Nortel Networks Annual Report 1998

Corporate Profile

Who we are

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 technologies in a seamless manner to deliver service predictability and security.

Customers include public and private A New Era of Networking enterprises and institutions; Internet service providers; local and long-distance, cellular, and PCS communications companies; cable www.nortelnetworks.com television carriers; and public utilities. annual.report.98 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.

65097.11/03-99 www.nortelnetworks.com Annual.report.98

The Web is changing everything

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 communications, 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 company, 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.

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

All dollar amounts in this annual report are in U.S. dollars unless otherwise stated. Annual.report.98

Letter to Shareholders Annual.report.98

Letter to Shareholders

A New Era of Networking

The global communications industry has technology is powering the Internet revolu- will be with us for many years to come. experienced more than two decades of rev- tion that’s changing the way the world com- Customers today require networks capa- olutionary ferment. As we approach the end municates. Seventy-five percent of Internet ble of handling both voice and data traffic, of the twentieth century, the pace of change traffic in North America is carried on Nortel unifying circuit and packet systems. has never been more rapid nor the changes Networks high-performance optical networks. Leading-edge networks blend switching, more profound. After just a few short years, the Internet routing, IP networking, fiber optics, wireless, The marketplace is being dramatically is becoming part of everyday life. It elimi- and other technologies. These are the funda- reshaped by deregulation, technology, and nates the constraints of time and distance mental building blocks for networks capable mobility, compounded by the explosive and gives us global access to information, of carrying huge volumes of Internet traffic growth of the Internet, as both a communi- not only in online libraries, but in businesses efficiently, quickly, and  most important as cations medium and a business phenomenon. and in people’s minds. commerce moves onto the Web  reliably. Powerful drivers of change are transforming Together, the Internet and the World Nortel Networks brings to the market network economics, creating new customer Wide Web are having a major impact on the a unique ability to integrate and combine relationships, and generating massive invest- volume and kinds of traffic carried on the disparate technologies in reliable, secure ment in network infrastructure, services, world’s networks. They’re helping to change Unified Networks that span data and telephony. With our competence and strength in Nortel Networks is at the heart of the Internet all major networking technologies, we can reach into our portfolio of technologies and revolution and the opportunities it offers for creating a services and put together solutions that meet new era of networking. diverse needs. We are one of the few companies capable of guiding customers to the future, no matter how their networks evolve. and applications. These are the characteris- the way we think about networks and the Our mission is to deliver greater value to tics of a new era of networking that will very nature of what networks do. customers worldwide through integrated define the global economy and society of Until recently, “the network” referred to network solutions. We’re bringing together the next century. the worldwide telecommunications infra- and unifying many diverse networks and The new era of networking excites the structure of local and long-distance networks building a more reliable Internet to enable imagination in many ways. Sometimes it’s whose primary service was voice telephony. new ways for people to share ideas, do the little things that capture our attention, Not any more. Today, “the network” is an business, and improve the quality of life for such as getting a better deal on a new car expanding web of interconnected voice and themselves and their communities. after comparison shopping on the Web, or data networks, private and public networks, effortlessly reaching the office through a and wireline and wireless networks. Our Financial Performance wireless laptop connection. The traditional telecom and data net- Our strong position was gained during a But the new era of networking is about working industries have changed fundamen- year of dramatic change in the industry and big things, too. It offers a panoramic vision tally. The market is volatile and customers the global economy, as well as in Nortel of a networked society that allows our ideas are uncertain about the demands end- Networks, which experienced more funda- and aspirations to soar around the globe and users will put on their networks and how mental change in 1998 than at any other into cyberspace. those networks will evolve. The boundaries time in its history. But your company between enterprise and carrier networks and entered 1999 in better shape than ever, lay- At the Heart of the Revolution between wireless and wireline are blurring. ing new foundations for growth by working Telecommunications is the “killer app” driv- New and traditional customers are moving with customers and partners to create a new ing the Internet revolution. This is good into a world of networks designed for data. era of networking. news for a company like Nortel Networks Increasingly, these data networks use the By any measure, 1998 was a year of ac- that understands both telecommunications Internet Protocol (IP), the language of the complishment for your company. Thanks to and the Internet. It puts your company at Internet and the standard for the networks the support of our customers and investors, the heart of the revolution  the coming of the future. But the thousands of circuit- and the commitment of 75,000 employees together of public and private networks with switched networks built for voice commu- around the world, Nortel Networks set new the Internet. High-performance optical nication worldwide during the past century records for financial performance:

2 NORTEL NETWORKS 1998 ANNUAL REPORT • Revenues rose 14 percent to an all-time faction and loyalty of our customers. brought us expertise in next-generation high of $17.6 billion. Customer satisfaction and loyalty ratings remote-access data networking and virtual • Net earnings applicable to common both increased two percentage points over private networks. With Cambrian Systems shares of $1.07 billion (before acquisition- 1997. With our solid fourth quarter and Corporation, we added metropolitan areas related costs, one-time gains, and charges), record order input for the year, we began to our world-leading position in optical or $1.86 per share, were up 32 percent and 1999 with strong momentum and confi- networking. 21 percent, respectively, over 1997. dence in the future. The acquisition of Bay Networks, com- • Record order input of $18.5 billion from pleted smoothly and in record time, ongoing operations represented an increase A More Powerful Company brought us leading-edge customers and of 16 percent over 1997. Our customers are seeing a more powerful enterprise sales channel partners, a strong Nortel Networks is a well-balanced com- company building even greater strength by portfolio, and 7,000 talented people skilled pany, supported by a broad customer base bringing together new technologies, skills, in routing and IP technologies. By the end and the broadest portfolio of technologies and network solutions in the industry. Nortel Networks brings to the market a unique ability to Revenues from carrier customers grew 14 percent globally, with a dramatic increase integrate and combine disparate technologies in reliable, in sales of our broadband network offerings. secure Unified Networks that span data and telephony. Enterprise revenues were up 26 percent over 1997, reflecting the comprehensive data networking portfolio we can offer since channels to the market, and integrated of the year, we were recognized by Network acquiring Bay Networks. networking capabilities designed to meet World magazine as one of the five most Nortel Networks is well-balanced geo- their needs. powerful companies in the global network- graphically, and revenues from North This demonstrates the major progress in ing industry. America, Europe, Asia Pacific, and CALA building Nortel Networks into an IP data- We made organizational changes to con- (Caribbean and Latin America) all showed networking powerhouse ready to capitalize centrate our efforts on new opportunities in strong growth during the year. As the Year on new market opportunities and satisfy both the carrier and enterprise segments. in Review following this letter highlights, changing customer demands. During 1998, We merged Bay Networks with our enter- we had major wins in markets around the we brought together the portfolio of tech- prise data networks unit and consolidated world and in all market segments. nologies, products, and solutions to establish our packet technologies, products, and Expenses relating to sales, marketing, Nortel Networks as a new class of company, skills within a new and formidable business and general administration were $3.09 bil- and equipped our people to build next- capable of offering carriers an impressive lion, or 17.6 percent of revenues, reflecting generation wireless and wireline networks. array of Unified Network solutions. our investments to support global market- To help expand the portfolio and We continued retooling the Corporation ing programs and streamline our business strengthen our position, we invested in a host for greater speed and responsiveness. We processes. We continue to focus on mak- of companies developing innovative tech- completed the reengineering of the R&D ing every dollar of expense go further in nologies in high-growth market segments organization to bring customers and design- research and development (R&D) and and sold minority investments in others ers closer together, initiated the consoli- other activities. R&D expenses increased to that no longer served our strategic needs. dation of manufacturing, and eliminated $2.45 billion, or 14 percent of revenues, With internally generated innovations, our business practices no longer appropriate for from $2.15 billion, or 13.9 percent of rev- large portfolio of patents is growing at a rate our future. enues, in 1997, a level consistent with of three patent filings per day. During the coming year, we’ll continue planned and ongoing investments across all We made selective acquisitions to bring leveraging our unique breadth of people, business units. new technology, skills, and capabilities skills, and technologies to generate new Our strong financial performance in into the company. With the purchase of revenues, gain market share, and deliver 1998 demonstrated the effectiveness of our Broadband Networks Inc., we could offer greater value to our customers and share- strategy of increasing value for our share- innovative technology for high-quality wire- holders. We’ll continue building the portfo- holders by building on our core strengths less voice, video, data, and Internet services. lio, streamlining our procedures, and moving and by working hard to increase the satis- The purchase of Aptis Communications, Inc. more of our business processes to the Web.

NORTEL NETWORKS 1998 ANNUAL REPORT 3 The Network is our Business effective, efficient, and flexible in respond- As we come to the end of the century, As this annual report demonstrates, we’re ing to market needs. Doing more business we’re pursuing several of the biggest growth increasingly using the Web to communicate electronically will have a positive impact on opportunities in the history of our industry with our employees, partners, suppliers, and revenues, profitability, and value for our and our company. We’re determined to seize investors, as well as build closer relation- customers and shareholders. these opportunities. In the process, we’ll ships with our customers. We’re leading the play a role in reshaping economic life and way in leveraging networking technology Capitalizing on Change how the world shares ideas, overcoming old for critical business applications. Our inter- Your company has always succeeded by barriers and boundaries that have limited nal network is much more than a collection taking a leadership position, embracing the possibilities for interaction, coopera- of technologies linking people at corpo- discontinuities and capitalizing on change tion, and growth. In these efforts, thanks to rate sites worldwide. At Nortel Networks, to fuel new growth and improve competi- the support of our customers, employees, as at other companies today, the network is tiveness. Nortel Networks rose to the chal- and shareholders, we’re strongly positioned our business. lenges of leadership with digital, wireless, for success. That’s why we’re building a Web reliable and fiber-optic systems. Now we are leading We also wish to thank Paul Oreffice for enough to handle our business 24 hours the way by providing enterprises and service the contributions he made during his years a day. We operate one of the largest corpo- providers with high-value, Unified Network of distinguished service as a director of rate networks in the world, managing voice, solutions spanning data and telephony, the Corporation. Mr. Oreffice retired as a data, and video traffic between employees, wireless and wireline, and circuit-switched director on April 23, 1998. At the same management teams, R&D labs, manufac- and packet technologies. time, we welcome to the board of directors turing operations, and many customers, As we take up the challenge of creating a Sir Antony Pilkington, retired chairman, suppliers, and partners. The network is a new era of networking, we’re continuing Pilkington plc; Richard J. Currie, president living lab that gives us tremendous insights our efforts to help our customers succeed in of George Weston Limited; and David L. into the architecture, the components, a highly competitive world. We’re providing House, who joined the board as president and the expertise required to build next- integrated network solutions to a diverse of Northern Telecom Limited in August, generation networks with the capacity, reli- and growing base of customers in more following the acquisition of Bay Networks, ability, and quality of service that can make than 150 countries and territories, building where he was chairman, president, and chief businesses more competitive and meet some of the fastest, most reliable, and cost- executive officer. future growth needs. effective networks in the world today. Nortel Networks is already a leader in We’re laying the foundation for new implementing “network commerce,” a term growth, guided by the vision of making encompassing all forms of e-commerce/ Nortel Networks the most valued company telephony commerce, including electronic in the industry. We will be valued by our data interchange (EDI), electronic funds employees by continuing to provide a great transfer, and various forms of telephony place to work, with multiple career paths commerce, such as 1-800 services, call cen- and challenging opportunities. We will be Donald J. Schuenke ters, and interactive voice response systems. valued by the communities where our people Our ServiceWeb customer service and live and work by continuing our tradition Donald J. Schuenke support tool lets customers receive product of community support, with an emphasis Chairman of the Board information, download software patches, on expanding educational opportunities in and resolve issues via the Internet. With every region where we operate. 1,700 users and 130 user sessions a day at Nortel Networks will be valued by cus- the end of 1998, volume is expected to tomers by providing the network solutions, John A. Roth reach 10,000 users and 1,000 sessions a day applications, services, and skills that help by 2000. them make the transition to the new era of John A. Roth Our network has already had a major networking. And that will help us continue Vice-Chairman and Chief Executive Officer impact on the way we do business, moving generating the strong returns that build us closer to customers and making us more long-term value for our shareholders. February 25, 1999

4 NORTEL NETWORKS 1998 ANNUAL REPORT Annual.report.98

Year in Review Annual.report.98

Year in Review

Acquisitions effective services, including access to the Internet. ■■ Iomega Corporation, United States: To save time and increase produc- ■■ Bay Networks, Inc., a California-based leader in the world- tivity, the manufacturer of the award-winning Zip and Jaz drives wide data networking market. Northern Telecom acquired Bay and disks has implemented Nortel Networks Symposium Call Networks, which more than doubled the number of registered and Center Server, a leading-edge software solution utilizing Microsoft beneficial shareholders of Nortel Networks stock, and announced Windows NT. Hewlett-Packard and Bell Canada are among the new corporate brand name of the merged business  Nortel other customers who have installed the system. ■■ Reuters, Networks. This new brand communicates and reinforces our lead- London: The world’s leading financial and news information ership in providing high-value, unified network solutions to a organization wanted to build a network with new architecture and diverse and growing base of telephony and data customers world- network infrastructure capable of scaling well beyond anything wide. Nortel Networks’ $6.9 billion acquisition of Bay Networks predictable today. Reuters chose a next generation high-performance expanded significantly its base of high-speed packet and IP- WAN backbone based on a Nortel Networks Passport infrastruc- optimized network solutions. As a result of the acquisition, ture. Nortel Networks’ architecture will carry all Reuters’ legacy Nortel Networks became the largest company in Canada and BCE products on one network, together with its IP and frame relay Inc. reduced its ownership to approximately 41 percent. ■■ Aptis traffic, as well as saving money by using asynchronous transfer Communications, Inc., a Massachusetts-based, data network- mode (ATM) backbones. Nortel Networks dominates the infor- ing start-up company, with leadership in the remote-access area. mation provider market, which includes Reuters, Telerate, ■■ Broadband Networks Inc., a Manitoba-based start-up com- Bloombergs, and Bridge Information Systems. ■■ Primus, pany and a leader in the design and manufacture of fixed broad- Australia: Primus Telecommunications, one of Australia’s leading band wireless communications networks. ■■ Cambrian Systems carriers, selected Nortel Networks to provide a turnkey solution for Corporation, an Ontario-based developer of an innovative tech- its new Internet service, internetPrimus, which will cover all the nology to speed the flow of network traffic between metropolitan capital cities in Australia and an additional twenty-seven major areas and optical Internet backbone networks. ■■ Minority regional centers. ■■ Cable & Wireless Communications, interests in companies such as Avici Systems, Inc. and interWAVE London: Corporate and business customers will have increased Communications International Ltd. speed, capacity, and reliability in voice and data services through Cable & Wireless Communications’ $650 million network upgrade Achievements and expansion, which will be created through a three-year working relationship with Nortel Networks and will produce substantial ■■ Internet Backbones: 75 percent of backbone Internet traffic operating efficiencies for Cable & Wireless Communications. in North America is carried on optical equipment supplied by ■■ Federa, The Netherlands: A new GSM 1800 radio network Nortel Networks, which also supplies six out of seven pan-European is now available in The Netherlands, as Nortel Networks supplied Internet backbones. ■■ Qwest, United States: Augmenting its several hundred cell sites for the network to Federa, the new Dutch 1997 purchase of Nortel Networks advanced fiber-optic transmission telecom operator owned by France Télécom Mobiles International, equipment for its 16,000-mile coast-to-coast telecommunications ABN Amro Bank, and Rabobank. ■■ Hebei PTA, The People’s network, Qwest Communications International, Inc., a multimedia Republic of China: By mid-year 1999, a major expansion of the communications company, has chosen Nortel Networks backbone province’s GSM digital cellular network will create the capacity for switching hubs  Nortel Networks DMS-250 SuperNode tandem 651,000 new subscribers. The Hebei Post and Telecommunications switching systems and ServiceBuilder Intelligent Network (IN) Administration’s Phase Five expansion project represents the largest service creation platform  to address its expanding network contract for a single project that Nortel Networks has ever signed needs. ■■ Level 3 Communications, Inc., United States: To in China. ■■ State Postal Bureau, The People’s Republic complete Level 3 Communications’ global end-to-end network by of China: China’s State Postal Bureau is constructing computer the year 2001, using IP-based technology, Nortel Networks and networks to connect central offices and branches in ministries, Corning Incorporated worked together on delivering the best provinces, and post areas. Nortel Networks will supply all of fiber solution, using Siecor’s cable design and Corning’s fiber. the routing equipment, which includes 237 different router ■■ Colombia: In April 1998, Nortel Networks announced products, for the integrated service network router backbone. that more than 80 percent of Colombia’s 1.2 million cellular sub- ■■ SUNDAY, Hong Kong SAR: Hong Kong’s new generation scribers were being served by Nortel Networks wireless solutions. GSM operator awarded Nortel Networks a series of projects to ■■ Cellcom Israel: Nortel Networks helped Cellcom Israel build strengthen and expand its mobile phone network, which will enable the world’s first all-digital TDMA wireless network to reach one SUNDAY to become one of the most comprehensive networks million subscribers. ■■ Bouygues Telecom, France: Superior in Hong Kong. ■■ Telstra, Australia: Australia’s principal tele- quality of service is available to subscribers in the Paris, Bordeaux, communications company and largest mobile telecommunications Aquitaine Poitou, and Southwestern regions, as Bouygues Telecom company has selected Nortel Networks to build a national turn- continues to use Nortel Networks’ radio equipment and installa- key cdmaOne (IS-95 CDMA) mobile telephone network with tion services to expand its GSM 1800 digital wireless network. service beginning in the third quarter of 1999. ■■ Net2000 ■■ JazzTel, Spain: Jazz Telecom S.A., Spain’s first competitive Communications, United States: To support Net2000’s goal to local exchange carrier, is building a new national network with be the leading super-regional integrated communications provider, Spain’s SAINCO and Nortel Networks. The new network will offer Nortel Networks will provide the foundation for this emerging business customers a broader range of advanced, high-quality, cost- competitive local exchange carrier’s state-of-the-art voice and data

6 NORTEL NETWORKS 1998 ANNUAL REPORT network serving the eastern United States. ■■ Liz Claiborne Francisco, Los Angeles, Fort Worth, Texas, and New York and a Inc., United States: One of the largest manufacturers of women’s southeastern route connecting New York, Washington, D.C., apparel and accessories in the United States will help maximize its Atlanta, and Houston, Texas. Using 10 Gbps product and Multi- competitive position with a Nortel Networks high-speed network that wavelength Optical Repeater (MOR) Systems, these networks will features a multi-service ATM and Ethernet-switched backbone. enable the transmission of up to 80 Gbps of multimedia, data, ■■ City of Philadelphia, United States: Philadelphia deployed and voice traffic. ■■ Focal Communications Corporation, Nortel Networks Accelar 1200 routing switches in two new five- United States: This competitive local exchange carrier has story city administration buildings to provide high-speed, Layer 3 selected DMS-500 local and long-distance switching systems IP-forwarding for citywide applications. ■■ BT, its European and full-service AccessNode Express platforms to extend its exist- partners  Albacom (Italy), BT Belgium, Cegetel (France), ing facilities-based telecommunications services into a nation- Sunrise (Switzerland), Telfort (The Netherlands), and Viag wide presence. ■■ Kaiser Permanente, United States: The largest Interkom (Germany)  and Nortel Networks are building a new not-for-profit health maintenance organization (HMO) in the pan-European network to meet the explosive growth in the United States is implementing a nationwide high-performance Internet and demand for bandwidth-hungry, high-speed data ser- data network with more than 350 Nortel Networks Passport 6400 vices. ■■ Formus Communications, United States: This global enterprise network switches, which will enable it to enhance and competitive carrier will provide data and Internet services to busi- increase support to almost nine million health care customers and nesses in selected markets around the world with Nortel Networks medical centers, data centers, and satellite offices. ■■ SBC Unified Network solutions for high-speed, broadband wireless Communications Inc., United States: SBC Communications services. The deal is expected to be worth as much as $500 million has selected Nortel Networks industry-leading network products and will include Nortel Networks Reunion broadband wireless  DMS-100 digital switching equipment, hardware and software access equipment, Passport ATM switching, and system integra- upgrades, and product conversion services  for the company’s tion services. ■■ MetroNet Communications Corp., Canada: seven-state region, in a five-year contract expected to exceed Business customers of Canada’s first and largest facilities-based $1.5 billion. ■■ Electric Lightwave, United States: Electric national competitive provider of local telecommunications ser- Lightwave, one of this nation’s leading integrated communications vices will have access to one of the most advanced networks in providers, will deploy a high-capacity optical networking solution Canada, through access, high-capacity and local transport optical in a 3,000-mile western SONET ring. As part of a five-year equipment, and switching systems from Nortel Networks. ■■ agreement, the network will carry traffic over a high-capacity net- AT&T, United States: To support its thrust into local telephony, work scalable up to 320 Gbps, using Nortel Networks’ 10 Gbps AT&T has selected the Cornerstone cable telephony communi- four-fiber ring architecture with Dense-Wavelength Division cations system from ANTEC and Arris Interactive, a Nortel Multiplexing (D-WDM). ■■ Omnipoint Communications, Networks/ANTEC joint venture, to serve up to two million homes. United States: Omnipoint has selected Nortel Networks to build The initial order for Cornerstone product represents the first step GSM 1900 digital networks in Indianapolis, Detroit, and several in an agreement that could result in sales of up to $900 million. other basic trading areas (BTAs) under terms of a three-year More cable operators have deployed Cornerstone than any other supply agreement. ■■ Bell Atlantic, United States: Bell cable telephony product worldwide, including Cox, TCI, Atlantic is modernizing its advanced telecommunications network Cablevision Lightpath, Time Warner, Titus Communications to better meet customer needs for new products and advanced (Japan), VTR Telefonica (Chile), Jupiter Telecommunications services, through DMS SuperNode processor upgrades, DMS (Japan), and Priority Telecom (Austria). ■■ Telgua, Guatemala: Enhanced Networks, and Primary Rate ISDN hardware and Several key regions in Guatemala will benefit from more readily software. ■■ United States Cellular, United States: Needing available voice, data, and enhanced calling services. Guatemala to rapidly address competitive challenges with new digital wireless City was the first to have Nortel Networks’ infrastructure installed service in Milwaukee and other markets in Wisconsin and Illinois, for a 150,000-subscriber expansion of the Telecomunicaciones de United States Cellular selected Nortel Networks to build new Guatemala network. This agreement with Telgua for a CDMA- CDMA and TDMA digital wireless networks under a con- based network makes Nortel Networks the only supplier to have all tract potentially worth more than $400 million over four years. major wireless technologies (AMPS, GSM, TDMA, and CDMA) ■■ Société Européenne des Satellites, Luxembourg: SES in implementation in Latin America. ■■ Cybercare Inc., has signed a contract with Nortel Networks for the provision United States: Cybercare selected Nortel Networks to provide a of a turnkey interactive satellite system, which will consist of complete home health/remote health system known as Cybercare the Ground Network as well as Satellite Interactive Terminals to Electronic House Call system, which incorporates technology provide interactive broadband and bandwidth-on-demand developed by Medical College of Georgia and Georgia Institute of multimedia services on upcoming ASTRA satellites. ■■ Turk Technology. Health care providers will be able to see and talk with Telekom, Turkey: Turk Telekom is using Nortel Networks’ patients in their homes and assess key health indicators such Proximity I fixed wireless access solution to provide domestic tele- as heart rate, blood pressure, blood-oxygen and blood-sugar phone service with wireline-equivalent digital voice, fax, high- levels, thanks to this system which enhances the accessibility speed data, Internet access, and other services for residential and delivery of medical care at a lower overall cost. ■■ IXC and small business customers. ■■ Copesa Comunicaciones Communications, Inc., United States: This provider of inte- Personales S.A., Paraguay: Copesa selected Nortel Networks to grated network solutions is using Nortel Networks optical net- supply a complete GSM 1900 digital PCS network, including working equipment for a coast-to-coast network linking San switching, radio base stations, and services for a nationwide

NORTEL NETWORKS 1998 ANNUAL REPORT 7 network expected to serve up to 100,000 subscribers. ■■ Bell Nortel Networks is supplying this leader in television ratings Canada: Bell Canada is using the 1-Meg Modem in Canada’s and audience estimates with reliable, high-performance Accelar largest deployment of high-speed data access services. Nortel 1200 routing switches to improve the performance of its existing Networks’ revolutionary plug-and-play 1-Meg Modem was declared mission-critical network infrastructure and provide Gigabit “the easiest, least expensive, and most practical” high-speed Ethernet connectivity to link customers to the company’s analyti- modem to use in the industry by Computer Reseller News. cal databases and products. ■■ AirTouch Communications, Test engineers for Computer Reseller News noted the 1-Meg United States: To lower costs, meet future demands of wireless Modem solution “is the only one that can be rolled out to service customers, and achieve a better balance among its mix of infra- more than 70 million subscribers today.” Just eight months after structure suppliers, the world’s largest cellular phone service provider launching the 1-Meg Modem, Nortel Networks had received more signed a letter of intent with Nortel Networks for the multi-year than $1 billion in orders from public institutions, Internet Service purchase of state-of-the-art network switches, base stations, and con- Providers, and service providers throughout the United States. trollers. AirTouch will purchase analog and cdmaOne (IS-95 CDMA) Major contracts include Transwire Communications Inc. of digital network infrastructure in a contract which could reach New York, MegsINet of Chicago, and AGIS Communications $500 million. ■■ U S West, United States: U S West is enhancing of Detroit. ■■ Global One: Global One, the worldwide joint its advanced payphone system by installing more than 5,000 Nortel venture of Deutsche Telekom, France Télécom, and Sprint, is Networks Millennium MultiPay MultiApplication payphones, preparing to provide its customers with an advanced array of capable of evolving with the dynamic needs of the public access integrated telecommunications services spanning the globe. A and electronic commerce marketplace. ■■ MCI WorldCom, three-year supply and resale agreement covers the purchase United States: At the second annual InfoVision Exhibit on of Nortel Networks Multimedia Carrier Switch (MMCS), October 5, 1998, MCI WorldCom received a product recognition DMS-Global Services Platform (DMS-GSP) switching systems, award for the deployment of the world’s first 80 Gbps route using and NetWORKS network supervision systems, as well as the Nortel Networks’ industry-leading S/DMS TransportNode OC-192 purchase and resale of Nortel Networks Passport and the resale (10 Gbps) system with Dense-Wavelength Division Multiplexing. of Nortel Networks Vector multimedia ATM switching systems. In December of 1997, MCI WorldCom turned up live customer ■■ GST Telecom, Inc., United States: GST and Nortel traffic on the 80 Gbps network span extending 170 miles from Los Networks are jointly building a “converged network,” integrating Angeles to Rialto, California. MCI WorldCom is also deploying an data, voice, and video on a single network using a combination interexchange carrier market beta trial of Nortel Networks DMS- of packet, frame, and cell technologies. GST will deploy the next Spectrum Peripheral Module. The DMS-SPM is a new peripheral generation Virtual Integrated Transport and Access (VITA) net- services platform for public network service providers delivering work using Nortel Networks Passport and Concorde ATM switches high-speed, direct optical network connectivity. ■■ Sprint PCS,  complementing its existing network of Nortel Networks United States: In early 1999, Nortel Networks cdmaOne equip- voice, access, and optical network equipment. ■■ Telemig ment will provide Sprint PCS service across the southern and Celular S.A., Brazil: Telemig has selected Nortel Networks to midwestern United States as a result of an intensive, thirty-month expand its statewide cellular network over the next three years rollout involving more than 4,700 base stations and an infrastructure through the manufacture, deployment, and integration of Nortel investment of $1.3 billion. ■■ Defense Advanced Research Networks DualMode Radios, DMS-MTX SuperNode digital Projects Agency (DARPA), United States: In an effort to jumpstart switching systems, and other equipment and services. In addition the development and deployment of the high-speed, high-band- to the Telemig project, Nortel Networks is deploying TDMA width networks needed to maintain United States competitiveness IS-136 digital wireless networks for operators in the city of in the global markets of the 21st century, DARPA has collectively Sao Paulo, in the capital city of Brasilia, and in the western awarded Nortel Networks; GST Telecommunications, Inc.; Sprint and northeastern regions of Brazil. ■■ Walgreen Company, and Lawrence Livermore National Laboratory a $10 million, three- United States: The ten-millionth Norstar telephone system was year contract to build the West Coast leg of its Next Generation sold to this national drugstore chain. Norstar Integrated Internet (NGI) research network, an ultra high-speed, high-band- Communications System is a leader in the global key system mar- width network linking Seattle to San Diego with major nodes in ket. The Norstar system has received the Editor’s Choice Award the Portland, San Francisco, and Los Angeles areas. ■■ Abilene from CTI Magazine and Teleconnect. ■■ Université Laval, Network, United States: Set to launch formally in February 1999, Canada: When a greater demand for bandwidth, resulting from an Abilene is a high-speed data network managed by the University increased number of users and increasingly demanding engineer- Corporation for Advanced Internet Development linking sixty uni- ing applications, made necessary an upgrade to the networking versities together for the development of new applications and other infrastructure of its new sciences and engineering faculty building, experiments. Its aim is to improve quality and performance while Université Laval selected Nortel Networks Accelar 1200 routing developing pioneering new uses for the global computer network. switches and Gigabit Ethernet technology to deliver high-speed Nortel Networks has donated leading-edge optical networking switching and routing. ■■ Rite Aid, United States: Rite Aid, equipment to assist Qwest in the deployment of a 10,000-mile fiber- one of this nation’s largest drug store chains, wanted a highly optic backbone linking all members of the Abilene consortium. scalable, resilient network to serve customers quickly and effi- Nortel Networks’ market-leading optical networking systems will ciently and is installing equipment such as Nortel Networks initially send data at the speed of 2.5 Gbps on the Abilene network, Accelar routing switches for Gigabit Ethernet switching and before rising to full capacity of 10 Gbps. The network being pro- Layer 3 connectivity into the company’s state-of-the-art distri- vided to Abilene by Qwest, Nortel Networks, and Cisco Systems bution centers. ■■ Nielsen Media Research, United States: Inc. will represent an investment worth $500 million.

8 NORTEL NETWORKS 1998 ANNUAL REPORT Annual.report.98

Financial Section

Revenues Supplementary Supplementary ($ millions) measure of net measure of earnings earnings applicable per common share to common shares ($) ($ millions)

18,000 1,800 2.4

15,000 1,500 2.0

12,000 1,200 1.6

9,000 900 1.2

6,000 600 .8

3,000 300 .4

0 0 0 1994 1995 1996 1997 1998 1994 1995 1996 1997 1998 1994 1995 1996 1997 1998 ➔ ➔ ➔

Up Up Up 14% 32% 21% Annual.report.98

Financial Review

The following provides additional analysis as to Nortel Networks’ operations and current ﬁnancial situation. This commentary is supplementary to and should be read in conjunction with the Consolidated Financial Statements which begin on page 30. Unless the context indicates otherwise, Northern Telecom Limited (the Corporation) and its 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 a leading provider of data networking products and services (the Bay Networks Merger). The aggregate purchase price was approximately $6.9 billion, which was based on the closing market price of the Corporation’s common shares on the closing day of the acquisition, the value of the assumed Bay Networks stock options, and merger-related costs. For the purpose of United States generally accepted accounting principles (GAAP), the aggregate purchase price was approximately $9.0 billion. The Bay Networks Merger added to Nortel Networks’ expertise and product portfolios in data and Internet Protocol (IP), increased Nortel Networks’ intellectual capital, provided new distribution channels to market, and broadened Nortel Networks’ customer base. The rapid change of communications systems technology, based on current and future customer needs, is driving the convergence of data, telephony and video, and wireless and wireline technologies. The communications networks of the future are expected to combine packet and circuit technologies in a unified manner, allowing the smooth operation of applications using the best technology for each kind of traffic. These future networks are expected to create opportunities 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 telephony technologies. Nortel Networks’ ability to develop products and services to meet these new market opportunities and customer needs is critical to its future success.

Acquisitions and dispositions In pursuing its vision of Uniﬁed Networks (integrated networks blending routing, optical, wireless, wireline, switching, and IP technologies in a seamless manner) and in strengthening its core business, Nortel Networks has completed the 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 Technology Limited (formerly Bell-Northern Research Ltd.) from Bell Canada, increasing its ownership 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 networking start-up company. January 9, 1998 Acquisition of Broadband Networks Inc. (BNI), a designer and manufacturer of ﬁxed broadband wireless communications networks. April 1, 1997 Sales of TTS Meridian Systems Inc. and Nortel Communications Systems Inc. distribution channels to WilTel Communications, LLC (the WilTel Transaction). June 21 1996 Acquisition of MICOM Communications Corp. (MICOM), a manufacturer and distributor 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.

10 NORTEL NETWORKS 1998 ANNUAL REPORT Financial Review

Streamlining of business processes On January 13, 1999, Nortel Networks announced the acceleration of its operations strategy designed to better meet the rapidly changing needs and values of its customers worldwide. The strategy will simplify and streamline Nortel Networks’ 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 assembling most 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 Networks to focus on customers’ changing requirements for software technology and higher value-added integrated systems and 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 affected by the program. Divestitures, retraining, and attrition will minimize employee impact. As the program evolves over the next eighteen to thirty-six months, the Corporation expects to realize savings in the range of $250 to $300 million a year. The efficiencies generated by the program are not expected to significantly impact 1999 results from continuing operations, but will position the Corporation for future growth. Over the coming years, the impact of the operations strategy 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 economics of networking take hold. The explosive growth of the Internet and data networking is shifting Nortel Networks’ product mix from hardware to software. In conjunction with these changes, speed-to-market is a critical factor in meeting customers’ demands for fast delivery, testing, and implementation of their unified telephony and data networks. Use of the World Wide Web, EDI (Electronic Document Interchange), and 800 numbers for order entry and fulfillment will 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 comprised of products included in broadband networks, public carrier networks, and wireless networks. Enterprise segment  Nortel Networks’ operating segment delivering network solutions to enterprise customers comprised of products included in enterprise networks and Bay Networks. Corporate and Other segment (Other)  Nortel Networks’ non-operating segment which includes revenues from divested businesses (restated annually to reflect in-year divestitures) and the components business, which provides high-performance semi-conductors, microwave modules, and other sub-assemblies and services. Other also includes expenses for internal functions of the Corporation which are charged to the operating segments. Costs not charged to 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 $12,847 Carrier segment revenues 12,374 10,879 8,269 Enterprise segment revenues 4,877 3,879 3,672

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

Supplementary measure of net earnings† $ 1,065 $ 804 $ 619 Supplementary measure of net earnings per common share† 1.86 1.54 1.20 Earnings before income taxes $ 64 $ 1,267 $ 944 Earnings 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 shares for 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 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. ‡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 service indebtedness 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.

NORTEL NETWORKS 1998 ANNUAL REPORT 11 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 Networks intangible assets ($1,056 million), amortization of purchased in-process R&D from other acquisitions ($574 million), 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 Advanced Power Transaction; $70 million from the sale of Lagardère SAS (Lagardère) shares; $89 million relating to Entrust Technologies Inc. (Entrust Technologies); $30 million from the Creedmoor Facility Transaction; $24 million from the sale of Netspeed Inc. shares; $16 million loss from the GSM Terminals Transaction; and $14 million from the disposition, 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 of net 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 common shares for 1997 included a pre-tax gain of $102 million related to the WilTel Transaction and pre-tax special charges of $95 million related to the write-down of certain investments and the rationalization and/or relocation of certain manufacturing facilities.

Supplementary measure of net earnings The supplementary measure of net earnings, which excludes the amortization of the Bay Networks intangible assets and 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 to 1997, and of 28 percent for 1997 compared to 1996. The increase in the supplementary measure of net earnings for 1998 primarily reflected a substantial increase in operating earnings, partially offset by a substantial increase in interest expense. 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 acquisitions, 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-related costs will continue to negatively impact Nortel Networks’ earnings before income taxes over the next years. On a segmented basis, earnings before income taxes from operations for Nortel Networks’ carrier segment was $1.58 billion, an increase of $411 million over 1997 results, which were $354 million greater than 1996. The earnings before income 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 from operations 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 interest expense 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 segment Public carrier networks $ 4,118 23 $ 4,054 26 2 Wireless networks 3,743 21 3,454 22 8 Broadband networks 4,513 26 3,371 22 34 12,374 70 10,879 70 14 Enterprise segment Enterprise networks 4,877 28 3,879 25 26 Other 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 management structure. The primary effect of this reclassiﬁcation was to move revenues from the enterprise segment to Other as a result of the WilTel Transaction and the MET Transaction.

12 NORTEL NETWORKS 1998 ANNUAL REPORT Financial Review

The 14 percent increase in consolidated revenues in 1998 was attributable to an increase in sales volume of approximately 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 for the impact of divested businesses (primarily the MET Transaction, the GSM Terminals Transaction, the WilTel Transaction, and the Advanced Power Transaction). Carrier segment revenue growth of 14 percent in 1998 was largely driven by the growth in revenues of Nortel Networks’ optical networking solutions and also reflected growth in all carrier lines of business. This revenue growth was attributable to a volume increase of approximately 17 percent, partially offset by price reductions of approximately 3 percent. The 34 percent increase in broadband networks revenues in 1998 was driven by considerable growth across all regions. Wireless networks revenues increased 8 percent over 1997 levels as a result of considerable growth 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 a result of higher sales in the United States and strong growth in Europe, offset by considerably lower sales in Asia Pacific and CALA, and significant decreases in Canada. North American revenues from traditional public carrier products are expected to continue to be negatively affected by the shift in capital spending from public carrier products to high bandwidth broadband products. Enterprise segment revenues in 1998 increased 26 percent over the same period in 1997. This increase was due to growth across all major products and was primarily driven by the Bay Networks Merger. The increase in enterprise segment revenues was attributable to a volume increase of approximately 27 percent, partially offset by price reductions of approximately 1 percent. Enterprise networks revenue growth was a result of a considerable increase in revenues from the United States (primarily as the result of the Bay Networks Merger) and strong revenue increases in all other regions, 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 primarily 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 19 Canada 1,360 8 1,374 9 (1) All other countries Europe 3,718 21 3,476 22 7 Other 2,656 15 2,301 15 15 6,374 36 5,777 37 10 Total $17,575 100 $15,449 100 14

United States The increase of 19 percent in revenues from the United States was primarily the result of substantially increased revenues in enterprise networks, reflecting the Bay Revenues by Networks Merger, and substantially increased revenues in broadband networks. customer location Revenues increased in public carrier networks, signiﬁcantly increased in wireless (percent) networks, and declined substantially in Other (primarily the result of the WilTel

Transaction). The increase in revenues from the United States over 1997 was the 100 result of substantially higher sales to interexchange carriers (IECs), independent telephone operating companies (IOCs), and other United States customers and 75 distributors (the latter two increases were primarily as a result of the Bay Networks Merger). Excluding the contribution of Bay Networks, revenues in the United 50 States increased signiﬁcantly.

Canada 25 Revenues in Canada decreased one percent compared to 1997 due to considerably lower sales in wireless networks and signiﬁcantly lower sales in public carrier net- 0 United States Canada works, partially offset by substantially higher sales in broadband networks. Sales to Europe 1996 1997 1998 Bell Canada and other subsidiaries and related companies of BCE Inc. (the BCE Other group) declined from their 1997 level, and sales to other Canadian customers showed a modest increase for the year.

NORTEL NETWORKS 1998 ANNUAL REPORT 13 Financial Review

Other countries 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 the MET Transaction and the GSM Terminals Transaction) and significantly lower revenues in wireless networks. Public carrier networks revenues increased from 1997. Revenues in other markets, comprising CALA and Asia Pacific, increased 15 percent in 1998 when compared to 1997. In CALA, sales in wireless networks increased substantially and both enterprise networks and broadband networks sales rose significantly from 1997. Public carrier networks sales fell considerably compared to 1997. Revenues in Asia Pacific increased significantly in 1998 when compared to 1997, primarily driven by considerable increases in wireless networks revenues, partially offset by a sharp decrease in public carrier networks revenues. Sales in 1998 when compared 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 anticipates 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 unstable economies caused in part by the volatility of certain currencies. Revenues from Asia Pacific (excluding China) were less than 3 percent and 4 percent, respectively, of the consolidated revenues for the years ended December 31, 1998, and 1997. The current economic crisis in the affected Asia Pacific countries resulted in lower than anticipated demand for the Corporation’s products in the second half of 1998 and it is expected that demand will continue to be impacted by the 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 segment Public carrier networks $ 4,054 26 $ 3,441 26 18 Wireless networks 3,454 22 2,281 18 51 Broadband networks 3,371 22 2,547 20 32 10,879 70 8,269 64 32 Enterprise segment Enterprise networks 3,879 25 3,672 29 6 Other segment 691 5 906 7 (24) Total $15,449 100 $12,847 100 20

The 20 percent increase in consolidated revenues in 1997 was attributable to an increase in sales volume of approximately 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 for the 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 a volume increase of approximately 33 percent partially offset by price reductions of approximately 1 percent. Public carrier networks revenues increased 18 percent in 1997 compared to 1996, primarily due to substantially increased sales in the United States. Sales in 1997 when compared to 1996 were substantially lower in Asia Pacific, significantly higher 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. Broadband networks revenues were up 32 percent in 1997 compared to 1996, primarily due to substantially increased sales in the 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 increased in the United States, increased substantially in CALA, increased in Asia Pacific, were essentially flat in Europe, and were down slightly in Canada compared to 1996. The higher enterprise segment revenues in 1997 were attributable to an increase in sales volume.

14 NORTEL NETWORKS 1998 ANNUAL REPORT 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 21 Canada 1,374 9 1,233 10 11 All other countries Europe 3,476 22 3,029 24 15 Other 2,301 15 1,727 13 33 5,777 37 4,756 37 21 Total $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 lines compared to 1996. The increased revenues were due primarily to substantially higher sales to IECs, regional Bell operating 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 due to 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 wireless networks. Revenues in 1997 compared to 1996 were significantly higher in public carrier networks, broadband networks, 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 with 1996. Revenues in Asia Pacific increased significantly in 1997 compared to 1996, primarily due to substantially increased 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 in wireless networks. Sales in 1997 when compared to 1996 were substantially higher in public carrier networks and enterprise networks, partially offset by lower sales in broadband networks and other revenues.

Gross profit

(billions of U.S. dollars) 1998 1997 1996 Gross profit $7.53 $6.34 $5.13 Gross 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 and enterprise segments, partially offset by lower sales volume in Other, primarily due to the 1998 dispositions. Within the 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 1997 increase in gross profit was primarily the result of increased sales in all segments, except Other, and improved margins in 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. Within the 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 been able to offset such pressure through the sale of higher-margin products and manufacturing and other cost-reduction programs. Gross margin is also affected by the level of software sales. Gross margin was negatively affected by the introduction of new products, the continued expansion into new markets, and the increase in products manufactured by other suppliers in network solutions offered by Nortel Networks.

NORTEL NETWORKS 1998 ANNUAL REPORT 15 Financial Review

Selling, general and administrative (SG&A) expense

(billions of U.S. dollars) 1998 1997 1996 SG&A expense $3.09 $2.71 $2.20 As 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 1998 increase in absolute dollars reflected the funding of North American and international market investments across both operating segments, as well as increased investments supporting Nortel Networks’ global marketing programs and operations systems to simplify and streamline Nortel Networks’ business processes, ongoing investment in computer 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 ﬁnancing risk. 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 1996 R&D expense* $2.45 $2.15 $1.81 As 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 carrier and enterprise segments for new products, process development, advanced capabilities, and services for a broad array of 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 established accounting 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 Exchange Commission regarding valuation methodology. Based on this new valuation methodology, the value of the purchased in-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 related to the BNI acquisition was reduced to $329 million and goodwill was increased by $64 million.

(millions of U.S. dollars) 1998 1997 1996 In-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 related to the acquisitions of Bay Networks, BNI, Aptis, and Cambrian. The capitalized amount of Research and purchased in-process R&D as at December 31, 1998, was $509 million. development The amortization of acquired technology for 1998 reflects the charge related to the Bay ($ millions) Networks Merger. The capitalized amount of acquired technology as at December 31, 1998,

was $1.82 billion. 3,000 Goodwill for 1998 primarily reflects charges related to the Bay Networks Merger and to investments in STC plc, MNC, and MICOM. The capitalized amount of goodwill as at 2,500

December 31, 1998, was $3.29 billion. 2,000

Special charges 1,500 Special charges, aggregating $447 million, were included in the results for the period ended 1,000 December 31, 1998. 500 As part of the special charges, a provision of $377 million related to steps taken to streamline management layers, gain operational efﬁciencies, and realign resources and investments was 0 recorded. Included in the provision was $261 million representing the cost of severance and related beneﬁts for approximately 4,100 employees worldwide, which includes $70 million for 1996 1997 1998

16 NORTEL NETWORKS 1998 ANNUAL REPORT Financial Review

individuals in R&D activities. The majority of Nortel Networks’ business functions, job classes, and geographic areas were impacted, with a majority of the reductions taking place in the United States and Canada. Also included in this provision was $93 million in non-cash expenses for plant and equipment and other write-downs, and $23 million in facilities and other costs, primarily related to wireless networks and enterprise networks. The anticipated benefits of these activities began to materialize in the Corporation’s consolidated results of operations during the fourth quarter of 1998. 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 costs had 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 the reductions in the carrying value of certain assets. Nortel Networks’ proportionate share of this reduction was 50 percent 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, and plant rearrangement and relocation costs of $11 million. The majority of the severance and plant rearrangement and relocation costs related to a charge taken by Nortel plc to downsize a portion of its Fixed Wireless Access manufacturing operations 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 rationalization and/or relocation of certain of the Corporation’s manufacturing facilities. These activities were substantially completed by September 30, 1998.

Investment and other income – net and interest expense

(millions of U.S. dollars) 1998 1997 1996 Equity 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 of associated companies, was primarily the result of the following items: a pre-tax gain of $70 million from the sale of Lagardère shares; a pre-tax gain of $77 million relating to Entrust Technologies’ initial public offering concurrent with a secondary offering of Entrust Technologies common shares by the Corporation; a pre-tax gain of $24 million on the sale of Nortel Networks’ equity interest in Netspeed Inc.; and a pre-tax dilution gain of $12 million resulting from Entrust Technologies’ acquisition of r3 Security Engineering AG (r3). Also contributing to the increase in investment and other income  net in 1998 was an increase of $29 million in interest income, primarily resulting from higher cash balances following the Bay Networks Merger and higher levels of short-term investments due to increased cash flows from United States operations. In addition, minority interest has moved from an expense to an income, primarily due to the loss recorded by Entrust Technologies as a result of its acquisition of r3. These increases were partially offset by the Corporation’s loss of $19 million from its equity in net earnings (loss) of associated companies, and by increased foreign exchange losses (see below). The decrease in investment and other income  net in 1997 as compared to 1996 was primarily a result of substantially higher net customer financing expenses, partially offset by significantly higher equity earnings. Investment and 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 higher minority 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 first quarter of 1998 of a C$300 million debt which had been swapped to sterling. The decreased interest expense for 1997, when compared to 1996, was primarily due to the reduced use of commercial paper as a result of higher cash balances, 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 business will be denominated in currencies other than United States dollars. As a result, fluctuations in foreign currencies may have an impact on Nortel Networks’ business and financial results. Nortel Networks endeavours to minimize the impact of such currency fluctuations through its ongoing commercial practices and by attempting to hedge its exposures to major currencies. In attempting to manage this foreign exchange risk, Nortel Networks identifies operations and transactions that may have foreign exchange exposure, based upon, among other factors, the excess or deficiency of

NORTEL NETWORKS 1998 ANNUAL REPORT 17 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 impact of foreign exchange fluctuations was a loss of $74 million compared to losses of $50 million and $44 million, respectively, 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 countries will continue to increase in the future, significant foreign exchange fluctuations may have an adverse impact on the Corporation’s results from operations. The introduction of the euro on January 1, 1999 may reduce the Corporation’s European foreign exchange exposure in the future (see “European monetary union and the euro”).

Income taxes

(millions of U.S. dollars) 1998 1997 1996 Income taxes $601 $438 $321 As 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. Nortel Networks’ earnings are subject to differing effective tax rates in each of the countries in which it operates. An increase in the Corporation’s tax rate can result when the proportions of revenues earned in high tax rate countries increases over the prior year.

Liquidity and capital resources Change (millions of U.S. dollars) 1998 1997 from 1997 Cash and cash equivalents $2,281 $1,371 $ 910 Cash flows from operating activities* 1,586 800 786 Cash flows from investing activities (105) (153) 48 Cash 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 have been restated to reflect this change.

Cash and cash equivalents at December 31, 1998 were $910 million higher than the balance a year earlier. Cash provided by operating activities in 1998 increased by $786 million when compared to 1997. Nortel Networks continues 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 expenditures amounted 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 net increase in long-term receivables of $356 million in 1998 was primarily the result of a higher balance of customer financing at year end. Acquisitions in 1998 generated $115 million, compared to outflows of $167 million in 1997. The improved cash flows from acquisitions primarily resulted from the Bay Networks Merger and were partially offset by other acquisitions during the year, primarily Cambrian and BNI. Proceeds from the sales of businesses were $751 million in 1998, an increase 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 primarily 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 of the Corporation, have $200 million of debt securities and warrants to purchase debt securities, to be offered by either the 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 securities remaining available to the Corporation under a separate United States registration statement. The Corporation has also filed, in each of the provinces of Canada, a short form shelf prospectus to issue up to C$500 million of debt securities

18 NORTEL NETWORKS 1998 ANNUAL REPORT 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 one year and 364 days, respectively. The entire amount of these committed facilities remains available. Nortel Networks expects 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 subordinated debentures outstanding. The debentures mature on May 15, 2003, and are convertible at the option of the holder into the Corporation’s common shares. The debentures are redeemable at the option of the issuer, initially at approximately 103.7 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 the Corporation for cancellation. The Board of Directors of the Corporation authorized the repurchase for cancellation of up 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 Corporation announced the commencement of a program (the 1998 program) to repurchase for cancellation up to 6.4 million of the Corporation’s common shares in the period from February 4, 1998, to February 3, 1999. At the expiration of the 1998 program, the Corporation had purchased and cancelled 4,347,400 common shares. On February 22, 1999, the Corporation announced the commencement of a new program (the 1999 program) to repurchase for cancellation up to 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 significant 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, Nortel Networks anticipates that, due to the amount of financing it expects to provide and the higher risks typically associated 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 of their term is expected to increase significantly in the future. At December 31, 1998, Nortel Networks had entered into certain financing agreements for the future provision of up to approximately $754 million of customer financing and had outstanding offers or commitments in connection with awarded supply contracts, subject to fulfilment of certain conditions, to provide up to approximately $1.46 billion of additional customer financings (not all of these offers 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 customer financings directly supported by Nortel Networks from working capital and conventional sources of external financing in the normal course. In light of recent economic uncertainty and reduced demand for financings in capital and bank markets, Nortel Networks may be required to continue to hold certain customer financing obligations for longer 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, the Corporation began to maintain 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 medium-term and long-term customer- financed receivables and guarantees. The allowance is part of the provision for uncol- Debt to lectibles. The allowance is reviewed quarterly for adequacy of impairment coverage and, in capitalization management’s opinion, the allowance is considered adequate to absorb credit-related losses (percent) in the Financing Portfolio. Prior to January 1, 1997, the Corporation reflected customer financing risk related to PCS contracts as a reduction in revenues. All customer financing 30 risk is now reflected through SG&A. Nortel Networks has entered into supply contracts with customers for products and 25 services, which in some cases involve new technologies currently being developed or 20 which have not yet been commercially deployed by Nortel Networks or require Nortel Networks to build and operate networks on a turnkey basis. These supply contracts may 15 contain delivery and installation timetables and performance criteria which, if not met, 10 could result in the payment of substantial penalties or liquidated damages by Nortel 5 Networks, the termination of the related supply contract, and/or the reduction of shared revenues under a turnkey arrangement. 0 On May 13, 1998, Nortel Networks and Lagardère entered into an amended and restated participation agreement to realign MNC, a joint venture in which Nortel Networks and 1996 1997 1998

NORTEL NETWORKS 1998 ANNUAL REPORT 19 Financial Review

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 percent 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 per annum and is payable by MNC to Nortel Networks either in cash or by way of transfer of MNC’s 34 percent equity interest in Nortel Matra Cellular SCA (NMC). Nortel Networks has the option, at its sole discretion, to require the repayment of the loan by way of transfer of the NMC shares and, as a result, Nortel Networks is accounting for NMC as if it was a wholly owned subsidiary. After July 1, 1999, Lagardère may, under speciﬁc circumstances, require Nortel Networks to purchase all of its equity participation in MNC at a price to be based partly on a formula and partly 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 due to adverse changes in financial market prices and rates. Nortel Networks’ market risk exposure is primarily a result of fluctuations in interest rates and foreign exchange rates. To manage the risk from these fluctuations, Nortel Networks enters into various derivative-hedging transactions that have been authorized pursuant to Nortel Networks’ policies and procedures. Risk management control systems are maintained by the Corporation to monitor market risks and counter-party risks. These systems rely on analytical techniques including both sensitivity analysis and 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 Consolidated Financial Statements. Foreign exchange exposures are managed using forward, cross currency swap, and option contracts to hedge net foreign investments and firm sale and purchase commitments. The most significant foreign exchange exposures for Nortel Networks relate to the Canadian dollar, the United Kingdom pound, and the French franc. The hedge of net foreign investments is accomplished through the use of forward and cross currency swap contracts, whereby any gain or loss on the derivative is recorded in the currency translation adjustment (CTA) in shareholders’ equity and is used to offset the gain or loss on the net assets of a foreign subsidiary, which is also recorded in CTA during translation. Nortel Networks enters into United States to Canadian dollar forward, option, and cross currency coupon swap contracts intended to hedge the United States to Canadian dollar exposure on future revenue, expenditure, and preferential cash dividend streams. 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 denominated in several major currencies, the largest exposure being in United States dollars. These exposures are managed using interest rate swaps and cross currency swaps. These derivative instruments reduce Nortel Networks’ cost of financing and reduce the fluctuations in the aggregate interest expense. Net settlements on these swap instruments are booked as an adjustment to interest expense. Sensitivity analysis is used to measure Nortel Networks’ foreign currency risk by computing the potential decrease in 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 flows that relate to the hedge of firm commitments are not included in the analysis. As at December 31, 1998, based on a one-year time horizon, a 10 percent adverse change in the exchange rates results in a potential decrease in after-tax cash flows of approximately $82 million. This potential decrease results primarily from Nortel Networks’ exposure to 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 basis point adverse change in interest rates would not have a material effect on the consolidated financial position, earnings, 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 District of New York purportedly on behalf of all persons whose Bay Networks common shares or stock options were exchanged for the Corporation’s common shares in the Bay Networks Merger. The complaint alleged that the Corporation and certain named ofﬁcers violated the Securities Act of 1933 and the Securities Exchange Act of 1934 because the proxy statement/prospectus and registration statement for the Bay Networks Merger and the related issuance of common shares of the Corporation (the Bay Networks Proxy Statement), as well as certain public statements made by the Corporation, contained materially false and misleading statements and omissions concerning the Corporation’s

20 NORTEL NETWORKS 1998 ANNUAL REPORT Financial Review

financial condition. Two additional class action complaints were filed in the same court on November 16, 1998, and December 11, 1998, alleging substantially similar claims. The complaints sought relief in the form of compensatory damages 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 to any of these complaints. In June 1998, four class actions were filed in the Delaware Court of Chancery, New Castle County, purportedly on behalf of all common shareholders of Bay Networks in connection with the announcement of the Bay Networks Merger. The complaints named the directors and officers of Bay Networks individually, as well as Bay Networks and the Corporation, as defendants. The complaints essentially alleged that the Bay Networks directors breached fiduciary duties owed to the Bay Networks shareholders by, among other things, failing to undertake an appropriate evaluation of Bay Networks’ net worth as a merger candidate and by failing in the Bay Networks Merger to obtain for the Bay Networks shareholders adequate value for their Bay Networks common shares. The complaints further alleged that the Corporation aided and abetted these alleged breaches of fiduciary duty. The complaints sought relief including a preliminary 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, the Corporation, 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 approval by the Delaware Court of Chancery. The Settlement Agreement provided that the Bay Networks Proxy Statement include certain additional information not included in the document filed with the United States Securities and Exchange Commission (the SEC) on July 2, 1998. It also provided that counsel for the plaintiff class may apply to the 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 of all common shareholders of Bay Networks. The complaint alleged that the Bay Networks Proxy Statement was materially misleading and violated applicable securities laws because Bay Networks failed to disclose the existence of litigation pending in Massachusetts State Court in which Bay Networks was suing six former employees for violations by such employees of their non-competition and non-solicitation agreements with Bay Networks. As part of this 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 the United States District Court for the Northern District of California (the Federal Court) and alleges violations of the federal securities laws (the Federal Action). The other lawsuit was filed in California Superior Court, County of Santa Clara (the California Court), and alleges violations of the California Corporations Code (the First State Action). 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 State Action purported to seek damages on behalf of a class of shareholders who acquired Bay Networks’ common shares pursuant 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 the Consolidated State Action have appealed this decision. No date for oral arguments in this appeal has been set. In September 1998, the Federal Court dismissed the plaintiffs’ complaint in the Federal Action, granting leave for the plaintiffs to amend the complaint. In November 1998, the Corporation and the plaintiffs in the Federal Action agreed to stay the proceedings until a decision regarding pleading standards in securities litigation has been rendered by the United States Ninth Circuit Court of Appeal in an unrelated case involving Silicon Graphics, Inc., and the Federal 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 States District Court for the Southern District of New York alleging that the Corporation and certain of its officers violated the 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 consolidated and the plaintiffs were permitted to file a Second Consolidated Amended Complaint after the first Consolidated Amended Complaint had been dismissed without prejudice. A defense motion challenging the sufficiency of the Second Consolidated Amended Complaint was denied in part and granted in part on August 19, 1994. An Answer

NORTEL NETWORKS 1998 ANNUAL REPORT 21 Financial Review

to this Complaint was filed on September 22, 1994. On February 24, 1995, the consolidated action was certified as a class action and on April 10, 1996, a Stipulation and Order of Dismissal was granted permitting one of the named officers to be dismissed from the suit. On May 2, 1996, the plaintiffs filed a motion to file a Third Consolidated Amended Complaint. The Corporation and the named officers filed an opposition to this and also filed a motion to dismiss 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 have filed 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 normal course of business. Northern Telecom, Inc. (NTI), the Corporation’s principal United States subsidiary, received a statutory notice of proposed assessment from the Internal Revenue Service (IRS) dated November 6, 1996 with respect to its 1980 through 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 been made which would reduce the proposed additional tax liability. On February 3, 1997, NTI filed a petition with the United States Tax Court opposing such proposed additional tax. If the IRS were to prevail, NTI would be entitled to a refund for later taxable years. Recently, NTI and the IRS have agreed on a basis for resolving the most significant issues involved 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 counsel and the Corporation’s independent accountants, 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 material adverse 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 liability or financial impact of these matters and therefore cannot determine whether these proceedings will, individually or 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 officers intend to vigorously defend these actions.

Environmental matters Nortel Networks, primarily as a result of its manufacturing operations, is subject to numerous environmental laws and regulations and is exposed to liabilities and compliance costs arising from its past and current generation, management, 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 over the next five years. Based on information presently available, management believes that the existing accruals are sufficient 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 connection with other locations currently under investigation, are not expected to have a material adverse impact on the consolidated 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 probable and 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 listed as a de minimis PRP at three of these Superfund sites. An estimate of Nortel Networks’ share of the anticipated remediation 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 Nortel Networks’ involvement. In addition, the accuracy of Nortel Networks’ estimate of environmental liability is affected by several uncertainties such as additional requirements which may be identified in connection with remedial activities, the complexity and evolution of environmental laws and regulations, and the identification of presently unknown remediation 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, the majority of whom are in Canada and the United States. Pension benefits are based on length of service and rates of compensation. In determining its pension obligations and expense, Nortel Networks’ weighted average discount rate used for 1998 pension calculations was 7.2 percent, which reflects the impact of economies with higher long-term discount rates than would typically be found in the United States. The Corporation believes that a downward adjustment of the discount rate may have a material effect on consolidated earnings.

22 NORTEL NETWORKS 1998 ANNUAL REPORT 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 the applicable year. Computer systems and products that have date-sensitive software may recognize a date using “00” as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in 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 information technology (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 establish a common suite of business applications throughout the Corporation and its subsidiaries. The new applications are being deployed as Year 2000 ready, and for those business units relying on replacement of certain legacy applications as part of their Year 2000 strategy, they are expected to replace a number of legacy applications by the end of the second quarter of 1999. All business system applications not addressed by the enterprise backbone deployment, including vendor 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 necessary to modify or replace significant portions of software so that business applications, computing environments and products would properly utilize Year 2000 dates before and beyond December 31, 1999. Nortel Networks’ Year 2000 Program 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 Bay Networks’ 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 products and deploying solutions to customers. Through this program the Corporation has made or will make its current product offerings Year 2000 ready. In addition, the Corporation is providing an upgrade or migration path and other information 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), and Phase 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), the Telco Year 2000 Forum in the United States, Alliance for Telecommunications Industry Solutions, and the Canadian Year 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 1999 at the request of Nortel Networks product users. The Corporation estimates that this phase will be substantially complete by mid-1999. Nortel Networks has initiated formal communications with its customers (except where Nortel Networks sells its products through distributors, in which case formal communications have been initiated primarily with such distributors). Customers and/or distributors are being notified of known risk areas and proposed remediation plans. Customers are being encouraged to arrange for deployment of Year 2000 ready products promptly to ensure the products will be deployed prior to the year 2000. Increased orders of Year 2000 ready products and product upgrades at 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 quarter of 1999. Thereafter, business continuity planning will be monitored and updated on an ongoing basis into the year 2000. 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 venture activities related to Year 2000 readiness. The IS Program consists of the following three major phases: Phase I (assessment and validation  inventory of Year 2000 affected items, assessment of Year 2000 readiness, and prioritization of items determined to be material to the Corporation); Phase II (implementation and deployment  repair and/or replacement of items determined not to be Year 2000 ready, testing of all items that have been repaired or replaced or have been identified as Year 2000 ready but are considered to be material to the Corporation, and re-deployment of tested items into Year 2000 ready operating environments); and Phase III (business continuity planning  planning to 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 percent complete at December 31, 1998, and the remaining Phases I and II activities are on schedule to be completed by the end of the second quarter of 1999. Most of the Phase I and II activities carried over into 1999 are related to the deployment of applications which have been determined to be Year 2000 ready, and were not deployed in 1998 for

NORTEL NETWORKS 1998 ANNUAL REPORT 23 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 expected to be in place by end of the third quarter of 1999, at which point monitoring and execution of business continuity plans 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 the Corporation. Assessment activities include the identification and prioritization of critical suppliers, direct communications 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 interfaces between the third-party supplier and Nortel Networks. Formal communications between Nortel Networks and significant third-party suppliers are focused to determine the extent to which Nortel Networks is vulnerable to these third parties’ potential failure to remedy their own Year 2000 issue. Where appropriate, the Corporation has or plans to execute Year 2000 compliance agreements with such parties. Detailed evaluations of the most critical third parties and their products or services have been initiated. Where appropriate, the results of such evaluations will initiate the development of business continuity plans. Business continuity planning commenced in the fourth quarter of 1998 and plans are expected to be in place by the end of the third quarter of 1999, at which point monitoring and execution 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 by the Corporation. Also addressed under the Facilities Program are factory-based embedded systems used in the manufacture and testing of Nortel Networks products. The Facilities Program is on schedule, and it is expected that the repair and testing of equipment will be substantially completed by the end of the second quarter of 1999. Business continuity planning for the Facilities Program commenced in the third quarter of 1998 and plans are expected to be in place by the end of the third quarter of 1999, at which point monitoring and execution of such plans will be undertaken, 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 Business Continuity 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 both internal and external customers, and to minimize the effects of the disruption on the operations of the Nortel Networks’ business. The planning process is based on an industry-accepted, process-focused approach, and the overall BCP Program has a scheduled completion date of the end of the third quarter, 1999, with implementation monitoring and execution of business continuity plans occurring during the fourth quarter. Interim planning milestones have been established and the progress of the BCP Program is monitored on a regular basis. Some business continuity planning 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 2000 modifications. The total cost associated with Nortel Networks’ Year 2000 Program is being funded through operating cash flows and is not expected to be material to the Corporation’s financial position. The estimated total cost of the Year 2000 Program is approximately $155 million. This amount does not include costs to upgrade products or product software as these costs have been absorbed indirectly through normal product upgrades. As well, this amount does not include Nortel Networks’ potential share of Year 2000 costs that may be incurred by partnerships and joint ventures in which the Corporation participates but is not the operator. The total amount expended on the Program through December 31, 1998, was $125 million. The estimated future cost of completing the Year 2000 Program is approximately $30 million. The costs of the Year 2000 Program and the date on which Nortel Networks plans to complete the Year 2000 Program are based on management’s best estimates, which were derived utilizing numerous assumptions of future events 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 materially from those plans. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, the timely 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 replacement, modifications, and conversions are not made, or are not completed on a timely basis and if Nortel Networks’

24 NORTEL NETWORKS 1998 ANNUAL REPORT 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 of legacy applications used by certain lines of business will be replaced by the end of the second quarter of 1999 through the enterprise backbone program, failure to replace such applications by the beginning of the year 2000 could have a material adverse effect on the business, results of operations, and financial condition of the Corporation. Nortel Networks’ 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 on presently available information. However, there can be no assurance that the systems of other companies on which Nortel Networks’ systems rely will be converted in a timely manner, or that a failure to convert by another corporation, 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 the Year 2000 issue for the products it has sold. In planning for the most reasonably likely worst-case scenarios, Nortel Networks has addressed all three programs which 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 to make their Nortel Networks products Year 2000 ready. Nortel Networks’ Product Program includes plans to place advertisements in trade journals, conduct seminars, and dedicate a website to contact all possible customers that may possess 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 infrastructure. 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 in process, and Nortel Networks is simultaneously putting the required resources in place to carry out those plans for key facilities. Critical business partners are being contacted to assess their readiness and appropriate business continuity plans will be developed by the end of the second quarter of 1999 to address potential business interruptions that 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 address key supplier relationships is currently underway. Although Nortel Networks values its established relationships with key 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 deliver products and/or services on a timely basis, due to their own Year 2000 issues, business continuity plans should assure a timely transition to an alternate supplier to provide the required products and/or services. Nortel Networks also recognizes the risks to its business if other key suppliers in utilities, communications, transportation, banking, and government are not ready for the Year 2000, and is developing business continuity plans to minimize the potential adverse 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 common 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, is now the responsibility of the European Central Bank. During a three-year transition period, parties may freely decide to conduct business in either a legacy currency or the cash-less euro under the EU principle of “no prohibition, no compulsion.” Euro notes and coins will be introduced on January 1, 2002, and legacy currencies will cease to be legal tender by July 1, 2002. Nortel Networks commenced preparation for the introduction of the euro in 1997 and all affected IT systems have been modified to ensure that Nortel Networks can conduct business with both suppliers and customers in either legacy currencies or the euro. The costs of this activity were minimal and are fully reflected in Nortel Networks’ 1998 results of operations. Internal transactions which were previously effected in legacy currencies in Euroland were switched to the euro on January 1, 1999. Where necessary, existing contracts will be amended to ensure that the introduction of the euro will not lead to the performance of the contract becoming impossible or frustrated. Direct and indirect taxation within Euroland is still the responsibility of each member state and hence no immediate changes are anticipated as a result of the introduction of the euro; however, further developments of the Economic and Monetary Union (EMU) may include harmonization of some taxes and Nortel Networks will closely monitor any resulting impact on its business operations. The creation of the euro is expected to have a minor but positive impact on Nortel Networks’ currency risk and risk management programs. The development of EMU may lead to increased price transparency within EU markets. Nortel Networks will continue 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.

NORTEL NETWORKS 1998 ANNUAL REPORT 25 Financial Review

Not later than January 1, 2002, all corporate entities in Euroland will have to switch their accounting base from legacy currencies to the euro. Nortel Networks is currently assessing the incremental cost of this activity, including related 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 euro are 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 statements containing words such as “could,” “expects,” “may,” “anticipates,” “believes,” “intends,” “estimates,” “plans,” and similar 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 assumptions regarding these markets. In addition, other written or oral statements which constitute forward-looking statements may 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 may differ materially from actual results or events. Factors which could cause results or events to differ from current expectations 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 modest growth expected for voice traffic. The growth of data traffic is expected to have a significant impact on traditional voice networks and create market discontinuities which will drive the convergence of data and telephony and give rise to the demand for IP-optimized networks. Many of Nortel Networks’ traditional customers have already begun to invest in data networking. Given the dynamic and evolving nature of the communications business and the technology involved, there can be no assurance as to the rate of such convergence. Consequently, there is no assurance that the market 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 products based on other technologies and reduce the demand for IP-optimized network equipment. A lack of demand for IP-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-optimized network equipment, Nortel Networks has made a number of strategic acquisitions, including the acquisition of Bay Networks. Acquisitions, particularly an acquisition the size of the Bay Networks acquisition, involve significant risks and uncertainties. These risks and uncertainties include the risk that the industry does not evolve as anticipated and that the technologies acquired do not prove to be those needed to be successful in the industry, the difficulty in integrating new businesses and operations in an efficient and effective manner, the risks of customers of Nortel Networks or the 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 attention of senior management from the operation of the business, and the risks of entering new markets in which Nortel Networks has limited experience. The inability to successfully integrate acquisitions made by Nortel Networks could have 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 industry standards, frequent new product introductions, and short product life cycles. Nortel Networks’ success is expected to depend, in substantial part, on the timely and successful introduction of new products and upgrades of current products to comply with emerging industry standards and to address competing technological and product developments carried out by others. The development of new, technologically advanced products, including IP-optimized network products, is a complex and uncertain process requiring high levels of innovation, as well as the accurate anticipation of technological and market trends. The success of new or enhanced products, including IP-optimized network products, is dependent on a number of other factors including the timely introduction of such products, market acceptance 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 market demand for products based on a specific technology, particularly lower than anticipated demand for IP-optimized network products, could have a material adverse effect on the business, results of operations, and financial condition of the Corporation if it fails to respond in a timely and effective manner to such changes.

26 NORTEL NETWORKS 1998 ANNUAL REPORT 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 growth and, in certain cases, low barriers to entry and rapid technological changes, smaller niche market companies and start-up ventures may become principal competitors in the future. The acquisition of Bay Networks by Nortel Networks was followed by Lucent’s agreement to acquire Ascend Communications Inc. These acquisitions may have the 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, thereby creating even more powerful or aggressive competitors. Nortel Networks expects that it will face additional competition from existing competitors and from a number of companies that may enter Nortel Networks’ existing and future markets. Some of Nortel Networks’ current and potential competitors have greater financial (which includes the ability to provide customer financing in connection with the sale of its products), marketing, and technical resources. Many of Nortel Networks’ current and potential competitors have also established relationships with Nortel Networks’ current and potential customers. Increased competition could result in price reductions, reduced profit margins, and loss of market share, each of which could have 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 international markets, 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, pursuit of such international growth opportunities may require significant investments for an extended period before returns on such investments, if any, are realized. Such projects and investments could be adversely affected by reversals or delays in 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 in which such opportunity arises. Difficulties in foreign financial markets and economies, and of foreign financial institutions, could adversely affect demand from customers in the affected countries. For a description of these matters as they relate 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 to provide significant amounts of customer financing in connection with the sale of products and services. For a description 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 in order to achieve favourable operating results. In addition, there are trends and factors beyond Nortel Networks’ control which affect its operations. Such trends and factors include adverse changes in the conditions in the speciﬁc markets for 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 economy generally; 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 vigorous competition for market share and rapid technological development carried out amidst uncertainty over adoption of industry standards and protection of intellectual property rights. These factors could result in aggressive pricing practices and growing competition both from start-up companies and from well-capitalized computer systems and communications companies.

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

NORTEL NETWORKS 1998 ANNUAL REPORT 27 Financial Review

resolving the Year 2000 problem. This may result in reduced spending to acquire new networking solutions particularly in the last quarter of 1999 and could have a material adverse effect on the business, results of operations, and ﬁnancial condition of the Corporation. For a description of Nortel Networks’ Year 2000 Program and other risks associated with 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 expected to continue. Nortel Networks and one or more of its competitors may each supply products to the corporations that have merged or will merge. This consolidation could result in delays in purchasing decisions by the merged corporations and/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 the accounting for software development costs and will require the capitalization of certain costs which the Corporation has historically expensed. The Corporation is currently analyzing the impacts of this SOP, which is required to be adopted for fiscal year 1999. In June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS No. 133), which established accounting and reporting standards for derivative instruments and hedging activities. It requires an entity to measure all derivatives at fair value and to recognize them in the balance sheet as an asset or liability, depending on the entity’s rights or obligations under the applicable derivative contract. Management has not yet evaluated the effects of this statement on its results of operations. As required, the Corporation will adopt SFAS No. 133 in the first 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 is currently 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.

28 NORTEL NETWORKS 1998 ANNUAL REPORT Financial Review

Dividends The Corporation declared a cash dividend in each quarter of $.075 per common share, for a total dividend of $.30 per common share for the year. Total dividends paid on common shares were $178 million in 1998 and $150 million in 1997. The Corporation intends to continue paying quarterly dividends on its common shares. The board of directors 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 generally to a 25 percent withholding tax, unless reduced by treaty. Under income tax conventions between Canada and both the United States and the United Kingdom, a withholding tax of 15 percent generally applies to residents of the United States and United Kingdom who do not have a “permanent establishment” or “ﬁxed base” in Canada with which the dividends are effectively connected. Persons subject to either United States or United Kingdom income tax on dividends generally will be entitled, subject to certain limitations, to either a credit or deduction with respect to the Canadian taxes withheld. Gains on disposals of common shares of the Corporation by owners who are not residents of Canada are generally not 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 Toronto Stock 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 1998 1st quarter 92.500 57.500 91.750 65.438 39.688 64.625 2nd quarter 100.250 75.500 83.400 69.250 51.375 56.750 3rd quarter 94.900 46.250 49.100 63.688 30.438 32.063 4th quarter 80.200 41.650 76.600 51.688 26.813 50.000 1997 1st quarter 52.250 41.703 45.175 38.500 30.250 32.687 2nd quarter 62.500 43.500 62.125 45.500 31.063 45.000 3rd quarter 74.703 63.875 72.125 53.875 45.125 51.968 4th 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 registered 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) 1998 Income taxes $ 493 Payroll, sales, property, and other taxes 555 Total $1,048

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

NORTEL NETWORKS 1998 ANNUAL REPORT 29 Annual.report.98

Management’s Report

The accompanying consolidated financial statements of Northern Telecom Limited and all information in this annual 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 accounting principles 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, has developed 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 a proper 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 ethical business conduct. The board of directors carries out its responsibility for the financial statements in this annual report principally through its audit committee, consisting solely of outside directors. The audit committee reviews the Corporation’s annual 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, Chartered Accountants, and their report follows.

John A. Roth Frank A. Dunn John A. Roth Frank A. Dunn Vice-Chairman Senior Vice-President and Chief Executive Ofﬁcer and Chief Financial Ofﬁcer

Annual.report.98

Independent Auditors’ Report

To the Shareholders Northern Telecom Limited We have audited the consolidated balance sheets of Northern Telecom Limited as at December 31, 1998 and 1997 and the consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period 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 standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of the Corporation as at December 31, 1998 and 1997 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1998 in accordance with accounting principles generally accepted in Canada.

Deloitte & Touche LLP Deloitte & Touche LLP Chartered Accountants Toronto, Canada February 1, 1999

30 NORTEL NETWORKS1998ANNUAL REPORT 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 1996 Revenues (note 2) $17,575 $15,449 $12,847 Cost of revenues 10,050 9,111 7,714 Gross profit 7,525 6,338 5,133

Selling, general and administrative expense 3,093 2,714 2,195 Research and development expense (note 5) 2,453 2,147 1,813 Amortization 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) 47 Interest 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) 601 438 321 Net earnings (loss) (537) 829 623

Dividends on preferred shares 32 17 4 Net 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

NORTEL NETWORKS 1998 ANNUAL REPORT 31 Annual.report.98

Consolidated Balance Sheets

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

1998 1997 Assets Current assets Cash and cash equivalents $ 2,281 $ 1,371 Accounts receivable Related parties (note 22) 248 214 Trade (less provision for uncollectibles  $260 for 1998, $223 for 1997) 5,214 4,666 Inventories (note 12) 1,687 1,765 Prepaid expenses 223 155 Deferred 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 103 118 Other 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

32 NORTEL NETWORKS 1998 ANNUAL REPORT 1998 1997 Liabilities and shareholders’ equity Current liabilities Notes payable $ 186 $ 180 Accounts payable and accrued liabilities Trade and other payables 1,555 1,405 Related parties (note 22) 11 4 Payroll 172 323 Other accrued liabilities 3,697 2,591 Income taxes payable 253 157 Long-term debt due within one year (note 15) 19 223 5,893 4,883 Long-term liabilities Deferred income 77 28 Long-term debt (note 15) 1,648 1,565 Deferred income taxes 94 169 Other liabilities 366 367 8,078 7,012 Minority interest in subsidiary companies 89 132 Commitments 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 3,514 Additional paid-in capital 199 - Foreign currency translation adjustment (364) (322) 11,565 5,410 Total liabilities and shareholders’ equity $19,732 $12,554

On behalf of the Board of Directors

Donald J. Schuenke Ralph M. Barford Donald J. Schuenke Ralph M. Barford Director Director

NORTEL NETWORKS 1998 ANNUAL REPORT 33 Annual.report.98

Consolidated Statements of Shareholders’ Equity

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

1998 1997 1996 Preferred shares (note 18) Balance at beginning of year $ 609 $ 367 $ 73 New issues - 242 294 Balance at end of year $ 609 $ 609 $ 367

Common shares (note 18) Balance at beginning of year $1,609 $1,461 $1,273 Shareholder dividend reinvestment and stock purchase plan 4 43 Stock option plan 121 172 185 Shares 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 $2,800 Net earnings (loss) (537) 829 623 Dividends 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) 107 Impact of foreign currency hedges (19) 71 (74) Balance at end of year $ (364) $ (322) $ (242)

34 NORTEL NETWORKS 1998 ANNUAL REPORT Annual.report.98

Consolidated Statements of Cash Flows

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) 829 623 Items not involving cash and cash equivalents Amortization 2,259 546 525 Equity in net (earnings) loss of associated companies in excess of dividends received 24 (6) 8 Increase (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 27 538 Increase in long-term receivables (651) (376) (238) Decrease in long-term receivables 295 570 106 Acquisitions and other investments (note 20) 115 (167) (197) Proceeds on sales of businesses (note 9) 751 390 113 Total (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 56 164 457 Reductions of long-term debt (281) (38) (347) Reductions of capital leases (3) (1) (7) Issue of preferred shares (note 18) - 242 294 Issue of common shares 125 176 188 Common 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

NORTEL NETWORKS 1998 ANNUAL REPORT 35 Annual.report.98

Notes to Consolidated Financial Statements

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

1. Significant accounting policies The consolidated ﬁnancial statements have been prepared in accordance with accounting principles generally accepted in 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 Canadian and United States generally accepted accounting principles (GAAP) except as described in notes 11 and 21. Nortel Networks’ operations domiciled in Canada measure their operations in Canadian dollars and translate to U.S. dollars for 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 consolidated; entities which are jointly controlled, referred to as joint ventures, are proportionately consolidated; entities which are not controlled but over which the Corporation has the ability to exercise significant influence, referred to as associated companies, are accounted for using the equity method; and investments in other entities are accounted for 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 assets of 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. Assets and liabilities are translated at the exchange rates in effect at the balance sheet date. Revenues and expenses, including gains and losses on foreign exchange transactions other than long-term intercompany advances, are translated at average rates for the period. The unrealized translation gains and losses on the Corporation’s net investment, including long-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 losses on certain debt and foreign exchange contracts designated as partial hedges of foreign self-sustaining operations are also included in CTA. These gains and losses may be realized on the payment of dividends by, or a change in the equity capital 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 parent company. 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 rates for the period, except for amortization which is translated on the same basis as the related assets. Translation exchange gains or losses of integrated subsidiaries, joint ventures, and those subsidiaries operating in hyperinflationary economic environments are reflected in net earnings. Unrealized gains and losses on long-term monetary assets and liabilities are 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 significant contractual obligations have been satisfied and collection is reasonably assured. Software revenues are recognized when delivered in accordance with all terms and conditions of the customer contracts and upon acceptance from the customer. Revenues on long-term contracts are recognized using the percentage-of-completion method. Profit estimates on long-term contracts are revised periodically based on changes in circumstances, and losses on contracts are recognized immediately. Service revenues are recognized at the time of performance or proportionately over the term of the 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, except for costs incurred pursuant to speciﬁc contracts with third parties, which are charged to earnings in the same period as the related revenue is recognized. Related investment tax credits reduce R&D expense in the same period in which the related expenditures are charged to earnings, provided there is reasonable assurance the beneﬁts will be realized.

36 NORTEL NETWORKS 1998 ANNUAL REPORT 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 this method, taxes are computed using current tax rates regardless of when such income is subject to taxes under the tax laws. The deferred tax balances which result are not adjusted for any subsequent changes in tax rates and include accrued 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 of the acquisition date and has no alternative future use, and is charged to earnings using an accelerated amortization method 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 identiﬁable assets of subsidiary companies, joint ventures, and associated companies, and is amortized on a straight-line basis over its 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 technology, and goodwill for potential permanent impairment. In order to determine if such a permanent impairment exists, Nortel Networks’ management compares the carrying value of these intangible assets to the ﬁnancial condition and the present value of the expected future earnings before tax, of the related operations. A permanent impairment in 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 are based 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 interest rates and foreign exchange rates. These derivative financial instruments are effective in meeting the risk reduction objectives 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 instruments for trading purposes. Forward and cross currency swap contracts are used to hedge certain net foreign investments. Gains and losses on these instruments are deferred and reported as part of CTA, as outlined in note 1(b). Forward, option, and cross currency 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 are recognized in income when the hedged transaction occurs. Amounts that are receivable or payable under interest rate swaps are accrued and recorded as adjustments to interest expense. Any premiums paid with respect to derivative 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 make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Estimates are used when accounting for items and matters such as long-term contracts, allowance for uncollectible accounts receivable, inventory obsolescence, product warranty, amortization, employee benefits, taxes, provisions, and contingencies.

NORTEL NETWORKS 1998 ANNUAL REPORT 37 Notes to Consolidated Financial Statements

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

(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 composed of medium-term and long-term customer-ﬁnanced receivables and guarantees. This allowance is part of the provision for uncollectibles. The allowance is reviewed quarterly for adequacy of impairment coverage and, in management’s opinion, 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 pension beneﬁts 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 average remaining service life of the employee group. The costs of postemployment health care and life insurance beneﬁts are expensed as incurred.

2. Information on operating segments General description Nortel Networks’ operations include two reportable operating segments: carrier and enterprise. The carrier segment includes: products which are used by telecommunications operating companies to interconnect access lines and transmission facilities to provide local or long-distance services, products to address wireless communications, and products which 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, usually located on the customer’s premises, which permit voice, data, or multimedia terminals to communicate with each other, 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 solutions to two specific customer groups. These segments provide network solutions that integrate data, voice, and video on a single network using a combination of packet frame and cell technologies. The network solutions involve the convergence of traditionally disparate networks for seamless end-user connectivity, reduced costs, and flexible bandwidth management. The solutions address corporate intranet (enterprise) and Internet access, as well as high-speed network transport (carrier). The accounting policies of the segments are the same as those described in note 1. The Corporation evaluates financial performance based on measures of profit or loss from operations before income taxes, excluding the impact of the amortization of the Bay Networks, Inc. (Bay Networks) intangible assets and purchased in-process R&D from other acquisitions, and one-time gains and charges (see notes 4, 7, 8, and 9). Inter-segment revenues were immaterial for the years ended December 31, 1998, 1997, and 1996.

38 NORTEL NETWORKS 1998 ANNUAL REPORT Notes to Consolidated Financial Statements

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

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

Carrier Enterprise Corporate 1998 Segment Segment & Other Total Customer revenues $12,374 $ 4,877 $ 324(a) $17,575 Earnings 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 92 121 Amortization 194 74 282 550 Interest expense 29 1 202 232 Total assets 6,692 2,678 10,362(e) 19,732 Capital expenditures 309 104 229 642

Carrier Enterprise Corporate 1997 Segment Segment & Other Total Customer revenues $10,879 $ 3,879 $ 691(a) $15,449 Earnings before income taxes from operations 1,165 455 (360)(b) 1,260(c) Earnings per share from operations 1.46 .62 (.54) 1.54(d) Interest income 2936092 Amortization 159 61 267 487 Interest expense 16 5 148 169 Total assets 5,351 1,804 5,399(e) 12,554 Capital expenditures 287 121 167 575

Carrier Enterprise Corporate 1996 Segment Segment & Other Total Customer revenues (f) $ 8,269 $ 3,672 $ 906(a) $12,847 Earnings before income taxes from operations 811 506 (373)(b) 944(c) Earnings per share from operations 1.04 .60 (.44) 1.20(d) Interest income 36 3 61 100 Amortization 134 63 287 484 Interest expense 11 11 153 175 Total assets 4,836 1,830 4,237(e) 10,903 Capital expenditures 305 111 185 601

(a) Represents revenues from business units below the quantitative thresholds, primarily divested businesses and components businesses which provide high-performance semi-conductors, microwave modules, and other sub-assemblies and 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 operating segments either on a direct basis or through a matrix allocation. Direct charges are based on actual usage of services while matrix allocation is based on revenue, headcount, or some other appropriate driver. Costs not charged to the operating segments remain within Corporate & Other. Excludes the impact of the amortization of the Bay Networks intangible assets and purchased in-process R&D from other acquisitions and one-time gains and charges.

NORTEL NETWORKS 1998 ANNUAL REPORT 39 Notes to Consolidated Financial Statements

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

(c) Earnings before income taxes 1998 1997 1996 Total earnings before income taxes from operations for 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 the years 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 to restate other line items.

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

Public Customer Carrier Broadband Wireless Enterprise Revenues Networks Networks Networks Networks Other Total 1998 $ 4,118 $ 4,513 $ 3,743 $ 4,877 $ 324 $17,575 1997 4,054 3,371 3,454 3,879 691 15,449 1996 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 the geographic areas. The following table sets forth information about geographic areas for the year ended December 31:

1998 1997 1996 Total revenues: United States Customers $10,942 $ 9,105 $ 7,401 Transfers between geographic areas 887 934 1,067 11,829 10,039 8,468 Canada Customers 1,802 1,858 1,489 Transfers between geographic areas 3,611 3,443 2,777 5,413 5,301 4,266 All other countries Customers 4,831 4,486 3,957 Transfers between geographic areas 504 697 605 5,335 5,183 4,562 Elimination of transfers between geographic areas (5,002) (5,074) (4,449) Total customer revenues $17,575 $15,449 $12,847

40 NORTEL NETWORKS 1998 ANNUAL REPORT Notes to Consolidated Financial Statements

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

1998 1997 1996 Contribution to operating earnings: United States $ 1,747 $ 2,148 $ 1,900 Canada 520 957 712 Other 505 754 708 2,772 3,859 3,320 R&D expense (2,453) (2,147) (1,813) General corporate expenses (496) (378) (427) Operating earnings (177) 1,334 1,080 Other 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 $ 4,213 Canada 2,916 2,632 2,274 Other 4,360 4,697 3,610 Adjustments and eliminations (1,244) (2,054) (957) Identiﬁable assets 15,959 10,330 9,140 Corporate assets 3,773 2,224 1,763 Total assets $19,732 $12,554 $10,903

Plant and equipment and goodwill: United States $ 3,154 $ 620 $ 639 Canada 911 734 769 Other 1,487 1,539 1,569 Total $ 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 $ 6,858 Canada 1,360 1,374 1,233 Other 6,374 5,777 4,756 Total $17,575 $15,449 $12,847 Export sales, defined as revenues from Canada to customers outside Canada, and intercompany transfers out of Canada, 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 other income (expense) – net, interest expense, gain on sales of businesses, general corporate expenses, R&D expense, and income tax provision. Identifiable assets are those assets of Nortel Networks that are identified with the operations in the geographic area. Corporate assets are principally cash and cash equivalents and corporate plant and equipment.

NORTEL NETWORKS 1998 ANNUAL REPORT 41 Notes to Consolidated Financial Statements

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

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 earnings per 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 earnings and earnings per share are as follows: 1998 1997 1996 Net earnings (loss) applicable to common shares $ (569) $ 812 $ 619 Add back: Acquisition-related amortization Purchased 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 1.20 Weighted 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 Technology Limited (Nortel Technology), formerly known as Bell-Northern Research Ltd., owned by Bell Canada for approximately $18 in cash, which approximated the fair value of such shares. The transaction increased the Corporation’s ownership 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 Cambrian Systems 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. In addition, approximately $60 in cash is contingent upon the achievement of certain milestones in 1999. The acquisition was accounted for using the purchase method. The allocation of the purchase price was to assumed liabilities net of tangible assets of $4, purchased in-process R&D assets of $204, and goodwill of $48. This allocation is subject to reﬁnement. The purchased in-process R&D assets are being charged to earnings over a six-month period, using an accelerated amortization method. Goodwill is being amortized on a straight-line basis over ﬁve years. As at December 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 networking products and services. The acquisition was consummated by way of a merger of Bay Networks with and into a wholly owned subsidiary of the Corporation (the Bay Networks Merger). The aggregate purchase price was approximately $6.9 billion, which was based on the closing market price of the Corporation’s common shares on the closing day of the Bay Networks Merger, the value of the assumed Bay Networks stock options, and the merger-related costs. At closing, the Corporation issued approximately 135 million common shares and assumed 39.4 million options to purchase Bay Networks common stock, which were equivalent to 23.6 million options to purchase common 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 tangible assets of $1,881, assumed liabilities of $475, acquired technology assets of $2,050, purchased in-process R&D assets of $1,000, and goodwill of $2,417. This allocation is subject to reﬁnement. The acquired technology assets are being charged to earnings on a straight-line basis over thirty-six months and the purchased in-process R&D assets are being charged to earnings over a nine-month period using an accelerated amortization method. Goodwill is being amortized on a straight-line basis over ﬁve years.

42 NORTEL NETWORKS 1998 ANNUAL REPORT Notes to Consolidated Financial Statements

NORTHERN TELECOM LIMITED (MILLIONS OF U.S. DOLLARS EXCEPT PER SHARE FIGURES AND UNLESS OTHERWISE STATED) r3 Security Engineering AG On June 8, 1998, Entrust Technologies Inc. (Entrust Technologies), a Nortel Networks subsidiary, completed the acquisition 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. The aggregate purchase price was approximately $24, comprising approximately 1.1 million common shares of Entrust Technologies and cash consideration of approximately $4. The acquisition has been accounted for by Entrust Technologies using the purchase method. The allocation of the purchase price was to purchased in-process R&D assets of $20 and goodwill of $4. The purchased in-process R&D assets are being charged to earnings over a nine-month period 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 participation agreement to realign Matra Nortel Communications S.A.S., a joint venture in which Nortel Networks and 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. (MNC), (ii) Nortel Networks to transfer at their exchange amounts the assets and liabilities of its distribution business in France 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, bears interest at 3 percent per annum, and is payable by MNC to Nortel Networks either in cash or by way of transfer of MNC’s 34 percent equity interest in Nortel Matra Cellular SCA (NMC). Nortel Networks has the option, at its sole discretion, to require the repayment of the loan by way of transfer of the NMC shares, and as a result, Nortel Networks is accounting for NMC as if it were a wholly owned subsidiary. After July 1, 1999, Lagardère may, under speciﬁc circumstances, require Nortel Networks to purchase all of its equity participation in MNC at a price to be based 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 and into a wholly owned subsidiary of the Corporation. The aggregate purchase price was approximately $286 including contingent consideration. At closing, the Corporation issued approximately 2.5 million common shares and paid approximately $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 upon the achievement of certain milestone events scheduled to occur subsequent to closing and has been payable, at the Corporation’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 net tangible assets of $8, purchased in-process R&D assets of $203, and goodwill of $75. This allocation is subject to refinement. The purchased in-process R&D assets are being charged to earnings over a nine-month period using an accelerated 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 Networks Inc. (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 approximately 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, and goodwill of $75. The purchased in-process R&D assets are being charged to earnings over a nine-month period using an 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 of approximately $150. The acquisition was accounted for using the purchase method. The allocation of the purchase price was to net tangible assets of $35 and goodwill of $115. Goodwill is being amortized on a straight-line basis over ten years.

NORTEL NETWORKS 1998 ANNUAL REPORT 43 Notes to Consolidated Financial Statements

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

Purchased in-process R&D Although Nortel Networks reported its ﬁrst, second, and third quarter results of 1998 in accordance with established accounting practice and valuations of acquired in-process R&D provided by independent valuators, these valuations have been reconsidered in light of guidance provided by the United States 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 Bay Networks Merger was reduced to $1,000 and goodwill was increased by $440. With respect to the Aptis acquisition, the value of the purchased in-process R&D was reduced to $203 and goodwill was increased by $75. Similarly, the amount of purchased 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 1996 Opening $ - $ - $ - 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 development 1998 1997 1996 R&D expense $2,453 $2,147 $1,813 R&D costs incurred on behalf of others* 97 125 166 Total $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 development, 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, and realign resources and investments. Included in the provision was $261 representing the cost of severance and related benefits for approximately 4,100 employees worldwide, which includes $70 for individuals in R&D activities. The majority of Nortel Networks’ business functions, job classes, and geographic areas were impacted, with a majority of the reductions taking place in the United States and Canada. Also included in the provision was $93 in non-cash expenses for plant and equipment and other write-downs, and $23 in facilities and other costs, primarily related to wireless networks and enterprise networks. All of these activities are expected to be substantially completed by September 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 other write-downs had been recognized.

44 NORTEL NETWORKS 1998 ANNUAL REPORT Notes to Consolidated Financial Statements

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

(ii) A write-down of approximately $22 in connection with MNC, primarily related to reductions in the carrying value 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 and plant rearrangement and relocation costs related to a charge taken by Nortel plc to downsize a portion of its Fixed Wireless Access (FWA) manufacturing operations in Paignton, United Kingdom. These activities are expected to be substantially 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 of Nortel Networks’ minority ownership of ICL plc, with the remainder related to reductions in the carrying value of certain 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 ﬂows and 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. Approximately one-half of this provision related to a charge taken by MNC, the Corporation’s joint venture in France, to relocate a portion of its terminals manufacturing operations from Germany to France. Other affected facilities include the terminals manufacturing operations in Calgary, Alberta, and Cwmcarn, Wales. The provision was established to provide primarily for severance payments of approximately $26 and plant rearrangements and relocation costs of $13, with the remainder related to asset impairments. As at December 31, 1998, these activities were substantially completed.

8. Investment and other income (expense) – net 1998 1997 1996 Interest income $121 $ 92 $100 Royalty income 38 26 33 Currency 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 -19 Other (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 held at 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 investment 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 received aggregate proceeds of approximately $32, comprising cash and common shares of the acquirer, resulting in a pre-tax gain of $24.

NORTEL NETWORKS 1998 ANNUAL REPORT 45 Notes to Consolidated Financial Statements

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

(iv) Investments in Entrust Technologies During 1996, Nortel Networks formed Entrust Technologies to carry on the business of its secure networks business unit 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 260,000 Series B Common Shares for total consideration of $26, which reduced Nortel Networks’ ownership interest in Entrust 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 resulted in 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 by certain 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 facility in Creedmoor, North Carolina, to C-MAC Industries Inc. On the closing of this transaction, Nortel Networks received 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 GSM Terminals business to Finland Nokia Group. On the closing of this transaction, MNC received cash proceeds of approximately $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 cash proceeds of approximately $114, resulting in a pre-tax gain of $28. Nortel Networks’ proportionate share of this transaction 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 Communications Systems Inc. distribution channels to WilTel Communications, LLC. On the closing of the transaction, Nortel Networks 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 to Cable 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.

46 NORTEL NETWORKS 1998 ANNUAL REPORT Notes to Consolidated Financial Statements

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

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

1998 1997 1996 Income taxes at Canadian rates (1998  43.0%, 1997  43.0%, 1996  42.9%) $ 28 $ 545 $ 405 Increase (reduction) of Canadian taxes applicable to manufacturing proﬁts (18) (14) 3 Difference 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 19 Other (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 1,009 976 Gain 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 434 366 339 Gain on sales of businesses 81 9- $ 601 $ 438 $ 321

Income tax provision (recovery): Current $ 641 $ 484 $ 373 Deferred (40) (46) (52) $ 601 $ 438 $ 321

The deferred portion of the income tax provision results from the recognition of certain revenues and expenses in the ﬁnancial statements in different periods from those for income tax purposes. The following is a summary of the components: 1998 1997 1996 Amortization $ (13) $ (8) $ (14) Contracts in progress and other income items - (2) 4 Realignment costs and other charges (65) 820 Gain 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 jurisdictions excluding 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 the Bay Networks intangible assets and purchased in-process R&D from other acquisitions.

NORTEL NETWORKS 1998 ANNUAL REPORT 47 Notes to Consolidated Financial Statements

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

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 following exceptions:

Net earnings reconciliation 1998 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 $ 560 Basic earnings per common share  United States GAAP (viii) $ (2.24) $ 1.33 $ 1.08 Fully diluted earnings per common share  United States GAAP (viii) $ (2.24) $ 1.30 $ 1.07 Common 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 purchased in-process R&D assets and, accordingly, the purchased in-process R&D assets acquired on the acquisitions of Cambrian of $204, Bay Networks of $1,000, r3 of $20, Aptis of $203, and BNI of $329 were written off at the time of acquisition. The pre-tax adjustment represents the difference between the write-off of purchased in-process R&D recorded 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 was approximately $9 billion, which was based on the average closing market price of the Corporation’s common shares around June 15, 1998 (the date of the announcement of the transaction), the value of the assumed Bay Networks stock options, and the merger-related costs. The aggregate purchase price under United States GAAP also includes the value of the assumed Bay Networks stock options, which resulted in further additional paid-in capital of $659 on a fair value basis using the Black-Scholes valuation model. In addition, as a result of the use of the asset and liability approach in accounting for income taxes, a deferred income tax liability has been calculated in respect of the acquired technology assets in accounting for the purchase under United States GAAP. The allocation of the purchase price under United States GAAP was to tangible assets of $1,881, assumed liabilities of $1,223, including a deferred income tax credit of $748, acquired technology assets of $2,050, purchased in-process R&D assets of $1,000, and goodwill of $5,352. The Corporation’s financial statements for the year ended December 31, 1998, include four months of financial results of Bay Networks. The following selected pro forma financial information is provided as additional disclosure, in accordance with United States GAAP, to present a summary of the combined results of the Corporation and Bay Networks as if the acquisition had occurred as at January 1, 1997, after giving effect to purchase accounting adjustments. The pro forma data is for information purposes only, and may not necessarily reflect the impact of the results of operations of Bay Networks had the acquired business operated as part of the Corporation for the years ended December 31, 1998 and 1997.

48 NORTEL NETWORKS 1998 ANNUAL REPORT Notes to Consolidated Financial Statements

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

1998 1997 Pro forma revenue $18,203 $16,883 Pro 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 accounting adjustments for the periods presented, and excluding the impact of the non-recurring charge for the purchased in-process R&D assets associated with the transaction.

(iii) For the purpose of reporting under United States GAAP, companies are required to accrue the expected cost of postretirement benefits other than pensions during the years employees provide service to the company. The adjustment represents the difference between recognizing the cost of postretirement benefits as claims are paid and using the 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 other postretirement benefits and standardizes them into a combined format. Prior years’ information has been reclassified for its impact. The following data are based upon the reports from independent consulting actuaries as at December 31:

1998 1997 1996 Accrued postretirement benefit cost: Accumulated postretirement benefit obligation $618 $580 $487 Plan assets at fair value (36) (36) (37) Unrecognized prior service cost (56) (61) (63) Unrecognized net gain (loss) (45) (39) 20 Accrued postretirement benefit cost $481 $444 $407 Postretirement benefit cost: Service cost $ 24 $ 21 $ 19 Interest on projected plan benefits 41 40 35 Return on plan assets (3) (3) (3) Amortization 4 44 Postretirement benefit cost 66 62 55 Less: Claims paid and expensed under Canadian GAAP 15 15 14 United States GAAP adjustment for postretirement benefits $ 51 $ 47 $ 41 After 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 1997 Change in postretirement benefit obligation: Benefit obligation at beginning of year $580 $487 Service cost 24 21 Interest on projected plan benefits 41 40 Amendments - 3 Plan participants’ contributions 1 1 Actuarial gain 8 60 Benefits paid (17) (18) Foreign exchange (19) (14) Benefit obligation at end of year $618 $580

NORTEL NETWORKS 1998 ANNUAL REPORT 49 Notes to Consolidated Financial Statements

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

1998 1997 Change in plan assets: Fair value of plan assets at beginning of year $ 36 $ 37 Actual return on plan assets 1 - Employer contribution 1 - Beneﬁts paid (2) (2) Expected interest on assets 2 2 Foreign 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 liability approach 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 in deferred income taxes under United States GAAP as at December 31: 1998 1997 Deferred income taxes: Assets: Tax beneﬁt of loss carry forwards and tax credits $ 473 $ 493 Provisions and reserves 810 456 Postretirement beneﬁts other than pensions 46 43 Amortization 34 - Other 53 49 1,416 1,041 Valuation allowance (250) (240) Goodwill 686 (12) 1,852 789 Liabilities: Acquired technology 665 - Provisions and reserves 358 391 Amortization 100 110 Pensions 57 21 Other 36 6 1,216 528 Net deferred income taxes $ 636 $ 261

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

50 NORTEL NETWORKS 1998 ANNUAL REPORT Notes to Consolidated Financial Statements

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

(vi) For the purpose of reporting under United States GAAP, companies are required to accrue, during the years employees provide service to the company, the expected cost of benefits to former or inactive employees after employment, but before retirement. The adjustment represents the difference between recognizing the cost of postemployment benefits as claims are paid and using the accrual method. The net accrued postemployment benefit cost that 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 adjustments on financial instruments that do not meet the specific criteria for hedge accounting. The adjustment represents the difference between hedge accounting for the cross currency coupon swap contracts under Canadian GAAP as described 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 per share. This is consistent with the calculation for Canadian GAAP. Under United States GAAP, companies are also required to present diluted earnings per share using the treasury stock method when entities have complex capital structures.

Stock option plans – compensation costs Had compensation costs for the stock option plans been recognized as a compensation expense consistent with the methodology prescribed under FASB Statement No. 123, “Accounting for Stock-Based Compensation,” the Corporation’s net earnings applicable to common shares and earnings per common share would have been reduced to the pro forma amounts indicated below: 1998 1997 1996 Net earnings (loss) applicable to common shares: Per United States GAAP $(1,282) $ 695 $ 560 Pro forma $(1,399) $ 601 $ 467 Earnings per common share: Per United States GAAP $ (2.24) $ 1.33 $ 1.08 Pro 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 calculated under United States GAAP and those calculated under Canadian GAAP and shown on the Corporation’s consolidated balance sheets, with the exception of the effect of proportionately consolidating the operations that are under joint control 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 benefit related 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’ equity item amounts calculated under United States GAAP and those calculated under Canadian GAAP and shown on the Corporation’s consolidated statements of shareholders’ equity, with the exception of the effect of proportionately consolidating the operations that are under joint control 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 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” as discussed in part (vii) of this note, and the effect of the change of unrealized gain on investments, net, as disclosed in the statements of comprehensive income.

NORTEL NETWORKS 1998 ANNUAL REPORT 51 Notes to Consolidated Financial Statements

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

Statements of comprehensive income For the purposes of reporting under United States GAAP, the following statements of comprehensive income are required: 1998 1997 1996 Net earnings (loss) applicable to common shares  United States GAAP $(1,282) $ 695 $ 560 Change in currency translation adjustment (42) (80) 33 Change 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 from the income tax provision. The difference in accounting standards for investment tax credits has no effect on the net earnings 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 the accounting for software development costs and will require the capitalization of certain costs which the Corporation has historically expensed. The Corporation is currently analyzing the impacts of this SOP, which is required to be adopted for fiscal year 1999. In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS No. 133), which established accounting and reporting standards for derivative instruments and hedging activities. It requires an entity to measure all derivatives at fair value and to recognize them in the balance sheet as an asset or liability, depending on the entity’s rights or obligations under the applicable derivative contract. Management has not yet evaluated the effects of this statement on its results of operations. As required, 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 of the Effective Date of a Provision of SOP 97-2,” which provide guidance in applying GAAP for recognizing revenue from software transactions. The adoption of SOP 97-2 and SOP 98-4 did not have a material impact on the Corporation’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 $ 567 Work in process 456 358 Finished goods 768 840 $1,687 $1,765

13. Plant and equipment At December 31, plant and equipment consisted of: 1998 1997 Cost: Land $ 67 $ 86 Buildings 967 987 Machinery and equipment 4,215 3,633 5,249 4,706 Less accumulated amortization: Buildings 261 325 Machinery and equipment 2,725 2,341 2,986 2,666 $2,263 $2,040

52 NORTEL NETWORKS 1998 ANNUAL REPORT Notes to Consolidated Financial Statements

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

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 other projections. Plan assets are represented primarily by common stocks, bonds, debentures, secured mortgages, and property. 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, with an 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 valuation of pension plan benefits. Within the consolidated balance sheets, pension plan assets are included in Other assets and 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 balance sheets as at December 31: Deferred pension asset Deferred pension liability 1998 1997 1998 1997 Funded status: Actuarial present value of: Accumulated benefit obligation $2,425 $2,195 $1,930 $1,751 Projected benefit obligation $2,895 $2,496 $2,198 $2,011 Plan assets at fair value 3,278 2,785 2,029 1,635 Excess (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) - 9 Other unrecognized net plan (benefits) obligations and amendments (160) 2 (87) 131 Net accrued pension asset (liability) $ 208 $ 275 $ (256) $ (236)

1998 1997 1996 Pension expense: Service cost  benefits earned $153 $137 $114 Interest on projected plan benefits 350 351 322 Estimated return on plan assets (370) (346) (319) Termination benefits 49 -- Amortization of net pension plan benefits and amendments 55 41 59 Net 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

NORTEL NETWORKS 1998 ANNUAL REPORT 53 Notes to Consolidated Financial Statements

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

Deferred pension asset Deferred pension liability 1998 1997 1998 1997 Change in benefit obligation: Benefit obligation at beginning of year $2,496 $2,115 $2,011 $1,943 Service cost  benefits earned 92 85 61 52 Interest on projected plan benefits 203 194 147 157 Amendments 7 (20) (7) 1 Actuarial gain 228 215 244 111 Acquisitions 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

Deferred pension asset Deferred pension liability 1998 1997 1998 1997 Change in plan assets: Fair value of plan assets at beginning of year $2,785 $2,440 $1,635 $1,565 Actual return on plan assets 445 377 233 222 Employer contribution 69 64 59 60 Acquisition/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 300 300 6% Notes due September 1, 2003 200 200 7.40% Notes due June 15, 2006 150 150 6 ₇⁄₈% Notes due September 1, 2023 200 200 7 ₇⁄₈% Notes due June 15, 2026 150 150 5₁⁄₄% 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% 177 202 Obligations under capital leases 28 7 1,667 1,788 Less: 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 presented at 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 at approximately 103.7 percent of the face value and decreasing premium prices thereafter to 100 percent at maturity.

54 NORTEL NETWORKS 1998 ANNUAL REPORT Notes to Consolidated Financial Statements

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

At December 31, 1998, the amounts of long-term debt payable (excluding obligations under capital leases) for the years 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 Operating Leases Leases Year ended December 31 1999 $ 5 $ 367 2000 5 315 2001 5 231 2002 5 172 2003 2 137 Thereafter - 350 Total future minimum lease payments 22 $1,572 Less: Imputed interest 3 Present 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 District of New York, purportedly on behalf of certain former Bay Networks securities holders, alleging that the proxy statement/prospectus and registration statement in connection with the Bay Networks Merger (the Bay Networks Proxy Statement) as well as certain public statements made by the Corporation and certain named officers violated applicable securities laws by containing materially false and misleading statements and omissions concerning the Corporation’s financial condition. Two additional class action complaints were filed in the same court on November 16, 1998 and December 11, 1998 alleging substantially similar claims. The court granted the plaintiffs’ motion to consolidate all three 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 directors breached fiduciary duties owed to the Bay Networks shareholders and that the Corporation aided and abetted the alleged breaches of fiduciary duty. On July 23, 1998, Bay Networks, the Corporation, and counsel for the plaintiff class 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 disclosures be made in the final Bay Networks Proxy Statement and that counsel for the plaintiff class may apply to the court for an award of legal fees up to $450 thousand and expenses up to $25 thousand. The Corporation has provided for these amounts. On August 26, 1998, a class action complaint was filed in the same court purportedly on behalf of all Bay Networks common shareholders, alleging that the Bay Networks Proxy Statement was materially misleading by failing to disclose pending litigation by Bay Networks against six former employees. This action may also be dismissed if the court approves the Settlement Agreement. On April 18, 1997, a lawsuit was filed in the California Superior Court, County of Santa Clara, purportedly on behalf of a class of shareholders who acquired Bay Networks common shares pursuant to the registration statement and prospectus that became effective on November 15, 1995. On March 4, 1997, Bay Networks announced that shareholders had filed two separate lawsuits in the United States District Court for the Northern District of California and the California Superior Court, County of Santa Clara against Bay Networks and ten of Bay Networks current and former officers and directors, purportedly on behalf of a class of shareholders who purchased Bay Networks common shares 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.

NORTEL NETWORKS 1998 ANNUAL REPORT 55 Notes to Consolidated Financial Statements

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

In June 1993, certain holders of the Corporation’s securities commenced a class action in the United States District Court for the Southern District of New York alleging that the Corporation and certain of its officers violated the 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. Nortel Networks is also a defendant in various other suits, claims, and investigations which arise in the normal course of business. Northern Telecom Inc. (NTI), the Corporation’s principal United States subsidiary, received a statutory notice of proposed assessment from the Internal Revenue Service (IRS) dated November 6, 1996 which proposes an additional tax liability of approximately $524, excluding interest, with respect to its 1980 through 1985 federal income tax returns. On February 3, 1997, NTI filed a petition with the United States Tax Court opposing such proposed additional 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 to the resolved or remaining unresolved issues, will not have a material adverse 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 liability or financial impact of these matters and therefore cannot determine whether these actions will, individually or 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 vigorously defend these actions.

Environmental matters Nortel Networks, primarily as a result of its manufacturing operations, is subject to numerous environmental laws and regulations and is exposed to liabilities and compliance costs arising from its past and current generation, management 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 over the next five years. Based on information currently available, management believes that the existing accruals are sufficient 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 connection with other locations currently under investigation, are not expected to have a material adverse impact on the consolidated 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 facilities and sites, to the extent probable and reasonably estimable, is included in the environmental accruals referred to above in an approximate amount of $30. Nortel Networks is also listed as a potentially responsible party (PRP) under the United States Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) at six Superfund sites in the United States and is listed as a de minimis PRP at three of these Superfund sites. An estimate of Nortel Network’s share of the anticipated remediation 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 Nortel Networks’ involvement. In addition, the accuracy of Nortel Networks’ estimate of environmental liability is affected by 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 unknown remediation 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 Preferred Shares, without nominal or par value, issuable in series. Class A Preferred Shares have been issued for consideration denominated in Canadian dollars (C$) and are presented in U.S. dollars after translation at the exchange rate in effect at the date of original issue. Each series of Class A Preferred Shares ranks in parity with every other series of Class A Preferred Shares.

56 NORTEL NETWORKS 1998 ANNUAL REPORT Notes to Consolidated Financial Statements

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

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

1998 1997 1996 Number Number Number of 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 auctions held at intervals of approximately one month on the business day immediately preceding the commencement of each dividend period. The Corporation can neither participate, nor oblige any subsidiary to participate, in the auction procedures. 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 of C$500,000 per share, on the business day immediately preceding any auction date. Dividends on the outstanding Series 4 Shares are declared and payable in Canadian dollars. Amounts equal to accrued and unpaid dividends are payable by the Corporation upon redemption of the Series 4 Shares. The applicable dividend must be declared prior to redemption. On July 8, 1994, the Corporation issued 200 Exchange Rights to the holders of its Series 4 Shares without cost to such holders. The Exchange Rights entitle the holders to exchange each Exchange Right, together with one Series 4 Share, for that number of common shares determined by dividing C$500,000 by the greater of C$2.50 and 95 percent of the weighted average trading price of the common shares on The Toronto Stock Exchange for the ten trading days ending 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 dividend rate in respect of the Series 4 Shares. At December 31, 1998, no Exchange Rights had been exercised. An Exchange Right 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 effected issue costs of approximately $4. Holders of the Series 5 Shares will, until November 30, 2001, be entitled to an annual fixed cumulative preferential cash dividend of C$1.275 per share (5.1 percent), payable, if declared, quarterly on the first day of March, June, September, and December. From December 1, 2001, holders of the Series 5 Shares will be entitled to, if declared, a monthly floating cumulative preferential cash dividend. Holders of Series 5 Shares will have the 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 of Series 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 they will 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’s option 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 and unpaid dividends up to, but excluding, the date of redemption, on December 1, 2006, and on December 1 of every fifth year thereafter.

NORTEL NETWORKS 1998 ANNUAL REPORT 57 Notes to Consolidated Financial Statements

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

The Non-cumulative Redeemable Class A Preferred Shares Series 7 (Series 7 Shares) are presented net of tax effected issue costs of approximately $4. Holders of the Series 7 Shares will, until November 30, 2002, be entitled to an 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 Series 7 Shares will be entitled to, if declared, a monthly floating non-cumulative preferential cash dividend. Holders of Series 7 Shares will have the right to convert their shares into Non-cumulative Redeemable Class A Preferred Shares Series 8 (Series 8 Shares), subject to certain conditions, on December 1, 2002, and on December 1 of every fifth year thereafter. Holders of the Series 8 Shares will have a similar right to convert back into Series 7 Shares every five years. In certain circumstances, conversions may be automatic. The Series 7 Shares are not redeemable prior to December 1, 2002, at which time they will be redeemable at the Corporation’s option at C$25 per share, together with declared and unpaid dividends to the date of redemption. The Series 7 Shares will be redeemable after that date at the Corporation’s option at C$25.50 per share together with declared and unpaid dividends to the date of redemption. The Series 8 Shares will also be redeemable at the Corporation’s option at C$25 per share, together with declared and unpaid dividends up to, but excluding, the date of redemption, on December 1, 2007, and on December 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. At December 31, the outstanding number of common shares included in shareholders’ equity consisted of:

1998 1997 1996 Balance at beginning of year 518,880,270 519,752,384 508,707,160 Shares 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 10,944,856 Shares 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 common shares. In January 1997, the Corporation commenced a program to repurchase up to 16 million common shares for cancellation during the one-year period ending January 29, 1998. On February 2, 1998, the Corporation announced the commencement of a new program to repurchase for cancellation up to 6.4 million of the Corporation’s common shares in the period from February 4, 1998, to February 3, 1999. The Corporation acquired and cancelled 4,297,300 of its shares in 1998 under both such programs. On February 22, 1999, the Corporation announced the commencement of a new program to repurchase for cancellation up to 10 million of the Corporation’s common shares in the period 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 a two-for-one basis (the stock split). The stock split was effective for registered common shareholders at the close of business on January 7, 1998. All references to common shares and per share amounts in the consolidated ﬁnancial statements 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 Reinvestment and Stock Purchase Plan  7,922,648; Investment Plan for Employees  Canada  4,000,346; Long-term Investment Plan  U.S.  354,470; and Stock Option Plans (including 22,618,531 for the assumed Bay Networks’ stock option plans)  57,850,990. At December 31, 1998 and 1997, BCE Inc. owned 40.7 percent and 51.7 percent of the outstanding common shares, respectively.

58 NORTEL NETWORKS 1998 ANNUAL REPORT Notes to Consolidated Financial Statements

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

19. Stock options Under the Northern Telecom Limited 1986 Stock Option Plan As Amended and Restated (the Plan), options to purchase common shares of the Corporation may be granted to employees of Nortel Networks which entitle the holder to purchase one common share at a subscription price of not less than 100 percent of market value on the effective date of the grant. Subscription prices are stated in U.S. dollars for U.S. options and in Canadian dollars for Canadian options. Generally, the holder has the right to exercise the options as follows: 1997 and subsequent grants vest 33₁⁄₃ percent at the end of each year for three years; 1991 through 1996 grants vest 50 percent after the first year and the remainder after two years; pre-1991 grants vest 50 percent after the first two years and 50 percent after the third year. The committee that administers the Plan has the discretion to vary the period during which the holder has the right to exercise options and, in certain circumstances, may accelerate the right of the holder to exercise options, but in no case shall the exercise period exceed ten years. The Corporation will meet its obligation under the Plan 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 to receive payment of an amount equivalent to the excess of the market value of a common share at the time of exercise of the SAR over the subscription price of the common share to which the option relates. Options with SARs may be granted on a cancellation basis, in which case the exercise of one causes the cancellation of the other, or on a simultaneous basis, in which case the exercise of one causes the exercise of the other. The maximum number of common shares authorized by the shareholders and reserved for issuance by the Board of Directors of the Corporation under the Plan is 77,429,510. The maximum number of common shares with respect to which options may be granted on an annual basis is 2 percent of the common shares issued and outstanding at the commencement of the year, subject to certain adjustments. In January 1995, a key contributor stock option program (the Program) was established under the Plan. Under the 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 exercise price 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 conditions for 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, and 35,232,459 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 common stock of Bay Networks. The number of options, and the exercise price of such options, were adjusted by the exchange 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 1994 Plan). Under the 1994 Plan, options granted were immediately exercisable; however, unvested shares at the date of termination of employment may be repurchased at the original exercise price. The Board of Directors of Bay Networks determined when the options were exercisable, their price and other terms, but the option price could not be less than the fair value of the share at the grant date. Options expired no later than eight years after the grant and generally vested at the rate of 25 percent after one year from the date of grant, and then ratably over the following thirty-six months. The remaining options to purchase shares of common stock of Bay Networks which were assumed by the Corporation were granted under the Bay Networks Outside Directors Stock Option Plan or under plans of various companies which were acquired by Bay Networks. These companies include Xylogics, Inc., Rapid City Communications, New Oak Communications, Inc., and Netwave Technologies, Inc.

NORTEL NETWORKS 1998 ANNUAL REPORT 59 Notes to Consolidated Financial Statements

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

The following is a summary of the maximum number of common shares issuable pursuant to outstanding stock options and available for future issuance: Available Outstanding for Issuance 1998 1997 1996 1998 January 1 25,087,076 25,346,634 27,011,670 13,253,310 Additional shares listed 23,643,900 Increase (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 25,346,634 949,911 Weighted average subscription price of options: U.S. dollars $36.00 $26.00 $20.00 Canadian 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 $18.00 Canadian 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 the assumed plans, and the related options are included in the preceding table. At December 31, 1998, the total number of options outstanding under Nortel Networks’ stock option plans was 55,012,472. The number of common shares authorized 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 have been granted with SARs, are exercisable on a cancellation basis. At December 31, 1998, 81,400 SARs were outstanding at 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 1996 High/Low High/Low High/Low U.S. dollars: Grant of additional options $64.40/31.69 $52.08/ 35.41 $30.40/ 22.47 Exercise of options $47.60/ 0.03 $35.41/ 7.85 $24.28/ 7.00 Exercise of SARs - - $14.66/ 7.85 Cancellation 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/ 30.94 Exercise of options C$50.81/ 9.28 C$40.01/ 9.28 C$28.66/ 9.28 Exercise of SARs - -- Cancellation of options C$89.79/14.25 C$72.08/ 16.45 C$30.94/ 16.45

60 NORTEL NETWORKS 1998 ANNUAL REPORT Notes to Consolidated Financial Statements

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

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 the Canadian 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 portion 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 321 661 339 Income taxes payable 3 20 65 Interest 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 paid 1998 1997 1996 Income taxes paid $ 493 $ 336 $ 251 Interest paid $ 233 $ 167 $ 181

NORTEL NETWORKS 1998 ANNUAL REPORT 61 Notes to Consolidated Financial Statements

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

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

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

Cash acquired $ - $ 17 $ 721 $ - $ - $ 7 $ 20 $ - $ 765 $ (9) $ 2 Total 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 options consideration 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 ventures, are included in the consolidated financial statements and are summarized below. A substantial portion of the amounts proportionately consolidated relates to the operations of MNC. Nortel Networks’ other joint ventures are in Germany, China, and the United Kingdom. Nortel Networks and Lagardère each hold, directly or indirectly, 50 percent of MNC. After July 1, 1999, Lagardère may, under specific circumstances, require Nortel Networks to purchase all of its equity participation in MNC at a price to be based partly on a formula and partly on the fair market price as determined at that time. The figures below 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 by applying 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 financial statements of the venturer. The difference in accounting standards for joint ventures has no effect on the net earnings of the Corporation. As at December 31 Balance Sheets 1998 1997 Total assets $857 $952 Total liabilities $499 $569

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

Year ended December 31

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

62 NORTEL NETWORKS 1998 ANNUAL REPORT Notes to Consolidated Financial Statements

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

22. Related party transactions Nortel Networks engages in transactions with certain of its equity-owned investees, with joint ventures of the Corporation, and with entities which are owned by Nortel Networks’ major shareholder, BCE Inc., the owner of approximately 41 percent of the Corporation’s common shares. These transactions are sales and purchases of goods under usual trade terms and are disclosed at their exchange amounts. Transactions with related parties are summarized as follows: 1998 1997 1996 Revenues $1,288 $1,108 $ 835 Purchases $ 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 negatively impacted by fluctuations in interest and foreign exchange rates. To effectively manage this risk, Nortel Networks enters 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 for trading 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 currency swaps involve either swapping the underlying debt denominated in U.S. dollars to U.K. pounds, as summarized in note 15, or exchanging U.S. dollars for French francs or U.K. pounds. The notional principal amounts of the French franc denominated swaps were $234 and $268 as at December 31, 1998 and 1997, respectively. The notional principal amount of the U.K. pound denominated swaps, including those summarized in note 15, were $501 and $250 as at December 31, 1998 and 1997, respectively. Nortel Networks had forward contracts outstanding to sell the equivalent of $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 dollar exposure 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 in duration. Nortel Networks also enters into forward contracts, denominated in various currencies, mainly in Canadian and U.S. dollars, over terms of thirty days to two years, to limit its exposure to exchange ﬂuctuations on existing assets and liabilities and on future revenue and expenditure streams. At December 31, 1998 and 1997, Nortel Networks had forward contracts outstanding to purchase and sell the equivalent of $805 and $677, respectively, related to these assets and liabilities and future revenue and expenditure streams. Nortel Networks also enters into U.S. to Canadian dollar cross currency coupon swap contracts to limit its exposure to foreign currency ﬂuctuations on its non-cumulative preferential cash dividends on the outstanding Series 7 Shares.

NORTEL NETWORKS 1998 ANNUAL REPORT 63 Notes to Consolidated Financial Statements

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

Interest rate risk Nortel Networks enters into interest rate swap agreements to minimize financing costs on long-term debt and to manage interest rate risk on existing liabilities and receivables due to interest rate fluctuations. These agreements are denominated 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. Average floating rates are based on rates implied in the yield curve at the reporting date; those may change significantly, affecting future cash flows. These swap contracts primarily have remaining terms to maturity of between one and eight years.

1998 1997 Receive-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 $649 Average 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 current transaction between willing parties. Therefore, fair values are based on estimates using current value and other valuation techniques which are significantly affected by the assumptions used concerning the amount and timing of estimated future 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 value of interest rate swaps and forward contracts reflects the present value of the potential gain or loss if settlement were to take place on December 31, 1998, and the fair value of option contracts reflects the net liquidation cost to the Corporation if settlement were to take place on December 31, 1998. Accordingly, the estimates which follow are not necessarily 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 with the following exceptions: 1998 1997 Carrying Fair Carrying Fair Amount Value Amount Value Financial liabilities: Long-term debt due within one year $ 19 $ 19 $ 223 $ 225 Long-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.

64 NORTEL NETWORKS 1998 ANNUAL REPORT Notes to Consolidated Financial Statements

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

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 nonperformance by any of the counterparties. Nortel Networks limits its credit risk by dealing with counterparties that are considered to be of high quality and by utilizing an internal credit committee that actively monitors the credit exposure of the Corporation. At December 31, 1998 and 1997, the maximum credit exposure of the Corporation is $26 and $20, the majority of which relates to interest rate swaps. The exposure is limited to those derivatives which have a positive fair value at December 31, 1998. Nortel Networks is also exposed to credit risk from customers. However, Nortel Networks’ global orientation has resulted in a large number of diverse customers, which minimizes concentrations of credit risk. Pursuant to certain ﬁnancing agreements, Nortel Networks is committed to provide future ﬁnancing in connection with purchases of Nortel 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 of credit, 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 information using year 2000 dates is processed. In addition, similar problems may arise in some systems which use certain dates in 1999 to represent something other than a date. The effects of the Year 2000 Issue may be experienced before, on, or after January 1, 2000, and, if not addressed, the impact on operations and ﬁnancial reporting may range from minor errors to signiﬁcant systems failure which could affect an entity’s ability to conduct normal business operations. It is not possible to be certain that all aspects of the Year 2000 Issue affecting the Corporation, including those related to the 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 the 1998 presentation.

NORTEL NETWORKS 1998 ANNUAL REPORT 65 Annual.report.98

Consolidated Six-Year Review

NORTHERN TELECOM LIMITED (MILLIONS OF U.S. DOLLARS EXCEPT PER SHARE FIGURES AND UNLESS OTHERWISE STATED) (UNAUDITED) 1998 Earnings and related data Revenues $17,575 Cost of revenues 10,050 Selling, general and administrative expense 3,093 Research and development expense 2,453 Amortization of intangibles 1,709 Amortization on plant and equipment 471 Income tax provision (recovery) 601 Net 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§ 1,065 Supplementary measure of earnings (loss) per revenue dollar (cents)§ 6 Supplementary measure of earnings (loss) per common share (dollars)§ 1.86 Dividends per common share (dollars) .30 Financial position at December 31 Working capital 4,424 Plant and equipment (at cost) 5,249 Accumulated amortization 2,986 Total assets 19,732 Long-term debt 1,648 Redeemable preferred shares 609 Common shareholders’ equity 10,956 Return on common shareholders’ equity (7.2%) Supplementary measure of return on common shareholders’ equity§ 12.3% Capital expenditures 642 Employees 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.

Quarterly financial data Summarized consolidated quarterly ﬁnancial data for 1998 and 1997 are as follows: 4th Quarter 1998 1997 Revenues $5,768 $4,811 Gross proﬁt 2,529 2,047 ሻ Net earnings (loss), as reported (332) 390 ሻ Net earnings (loss) applicable to common shares, as reported (341) 386 ♦ ሻ Earnings (loss) per common share, as reported (.51) .74 The following amounts represent the summarized consolidated quarterly financial data for 1998 as restated: ሻ Net earnings (loss) (332) - Net earnings (loss) applicable to common shares (341) - ♦ ሻ Earnings (loss) per common share (.51) -

Supplementary measure of earnings per common share .72 .74 ♦ Weighted 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. ሻAlthough Nortel Networks reported its ﬁrst, second, and third quarter results of 1998 in accordance with established accounting 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 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 the acquisition 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

66 NORTEL NETWORKS 1998 ANNUAL REPORT 1997* 1996* 1995* 1994* 1993*

$15,449 $12,847 $10,672 $ 8,874 $ 8,148 9,111 7,714 6,379 5,605 5,199 2,714 2,195 1,923 1,681 1,598 2,147 1,813 1,579 1,156 1,040 48 45 39 18 44 439 439 430 390 426 438 321 233 161 (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 1 1.54 1.20 .92 .60 .11 .29 .25 .21 .18 .18

3,664 3,099 2,051 2,160 665 4,706 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 9,543 1,565 1,663 1,221 1,495 1,553 609 367 73 73 73 4,801 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% 575 601 577 389 471 72,896† 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-time gains 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 .21 572 522 527 524 524 522

(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. Nortel Networks reported a net loss applicable to common shares for 1998 of $569 million, or $.99 per share. Excluding the impact of the new valuation methodology, the net loss applicable to common shares for 1998 would have been $954 million, or $1.67 per share. For the year, net earnings applicable to 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 above schedule presents a complete quarterly reconciliation.

NORTEL NETWORKS 1998 ANNUAL REPORT 67 Annual.report.98

Directors and Officers

AS OF FEBRUARY 25, 1999

Directors Ofﬁcers

Donald J. Schuenke Hon. E. Peter Lougheed John A. Roth Margaret G. Kerr Elm Grove, Wisconsin P.C., C.C., Q.C. Vice-Chairman and Senior Vice-President, Chairman of the Board Calgary, Alberta Chief Executive Officer Human Resources Strategy Northern Telecom Limited Partner Former Chairman of the Board Bennett Jones David L. House William R. Kerr The Northwestern Mutual (law firm) President Senior Vice-President, Life Insurance Company 4, 6 Finance and Business Clive V. Allen Development (life insurance company) Executive Vice-President, Law 1,* 2, 3,* 7 Jean C. Monty, C.M. Montréal, Québec James R. Long Klaus M. Buechner Executive Vice-President John A. Roth President and Senior Vice-President, Orangeville, Ontario Chief Executive Officer and President, Corporate Strategy Enterprise Solutions Vice-Chairman and BCE Inc. and Alliances (telecommunications company) Chief Executive Officer Arthur A. MacDonald 3, 4 Northern Telecom Limited David L. Burn Senior Vice-President, 3 Vice-President, Taxation Sir Antony Pilkington Corporate Services David L. House Cheshire, United Kingdom Clarence J. Chandran Robert Mao Saratoga, California Corporate Director Executive Vice-President Senior Vice-President, President Retired Chairman and President, President and Northern Telecom Limited Pilkington plc Carrier Packet Solutions and Chief Executive Officer, (manufacturer and distributor Group Executive, Asia Ralph M. Barford of glass products) Nortel China Toronto, Ontario 5, 7 F. William Conner Deborah J. Noble President Executive Vice-President, Vice-President, Corporate Valleydene Corporation Limited Guylaine Saucier Marketing Secretary and Associate (private investment company) C.M., F.C.A. 1, 2, 3, 5, 7* Montréal, Québec J. (Ian) A. Craig General Counsel Chairman of the Board Executive Vice-President Hon. James J. Blanchard MaryAnne E. Pahapill Canadian Broadcasting and President, Vice-President, Corporate Beverly Hills, Michigan Corporation Carrier Solutions Shareholder Reporting and (public broadcaster) Assistant Controller Verner, Liipfert, Bernhard, 1, 5, 6 Nicholas J. DeRoma McPherson and Hand Senior Vice-President and Keith I. Powell Sherwood H. Smith, Jr. (law firm) General Counsel Senior Vice-President, Raleigh, North Carolina 1, 7 Information Systems and Chairman of the Board Matthew J. Desch Chief Information Officer Frank C. Carlucci Carolina Power Executive Vice-President McLean, Virginia & Light Company and President, Katharine B. Stevenson Chairman (electric utility company) Wireless Solutions and Vice-President and Treasurer The Carlyle Group 2, 3, 5,,* 7 Group Executive CALA (merchant banking firm) Gordon H. Sumner 4, 6, 7 Lynton R. Wilson Gary R. Donahee Vice-President and Oakville, Ontario Senior Vice-President General Auditor Richard J. Currie Chairman and President, Toronto, Ontario BCE Inc. Carrier Solutions, Europe Blair F. Morrison President (telecommunications company) Assistant Secretary George Weston Limited 2 ,,,* 3 , 4 Adrian J. Donoghue (food processing and distribution Vice-President and Controller company) Frank A. Dunn 1 The board of directors, which Senior Vice-President and met fifteen times in 1998, is Chief Financial Officer Gerald V. Dirvin responsible for the management Ponte Vedra Beach, Florida of the Corporation’s business. Corporate Director Directors serve on one or more Daniel J. Hunt Former Executive of the board committees. Senior Vice-President Vice-President and President, Procter & Gamble Company Committees Nortel CALA (consumer products company) 4,,*6,,* 7 Jérôme P. Huret 1 Audit Senior Vice-President, L. Yves Fortier, C.C., Q.C. 2 Committee on Directors Corporate Development Westmount, Québec 3 Executive Chairman and Senior Partner 4 Management Resources Ogilvy Renault and Compensation (law firm) 5 Pension Fund Policy 1, 2, 5, 6 6 Stock Option Plan 7 Customer Finance *Chairman

68 NORTEL NETWORKS 1998 ANNUAL REPORT Annual.report.98

Corporate Information

Corporate Headquarters English and French Transfer Agents Trademarks Northern Telecom Limited versions and Registrars ACCESSNODE, 8200 Dixie Road of this annual report can Montreal Trust Company CONCORDE, Suite 100 be viewed at our website in of Canada CORNERSTONE, DMS, Brampton, Ontario pdf and HTML versions: Toronto, Montréal, and DMS-100, DMS-250, L6T 5P6 Canada www.nortelnetworks.com Vancouver DMS-500, DMS-MTX, Tel: (905) 863-0000 • About Us Tel: 1 800 663-9097 DMS-GLOBAL SERVICES • Investor Relations PLATFORM (DMS-GSP), Stock Exchange Listings • Quarterlies and Annual The Bank of Nova Scotia Trust DUALMODE, HOW THE The common shares of the Reports Company of New York WORLD SHARES IDEAS, Corporation are listed on the • 1998 Annual Report New York, New York MILLENNIUM, NORSTAR, New York, Toronto, Montréal, to Shareholders Tel: (212) 225-5000 NORTEL NETWORKS, Vancouver, and London stock PASSPORT, PROXIMITY, exchanges. Dividend Reinvestment CIBC Mellon Trust Company REUNION, S/DMS and Stock Purchase Plan Ilford, Essex, United Kingdom TRANSPORTNODE, Annual Meeting Registered holders of common Tel: (44-181) 478-1888 SERVICEBUILDER, The Corporation’s annual shares of the Corporation SUPERNODE, SYMPOSIUM, and special meeting of share- wishing to purchase additional Share Repurchase Program UNIFIED NETWORKS, holders will take place at common shares may participate The Corporation has initiated and VECTOR are trademarks 11:15 a.m. (local time), inaconvenientinvestment a normal course issuer bid to of Northern Telecom. Thursday, April 29, 1999, plan. Quarterly dividends may repurchase common shares. at Nortel Networks’ be reinvested automatically This share repurchase program ACCELAR is a trademark of Brampton Centre, Brampton, to purchase additional common will enable the Corporation Bay Networks, Inc. Ontario, Canada. shares at the average market to buy back up to 10 million price (calculated during a fixed (approximately 1.5 percent) ZIP and JAZ are trademarks Form 10-K period each quarter). Common of its common shares in the of Iomega Corporation. The Annual Report on Form shares may also be purchased period from February 1999 to 10-K for 1998, as filed with at the average market price by February 2000. Shares will cdmaOne is a trademark of the United States Securities voluntary cash payments of as be purchased on the Toronto, the CDMA Development and Exchange Commission, little as US$40 to a maximum Montréal, and New York stock Group, Inc. is available without charge of US$5,000 during a quarter. exchanges at market prices. upon request to: In either case, there are gener- Shares may be repurchased MICROSOFT, NETSHOW, Nortel Networks ally no brokerage fees or other by the Corporation to offset and WINDOWS NT are Attention: 1 800 4NORTEL service charges. issuances of new shares under trademarks of Microsoft One Brunswick Square employee benefit programs, Corporation. Atrium Suite 100 Additional information may or when such purchases would Saint John, New Brunswick be obtained from: represent an appropriate use www.nortelnetworks.com E2L 4V1 Canada Dividend Reinvestment of corporate funds. No special Visit our corporate website Services arrangements will be made for comprehensive information Tel: North America Montreal Trust Company with particular shareholders to about our business and 1 800 4NORTEL of Canada repurchase common shares. integrated network solutions. Outside North America 151 Front Street West Click on Custom News (506) 674-5471 8th Floor A copy of the notice filed with and register for our email Fax: (506) 632-8208 Toronto, Ontario and accepted by the Toronto newsletter to keep abreast Email: [email protected] M5J 2N1 Canada and Montréal stock exchanges of the latest announcements Tel: (416) 981-9633 may be obtained, without from Nortel Networks. Email: [email protected] charge, upon request to: Investor Relations Northern Telecom Limited 8200 Dixie Road Suite 100 Brampton, Ontario L6T 5P6 Canada

Common Share Dividend Record and Payment Dates for 1999*

Deadline for Receipt of Optional Payment Date/ Record Date Cash Payments Investment Date

March 8 March 30 March 31 Consistent with our commit- June 8 June 29 June 30 ment to the protection and September 3 September 29 September 30 enhancement of the environment, the paper used in this December 3 December 30 December 31 document contains 20 percent *Subject to conﬁrmation by the Board of Directors post-consumer waste. Corporate Profile

Who we are

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.

65097.11/03-99 www.nortelnetworks.com