the Bay NetworksMerger was reduced to $1,000 and goodwill was increased by $440. With respect to the Aptis acquisition, the valueof the purchased in-process R&D was reduced to $203 and goodwill was increased by $75. Similarly, the amount ofpurchased in-process R&D related to the BNI acquisition was reduced to $329 and goodwill was increased by $64.The cumulative net effect in 1998 was to reduce the loss applicable to common shares by $385.

The table below is a reconciliation of the purchased in-process R&D reflected from the above-mentioned acquisitions.

1998 1997 1996Opening $ - $ - $ -Plus: Purchased in-process R&D:

Cambrian 204 - -Bay Networks 1,000 - -r3 20 - -Aptis 203 - -BNI 329 - -

Less: Amortization (1,241) - -Foreign exchange adjustment (6) - -

Closing $ 509 $ - $ -

5. Research and development1998 1997 1996

R&D expense $2,453 $2,147 $1,813R&D costs incurred on behalf of others* 97 125 166Total $2,550 $2,272 $1,979

*These costs include R&D charged to customers of Nortel Networks pursuant to contracts that provide for full recovery of the estimated cost of devel-opment, material, engineering, installation, and all other attracted costs, which are accounted for as contract costs.

The above amounts are net of global investment tax credits of $125, $123, and $118 in 1998, 1997, and 1996, respectively.

6. Goodwill amortization

Total goodwill amortization charged to operations for the years ended December 31, 1998, 1997, and 1996 was $240,$48, and $45, respectively.

7. Special charges

The following special charges, aggregating $447, were reflected in the 1998 results:

(i) A provision of $377 related to steps taken to streamline management layers, gain operational efficiencies, andrealign resources and investments. Included in the provision was $261 representing the cost of severance and relatedbenefits for approximately 4,100 employees worldwide, which includes $70 for individuals in R&D activities. Themajority of Nortel Networks’ business functions, job classes, and geographic areas were impacted, with a majority ofthe reductions taking place in the United States and Canada. Also included in the provision was $93 in non-cashexpenses for plant and equipment and other write-downs, and $23 in facilities and other costs, primarily related towireless networks and enterprise networks. All of these activities are expected to be substantially completed bySeptember 30, 1999. As at December 31, 1998, $119 of severance, benefits, and other personnel-related costs, and$23 in facilities and other costs had been paid, and $60 in non-cash expenses for plant and equipment and otherwrite-downs had been recognized.




(ii) A write-down of approximately $22 in connection with MNC, primarily related to reductions in the carryingvalue of certain assets. Nortel Networks’ proportionate share of this reduction was 50 percent, resulting in a write-down of approximately $11.

(iii) A provision of $59 comprising a write-down of $32 related to certain assets and investments held by the Cor-poration, severance of $16, and plant rearrangement and relocation costs of $11. The majority of the severance andplant rearrangement and relocation costs related to a charge taken by Nortel plc to downsize a portion of its FixedWireless Access (FWA) manufacturing operations in Paignton, United Kingdom. These activities are expected to besubstantially completed by June 30, 1999.

The following special charges, aggregating $95, were reflected in the 1997 results:

(i) A write-down of $51 related to certain investments held by the Corporation, including a $22 write-down ofNortel Networks’ minority ownership of ICL plc, with the remainder related to reductions in the carrying value ofcertain assets and/or the revaluation of goodwill associated with certain Nortel Networks investments or operations,principally in China and Taiwan. These charges are due to the Corporation’s expectations of lower future cash flowsand earnings from these non-core businesses. As at December 31, 1998, these activities were substantially completed.

(ii) A provision of $44 for the rationalization and/or relocation of certain manufacturing facilities. Approximatelyone-half of this provision related to a charge taken by MNC, the Corporation’s joint venture in France, to relocate aportion of its terminals manufacturing operations from Germany to France. Other affected facilities include the ter-minals manufacturing operations in Calgary, Alberta, and Cwmcarn, Wales. The provision was established to provideprimarily for severance payments of approximately $26 and plant rearrangements and relocation costs of $13, with theremainder related to asset impairments. As at December 31, 1998, these activities were substantially completed.

8. Investment and other income (expense) – net1998 1997 1996

Interest income $121 $ 92 $100Royalty income 38 26 33Currency exchange losses (74) (50) (44)Minority interest 15 (26) (19)Lagardère share sale 70 - -NetSpeed Inc. share sale 24 - -Entrust Technologies share sale 34 - -Gain on reduction in ownership of subsidiary stock 55 - 19Other (49) (56) (42)Investment and other income (expense) net $234 $ (14) $ 47

The following transactions, aggregating to $183, were reflected in the 1998 results:

(i) During 1998, Nortel Networks sold approximately 2.5 million common shares of Lagardère, an investment heldat cost, for proceeds of approximately $105, resulting in a pre-tax gain of $70.

(ii) On September 30, 1998, Nortel Networks exercised its option to sell its 9.9 percent holding in ICL plc, an invest-ment held at cost, in return for proceeds of approximately $93, resulting in neither a gain nor a loss.

(iii) Effective April 10, 1998, Nortel Networks sold its equity interest in NetSpeed Inc. Nortel Networks receivedaggregate proceeds of approximately $32, comprising cash and common shares of the acquirer, resulting in a pre-taxgain of $24.




(iv) Investments in Entrust TechnologiesDuring 1996, Nortel Networks formed Entrust Technologies to carry on the business of its secure networks businessunit and to provide key infrastructure software products for the encryption and digital signature of information com-municated between client workstations over the Internet and intranets. In 1996, Entrust Technologies issued 260,000Series B Common Shares for total consideration of $26, which reduced Nortel Networks’ ownership interest inEntrust Technologies to 72.9 percent.

On June 8, 1998, the issuance of 1.1 million common shares by Entrust Technologies in connection with the r3

acquisition reduced Nortel Networks’ interest in Entrust Technologies from 72.9 percent to 69.9 percent, and resultedin a gain on reduction in ownership in subsidiary stock of approximately $12.

Effective August 21, 1998, Entrust Technologies completed an initial public offering and secondary offering bycertain of its shareholders, including Nortel Networks, of its common shares. These offerings reduced Nortel Networks’ownership interest in Entrust Technologies to 53.4 percent and resulted in pre-tax gains of approximately $77.

9. Sales of businesses

The following transactions, aggregating to a gain of $258, were reflected in the 1998 results:

(i) On September 25, 1998, Nortel Networks completed the sale of its Advanced Power Systems business to Astec(BSR) plc, for cash consideration before closing adjustments of $325, resulting in a pre-tax gain of approximately $230.

(ii) On July 24, 1998, Nortel Networks completed the sale of its assembling and testing frames and cabinets facilityin Creedmoor, North Carolina, to C-MAC Industries Inc. On the closing of this transaction, Nortel Networksreceived cash proceeds of approximately $54, resulting in a pre-tax gain of $30.

(iii) On June 25, 1998, MNC entered into an agreement to sell the Research and Development Centre of its GSMTerminals business to Finland Nokia Group. On the closing of this transaction, MNC received cash proceeds ofapproximately $18, resulting in a pre-tax loss of $32. Nortel Networks’ proportionate share of this transaction is 50 percent, resulting in a pre-tax loss of $16.

(iv) As part of its realignment (note 4), MNC sold its 50 percent ownership interest in MET in return for cashproceeds of approximately $114, resulting in a pre-tax gain of $28. Nortel Networks’ proportionate share of thistransaction is 50 percent, resulting in a pre-tax gain of $14.

The following transactions were reflected in the 1997 and 1996 results:

(i) Effective April 1, 1997, Nortel Networks sold its TTS Meridian Systems Inc. and Nortel CommunicationsSystems Inc. distribution channels to WilTel Communications, LLC. On the closing of the transaction, NortelNetworks received cash proceeds of $216 and a 30 percent ownership interest in WilTel Communications, LLC,resulting in a pre-tax gain of $102.

(ii) Effective February 2, 1996, Nortel Networks sold its structured wiring and copper wire and cable business toCable Design Technologies (CDT) Canada Inc., since renamed NORDX/CDT, Inc., for gross proceeds, before closing adjustments, of $90, resulting in no material gain or loss.




10. Income taxes

The following is a reconciliation of income taxes calculated at the Canadian combined federal and provincial incometax rate to the income tax provision included in the consolidated statements of operations:

1998 1997 1996Income taxes at Canadian rates

(1998 43.0%, 1997 43.0%, 1996 42.9%) $ 28 $ 545 $ 405Increase (reduction) of Canadian taxes applicable

to manufacturing profits (18) (14) 3Difference between Canadian rate and rates applicable

to United States and other subsidiaries (92) (46) (67)Difference between basic Canadian rate and rates

applicable to gain on sales of businesses (30) (35) -Non-deductible amortization of acquired intangibles 735 21 19Other (22) (33) (39)Income tax provision $ 601 $ 438 $ 321

Details of Nortel Networks’ income taxes:Earnings (loss) before income taxes:

Canadian, excluding gain on sales of businesses $(1,036) $ 156 $ (32)United States and other, excluding gain on sales of businesses 842 1,009 976Gain on sales of businesses 258 102 -

$ 64 $1,267 $ 944

Income tax provision (recovery):Canadian, excluding gain on sales of businesses $ 86 $ 63 $ (18)United States and other, excluding gain on sales of businesses 434 366 339Gain on sales of businesses 81 9 -

$ 601 $ 438 $ 321

Income tax provision (recovery):Current $ 641 $ 484 $ 373Deferred (40) (46) (52)

$ 601 $ 438 $ 321

The deferred portion of the income tax provision results from the recognition of certain revenues and expenses inthe financial statements in different periods from those for income tax purposes. The following is a summary of thecomponents:

1998 1997 1996Amortization $ (13) $ (8) $ (14)Contracts in progress and other income items - (2) 4Realignment costs and other charges (65) 8 20Gain on sales of businesses (14) (2) -Other 52 (42) (62)

$ (40) $ (46) $ (52)

At December 31, 1998, for income tax purposes, Nortel Networks had operating loss carry forwards of approximately$290, the majority of which expire between 1999 and 2005, and approximately $241 from other foreign jurisdictionsexcluding the United States, which can be applied indefinitely against future income.

The Corporation’s effective tax rate for the year ended 1998 was 35.5 percent, excluding the amortization of theBay Networks intangible assets and purchased in-process R&D from other acquisitions.




11. The effect of applying United States GAAP

The Corporation’s accounting policies are consistent in all material aspects with United States GAAP with the follow-ing exceptions:

Net earnings reconciliation1998 1997 1996

Net earnings applicable to common shares Canadian GAAP $ (569) $ 812 $ 619

Adjustments:Purchased in-process R&D (i) (515) - -Goodwill (ii) (196) - -Postretirement benefits other than pensions (iii) (31) (29) (26)Income taxes (iv) 62 (59) (33)Income tax benefit related to stock options (v) (28) (38) -Postemployment benefits (vi) 3 9 -Financial instruments and hedging activities (vii) (8) - -

Net earnings applicable to common shares United States GAAP $(1,282) $ 695 $ 560Basic earnings per common share United States GAAP (viii) $ (2.24) $ 1.33 $ 1.08Fully diluted earnings per common share United States GAAP (viii) $ (2.24) $ 1.30 $ 1.07Common share effect of GAAP differences in year $ (1.25) $ (.23) $ (.12)Cumulative per common share effect of GAAP

differences since January 1, 1993 $ (1.88) $ (.63) $ (.40)

The cumulative effect on retained earnings of GAAP differences since January 1, 1993, as at December 31, 1998, 1997,and 1996, was $(1,035), $(322), and $(205), respectively.

(i) For the purpose of reporting under United States GAAP, companies are required to immediately write off purchasedin-process R&D assets and, accordingly, the purchased in-process R&D assets acquired on the acquisitions ofCambrian of $204, Bay Networks of $1,000, r3 of $20, Aptis of $203, and BNI of $329 were written off at the timeof acquisition. The pre-tax adjustment represents the difference between the write-off of purchased in-process R&Drecorded under United States GAAP and the purchased in-process R&D expense recorded under Canadian GAAP,which is amortized over the useful life of the asset.

(ii) For the purpose of reporting under United States GAAP, the aggregate purchase price of Bay Networks wasapproximately $9 billion, which was based on the average closing market price of the Corporation’s common sharesaround June 15, 1998 (the date of the announcement of the transaction), the value of the assumed Bay Networksstock options, and the merger-related costs. The aggregate purchase price under United States GAAP also includesthe value of the assumed Bay Networks stock options, which resulted in further additional paid-in capital of $659 ona fair value basis using the Black-Scholes valuation model. In addition, as a result of the use of the asset and liabilityapproach in accounting for income taxes, a deferred income tax liability has been calculated in respect of theacquired technology assets in accounting for the purchase under United States GAAP. The allocation of the purchaseprice under United States GAAP was to tangible assets of $1,881, assumed liabilities of $1,223, including a deferredincome tax credit of $748, acquired technology assets of $2,050, purchased in-process R&D assets of $1,000, andgoodwill of $5,352.

The Corporation’s financial statements for the year ended December 31, 1998, include four months of financialresults of Bay Networks. The following selected pro forma financial information is provided as additional disclosure, inaccordance with United States GAAP, to present a summary of the combined results of the Corporation and BayNetworks as if the acquisition had occurred as at January 1, 1997, after giving effect to purchase accounting adjust-ments. The pro forma data is for information purposes only, and may not necessarily reflect the impact of the resultsof operations of Bay Networks had the acquired business operated as part of the Corporation for the years endedDecember 31, 1998 and 1997.




1998 1997Pro forma revenue $18,203 $16,883Pro forma loss from continuing operations* $ (1,647) $ (809)Pro forma loss per share* $ (2.54) $ (2.80)

*These pro forma amounts reflect the results of operations for the Corporation and Bay Networks having given effect to the purchase accountingadjustments for the periods presented, and excluding the impact of the non-recurring charge for the purchased in-process R&D assets associated withthe transaction.

(iii) For the purpose of reporting under United States GAAP, companies are required to accrue the expected cost ofpostretirement benefits other than pensions during the years employees provide service to the company. The adjust-ment represents the difference between recognizing the cost of postretirement benefits as claims are paid and usingthe accrual method.

The Corporation has adopted Financial Accounting Standard Board (FASB) Statement No. 132, “Employers’Disclosures about Pensions and Other Postretirement Benefits,” which revises the disclosures for pensions and otherpostretirement benefits and standardizes them into a combined format. Prior years’ information has been reclassifiedfor its impact. The following data are based upon the reports from independent consulting actuaries as at December 31:

1998 1997 1996Accrued postretirement benefit cost:

Accumulated postretirement benefit obligation $618 $580 $487Plan assets at fair value (36) (36) (37)Unrecognized prior service cost (56) (61) (63)Unrecognized net gain (loss) (45) (39) 20Accrued postretirement benefit cost $481 $444 $407

Postretirement benefit cost:Service cost $ 24 $ 21 $ 19Interest on projected plan benefits 41 40 35Return on plan assets (3) (3) (3)Amortization 4 4 4Postretirement benefit cost 66 62 55Less: Claims paid and expensed under Canadian GAAP 15 15 14United States GAAP adjustment for postretirement benefits $ 51 $ 47 $ 41After tax impact of adjustment $ 31 $ 29 $ 26

Assumptions:Weighted average discount rate 6.8% 7.1% 7.9%Expected long-term rate of return on assets 8.5% 7.8% 7.9%Weighted average health care cost trend rate 8.0% 7.7% 8.2%Weighted average ultimate health care cost trend rate 4.8% 5.3% 5.3%Year in which ultimate health care cost trend rate

will be achieved 2004 2002 2002

1998 1997Change in postretirement benefit obligation:

Benefit obligation at beginning of year $580 $487Service cost 24 21Interest on projected plan benefits 41 40Amendments - 3Plan participants’ contributions 1 1Actuarial gain 8 60Benefits paid (17) (18)Foreign exchange (19) (14)Benefit obligation at end of year $618 $580




1998 1997Change in plan assets:

Fair value of plan assets at beginning of year $ 36 $ 37Actual return on plan assets 1 -Employer contribution 1 -Benefits paid (2) (2)Expected interest on assets 2 2Foreign exchange (2) (1)Fair value of plan assets at end of year $ 36 $ 36

Assumed health care cost trend rates have a significant effect on the amounts reported for health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects:

1-percentage- 1-percentage-point increase point decrease

Effect on accumulated postretirement benefit obligation $45 $(25)Effect on aggregate of the service and interest cost components

of net postretirement benefit cost 4 (3)

(iv) For the purpose of reporting under United States GAAP, companies are required to use the asset and liabilityapproach in accounting for income taxes. The adjustment represents the difference between the deferral method,under Canadian GAAP, and the asset and liability method. The following table shows the main items included indeferred income taxes under United States GAAP as at December 31:

1998 1997Deferred income taxes:Assets:

Tax benefit of loss carry forwards and tax credits $ 473 $ 493Provisions and reserves 810 456Postretirement benefits other than pensions 46 43Amortization 34 -Other 53 49

1,416 1,041Valuation allowance (250) (240)Goodwill 686 (12)

1,852 789Liabilities:

Acquired technology 665 -Provisions and reserves 358 391Amortization 100 110Pensions 57 21Other 36 6

1,216 528Net deferred income taxes $ 636 $ 261

(v) For the purpose of reporting under United States GAAP, the tax benefit associated with deductible stock optioncompensation is treated as an increase in share capital. For reporting under Canadian GAAP, the income tax benefitis more appropriately treated as a reduction to the income tax provision if compensation costs are not recorded.




(vi) For the purpose of reporting under United States GAAP, companies are required to accrue, during the yearsemployees provide service to the company, the expected cost of benefits to former or inactive employees afteremployment, but before retirement. The adjustment represents the difference between recognizing the cost of post-employment benefits as claims are paid and using the accrual method. The net accrued postemployment benefit costthat had not been accrued under Canadian GAAP as at December 31, 1998 and 1997 was $23 and $27, respectively.

(vii) For the purpose of reporting under United States GAAP, companies are required to record mark-to-market adjust-ments on financial instruments that do not meet the specific criteria for hedge accounting. The adjustment representsthe difference between hedge accounting for the cross currency coupon swap contracts under Canadian GAAP as des-cribed in note 23, and the recognition of the mark-to-market differential on this specific type of financial instrument.

(viii) For the purpose of reporting under United States GAAP, companies are required to present basic earnings pershare. This is consistent with the calculation for Canadian GAAP. Under United States GAAP, companies are alsorequired to present diluted earnings per share using the treasury stock method when entities have complex capitalstructures.

Stock option plans – compensation costs

Had compensation costs for the stock option plans been recognized as a compensation expense consistent with themethodology prescribed under FASB Statement No. 123, “Accounting for Stock-Based Compensation,” theCorporation’s net earnings applicable to common shares and earnings per common share would have been reducedto the pro forma amounts indicated below:

1998 1997 1996Net earnings (loss) applicable to common shares:

Per United States GAAP $(1,282) $ 695 $ 560Pro forma $(1,399) $ 601 $ 467

Earnings per common share:Per United States GAAP $ (2.24) $ 1.33 $ 1.08Pro forma $ (2.45) $ 1.14 $ .90

Black-Scholes option-pricing model assumptions:Dividend yield .51% .67% .93%Expected volatility 42.34% 31.04% 33.58%Risk-free interest rate 4.81% 5.00% 6.02%Expected option life 4 yrs 6 yrs 7 yrs

Balance sheets

At December 31, 1998 and 1997, there were no material differences between balance sheet item amounts calculatedunder United States GAAP and those calculated under Canadian GAAP and shown on the Corporation’s consolidatedbalance sheets, with the exception of the effect of proportionately consolidating the operations that are under jointcontrol as disclosed in note 21, the “purchased in-process R&D” as discussed in part (i) of this note, the “goodwill”and “additional paid-in capital” as discussed in part (ii) of this note, the “postretirement benefits other than pensions”as discussed in part (iii) of this note, the “income taxes” as discussed in part (iv) of this note, the “income tax benefitrelated to stock options” as discussed in part (v) of this note, the “postemployment benefits” as discussed in part (vi)of this note, and the “financial instruments and hedging activities” as discussed in part (vii) of this note.

Statements of shareholders’ equity

At December 31, 1998, 1997, and 1996, there were no material differences between statements of shareholders’ equityitem amounts calculated under United States GAAP and those calculated under Canadian GAAP and shown on theCorporation’s consolidated statements of shareholders’ equity, with the exception of the effect of proportionatelyconsolidating the operations that are under joint control as disclosed in note 21, the “purchased in-process R&D” asdiscussed in part (i) of this note, the “goodwill” and “additional paid-in capital” as discussed in part (ii) of this note,the “postretirement benefits other than pensions” as discussed in part (iii) of this note, the “income taxes” as discussedin part (iv) of this note, the “income tax benefit related to stock options” as discussed in part (v) of this note, the“postemployment benefits” as discussed in part (vi) of this note, the “financial instruments and hedging activities” asdiscussed in part (vii) of this note, and the effect of the change of unrealized gain on investments, net, as disclosed inthe statements of comprehensive income.




Statements of comprehensive income

For the purposes of reporting under United States GAAP, the following statements of comprehensive income arerequired:

1998 1997 1996

Net earnings (loss) applicable to common shares United States GAAP $(1,282) $ 695 $ 560

Change in currency translation adjustment (42) (80) 33Change in unrealized gain on investments, net 10 - -Comprehensive income (loss) $(1,314) $ 615 $ 593

Global investment tax credits

For purposes of reporting under United States GAAP, global investment tax credits are required to be deducted fromthe income tax provision. The difference in accounting standards for investment tax credits has no effect on the netearnings of the Corporation.

Recent pronouncements

In March 1998, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 98-1,“Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” This SOP revised theaccounting for software development costs and will require the capitalization of certain costs which the Corporationhas historically expensed. The Corporation is currently analyzing the impacts of this SOP, which is required to beadopted for fiscal year 1999.

In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, “Accounting for DerivativeInstruments and Hedging Activities” (SFAS No. 133), which established accounting and reporting standards forderivative instruments and hedging activities. It requires an entity to measure all derivatives at fair value and to recog-nize them in the balance sheet as an asset or liability, depending on the entity’s rights or obligations under the applicablederivative contract. Management has not yet evaluated the effects of this statement on its results of operations. Asrequired, the Corporation will adopt SFAS No. 133 in the first quarter of 2000.

During the year, the Corporation adopted SOP 97-2 “Software Revenue Recognition” and SOP 98-4 “Deferral ofthe Effective Date of a Provision of SOP 97-2,” which provide guidance in applying GAAP for recognizing revenuefrom software transactions. The adoption of SOP 97-2 and SOP 98-4 did not have a material impact on theCorporation’s results as at and for the years ended December 31, 1998, 1997, and 1996.

12. Inventories

At December 31, inventories consisted of:1998 1997

Raw materials $ 463 $ 567Work in process 456 358Finished goods 768 840

$1,687 $1,765

13. Plant and equipment

At December 31, plant and equipment consisted of:1998 1997

Cost:Land $ 67 $ 86Buildings 967 987Machinery and equipment 4,215 3,633

5,249 4,706Less accumulated amortization:

Buildings 261 325Machinery and equipment 2,725 2,341

2,986 2,666$2,263 $2,040




14. Plans for employees’ pensions

Nortel Networks has non-contributory defined benefit pension plans covering substantially all of its employees. The benefits are based on length of service and rates of compensation.

Nortel Networks’ policy is to fund pensions based on widely used actuarial methods as permitted by pension regulatory authorities. The funded amounts reflect actuarial assumptions regarding compensation, interest, and otherprojections. Plan assets are represented primarily by common stocks, bonds, debentures, secured mortgages, andproperty. Included in plan assets are common shares and debentures of BCE Inc., a major shareholder of the Cor-poration, and common shares of Bell Canada International Inc., a company under common significant influence, withan aggregate market value of $23 ($15 in 1997).

Pension costs reflected in the consolidated statements of operations are based on the unit credit method of valua-tion of pension plan benefits. Within the consolidated balance sheets, pension plan assets are included in Other assetsand pension plan liabilities are included in Other liabilities.

The following are details of the funded status of the plans and amounts recognized in the consolidated balancesheets as at December 31:

Deferred pension asset Deferred pension liability

1998 1997 1998 1997Funded status:Actuarial present value of:Accumulated benefit obligation $2,425 $2,195 $1,930 $1,751Projected benefit obligation $2,895 $2,496 $2,198 $2,011Plan assets at fair value 3,278 2,785 2,029 1,635Excess (deficiency) of plan assets at

fair value over projected plan benefits 383 289 (169) (376)Unrecognized net plan (benefits)

obligations existing at January 1, 1987 (15) (16) - 9Other unrecognized net plan (benefits)

obligations and amendments (160) 2 (87) 131Net accrued pension asset (liability) $ 208 $ 275 $ (256) $ (236)

1998 1997 1996Pension expense:Service cost benefits earned $153 $137 $114Interest on projected plan benefits 350 351 322Estimated return on plan assets (370) (346) (319)Termination benefits 49 - -Amortization of net pension plan benefits

and amendments 55 41 59Net pension expense $237 $183 $176

Assumptions:Discount rates 7.2% 8.0% 8.3%Rate of return on assets 8.5% 8.3% 8.6%Rate of compensation increase 4.3% 4.6% 4.5%Amortization period (years) 12.6 12.5 12.8





1998 1997 1998 1997Change in benefit obligation:

Benefit obligation at beginning of year $2,496 $2,115 $2,011 $1,943Service cost benefits earned 92 85 61 52Interest on projected plan benefits 203 194 147 157Amendments 7 (20) (7) 1Actuarial gain 228 215 244 111Acquisitions 49 (46) - -Benefits paid (161) (17) (133) (155)Foreign exchange (19) (30) (125) (98)Benefit obligation at end of year $2,895 $2,496 $2,198 $2,011


1998 1997 1998 1997Change in plan assets:

Fair value of plan assets at beginning of year $2,785 $2,440 $1,635 $1,565Actual return on plan assets 445 377 233 222Employer contribution 69 64 59 60Acquisition/divestiture/settlements - (45) - -Benefits paid (19) (16) (107) (132)Change in valuation 2 - 331 -Foreign exchange (4) (35) (122) (80)Fair value of plan assets at end of year $3,278 $2,785 $2,029 $1,635

15. Long-term debt

At December 31, long-term debt consisted of:1998 1997

7.45% Notes (C$300 million) due March 9, 1998, swapped to U.K. pounds, principal and interest with an average floating rate of 7.79%* $ - $ 209

8₃⁄₄% Notes due June 12, 2001,swapped to U.K. pounds, principal and interest of 10.75%* 250 250

Term credit facility ($120) due June 28, 2001, with an average floating interest rate of 5.51% based on LIBOR 120 120

6 ₇⁄₈% Notes due October 1, 2002 300 3006% Notes due September 1, 2003 200 2007.40% Notes due June 15, 2006 150 1506 ₇⁄₈% Notes due September 1, 2023 200 2007 ₇⁄₈% Notes due June 15, 2026 150 1505₁⁄₄% Convertible debentures, maturing May 15, 2003** 92 -Other long-term debt with various repayment terms,

and interest rates ranging from LIBOR + .03% to LIBOR + 1% 177 202Obligations under capital leases 28 7

1,667 1,788Less: Amount included in current liabilities 19 223

$1,648 $1,565

*Designated as a hedge of foreign currency exposure relating to Nortel Networks’ net investment in the United Kingdom. Long-term debt is presentedat face value, with the net value of each swap reflected in long-term assets or long-term liabilities as appropriate. **Convertible at the option of the holder into the Corporation’s common shares. The debentures are redeemable at the option of the issuer, initially atapproximately 103.7 percent of the face value and decreasing premium prices thereafter to 100 percent at maturity.




At December 31, 1998, the amounts of long-term debt payable (excluding obligations under capital leases) for theyears 1999 through 2003 were $14, $79, $386, $350, and $292, respectively.

16. Commitments

At December 31, 1998, the future minimum lease payments under capital leases and operating leases consisted of:

Capital OperatingLeases Leases

Year ended December 311999 $ 5 $ 3672000 5 3152001 5 2312002 5 1722003 2 137

Thereafter - 350Total future minimum lease payments 22 $1,572Less: Imputed interest 3Present value of net minimum lease payments $ 19

Rental expense on operating leases for the years ended December 31, 1998, 1997, and 1996 amounted to $431, $264,and $238, respectively.

17. Contingencies

On October 14, 1998, a class action complaint was filed in the United States District Court for the Southern Districtof New York, purportedly on behalf of certain former Bay Networks securities holders, alleging that the proxy state-ment/prospectus and registration statement in connection with the Bay Networks Merger (the Bay Networks ProxyStatement) as well as certain public statements made by the Corporation and certain named officers violated applicablesecurities laws by containing materially false and misleading statements and omissions concerning the Corporation’sfinancial condition. Two additional class action complaints were filed in the same court on November 16, 1998 andDecember 11, 1998 alleging substantially similar claims. The court granted the plaintiffs’ motion to consolidate allthree actions on February 1, 1999.

In June 1998, four class action complaints were filed in the Delaware Court of Chancery, New Castle County,purportedly on behalf of all common shareholders of Bay Networks, alleging that the Bay Networks directorsbreached fiduciary duties owed to the Bay Networks shareholders and that the Corporation aided and abetted thealleged breaches of fiduciary duty. On July 23, 1998, Bay Networks, the Corporation, and counsel for the plaintiffclass entered into an agreement in principle (the Settlement Agreement) under which the actions will be dismissed(subject to confirmation by the parties and the approval of the court) and which provided that additional disclosuresbe made in the final Bay Networks Proxy Statement and that counsel for the plaintiff class may apply to the court foran award of legal fees up to $450 thousand and expenses up to $25 thousand. The Corporation has provided for theseamounts. On August 26, 1998, a class action complaint was filed in the same court purportedly on behalf of all BayNetworks common shareholders, alleging that the Bay Networks Proxy Statement was materially misleading by failingto disclose pending litigation by Bay Networks against six former employees. This action may also be dismissed ifthe court approves the Settlement Agreement.

On April 18, 1997, a lawsuit was filed in the California Superior Court, County of Santa Clara, purportedly onbehalf of a class of shareholders who acquired Bay Networks common shares pursuant to the registration statementand prospectus that became effective on November 15, 1995. On March 4, 1997, Bay Networks announced thatshareholders had filed two separate lawsuits in the United States District Court for the Northern District of Californiaand the California Superior Court, County of Santa Clara against Bay Networks and ten of Bay Networks current andformer officers and directors, purportedly on behalf of a class of shareholders who purchased Bay Networks commonshares during the period of May 1, 1995 through October 14, 1996. The two actions in the California Superior Court,County of Santa Clara, were consolidated in April 1998.




In June 1993, certain holders of the Corporation’s securities commenced a class action in the United States DistrictCourt for the Southern District of New York alleging that the Corporation and certain of its officers violated theSecurities Exchange Act of 1934 and common law by making material misstatements of, or omitting to state, materialfacts relating to the business operations and prospects and financial condition of the Corporation.

Nortel Networks is also a defendant in various other suits, claims, and investigations which arise in the normalcourse of business.

Northern Telecom Inc. (NTI), the Corporation’s principal United States subsidiary, received a statutory notice ofproposed assessment from the Internal Revenue Service (IRS) dated November 6, 1996 which proposes an additionaltax liability of approximately $524, excluding interest, with respect to its 1980 through 1985 federal income taxreturns. On February 3, 1997, NTI filed a petition with the United States Tax Court opposing such proposed addi-tional tax. Recently, NTI and the IRS have agreed on a basis for resolving the most significant issues in this matter,subject only to review and approval by the Joint Committee on Taxation as required by the Internal Revenue Code.After consultation with outside tax advisors, it is management’s opinion that additional tax liability, if any, relating tothe resolved or remaining unresolved issues, will not have a material adverse impact on the consolidated financialposition or results of operations of the Corporation.

Except where noted above, the Corporation is unable to ascertain the ultimate aggregate amount of monetary liability or financial impact of these matters and therefore cannot determine whether these actions will, individuallyor collectively, have a material adverse impact on the consolidated financial position or results of operations of the Corporation. Unless otherwise noted, the Corporation and any named directors and officers intend to vigorouslydefend these actions.

Environmental matters

Nortel Networks, primarily as a result of its manufacturing operations, is subject to numerous environmental lawsand regulations and is exposed to liabilities and compliance costs arising from its past and current generation, man-agement and disposition of hazardous substances and wastes.

At December 31, 1998, the accruals on the Corporation’s consolidated balance sheet for environmental matters,including those referred to below, were $32. It is anticipated that, for the most part, these amounts will be paid overthe next five years. Based on information currently available, management believes that the existing accruals are suf-ficient to satisfy probable and reasonably estimable environmental liabilities related to known environmental matters.Any additional liability that may result from these matters, and any additional liabilities that may result in connectionwith other locations currently under investigation, are not expected to have a material adverse impact on the consoli-dated financial position or results of operations of the Corporation.

Nortel Networks has remedial activities under way at eight of its facilities and seven previously occupied sites. Anestimate of Nortel Networks’ anticipated remediation costs associated with all such facilities and sites, to the extentprobable and reasonably estimable, is included in the environmental accruals referred to above in an approximateamount of $30.

Nortel Networks is also listed as a potentially responsible party (PRP) under the United States ComprehensiveEnvironmental Response, Compensation and Liability Act (CERCLA) at six Superfund sites in the United States andis listed as a de minimis PRP at three of these Superfund sites. An estimate of Nortel Network’s share of the anticipatedremediation costs associated with such Superfund sites is included in the environmental accruals referred to above.

Liability under CERCLA may be imposed on a joint and several basis, without regard to the extent of NortelNetworks’ involvement. In addition, the accuracy of Nortel Networks’ estimate of environmental liability is affectedby several uncertainties such as additional requirements that may be identified in connection with remedial activities,the complexity and evolution of environmental laws and regulations, and the identification of currently unknownremediation sites. Consequently, Nortel Networks’ liability could be greater than its current estimate.

18. Preferred shares and common shares

Preferred shares

The Corporation is authorized to issue an unlimited number of Class A Preferred Shares and Class B PreferredShares, without nominal or par value, issuable in series. Class A Preferred Shares have been issued for considerationdenominated in Canadian dollars (C$) and are presented in U.S. dollars after translation at the exchange rate ineffect at the date of original issue. Each series of Class A Preferred Shares ranks in parity with every other series ofClass A Preferred Shares.




At December 31, the outstanding Class A Preferred Shares included in shareholders’ equity consisted of:

1998 1997 1996Number Number Numberof shares Amount of shares Amount of shares Amount

Series 4, issued June 25, 1985 for consideration of C$100 million 200 $ 73 200 $ 73 200 $ 73

Series 5, issued November 26, 1996 for consideration of C$400 million 16,000,000 $294 16,000,000 $294 16,000,000 $294

Series 7, issued November 28, 1997 for consideration of C$350 million 14,000,000 $242 14,000,000 $242 - $ -

The Cumulative Redeemable Class A Preferred Shares Series 4 (Series 4 Shares) dividend rate is determined by auc-tions held at intervals of approximately one month on the business day immediately preceding the commencement ofeach dividend period. The Corporation can neither participate, nor oblige any subsidiary to participate, in the auctionprocedures. The annual dividend rate may not exceed the Bankers’ Acceptance Rate in effect on the auction date plus.40 percent. The annual dividend rate in effect on December 31, 1998, 1997, and 1996 was 4.40 percent, 3.34 percent,and 2.29 percent, respectively. The Corporation may call all, or a part of, the Series 4 Shares for redemption at a price ofC$500,000 per share, on the business day immediately preceding any auction date. Dividends on the outstandingSeries 4 Shares are declared and payable in Canadian dollars. Amounts equal to accrued and unpaid dividends arepayable by the Corporation upon redemption of the Series 4 Shares. The applicable dividend must be declared priorto redemption.

On July 8, 1994, the Corporation issued 200 Exchange Rights to the holders of its Series 4 Shares without cost tosuch holders. The Exchange Rights entitle the holders to exchange each Exchange Right, together with one Series 4Share, for that number of common shares determined by dividing C$500,000 by the greater of C$2.50 and 95 percentof the weighted average trading price of the common shares on The Toronto Stock Exchange for the ten trading daysending immediately preceding the exchange date. The Exchange Rights will be of no force or effect until the occur-rence of two consecutive unsuccessful auctions in which there are not sufficient clearing bids to determine a dividendrate in respect of the Series 4 Shares. At December 31, 1998, no Exchange Rights had been exercised. An ExchangeRight has no value except in connection with a Series 4 Share.

The Cumulative Redeemable Class A Preferred Shares Series 5 (Series 5 Shares) are presented net of tax effectedissue costs of approximately $4. Holders of the Series 5 Shares will, until November 30, 2001, be entitled to an annualfixed cumulative preferential cash dividend of C$1.275 per share (5.1 percent), payable, if declared, quarterly on thefirst day of March, June, September, and December. From December 1, 2001, holders of the Series 5 Shares will beentitled to, if declared, a monthly floating cumulative preferential cash dividend. Holders of Series 5 Shares will havethe right to convert their shares into Cumulative Redeemable Class A Preferred Shares Series 6 (Series 6 Shares),subject to certain conditions, on December 1, 2001, and on December 1 of every fifth year thereafter. Holders ofSeries 6 Shares will have a similar right to convert back into Series 5 Shares every five years. In certain circumstances,conversions may be automatic. The Series 5 Shares are not redeemable prior to December 1, 2001, at which time theywill be redeemable at the Corporation’s option at C$25 per share together with accrued and unpaid dividends up to,but excluding, the date of redemption. The Series 5 Shares will be redeemable after that date at the Corporation’soption at C$25.50 per share together with accrued and unpaid dividends up to, but excluding, the date of redemption.The Series 6 Shares will also be redeemable at the Corporation’s option at C$25 per share, together with accrued andunpaid dividends up to, but excluding, the date of redemption, on December 1, 2006, and on December 1 of everyfifth year thereafter.




The Non-cumulative Redeemable Class A Preferred Shares Series 7 (Series 7 Shares) are presented net of taxeffected issue costs of approximately $4. Holders of the Series 7 Shares will, until November 30, 2002, be entitled toan annual fixed non-cumulative preferential cash dividend of C$1.225 per share (4.9 percent), payable, if declared,quarterly on the first day of March, June, September, and December. From December 1, 2002, holders of the Series7 Shares will be entitled to, if declared, a monthly floating non-cumulative preferential cash dividend. Holders ofSeries 7 Shares will have the right to convert their shares into Non-cumulative Redeemable Class A Preferred SharesSeries 8 (Series 8 Shares), subject to certain conditions, on December 1, 2002, and on December 1 of every fifthyear thereafter. Holders of the Series 8 Shares will have a similar right to convert back into Series 7 Shares every fiveyears. In certain circumstances, conversions may be automatic. The Series 7 Shares are not redeemable prior toDecember 1, 2002, at which time they will be redeemable at the Corporation’s option at C$25 per share, togetherwith declared and unpaid dividends to the date of redemption. The Series 7 Shares will be redeemable after that dateat the Corporation’s option at C$25.50 per share together with declared and unpaid dividends to the date of redemp-tion. The Series 8 Shares will also be redeemable at the Corporation’s option at C$25 per share, together withdeclared and unpaid dividends up to, but excluding, the date of redemption, on December 1, 2007, and onDecember 1 of every fifth year thereafter.

Common shares

The Corporation is authorized to issue an unlimited number of common shares without nominal or par value. AtDecember 31, the outstanding number of common shares included in shareholders’ equity consisted of:

1998 1997 1996Balance at beginning of year 518,880,270 519,752,384 508,707,160Shares issued pursuant to:

Shareholder dividend reinvestment and stock purchase plan 90,656 97,538 100,368

Stock option plans 5,033,096 9,000,948 10,944,856Shares issued relating to acquisitions 143,397,759 - -Shares purchased and cancelled (4,297,300) (9,970,600) -

Balance at end of year 663,104,481 518,880,270 519,752,384

On August 31, 1998, pursuant to the Bay Networks Merger, the Corporation issued approximately 135 million com-mon shares.

In January 1997, the Corporation commenced a program to repurchase up to 16 million common shares for can-cellation during the one-year period ending January 29, 1998. On February 2, 1998, the Corporation announced thecommencement of a new program to repurchase for cancellation up to 6.4 million of the Corporation’s commonshares in the period from February 4, 1998, to February 3, 1999. The Corporation acquired and cancelled 4,297,300of its shares in 1998 under both such programs. On February 22, 1999, the Corporation announced the commence-ment of a new program to repurchase for cancellation up to 10 million of the Corporation’s common shares in theperiod from February 26, 1999, to February 25, 2000.

On December 18, 1997, the shareholders of the Corporation approved the division of its common shares on atwo-for-one basis (the stock split). The stock split was effective for registered common shareholders at the close ofbusiness on January 7, 1998. All references to common shares and per share amounts in the consolidated financialstatements have been restated to reflect the stock split on a retroactive basis.

Common shares listed and available for issuance under the following plans were Shareholder Dividend Reinvestmentand Stock Purchase Plan 7,922,648; Investment Plan for Employees Canada 4,000,346; Long-term InvestmentPlan U.S. 354,470; and Stock Option Plans (including 22,618,531 for the assumed Bay Networks’ stock optionplans) 57,850,990.

At December 31, 1998 and 1997, BCE Inc. owned 40.7 percent and 51.7 percent of the outstanding commonshares, respectively.




19. Stock options

Under the Northern Telecom Limited 1986 Stock Option Plan As Amended and Restated (the Plan), options topurchase common shares of the Corporation may be granted to employees of Nortel Networks which entitle theholder to purchase one common share at a subscription price of not less than 100 percent of market value on theeffective date of the grant. Subscription prices are stated in U.S. dollars for U.S. options and in Canadian dollars forCanadian options. Generally, the holder has the right to exercise the options as follows: 1997 and subsequent grantsvest 33₁⁄₃ percent at the end of each year for three years; 1991 through 1996 grants vest 50 percent after the first yearand the remainder after two years; pre-1991 grants vest 50 percent after the first two years and 50 percent after thethird year. The committee that administers the Plan has the discretion to vary the period during which the holderhas the right to exercise options and, in certain circumstances, may accelerate the right of the holder to exerciseoptions, but in no case shall the exercise period exceed ten years. The Corporation will meet its obligation under thePlan either by issuance or by purchase on the open market of common shares.

Each option may be granted with or without a stock appreciation right (SAR). A SAR entitles the holder toreceive payment of an amount equivalent to the excess of the market value of a common share at the time of exerciseof the SAR over the subscription price of the common share to which the option relates. Options with SARs may be granted on a cancellation basis, in which case the exercise of one causes the cancellation of the other, or on asimultaneous basis, in which case the exercise of one causes the exercise of the other.

The maximum number of common shares authorized by the shareholders and reserved for issuance by the Boardof Directors of the Corporation under the Plan is 77,429,510. The maximum number of common shares with respectto which options may be granted on an annual basis is 2 percent of the common shares issued and outstanding at thecommencement of the year, subject to certain adjustments.

In January 1995, a key contributor stock option program (the Program) was established under the Plan. Underthe terms of the Program, participants are granted an equal number of initial options and replacement options. The initial options generally vest after five years and expire after ten years. The replacement options are granted con-currently with the initial options and also expire after ten years. The replacement options generally have an exerciseprice equal to the market value of the common shares of the Corporation on the day the initial options are fully exercised, and are generally exercisable commencing thirty-six months thereafter, provided certain other conditionsfor exercise, including share ownership, are met. In January 1998, 1997, and 1996, respectively, 854,000, 1,010,000,and 2,080,000 options were granted pursuant to the Program under the Plan.

At December 31, 1998, 34,765,341 common shares had been issued pursuant to stock option exercises, and35,232,459 common shares remained listed with various stock exchanges for issuance under the Plan (note 18).

Bay Networks’ employee stock option plans

Pursuant to the Bay Networks Merger, the Corporation assumed 39.4 million options to purchase shares of commonstock of Bay Networks. The number of options, and the exercise price of such options, were adjusted by theexchange ratio of 0.6 which was used in the Bay Networks Merger.

The majority of options assumed were granted under the Bay Networks, Inc. 1994 Stock Option Plan (the 1994Plan). Under the 1994 Plan, options granted were immediately exercisable; however, unvested shares at the date oftermination of employment may be repurchased at the original exercise price. The Board of Directors of BayNetworks determined when the options were exercisable, their price and other terms, but the option price could notbe less than the fair value of the share at the grant date. Options expired no later than eight years after the grant andgenerally vested at the rate of 25 percent after one year from the date of grant, and then ratably over the followingthirty-six months.

The remaining options to purchase shares of common stock of Bay Networks which were assumed by theCorporation were granted under the Bay Networks Outside Directors Stock Option Plan or under plans of variouscompanies which were acquired by Bay Networks. These companies include Xylogics, Inc., Rapid CityCommunications, New Oak Communications, Inc., and Netwave Technologies, Inc.




The following is a summary of the maximum number of common shares issuable pursuant to outstanding stockoptions and available for future issuance:

Available Outstanding for Issuance

1998 1997 1996 1998January 1 25,087,076 25,346,634 27,011,670 13,253,310Additional shares listed 23,643,900Increase (decrease) resulting from:

Granted and assumed options 37,438,955 9,657,390 10,443,100 (37,438,955)Options exercised (5,033,096) (9,000,948) (10,944,856) -SARs exercised - - (41,000) -Options cancelled (2,480,463) (916,000) (1,122,280) 1,491,656

December 31 55,012,472 25,087,076 25,346,634 949,911Weighted average subscription

price of options:U.S. dollars $36.00 $26.00 $20.00Canadian dollars $55.00 $37.00 $27.00

Exercisable (vested) at December 31 32,460,524 8,039,976 9,232,448

Weighted average subscription price of exercisable options:U.S. dollars $34.00 $19.00 $18.00Canadian dollars $52.00 $27.00 $25.00

In connection with the acquisition of Bay Networks, the Corporation has assumed the stock option plans of Bay Networks. A total of 23,643,900 common shares of the Corporation have been listed for issuance under theassumed plans, and the related options are included in the preceding table. At December 31, 1998, the total numberof options outstanding under Nortel Networks’ stock option plans was 55,012,472. The number of common sharesauthorized for issuance under Nortel Networks’ stock option plans, in addition to those authorized in respect of outstanding options, was 8,379,421 (of which 949,911 were listed and available for issuance). Options which havebeen granted with SARs, are exercisable on a cancellation basis. At December 31, 1998, 81,400 SARs were outstandingat a weighted average subscription price per share of approximately $12.00 (C$18.00). At December 31, 1997,128,300 SARs were outstanding at a weighted average subscription price per share of approximately $12.00 (C$17.00).SARs exercisable as at December 31, 1998 and 1997 were nil.

The range of prices for options granted, exercised, and canceled and for SARs exercised were as follows:

1998 1997 1996High/Low High/Low High/Low

U.S. dollars:Grant of additional options $64.40 /31.69 $52.08 / 35.41 $30.40 / 22.47Exercise of options $47.60 / 0.03 $35.41 / 7.85 $24.28 / 7.00Exercise of SARs - - $14.66 / 7.85Cancellation of options $68.89 / 0.03 $52.08 / 9.77 $29.25 / 12.44

Canadian dollars:Grant of additional options C$93.80 /48.35 C$72.08 / 47.73 C$40.01 / 30.94Exercise of options C$50.81 / 9.28 C$40.01 / 9.28 C$28.66 / 9.28Exercise of SARs - - -Cancellation of options C$89.79 /14.25 C$72.08 / 16.45 C$30.94 / 16.45




The following table summarizes information about stock options outstanding at December 31, 1998:

Options Outstanding Options Exercisable

Weighted-Average

Number Remaining Weighted- Weighted-Outstanding Contractual Life Average Number Average

Range of Exercise Prices (thousands) (in years) Exercise Price Exercisable Exercise Price

$ 0.03 – $30.63 15,670 5.89 $20.10 12,404 $20.48$30.83 – $32.50 7,147 6.74 $31.92 4,966 $32.25$32.51 – $40.00 10,120 7.26 $37.04 6,457 $37.95$40.21 – $53.33 15,464 8.90 $45.12 3,099 $46.22$53.65 – $73.26 6,611 7.76 $55.78 5,534 $55.14

55,012 7.32 $36.07 32,460 $34.12

20. Consolidated statements of cash flows

In the consolidated statements of cash flows for each of the years in the three-year period ended December 31, 1998,comparative figures for 1997 and 1996 have been restated to reflect the new requirements under Section 1540 of theCanadian Institute of Chartered Accountants Handbook, “Cash Flow Statements.”

Changes in non-cash working capital components

Changes in the components of working capital, excluding cash and cash equivalents, notes payable, and current por-tion of long-term debt, for the years ended December 31 were:

1998 1997 1996(Increase) decrease in:

Accounts receivable $(226) $(917) $(400)Inventories 185 (117) (34)Prepaid expenses (4) (62) (4)Deferred income taxes (156) (101) (72)Interest receivable (10) (3) 3

Increase (decrease) in:Accounts payable and accrued liabilities 321 661 339Income taxes payable 3 20 65Interest payable - - 1

Increase (decrease) in non-cash working capital components $ 113 $(519) $(102)

Trade accounts receivable

Nortel Networks has programs in place to sell trade accounts receivable. While these programs continue to be used,no trade accounts receivable had been sold with recourse as of December 31, 1998 and 1997.

Interest and income taxes paid1998 1997 1996

Income taxes paid $ 493 $ 336 $ 251Interest paid $ 233 $ 167 $ 181




Acquisitions and other investments

The following table summarizes the Corporation’s cash flows from investing activities resulting from acquisitions andother investments (note 4).

Nortel Bay TotalTechnology Cambrian Networks r3 NMC Aptis BNI Other 1998 1997 1996

Cash acquired $ - $ 17 $ 721 $ - $ - $ 7 $ 20 $ - $ 765 $ (9) $ 2Total net assets

acquired other than cash 18 231 6,152 24 65 279 413 162 7,344 167 197

Total purchase price 18 248 6,873 24 65 286 433 162 8,109 158 199

Less: cash acquired - (17) (721) - - (7) (20) - (765) 9 (2)Less: non-cash

consideration paid - - (6,685) (20) - (255) (284) - (7,244) - -Less: common

share optionsconsideration paid - - (189) - - (26) - - (215) - -

Cash paid net of cash acquired $ 18 $ 231 $ (722) $ 4 $ 65 $ (2) $ 129 $ 162 $ (115) $ 167 $ 197

21. Interests in joint ventures

Nortel Networks’ proportionate share of interests in joint ventures, including goodwill attributable to the joint ven-tures, are included in the consolidated financial statements and are summarized below. A substantial portion of theamounts proportionately consolidated relates to the operations of MNC. Nortel Networks’ other joint ventures arein Germany, China, and the United Kingdom.

Nortel Networks and Lagardère each hold, directly or indirectly, 50 percent of MNC. After July 1, 1999, Lagardèremay, under specific circumstances, require Nortel Networks to purchase all of its equity participation in MNC at aprice to be based partly on a formula and partly on the fair market price as determined at that time. The figuresbelow incorporate Nortel Networks’ existing 50 percent interest of MNC.

Under Canadian GAAP, investments in joint ventures are recognized in the financial statements of the venturer byapplying the proportionate consolidation method of accounting. For purposes of reporting under United States GAAP,the equity method of accounting is applied to investments in joint ventures when preparing consolidated financialstatements of the venturer. The difference in accounting standards for joint ventures has no effect on the net earningsof the Corporation.

As at December 31

Balance Sheets 1998 1997Total assets $857 $952Total liabilities $499 $569

Year ended December 31

Statements of Operations 1998 1997 1996Revenues $841 $868 $928Net loss $ 31 $ 68 $ 56

Year ended December 31

Statements of Cash Flows 1998 1997 1996Cash flows from operating activities $ 12 $ 16 $ (32)Cash flows from investing activities (12) (47) (71)Cash flows from financing activities (4) 32 66Foreign exchange gain on cash held in foreign currency 7 16 11Total cash flows $ 3 $ 17 $ (26)




22. Related party transactions

Nortel Networks engages in transactions with certain of its equity-owned investees, with joint ventures of theCorporation, and with entities which are owned by Nortel Networks’ major shareholder, BCE Inc., the owner ofapproximately 41 percent of the Corporation’s common shares. These transactions are sales and purchases of goodsunder usual trade terms and are disclosed at their exchange amounts. Transactions with related parties are summa-rized as follows:

1998 1997 1996Revenues $1,288 $1,108 $ 835Purchases $ 87 $ 31 $ 35

23. Financial instruments and hedging activities

Risk management

Nortel Networks operates internationally, which gives rise to a risk that its earnings and cash flows may be negativelyimpacted by fluctuations in interest and foreign exchange rates. To effectively manage this risk, Nortel Networksenters into foreign currency forward, swap, and option contracts and has established strict counterparty credit guide-lines, which are monitored regularly. Nortel Networks does not hold or issue derivative financial instruments fortrading purposes.

Hedge of net foreign investments

Nortel Networks enters into short-term and long-term cross currency swaps and forward contracts to limit its exposure to foreign currency fluctuations on its investments in the United Kingdom and France. The cross currencyswaps involve either swapping the underlying debt denominated in U.S. dollars to U.K. pounds, as summarized innote 15, or exchanging U.S. dollars for French francs or U.K. pounds. The notional principal amounts of the Frenchfranc denominated swaps were $234 and $268 as at December 31, 1998 and 1997, respectively. The notional principalamount of the U.K. pound denominated swaps, including those summarized in note 15, were $501 and $250 as atDecember 31, 1998 and 1997, respectively. Nortel Networks had forward contracts outstanding to sell the equivalentof $344 and $350 as at December 31, 1998 and 1997, respectively.

Hedge of firm commitments

Nortel Networks enters into U.S. to Canadian dollar option contracts intended to hedge the U.S. to Canadian dollarexposure on future revenue and expenditure streams. At December 31, 1998 and 1997, Nortel Networks had $707 and$531, respectively, of option contracts outstanding, which were principally between thirty days and two years induration. Nortel Networks also enters into forward contracts, denominated in various currencies, mainly in Canadianand U.S. dollars, over terms of thirty days to two years, to limit its exposure to exchange fluctuations on existing assetsand liabilities and on future revenue and expenditure streams. At December 31, 1998 and 1997, Nortel Networks hadforward contracts outstanding to purchase and sell the equivalent of $805 and $677, respectively, related to theseassets and liabilities and future revenue and expenditure streams. Nortel Networks also enters into U.S. to Canadiandollar cross currency coupon swap contracts to limit its exposure to foreign currency fluctuations on its non-cumu-lative preferential cash dividends on the outstanding Series 7 Shares.




Interest rate risk

Nortel Networks enters into interest rate swap agreements to minimize financing costs on long-term debt and tomanage interest rate risk on existing liabilities and receivables due to interest rate fluctuations. These agreements aredenominated in various currencies and are swapped from floating rate payments to fixed rate payments or vice versa.The following table indicates the types of swaps used and their aggregated weighted-average interest rates. Averagefloating rates are based on rates implied in the yield curve at the reporting date; those may change significantly, affect-ing future cash flows. These swap contracts primarily have remaining terms to maturity of between one and eight years.

1998 1997Receive-fixed swaps notional amount $538 $583

Average fixed rate received 7.0% 8.2%Average floating rate paid 5.3% 6.3%

Pay-fixed swaps notional amount $604 $649Average fixed rate paid 7.4% 8.3%Average floating rate received 5.4% 5.8%

Fair value

The estimated fair values approximate amounts at which these financial instruments could be exchanged in a currenttransaction between willing parties. Therefore, fair values are based on estimates using current value and other valuationtechniques which are significantly affected by the assumptions used concerning the amount and timing of estimatedfuture cash flows and discount rates which reflect varying degrees of risk. Specifically, the fair value of long-term debt instruments reflects a current yield valuation based on Nortel Networks’ incremental borrowing rate, the fair valueof interest rate swaps and forward contracts reflects the present value of the potential gain or loss if settlement were totake place on December 31, 1998, and the fair value of option contracts reflects the net liquidation cost to theCorporation if settlement were to take place on December 31, 1998. Accordingly, the estimates which follow are notnecessarily indicative of the amounts that Nortel Networks could potentially realize in a current market exchange.

At December 31, 1998 and 1997, the carrying amount for all financial instruments approximates fair value withthe following exceptions:

1998 1997Carrying Fair Carrying FairAmount Value Amount Value

Financial liabilities:Long-term debt due within one year $ 19 $ 19 $ 223 $ 225Long-term debt 1,648 1,779 1,565 1,570

Derivative financial instruments,net asset (liability) position:*

Hedges of foreign investments:Forward foreign exchange contracts - 1 (1) -Cross currency swaps 19 4 (15) (6)

Interest rate swap agreements - (18) - (15)Contracts relating to future revenues

and expenditures:Forward foreign exchange contracts - (31) - (22)Options - (19) - (24)Cross currency coupon swap contracts - (13) - -

*Trade receivable securitization balances are summarized in note 20. Long-term receivables of approximately $500 and $608 had also been sold, with limited recourse, as at December 31, 1998 and 1997, respectively.




Credit risk

Credit risk arises from the potential for counterparties to default on their contractual obligations to the Corporation.Nortel Networks is exposed to credit risk in the event of nonperformance, but does not anticipate nonperformanceby any of the counterparties. Nortel Networks limits its credit risk by dealing with counterparties that are consideredto be of high quality and by utilizing an internal credit committee that actively monitors the credit exposure of theCorporation. At December 31, 1998 and 1997, the maximum credit exposure of the Corporation is $26 and $20, themajority of which relates to interest rate swaps. The exposure is limited to those derivatives which have a positive fairvalue at December 31, 1998.

Nortel Networks is also exposed to credit risk from customers. However, Nortel Networks’ global orientation hasresulted in a large number of diverse customers, which minimizes concentrations of credit risk. Pursuant to certainfinancing agreements, Nortel Networks is committed to provide future financing in connection with purchases ofNortel Networks’ products and services. These commitments are approximately $754 and $736 as at December 31,1998 and 1997, respectively.

Guarantees

At December 31, 1998 and 1997, Nortel Networks had outstanding guarantees of approximately $591 and $547,respectively, which represent bid, performance, advance payment, and financial guarantees.

24. Unused bank lines of credit

At December 31, 1998, the Corporation and certain subsidiary companies had total unused committed bank lines ofcredit, generally available at rates slightly above LIBOR, of approximately $1,653.

25. Uncertainty due to the Year 2000 Issue

The Year 2000 Issue arises because many computerized systems use two digits rather than four to identify a year.Date-sensitive systems may recognize the year 2000 as 1900 or some other date, resulting in errors when informationusing year 2000 dates is processed. In addition, similar problems may arise in some systems which use certain dates in1999 to represent something other than a date. The effects of the Year 2000 Issue may be experienced before, on, orafter January 1, 2000, and, if not addressed, the impact on operations and financial reporting may range from minorerrors to significant systems failure which could affect an entity’s ability to conduct normal business operations. It isnot possible to be certain that all aspects of the Year 2000 Issue affecting the Corporation, including those related tothe efforts of customers, suppliers, or third parties, will be fully resolved.

26. Comparative figures

Certain 1997 and 1996 figures in the consolidated financial statements have been reclassified to conform with the1998 presentation.




1998

Earnings and related data

Revenues $17,575Cost of revenues 10,050Selling, general and administrative expense 3,093Research and development expense 2,453Amortization of intangibles 1,709Amortization on plant and equipment 471Income tax provision (recovery) 601Net earnings (loss) (537) Net earnings (loss) applicable to common shares (569)Earnings (loss) per revenue dollar (cents) (3)Earnings (loss) per common share (dollars) (.99)Supplementary measure of net earnings applicable to common shares§ 1,065Supplementary measure of earnings (loss) per revenue dollar (cents)§ 6Supplementary measure of earnings (loss) per common share (dollars)§ 1.86Dividends per common share (dollars) .30

Financial position at December 31Working capital 4,424Plant and equipment (at cost) 5,249Accumulated amortization 2,986Total assets 19,732Long-term debt 1,648Redeemable preferred shares 609Common shareholders’ equity 10,956Return on common shareholders’ equity (7.2%)Supplementary measure of return on common shareholders’ equity§ 12.3%Capital expenditures 642Employees at December 31 75,052†

*Comparative amounts have been restated to conform with the current year’s presentation.† Includes Nortel Networks’ proportionate share of the employees of all joint ventures.

NORTHERN TELECOM LIMITED (MILLIONS OF U.S. DOLLARS EXCEPT PER SHARE FIGURES AND UNLESS OTHERWISE STATED) (UNAUDITED)

Annual.report.98

Consolidated Six-Year Review

Quarterly financial data

Summarized consolidated quarterly financial data for 1998 and 1997 are as follows: 4th Quarter

1998 1997Revenues $5,768 $4,811Gross profit 2,529 2,047Net earnings (loss), as reported | (332) 390Net earnings (loss) applicable to common shares, as reported | (341) 386Earnings (loss) per common share, as reported♦ | (.51) .74

The following amounts represent the summarized consolidated quarterly financial data for 1998 as restated: |

Net earnings (loss) (332) -Net earnings (loss) applicable to common shares (341) -Earnings (loss) per common share♦ | (.51) -

Supplementary measure of earnings per common share .72 .74Weighted average number of common shares outstanding (millions)♦ 664 522

Reconciliation of reported net earnings (loss) applicable to common shares to restated amounts:Net earnings (loss) applicable to common shares, as reported (341) -Adjustments

Purchased in-process R&D - -Goodwill - -Income tax provision - -

Net earnings (loss) applicable to common shares, as restated (341) -♦All references to 1997 per share amounts have been restated to reflect the two-for-one stock split effective January 7, 1998.

|Although Nortel Networks reported its first, second, and third quarter results of 1998 in accordance with established accounting practice and valuationsof purchased in-process R&D provided by independent valuators, these valuations have been reconsidered in light of guidance provided by the UnitedStates Securities and Exchange Commission regarding valuation methodology. Based on this new valuation methodology, the value of the purchased in-process R&D related to the acquisition of Bay Networks was reduced to $1 billion and goodwill was increased by $440 million. With respect to theacquisition of Aptis, the value of the purchased in-process R&D was reduced to $203 million and goodwill was increased by $75 million. Similarly, the


1997* 1996* 1995* 1994* 1993*

$15,449 $12,847 $10,672 $ 8,874 $ 8,1489,111 7,714 6,379 5,605 5,1992,714 2,195 1,923 1,681 1,5982,147 1,813 1,579 1,156 1,040

48 45 39 18 44439 439 430 390 426438 321 233 161 (192)829 623 473 408 (878)812 619 469 404 (884)

5 5 4 5 (11)1.56 1.20 .92 .80 (1.77) 804 619 469 303 56

5 5 4 3 11.54 1.20 .92 .60 .11

.29 .25 .21 .18 .18

3,664 3,099 2,051 2,160 6654,706 4,680 4,533 3,910 4,026 2,666 2,645 2,610 2,205 2,127

12,554 10,903 9,480 8,797 9,5431,565 1,663 1,221 1,495 1,553

609 367 73 73 734,801 4,509 3,798 3,355 3,014

17.4% 14.9% 13.1% 12.7% (25.3%) 17.3% 14.9% 13.3% 8.4% 1.4%

575 601 577 389 47172,896† 67,584† 63,715‡ 57,054 60,293

‡ Includes Nortel Networks’ proportionate share of the employees of Matra Nortel Communications S.A.S.§ Excludes the impact of the amortization of Bay Networks intangible assets and purchased in-process R&D from other acquisitions, and one-timegains and charges.

3rd Quarter 2nd Quarter 1st Quarter

1998 1997 1998 1997 1998 1997$4,141 $3,498 $4,156 $3,787 $3,510 $3,353

1,795 1,455 1,737 1,521 1,464 1,315(298) 158 (62) 169 (55) 112(306) 153 (69) 165 (63) 108(.54) .29 (.13) .32 (.12) .21

(181) - - - (24) -(189) - (7) - (32) -(.33) - (.01) - (.06) -

.41 .29 .40 .32 .27 .21572 522 527 524 524 522

(306) - (69) - (63) -

121 - 66 - 32 -(7) - (6) - (2) -3 - 2 - 1 -

(189) - (7) - (32) -

amount of purchased in-process R&D related to the acquisition of BNI was reduced to $329 million and goodwill was increased by $64 million. NortelNetworks reported a net loss applicable to common shares for 1998 of $569 million, or $.99 per share. Excluding the impact of the new valuationmethodology, the net loss applicable to common shares for 1998 would have been $954 million, or $1.67 per share. For the year, net earnings applicableto common shares before the impact of the amortization of Bay Networks intangible assets and purchased in-process R&D from other acquisitions,and one-time gains and charges, was $1.86 per share compared with $1.88 per share before application of the new valuation methodology. The aboveschedule presents a complete quarterly reconciliation.


Directors

Donald J. SchuenkeElm Grove, WisconsinChairman of the BoardNorthern Telecom LimitedFormer Chairman of the BoardThe Northwestern MutualLife Insurance Company(life insurance company)1,* 2, 3,* 7

John A. RothOrangeville, OntarioVice-Chairman and Chief Executive OfficerNorthern Telecom Limited3

David L. HouseSaratoga, CaliforniaPresidentNorthern Telecom Limited

Ralph M. BarfordToronto, OntarioPresidentValleydene Corporation Limited(private investment company)1, 2, 3, 5, 7*

Hon. James J. BlanchardBeverly Hills, MichiganShareholderVerner, Liipfert, Bernhard,McPherson and Hand(law firm)1, 7

Frank C. CarlucciMcLean, VirginiaChairmanThe Carlyle Group (merchant banking firm)4, 6, 7

Richard J. CurrieToronto, OntarioPresidentGeorge Weston Limited(food processing and distributioncompany)1

Gerald V. DirvinPonte Vedra Beach, FloridaCorporate DirectorFormer Executive Vice-PresidentProcter & Gamble Company (consumer products company)4,,* 6,,* 7

L. Yves Fortier, C.C., Q.C.Westmount, QuébecChairman and Senior PartnerOgilvy Renault(law firm)1, 2, 5, 6

Officers

John A. RothVice-Chairman and Chief Executive Officer

David L. HousePresident

Clive V. AllenExecutive Vice-President, Law

Klaus M. BuechnerSenior Vice-President,Corporate Strategy and Alliances

David L. BurnVice-President, Taxation

Clarence J. ChandranExecutive Vice-President and President,Carrier Packet Solutions and Group Executive, Asia

F. William ConnerExecutive Vice-President,Marketing

J. (Ian) A. CraigExecutive Vice-President and President,Carrier Solutions

Nicholas J. DeRomaSenior Vice-President and General Counsel

Matthew J. DeschExecutive Vice-President and President,Wireless Solutions and Group Executive CALA

Gary R. DonaheeSenior Vice-President and President, Carrier Solutions, Europe

Adrian J. DonoghueVice-President and Controller

Frank A. DunnSenior Vice-President and Chief Financial Officer

Daniel J. HuntSenior Vice-President and President,Nortel CALA

Jérôme P. HuretSenior Vice-President,Corporate Development

Margaret G. KerrSenior Vice-President,Human Resources Strategy

William R. KerrSenior Vice-President,Finance and BusinessDevelopment

James R. LongExecutive Vice-President and President,Enterprise Solutions

Arthur A. MacDonaldSenior Vice-President, Corporate Services

Robert MaoSenior Vice-President,President and Chief Executive Officer,Nortel China

Deborah J. NobleVice-President, CorporateSecretary and AssociateGeneral Counsel

MaryAnne E. PahapillVice-President, CorporateReporting and Assistant Controller

Keith I. PowellSenior Vice-President,Information Systems and Chief Information Officer

Katharine B. StevensonVice-President and Treasurer

Gordon H. SumnerVice-President and General Auditor

Blair F. MorrisonAssistant Secretary

Annual.report.98

Directors and Officers

Hon. E. Peter LougheedP.C., C.C., Q.C.Calgary, AlbertaPartnerBennett Jones(law firm)4,6

Jean C. Monty, C.M.Montréal, QuébecPresident and Chief Executive OfficerBCE Inc.(telecommunications company)3, 4

Sir Antony PilkingtonCheshire, United KingdomCorporate DirectorRetired ChairmanPilkington plc (manufacturer and distributor of glass products)5, 7

Guylaine Saucier C.M., F.C.A.Montréal, QuébecChairman of the BoardCanadian BroadcastingCorporation(public broadcaster)1, 5, 6

Sherwood H. Smith, Jr.Raleigh, North CarolinaChairman of the BoardCarolina Power & Light Company(electric utility company)2, 3, 5,,* 7

Lynton R. WilsonOakville, OntarioChairmanBCE Inc.(telecommunications company)2,,,*3, 4

AS OF FEBRUARY 25, 1999

The board of directors, whichmet fifteen times in 1998, isresponsible for the managementof the Corporation’s business.Directors serve on one or moreof the board committees.

Committees

1 Audit2 Committee on Directors3 Executive4 Management Resources

and Compensation5 Pension Fund Policy6 Stock Option Plan7 Customer Finance

*Chairman

Corporate HeadquartersNorthern Telecom Limited 8200 Dixie Road Suite 100 Brampton, Ontario L6T 5P6 Canada Tel: (905) 863-0000

Stock Exchange ListingsThe common shares of theCorporation are listed on theNew York, Toronto, Montréal,Vancouver, and London stockexchanges.

Annual MeetingThe Corporation’s annual and special meeting of share-holders will take place at 11:15 a.m. (local time),Thursday, April 29, 1999, at Nortel Networks’ Brampton Centre, Brampton,Ontario, Canada.

Form 10-KThe Annual Report on Form 10-K for 1998, as filed with the United States Securitiesand Exchange Commission, is available without chargeupon request to: Nortel NetworksAttention: 1 800 4NORTEL One Brunswick Square Atrium Suite 100 Saint John, New Brunswick E2L 4V1 Canada

Tel: North America 1 800 4NORTELOutside North America(506) 674-5471Fax: (506) 632-8208Email: [email protected]

English and French versions of this annual report can be viewed at our website inpdf and HTML versions:www.nortelnetworks.com• About Us• Investor Relations• Quarterlies and Annual

Reports• 1998 Annual Report

to Shareholders

Dividend Reinvestment and Stock Purchase PlanRegistered holders of commonshares of the Corporationwishing to purchase additionalcommon shares may participatein a convenient investmentplan. Quarterly dividends maybe reinvested automaticallyto purchase additional commonshares at the average marketprice (calculated during a fixedperiod each quarter). Commonshares may also be purchasedat the average market price byvoluntary cash payments of aslittle as US$40 to a maximumof US$5,000 during a quarter.In either case, there are gener-ally no brokerage fees or otherservice charges.

Additional information may be obtained from: Dividend ReinvestmentServices Montreal Trust Company of Canada 151 Front Street West 8th Floor Toronto, Ontario M5J 2N1 Canada Tel: (416) 981-9633 Email: [email protected]

Transfer Agents and RegistrarsMontreal Trust Company of Canada Toronto, Montréal, andVancouver Tel: 1 800 663-9097

The Bank of Nova Scotia TrustCompany of New York New York, New York Tel: (212) 225-5000

CIBC Mellon Trust CompanyIlford, Essex, United Kingdom Tel: (44-181) 478-1888

Share Repurchase ProgramThe Corporation has initiateda normal course issuer bid torepurchase common shares.This share repurchase programwill enable the Corporation to buy back up to 10 million(approximately 1.5 percent) of its common shares in theperiod from February 1999 toFebruary 2000. Shares willbe purchased on the Toronto,Montréal, and New York stockexchanges at market prices.Shares may be repurchased by the Corporation to offsetissuances of new shares underemployee benefit programs, or when such purchases wouldrepresent an appropriate use of corporate funds. No specialarrangements will be madewith particular shareholders torepurchase common shares.

A copy of the notice filed withand accepted by the Torontoand Montréal stock exchangesmay be obtained, withoutcharge, upon request to: Investor Relations Northern Telecom Limited 8200 Dixie Road Suite 100 Brampton, Ontario L6T 5P6 Canada

Trademarks ACCESSNODE, CONCORDE, CORNERSTONE, DMS,DMS-100, DMS-250, DMS-500, DMS-MTX,DMS-GLOBAL SERVICESPLATFORM (DMS-GSP),DUALMODE, HOW THEWORLD SHARES IDEAS,MILLENNIUM, NORSTAR,NORTEL NETWORKS,PASSPORT, PROXIMITY,REUNION, S/DMS TRANSPORTNODE, SERVICEBUILDER, SUPERNODE, SYMPOSIUM,UNIFIED NETWORKS, and VECTOR are trademarksof Northern Telecom.

ACCELAR is a trademark ofBay Networks, Inc.

ZIP and JAZ are trademarks of Iomega Corporation.

cdmaOne is a trademark of the CDMA DevelopmentGroup, Inc.

MICROSOFT, NETSHOW,and WINDOWS NT aretrademarks of MicrosoftCorporation.

www.nortelnetworks.comVisit our corporate website for comprehensive information about our business andintegrated network solutions. Click on Custom News and register for our emailnewsletter to keep abreast of the latest announcementsfrom Nortel Networks.

Consistent with our commit-ment to the protection and enhancement of the environ-ment, the paper used in this document contains 20 percentpost-consumer waste.

Annual.report.98

Corporate Information

Common Share Dividend Record and Payment Dates for 1999*

Deadline forReceipt of Optional Payment Date/

Record Date Cash Payments Investment Date

March 8 March 30 March 31June 8 June 29 June 30September 3 September 29 September 30December 3 December 30 December 31

*Subject to confirmation by the Board of Directors

Corporate Profile

Who we are

65097.11/03-99www.nortelnetworks.com

Nortel Networks is a global supplier of

communications networks and services for

data and telephony, bringing together a

broad range of complementary networking

technologies, skills, distributor channels,

and integrated networking capabilities.

Nortel Networks works with carrier and

enterprise customers worldwide to design,

build, and deliver Unified Network

solutions. Unified Networks create greater

value for customers worldwide through

integrated network solutions spanning

data and telephony. Unified Networks

blend routing, optical, wireline, wireless,

switching, and Internet Protocol tech-

nologies in a seamless manner to deliver

service predictability and security.

Customers include public and private

enterprises and institutions; Internet service

providers; local and long-distance, cellular,

and PCS communications companies; cable

television carriers; and public utilities.

Nortel Networks’ common shares are

listed on the New York, Toronto, Montréal,

Vancouver, and London stock exchanges.

Nortel Networks had 1998 revenues

of $17.6 billion and has approximately

75,000 employees in over 150 countries

and territories.

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