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Tellabs Inc. (NASDAQ:TLAB)

Q3 2008 Earnings Call

October 21, 2008 8:30 am ET

Executives

Thomas Scottino - IR

Rob Pullen - CEO

Tim Wiggins - EVP and CFO

Analysts

Ken Muth - Robert W. Baird

Scott Coleman - Morgan Stanley

Nikos Theodosopoulos - UBS

Ehud Gelblum - JPMorgan

Simon Leopold - Morgan Keegan

Jeff Crowne - Barclays Capital

George Notter - Jefferies

Roger Chuchen - George White & Associates

Vivek Arya - Merrill Lynch

Steven Campro - Cambria

Ray Archibold - Kaufman Brothers

Dan Perkri - O'Connor

Brett Miller - Dialathy Capital

Todd Koffman - Raymond James

Operator

Good morning, my name is Tim, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Tellabs Investor Relations Conference Call.

All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions).

Mr. Scottino, you may begin your conference.

Thomas Scottino

Thank you, Sam, and good morning everyone. With me today are Tellabs CEO, Rob Pullen, and our Executive Vice President and CFO, Tim Wiggins. If you haven't seen the news release we issued this morning, you can access it at tellabs.com.

Before we begin, I would like to remind you that this presentation contains forward-looking statements about future results, performance or achievements, financial and otherwise. These statements reflect managements' current expectations, estimates and assumptions.

These forward-looking statements are not guarantees of future performance, and involve risks, uncertainties and other factors that may cause Tellabs' actual results to be materially different. A discussion of the factors that may affect future results is contained in Tellabs most recent SEC filings.

The forward-looking statements made in this presentation are being made as of the time and date of its live presentation. If this presentation is reviewed after the time and date of this slide presentation, it may contain current or accurate information. We disclaim any obligation to update or revise any forward-looking statement, based on new information, future events or otherwise.

This presentation may also include some non-GAAP financial measures. Reconciliation between non-GAAP financial measure and GAAP financial measure can be found at our Tellabs website and our SEC filings. Okay.

I'll turn the call over to Rob now.

Rob Pullen

Good morning, everyone. It's has been quite a quarter. There has been a lot of turbulence with the world economy, the stock markets, and the elections, not to mention the politics that go along with it.

But today, I would like to concentrate on the press release we issued this morning, because Tellabs has a lot of things to talk about. Tellabs executed successfully in the third quarter, as we reposition for the future. We had a goodwill impairment that dramatically affects our GAAP results.

Looking beyond that, we had solid execution in the quarter. Our profits are up 32% year-over-year. We made progress on a strategy to focus on large and growing markets, where we have a strong position. We will be a more focused company.

We announced a significant restructuring and we're reducing our investment and access to concentration on our optical and Ethernet portfolio, our carrier data and IP networking solutions, professional services, and we'll be expanding our sales coverage.

First, we took $988 million in non-cash charges related to goodwill impairment. As you know, we've been looking at our goodwill for a couple of quarters now. Based on our most recent review, we took the required charge. These are non-cash charges and account for this quarter's GAAP loss. While this impairment is unfortunate, it doesn't affect our ability to run the business. We continue to satisfy our customers need, and our cash position remained solid at $1.2 billion.

Speaking of cash, we've repositioned our portfolio for capital preservation. 90% of the portfolio is in bonds and notes issued by governments and government agencies. Substantially all of our investments are in highly liquid instruments. Tim is going to talk more about this later.

We had solid performance from the Tellabs team in the quarter, they were challenging for the industry. With the third quarter revenue of $424 million, we came in solidly within the guidance range we gave you on our July earnings call. The Tellabs's 8600 and 8800, which provides carrier data and IP networking, continue to be the fastest growing part of our portfolio.

We achieved record revenue in the third quarter. Year-to-date our carrier data and IP networking solutions have grown 29%, compared with first nine months of 2007. In addition we have record revenue from our 6300 optical and Ethernet products. The non-GAAP margin driven primarily by higher level of data revenue and our ongoing efforts to improve ROADM and ONT margins came in at almost 39% or specifically 38.5%, which was also better than expected.

And our operating expenses continued with a downward trajectory, that you saw in the first half of the year. Non-GAAP OpEx for the third quarter was $137 million, down from $141 million in Q2. Put it all together our non-GAAP EPS was $0.05 and that would compare with the first call estimate of $0.04.

At the same time we announced a significant restructuring this morning. I'm sad to say about 280 members of the Tellabs team will be leaving the company between now and the middle of next year. Most of those people will be notified this week. The restructuring touches all parts of Tellabs, but most significantly it affects the people and activities surrounding our Access business.

As you know, over the past few years, we have invested heavily in Access. As a result, we have developed a comprehensive development of solution, but they include fibers-to-the-node, fiber-to-the-curb, and fiber-to-the-prime applications, delivering some of the best broadband service in the world.

Given current market conditions and customer spending patterns, we are reducing our investment in Access. We'll continue to serve our Access customers with the same product platforms, and we'll continue new feature developments, but at a lower level than the previous years.

Doing so delivers a couple of different outcomes. Part of the cost savings associated with this restructuring will be towards completing our $100 million cost-reduction plan. At the same time, it frees up resources for investment in those areas, where we see greater and more profitable opportunity than our current pursuits.

This morning's restructuring will enable us to better address customer's needs and mobile backhaul, optical networking and business services delivery. These large and fast growing markets, where Tellabs has a strong position today, are strategic to us going forward.

To be specific, we are focusing on investment in our optical and Ethernet portfolio, our carrier data, and IP networking portfolios, which dominantly include the 7100, 6300, 8600, 8800. We are also going to focuses on the services function, including professional services. We are going to help differentiate these solutions in the marketplace. We are also going to expand our sales coverage. We intend to discuss this strategy in greater detail at our November 13th Investor Conference here in Naperville.

At this time, I'm going to ask Tim to take you through our financial results for the third quarter and our guidance for the fourth quarter, and then we'll come back for some Q&A. Tim?

Tim Wiggins

Thanks, Rob, and good morning, everyone. Let's take a look at the numbers. For the third quarter of 2008, total revenue amounted to $424 million, and that compares with $458 million in the third quarter of 2007. We saw year-over-year declines in both Broadband and Transport segments.

GAAP net loss for the third quarter amounted to $999 million or EPS of $2.51 a share, that compares with GAAP earnings of almost $4 million or $0.01 a share in the third quarter of last year.

As Rob mentioned at the top of the call, our GAAP net income for 3Q '08 includes a non-cash goodwill impairment of $988 million. In addition, we had a non-cash charge for intangible asset impairment of about $1 million.

In accordance with the applicable accounting literature, we review goodwill annually unless potential interim indicators exist that could result in an impairment. Given our market cap was below our book value for a sustained period, and the continuation of challenging market conditions, we performed an interim step one analysis in the Broadband, Transport and Services segments.

We estimate the fair value of the segments using expected present value future cash flows. Based on this analysis, we determined the fair values of Broadband and Transport segments to be less than their carrying values, which means we move to a step two analysis. Based on this analysis, the implied fair value of goodwill was less than the carrying value of goodwill in both Broadband and Services segments.

The Services segment does not incur an impairment of its goodwill because we determined that the fair value of the segment was greater than the carrying value. Largely as a result of the goodwill write-off, we also took a non-cash tax charge of $6 million for the establishment of a valuation allowance against our domestic deferred tax assets.

In addition to these charges, we had about $20 million in pre-tax charges for special items in the quarter, of which a little more than $9 million was related to previously announced restructuring actions.

Excluding goodwill, impairment and the other charges, our non-GAAP net income for the third quarter amounted to $19 million or $0.05 a share. Equity-based compensation for the quarter amounted to about $5 million or $0.01 a share.

Taking equity comp into consideration, as First Call does when compiling mean EPS estimates for Tellabs, the result is $0.04 in non-GAAP EPS for the third quarter. On a sequential basis, third quarter 2008 revenue of $424 million compares with $432 million in the second quarter of '08. A sequential revenue increase in the Broadband segment was offset by lower Transport and Services segment revenue.

Our GAAP loss for the third quarter of 2008 compares with earnings of $39 million or $0.10 per share in the second quarter of 2008. Our non-GAAP net income of $19 million or $0.05 per share compares with $52 million or $0.13 a share in the second quarter of 2008, when the successful resolution of IRS audits contributed $0.09 to our earning per share total.

As usual, you'll find a complete reconciliation of our GAAP and non-GAAP results in more detail of year-over-year comparisons in this morning's news release.

Revenue from customers in North America amounted to $264 million in the third quarter, compared with $287 million in the second quarter of '08. Revenue from customers outside North America increased to $160 million in the third quarter, up from $145 million in the second quarter.

Let's turn to our individual business segments. As you know, the Broadband segment includes our access, managed access and data products. Broadband segment revenue for the third quarter was $260 million, up 12% from $231 million in the second quarter of '08.

Looking at the individual segments of our Broadband or the individual elements of our Broadband segment, access revenue was $113 million in the third quarter, and that compares with $103 in the second quarter.

Sequentially higher sales of BPON ONTs and our Tellabs 1100 access platform offset declines in other access products. Improving ONT gross margins has better priority for Tellabs and we have successfully improved ONT margins in the last 7 quarters.

Fiber platforms overall, both fiber-to-the-curb and fiber-to-the-premise, account for approximately 74% of access product revenue in the third quarter, compared with 66% in Q2.

Managed Access revenue in 3Q was $79 million compared with $83 million in the second quarter of '08. Sequentially higher sales of our 6300 system were more than offset by lower sales of our 8100 system. On a year-to-date basis, revenue for the 6300 product is up 60% compared with the first nine months of '07.

The Tellabs 8800 multi-service router series and the Tellabs 8600 Managed Edge System make up our date category. For the third quarter, revenue for these products was $68 million, up 52% from $45 million in Q2. As Rob mentioned earlier, data is our fastest growing product category on a year-over-year basis. Looking at the first nine months of '08, revenue for this product category increased 29% compared with the comparable period in '07.

Broadband segment profit for the third quarter increased to $48 million compared with $23 million in 2Q '08. The improvement here is primarily related to the higher level of data revenue, improved standard margins, particularly on the ONT and lower R&D costs.

Let's turn to the transport segment. For the third quarter, transport segment revenue was $109 million compared with $141 million in the second quarter of this year. The change largely reflects sequential flat sales of our Tellabs 5500 systems and lower sales of our Tellabs 7100 ROADM.

Looking at the 5500 cross-connect business specifically, about 17% of this quarter's 5500 system revenue came from new systems, system expansions and system upgrades. Looking at the first nine months of '08, this percentage increases to 31%. The remaining balance consists of port card growth on the installed base. At the end of the quarter, 19% of the card slots in our installed base were open, consistent with the level at the end of Q2.

Turning to the ROADM, on a year-to-date basis, revenue from our 7100 ROADM product is up 40% compared with the same period in '07. ROADM sales did decline in Q3 for the first time in five consecutive quarters. While we have made good progress in adding new customers, we still rely on a relatively small number of customers for most of our sales, which affects the quarterly revenue of this product.

Improving ROADM gross margins has been a priority for Tellabs. With this quarter, we have improved ROADM gross margins in six of the last seven quarters. This improvement has come from cost reductions, the addition of new customers and a beneficial product mix shift toward more transponder cards.

North American wireless customers accounted for 23% of transport product sales in 3Q compared with 16% in 2Q '08. This shift reflects a lower level of 7100 ROADM sales in wireline networks during the quarter. Transport segment profit was $22 million compared with $31 million in Q2 '08. The decline here was primarily driven by lower level of 7100 system revenue.

Turning to the services segment, for the third quarter, services segment revenue was $55 million compared with $60 million in Q2. Services segment profit amounted to $21 million compared with $22 million in Q2 '08 due to the lower revenue. Non-GAAP gross margin was 38.5% for the third quarter and that compares with 35.1% in the second quarter of '08.

As you know, our gross profit margin depends on product and customer mix, which was responsible for the shift between 2Q and 3Q '08. Contributing to that shift this quarter was about 2 points of improvement attributable to the higher level of data products. Lower 7100 revenue combined with our ongoing cost reduction activities on the 7100 contributed another point of improvement. The remaining 0.5 point or so of improvement came from aggressively managing cost, including ONT cost reductions and overall variability related to products and customer mix.

Turning to operating expenses, non-GAAP operating expenses for the third quarter came in at $137 million or about 32% of revenue, and that's down from $141 million we recorded in Q2 '08. We saw improvements from actions associated with the $100 million cost reduction program we announced earlier this year. For the quarter, non-GAAP R&D expenses came in at $72 million and SG&A were $64 million. At $72 million, R&D equals about 17% of revenue.

Other income on a non-GAAP basis amounted to $1 million in the third quarter, and that compares with $12 million in the prior quarter. The decline here is primarily attributed to lower interest income and the net loss on the sale of investments and marketable securities. Our tax revision on a non-GAAP pre-tax income for the quarter was $9 million. We expect our effective tax rate for the balance of the year to be around 31% plus or minus.

Turning to the balance sheet quickly, days sales outstanding was 54 days in 3Q compared with 57 in the prior quarter. Inventory turns were 5.7 times versus 5.9 in Q2 '08. In the third quarter, inventory in terms of dollars declined to $161 million compared to $182 million at the end of the second quarter.

CapEx in the quarter was about $15 million. That's up slightly from $12 million in the year-ago quarter. The increase here reflects increased prototype activities for our optical networking and carrier Ethernet and IP networking products.

We used $11 million in cash from operating activities in 3Q. Looking at the first nine months of 2008, cash generated from operations equaled about $139 million, and that's up from $126 million in the comparable period of '07. During the quarter, we continue to keep our open market stock repurchase programs on hold.

At the end of the quarter, our cash and investment balances stood at $1.167 billion, that's down $29 million from the second quarter of this year. The decrease in our investment balance was driven primary by the impact of the strengthening US dollar on our foreign cash, marketable securities and working capital balances.

As Rob mentioned, about 90% of our portfolio is now in bonds and notes issued by governments and government agencies and substantially all our investments are in highly liquid instruments. We have taken numerous steps to avoid the negative effects of the financial crisis and we will continue to work toward capital preservation as we make future investment decisions.

Headcount at the end of the quarter stood at approximately 3,480, and that compares with 3,550 at the end of the second quarter. Book-to-bill in the quarter was less than one. As you will recall, we had a large multi-quarter order in Q1. Taking that order into account, our book-to-bill is over one for the first nine months of the year.

Turning to our outlook for the fourth quarter of this year; based on all the information and indicators we have today, we do not expect to see our typical fourth quarter seasonality. Normally, we would expect a sequential revenue increase going in to the fourth quarter. This year, based on our backlog, order flow, and feedback we're getting from our field sales force, we don't believe that to be the case.

At the same time, we continue to see unprecedented economic uncertainty, as you know and are all too well aware of. It's difficult for us to understand how the risks in the overall economy might affect our customer's spending patterns.

Assuming that our normal predictive models hold, and the quarter proceeds normally from here, we expect 4Q revenue to be flat to down from 3Q in a range between $424 million and the low $400 million. That's the way we see things today. We will be watching order flow closely going forward given the current market conditions.

We expect gross margin in the fourth quarter to be up slightly, plus or minus 2%. The variability here would be a function of customer and product mix. We have seen nice margin improvement recently and we will work hard to continue to improvement gross margins going forward. And we expect our non-GAAP OpEx for the fourth quarter to continue the downward trajectory we have seen all year.

I would like to add a caution to those of you who will be modeling our fourth quarter expense. Tellabs follows what they call a 52-53 week fiscal year, or each quarter comprises 13 weeks. Every five to six years depending on how the calendar falls, we get a quarter with one extra week, and that quarter is in the fourth quarter this year. The extra week means an extra week of payroll and other expenses and amounts to about 2% to 3% of our overall quarterly OpEx.

Taking this into account, we still expect 4Q OpEx to be below 3Q levels. As I mentioned earlier, we expect our tax rate for the fourth quarter and the full year 2008 to be around 31% plus or minus. In addition, we expect the effect of expensing equity-based compensation 4Q to be about $5 million, split between operating expense and cost of goods sold.

Okay. At this point, we will open the floor to your questions. Tim, we are ready for the first question.

Question-and-Answer Session

Operator

(Operator Instructions). And your first question will come from the line of Ken Muth with Robert Baird.

Ken Muth - Robert W. Baird

Hi. On the international markets you guys clearly had a nice uptick this quarter. But can you just kind of give us some of the regions and some of the locations you may? And then just a little bit more color on perhaps what products the 8600 appears to be doing well now? And just any highlights around why that might be taking off?

Rob Pullen

Yeah, Ken. Thanks. I'll take that question. So, first, the product lines were a mixture of our 86, 63, and 8800 products internationally. Additionally more than 1/3 or 38% of our revenue came from outside of North America, and I think most of you know that that's one of our strategic intents is to continue growing our global business.

Third, it was both in the optical and Ethernet portfolio in the mobile backhaul space. In the mobile backhaul space, our 8600 and 6300 are performing well. In fact, we have now 81 paying customers on a global basis for the 8600 program. And we expect to continue that direction and plow back money to invest in that segment going forward.

Ken Muth - Robert W. Baird

Okay. And then just any kind of regions, can you go into Latin America, Western Europe, or anything like that?

Rob Pullen

Sure, Ken. At a high level, yes, sorry, I didn't answer last part of your question… at a high level we have had growth in Latin America. Our orders are up from a revenue perspective over 70%, bookings over 40% for the region. We have been also successful in Europe selling to tier 1s, tier 1 carriers that we here to for haven't told to, and we have also had success in the south of Asia-Pacific.

Ken Muth - Robert W. Baird

Okay, great. Thank you much.

Operator

Your next question will come from the line of Scott Coleman with Morgan Stanley.

Scott Coleman - Morgan Stanley

Thanks, guys, and good morning. I'm wondering if you could give us a little more detail on your expectations for Q4. Do you expect continued growth and strength in broadband data, and that will be offset by Transport and Access? Is that how we should be thinking about business?

Rob Pullen

First of all, as Tim warned all of you, there is a lot of economic uncertain in the world right now, including in places that there shouldn't be, they are behaving on fear. Having said that, we expect the broadband data to continue to show some growth.

The transport from a seasonal perspective, I would expect to see a slight uptick. But as we have already guided, we typically see normal seasonality of an increase in the fourth quarter, and with this economic headwinds, we're guiding flat to the 400s.

Scott Coleman - Morgan Stanley

Thanks, Rob. And would you expect the geographic trends this quarter to continue, meaning, maybe some growth internationally offset by increased declines in North America?

Rob Pullen

I would see continued growth from a global basis. I can't say I see increased declines from North America. You are going to see a similar mix as you see now, maybe even a slight uptick in North America.

Scott Coleman - Morgan Stanley

Great. Thanks, guys.

Operator

Your next question will come from the line of Nikos Theodosopoulos with UBS.

Nikos Theodosopoulos - UBS

Yes, thank you. I know it's kind of early, well, two questions. In talking with your customers, what do you hear about how they are planning their capital budgets or just their overall investment strategy for 2009, given the cross-currents of the economy, the financial crisis, and then obviously there is still bandwidth growth on their networks. I'm just curious if you have got any insight how they are going to approach that?

And my second question, Tim, on the cash, could you give us a snapshot of how much of the cash you actually have that is overseas? And is that overseas because of some tax strategies you have used in the past and will have to stay there unless you repatriate it with a tax consequence? I'm trying to understand why you have the cash overseas. Thank you.

Rob Pullen

Maybe I'll take the first question. Tim, you take Nikos' second question. Nikos, we're hearing a diverse set of feedback from our customers. In developing countries, well, first of all as you alluded to, there is bandwidth growth dominantly because of the data networking over wireless and wireline as well as the video deployment in again both the wireless and wireline.

Having said that, I'll kind of give you two broad directions. In developing countries, customers are giving us feedback that they are going to be flat, and there's an issue of currency exchange and the strengthening dollar versus the currency in the local developing country.

In the developed countries, people are becoming more cautious as you know, and it's maybe a 5% CapEx decline, regardless, however, of that CapEx visibility that they are giving us. Most of our carriers and customers are saying we're going to continue to see investments in the mobile backhaul space, the optical and Ethernet networking space, and in business services delivery, notwithstanding the fact that some of the financial institutions in the world are in turmoil and going through consolidation.

Tim, I'll pass it over to you then for the Nikos' second part of the question.

Tim Wiggins

Sure, Nikos. Around $200 million of $1.2 billion is overseas. About 18 months ago, we repatriated a fairly sizeable amount of cash, $500 million or $600 million. We like to have cash overseas. It provides a hedge both in terms of investment options and currency options.

At this point, it is considered permanently reinvested, but we look at that from time to time. It's also there because our international businesses are profitability, so as we bring money back, they make more.

Nikos Theodosopoulos - UBS

Okay. Thank you.

Operator

Your next question will come from the line of Ehud Gelblum with JPMorgan.

Ehud Gelblum - JPMorgan

Thank you very much. Couple of questions, if I could. First, again, trying to look a little bit into the Q4 guidance and have us missed third quarter and trying to get track of the moving parts. It looked like fiber was actually strong this quarter, while 7100 was off, and like you said, the 5500 seemed to be flat. So it sounds like mobile backhaul seems to be doing fairly well and that's driven by the mobile, but driving the 5500.

I wonder as we look into Q4, do you expect fiber to remain strong or should that start tailing off as the BPON project that you are major customer their starts moving over to GPON, so should we see that moving kind of part come down?

And as you look again in the Q4, does the 7100 bounce back up again and the 5500 fall off or should that remain strong from this mobile backhaul and the 7100 remain weak? And then a follow-up if I could, just to get the sense of the moving part.

Rob Pullen

Ehud, you asked a lot of questions in there.

Ehud Gelblum - JPMorgan

It's really not a lot of question. It's kind of how included parts in those three pieces. And what created the strength in fiber this quarter, and the weakness in the 7100, and if that reverses itself?

Rob Pullen

Yes, sure. So, first of all, we did see strength in the fiber Access business this quarter. It should be flat to slightly down in the fourth quarter. You have the positive factor of some of our customers stealing broadband share. At the same time, you have the downward factor of new housing starts being down because of the economy.

As for the 7100, we should see flat to a slight uptick in that quarter-over-quarter. Most of our customers build out in the first half of the year, and then start planning for next year, and so that would equate to the 7100.

As for the 8600 for mobile backhaul, we should there see a slight uptick in our revenue quarter-over-quarter. And that will continue as we diversify our customer base over time.

As for the 5500, we should see a slight uptick. We normally see some upward seasonality of wireless spending. We don't know for sure based on this economy, but we should see some slight uptick if all of our indicators are true, but we'll have to play that out as the quarter goes along. I think I answered your question Ehud, but do you need clarification?

Ehud Gelblum - JPMorgan

No, you did. That's it. 7100 was the falloff this quarter, due to a falloff in both of the major customers or only one, the things get a little clarity as to why sell-off? And then, Tim, is there a sense you can give us as to where the gross margins are today in the 7100, are they up to 10% already?

Tim Wiggins

Of course, we are not going to go there Ehud, but we have had six out of seven quarters of improvement. And they are, as you can see from some of our segment analysis, and I'm sure you will take time with it, that it is a positive contributor, as you look at the change between our profitability between Q3 and Q2.

Rob Pullen

And Ehud, the first part of your question is, we saw a softness in all of our customer base, with respect to the 7100 in 3Q. We had big strength in 1Q and 2Q. As I said, we should see flat to slightly up for Q4 as people are transitioning for their budgets for next year, but we think that the economy slowed down some of the investment here.

Ehud Gelblum - JPMorgan

Thanks. Appreciate that.

Rob Pullen

Thank you.

Operator

Your next question will come from the line of Simon Leopold with Morgan Keegan.

Simon Leopold - Morgan Keegan

Thanks. Just a quick housekeeping one, I assume you guys gave and I missed was the Transporter or 5500 exposure to wireless? And then couple of follow-ups.

Rob Pullen

About 23% Simon.

Simon Leopold - Morgan Keegan

Thanks. Two questions, really, one is I think a lot of people are sort of dancing around what is going on in the segments, and one of the things that seems to be implied from this discussion, maybe is that the Managed Access business, which I think typically has a good seasonal pattern in the fourth quarter, you are seeing some softness in Europe, perhaps, that might be leading to different trends there. So if you could comment specifically on trends in Europe and Managed Access?

And the other question I wanted to touch on was the share buybacks on your philosophy there. I don't think you bought back as much stock this quarter as I thought you might have. If you could talk about what limitations you may be facing in terms of buying back your stock and your general philosophy continuing this year buybacks?

Rob Pullen

Yes. I'll take the first part of your question, Simon, and I'll pass it over to Tim for the second part. Managed Access is a combination of our 2300, 6300, and 8100. 8100 is moving toward its end of life cycle, and we're going to continue to see flat to slightly down there. 6300 has shown some uptick in that space, and we don't know for sure for the fourth quarter, but we should see flat to slightly down.

Tim Wiggins

On the share repurchase Simon, what we have done is put our open market program on hold. We do buy some shares back under a 10b5 plan if employees exercise any options. Our feeling is that today capital is very precious and very difficult to replace, and while we certainly see our shares at unprecedented levels, we think it is important for us to complete our thought process around strategically where we want to take the company and watch what is going on in the market and preserve capital. So in effect, we're trying to hold on to the cash for a rainy day. And it seems like it's pretty rainy out there right now.

Simon Leopold - Morgan Keegan

Okay. So in terms of preserving capital, then, is it safe to assume that also means you're not really shopping for acquisitions at this point then either?

Rob Pullen

Simon, for competitive reasons, we don't talk about whether we're going to shop for acquisitions or not. You can see that what we're trying to do here is execute successfully and improve our profitability and our track record is continuing to portray that and you will see more of it.

Simon Leopold - Morgan Keegan

Great. Thank you very much.

Operator

Your next question will come from the line of Jeff Crowne with Barclays Capital.

Jeff Crowne - Barclays Capital

Yes. I was wondering if you folks wouldn't mind characterizing where you would like to get the OpEx too either on an absolute number or perhaps in an operating margin metric? Thanks.

Tim Wiggins

Sure. I think our most immediate goal is that we are trying to take our OpEx down. We have got $100 million expense reduction plan that we have been working on. So to frame it up, if you think back to our '07 OpEx number was about $595 million. The $100 million, about 75% of it is related to the OpEx line and about 25% is above the line cost reduction.

So our target is, as we complete '08 and look in to '09, that we would like to get that 75%, or $75 million out of our OpEx expense, so that would put it on a base level in the $520 million range, so $595 million less $75 million.

So I think that's our most immediate focus, and we have got a lot of programs around that. I think as we look out and see what develops in terms of revenue, we may make a change to that target, but I think in the near term, that's a fairly big to do for us, and we are working hard toward that, and I think that's our most immediate goal.

Jeff Crowne - Barclays Capital

Okay. So this plan that you are discussing today is in support of that $100 million?

Tim Wiggins

Part of that will go to complete the $100 million plan. Part of it will be used to refocus our spending away from access and to areas where we see significant growth opportunities, and those would be solutions in the mobile backhaul space and the business service space, and the optical and also in our sales channel in services.

So our focus right now is to say let's move the chips away from some of these bets that aren't producing the kinds of capital returns we would like, and put those chips on areas where we have strength today in those markets. We have products that are growing. We see these markets as big and growing in terms of potential going forward.

So we think we have got a good base, right now that's in-house that we can move these chips over, make those investments and play those chips out. We think that's a better way to go. That's what we're going to talk about in depth on the 13th of November.

Rob Pullen

I would just like to add what Tim said, agreeing 100%, but I'd also say that some of that money we'll use to plow back for cost reductions, both in the supply chain and research and development. We're going to continue to be aggressive in this tough economic time to improve our profitability through cost reductions, through engineering and supply chain.

Jeff Crowne - Barclays Capital

Wonderful. Thanks. And then could I ask on the gross margin line, obviously you guys have made a lot of progress, also there's some volatility from quarter-to-quarter. Should we expect that volatility to continue? How should we be thinking about modeling gross margin for you folks? Thanks.

Tim Wiggins

Good question, and I think that over time as our data business continues to grow, we have seen some reduction in the volatility, but given that we have a series of products that are very profitability, we also have new high growth products that are early in their life cycle and are significantly less profitable.

Mix shifts between those product can play havoc to the margin, and that's why, while we have seen progressive improvements there, we are very focused on it. We gave you guidance, we would like to see it up again, we hope it's up sequentially but we said plus or minus 2%, depending on what happens to some of these new products that has vastly different margins. But I would hope over time that the volatility would continue to reduce itself.

Jeff Crowne - Barclays Capital

Thank you.

Tim Wiggins

You're welcome.

Operator

Your next question will come from the line of George Notter with Jefferies.

George Notter - Jefferies

Hi, thanks very much, guys. Pardon me I joined the call a little bit late, but I wanted to ask about the Access business. Which products and programs within Access are you planning on moving away from specifically, I can take some guesses here but I would like to get your perspective?

And also have you talked to customers about those plans, and what is the action there? And then how much can you actually peel out of the Access business in terms of operating expense savings? Thanks.

Rob Pullen

Okay. George, I'll take a stab at that. First of all, the Access business, we're staying in the Access business and we're going to continue in the 1000 and 1100 series product lines. Additionally, as you know, earlier this year, we canceled custom development we were doing for one mayor customer because it didn't show profitability going forward.

Lastly, we have talked to customers, and we have told them we are going to support them in their current and new installations, and they understand our decisions completely, and so we're going ahead with these plans, with the idea to improve the profitability.

Now, your last question of the Access, we haven't given out the specific number for reduction, but most of the reduction that we're talking about here is associated with the Access business.

George Notter - Jefferies

Got it. Okay. So it is fair to say that you are just cash cowing the existing products there, and then in terms of new product development moving resources away?

Rob Pullen

No, it's not fair to say that, we'll invest where it makes sense for profitable growth for our customers and for Tellabs. And we currently do have a road map on the products, but it will just be at a reduced rate.

George Notter - Jefferies

Got it. Okay. Thanks very much.

Operator

Your next question will come from the line of [Roger Dam with George White & Associates].

Roger Chuchen - George White & Associates

Hi. This is [Roger Chuchen] stepping in for Roger Dam. I just have a quick question. We have recently noted the company could be looking for strategic alternatives for the Access business. Could you, number 1, provide an update on the status? And number 2, if you could talk about how that could impact the gross margin profile as well as the EPS accretion?

Tim Wiggins

Yeah, well, I think we have looked at some alternatives for the Access business. I think what you're hearing today is given the current customer profile, and the conditions in the market, and our other investment choices, meaning focusing in these areas where we have high growth and strength. We made a decision to reduce our investment there.

As Rob mentioned, we're not exiting the business. We have over 700 customers in that space. We have a comprehensive portfolio of products, include fiber-to-the-frame, fiber-to-the-curb, fiber-to-the-node, as well as copper products.

So what you're seeing us saying today is with this significant investment and significant investment over the last number of years where it has been a number of our leading R&D areas, we're going to reduce that investment and move those chips over to areas where we see higher growth and profitability. So that is really the strategic decision that we're talking about today.

Roger Chuchen - George White & Associates

Assuming that the credit environment does improve going forward, do you think we could revisit, set up potentially overall alternatives for that business?

Tim Wiggins

I think we're very concerned about what we can do to continue to support the 700 customers including the very large ones, and we even today have number one share positions in some of the fiber positions in North America. So I think our focus is, what can we do that is so right for our customers? And our sense is that the investment decisions that we have made and announcing today are the most appropriate.

So I think when we look at overall alternatives, I suspect you're asking me should we sell the business, we didn't see that that made sense to either our shareholders or our customers, of course if somebody showed up with truckloads full of money, we take a look, but that's not the strategy.

We think the right answer is what we have chosen here which allows us to continue to support our customers, continue to invest on a lower level and getting the support of these customers with these really good solutions.

Roger Chuchen - George White & Associates

Got it. Thanks so much.

Operator

Your next question will come from the line of Tal Liani with Merrill Lynch.

Vivek Arya - Merrill Lynch

Thank you. It's Vivek Arya on Tal's behalf. Two questions. First, there was a very strong bump in your broadband data category. Was there an element of some lumpy revenue recognition here or like how should we think about growth in this segment going forward, and what is the competitive outlook for the segment?

Tim Wiggins

Well, first of all, we have seen some lumpiness with both products. They are both new and on fairly significant growth trajectories. We do have revenue recognition issues in this area, but not at the level that we have experienced in the 7100 in years past.

So what we'll see is, particularly, maybe a good example is the 8600 which is on a steep growth curve. We have talked about over 80 customers. And I think if you listen to our call, the challenge has been how do we turn those 80 customers in to revenue?

So part of it is we're in early lab trials with those customers. We may have systems in the field that meet certain specifications or requirements, feature development and the like. So I think you have a combination of high growth products early in their life cycle, relatively small number of customers, and then kind of just the normal mix shifts between the 86 and 88, all of those kind of combine.

We're very pleased with the results this quarter. We expect to see our data products continue to grow as we look out in to the balance of 2009.

Vivek Arya - Merrill Lynch

And I just wanted to press again on this issue of your expected use of cash, your market cap is only slightly above your cash balance, so either investors are very worried about your fundamental business trends or think that your cash balance is likely to be used for acquisition soon. So what is the message to investors there on how you see your cash balance and how does that form a part of your strategy going forward?

Tim Wiggins

Well, we think our cash balance is a strategic asset. We're delighted to be in a position where we have a solid balance sheet today, and then we have choices. I think Vivek there is a couple issues, it's hard to say what the market is doing at the moment other than maybe acting out of fear. There are a number of companies that trade below their cash value.

So we are certainly not pleased with the valuation of the stock. We think the best thing we can do is hold on to the cash, preserving the capital. One of the concerns is, is that -- or one of the positives of having that significant cash balance is that it provides a bit of a floor for the share price.

So I think our view at this point is that the capital is dear in these conditions. We think the right thing to do for us is to hold on to it, and to continue to make the strategic changes to the business that allows to focus our investment, target in to these growth markets continue to work on our gross margin and cost reduction to drive continued earnings improvement and challenging markets conditions, that's what you have seen us working on, and that's what we will continue to focus on.

Vivek Arya - Merrill Lynch

And just one last question, where are we in this migration of backhaul from the cross-connect architecture to more competitive Ethernet architecture, your 5500 sales have been okay, but over time they are going down. And I'm just trying to get a sense for how much of that decline is due to just the US wireless carriers curtailing CapEx and how much of that is the shift to Ethernet? Thanks.

Rob Pullen

Well, first of all, the 5500 has been around a long time, and will continue to be around for a long time. Our T1 sales for mobile backhaul continue to be deployed, but as you know, the whole network will eventually be in transition. That's why we have invented the 7100, 8800, maybe and 8600 product for that mobile backhaul, for wireless and wireline.

That shift is occurring as we speak, from the radio side back in to the mobile switching center is converting from T1s for E1s in to asynchronous transfer mode and eventually Ethernet and IP. We are now helping our customers transition that, and then slower than most people expect, but we're in a unique position to help in transition that, and move in to both WiMAX and LTE.

Vivek Arya - Merrill Lynch

Rob, as US wireless, let's say your carriers have not spent as much this year. So when they start spending next year, whenever they start spending, do you expect them to send on your 5500, or do you expect them to spend on Ethernet architecture because they are more competitive market?

Rob Pullen

When they start spending again, they'll buy both, because, I mean, you mentioned North America, the network is dominantly T1s and OCN signals for backhaul today, multiple T1s and in transition to Ethernet. And so when they come back and spend, they'll buy both.

Vivek Arya - Merrill Lynch

Thank you.

Operator

Your next question will come from the line of [Steven Campro with Cambria].

Steven Campro - Cambria

Good morning. Can you hear me?

Rob Pullen

Yes.

Steven Campro - Cambria

Just want to take another crack at sort of the impact to the overall business model from exiting portion of the Access business. So first of all, I assume that when you formulated your guidance, you knew that you were doing this, and your forced reduction starts basically immediately.

So I would think that that has an immediate affect. How much of the guidance reduction comes from or I should say how much of the sequential down guidance comes from the fact that certain parts of the Access business are likely to tail off even in Q4?

Tim Wiggins

Okay. Well, first of all, we're not exiting the Access business. And I guess what you need to think about is we have a several hundred billion dollars run rate that is going to continue to run. We have 700 customers that rely on these solutions and are embedded in their network.

So what you are seeing is cost reductions in the fourth quarter is part of this announcement that will largely impact our OpEx spend as opposed to our gross margin. So what you should expect in your Access business is like a radiator it's got a lot of heat, it will continue to generate heat for a significant amount of time. So we have continued roadmap, albeit reduced.

We have developed over the years. In the last couple of years, we have spent hundreds of millions of dollars on R&D, so we have at least a couple hundred million. So we have a very comprehensive portfolio. I think our thinking inside is it's time to pause that spending. This portfolio positioning is good. It's comprehensive.

So I think what you need to think about is we're not exiting the business, we're going to cur contain our investment, we're going to continue to support our customers, and what you should expect to see over time is the impact of reduced R&D spending as it relates to the overall OpEx and the impact on the profitability of that part of our business.

Steven Campro - Cambria

Basically just taking cost out of the business with no real, you don't expect a lot of changes in how the sales flow?

Rob Pullen

No, in fact that specifically what we're doing is reducing our expenses to improve profitability while giving customers a comprehensive solution in a portfolio that delivers fiber-to-the node, fiber-to-the-curb, and fiber-to-the-premise. And as noted by Tim earlier, customers, of course, know what is going on are actually our Access business slightly improved from 2Q to 3Q.

Steven Campro - Cambria

Okay. Thank you.

Operator

Your next question will come from the line of Ray Archibold with Kaufman Brothers.

Ray Archibold - Kaufman Brothers

Thanks for taking my questions. I just want to touch basically one of the comments in the release relating to the investments and sales, and perhaps if you can just give us a sense as to where are those investments going to be targeted?

And secondly, I think on the last call, you had suggested, if you will, reengaging tier 2 and tier 3 carriers for some of your GPON products and can you bring us up to date on where you are on that process or it just probably related to the sales?

Rob Pullen

Sure, first of all, we've improved our position with the tier 2 operators and sales on our Access products, but as for the reference to investing in sales, you are going to hear more on November 13th, but you are going to see us invest in developing countries, Brazil and South America is one example, India is another example, and we'll give you more insight in to that on the 13th.

Ray Archibold - Kaufman Brothers

Thank you.

Operator

Your next question will come from the line of [Dan Perkri with O'Connor].

Dan Perkri - O'Connor

First one, other than the 10b program, do you have an authorized share buyback program in place?

Tim Wiggins

We do and I think there's about $400 million that is available under that program.

Dan Perkri - O'Connor

Okay, great. In terms of the restructuring costs, as you talked about some of the things in Access and some of the employees leaving the company, do you know what the cash cost of those restructuring will be?

Tim Wiggins

I believe it's in the $20 million to $22 million range over the program. Most of that will occur next year.

Dan Perkri - O'Connor

Okay. So basically sort of $20 million, $22 million spread over three quarters, most of it in the first half of '09?

Tim Wiggins

Yes.

Dan Perkri - O'Connor

Okay. Then how much cash do you need do you think to run your business?

Tim Wiggins

Well, hopefully, we are generating cash, and so it's a cash generator as opposed to consumer. So it would be a question of how much risk do you want to take? But the business has been successful. We had a down cash generating quarter this time, largely due to the impact of the euro, the dollar strengthening against the euro.

But even with that we generated more cash this year than we did the same period last year, $3 million or $4 million more in the $130 million dollar range (inaudible). So we're focused on cash, the business is creating cash.

Dan Perkri - O'Connor

Would it be wrong to assume conservatively then $200 million in the US and $200 million overseas would be you need to sort of run your business from a day-to-day operational standpoint?

Tim Wiggins

I think today we made the business that we need $1.2 million, and that's the way we are operating.

Dan Perkri - O'Connor

I guess that's my last question is sort of how should we weigh as potential shareholders the decisions that you want to hold, an extra $400 million, $500 million, some could even say $700 million cash on the balance sheet for future potential acquisitions or just to hold on the balance sheet versus buying back your stock at or close to cash per share? Sort of what is the company's thought process weighing stock buybacks versus acquisitions versus just sitting there in treasuries?

Tim Wiggins

Well, I think given what is going on around us, we're very comfortable with what we're doing. We do talk to our Board every quarter about these issues, and it's really upto our Board to make that call. But I think everybody inside the company, and I think our customers as well take a lot of comfort that we have a very solid balance sheet given what is going on around us.

As we go forward, and we finish the thinking around the strategic stuff and talk to you about that, it is possible we might reengage in the share buyback. The answer is of course. I think right now is not the time, but something we think about on a regular basis.

Dan Perkri - O'Connor

Okay.

Rob Pullen

I would also just add to that, we have already purchased over $800 million of our stock, we think that that is a very good investment. Our customers view this position as outstanding. They are concerned about the health of most of their vendors at this stage, and it give us the option value for two things.

One is to invest and through this downturn and come out at a stronger more focused company, and give us the option value to look at acquisitions, notwithstanding the fact we have nothing eminent going on now.

Dan Perkri - O'Connor

Okay. Well thank you very much for your questions and good luck.

Rob Pullen

Thank you.

Operator

Your next question will come from the line of [Brett Miller with Lending Capital].

Brett Miller - Dialathy Capital

Hi, it's actually [Dialathy Capital]. I just wanted to reiterate and follow up on the previous question concerning stock buyback. It doesn't make any sense to me right now given the amount of cash you guys have on hand, the fact that you have been generally consistently generating operating and free cash flow in the past that you don't think the best return on any investment alternative right now is your own stock, given that it's trading, it looks like in pre-market at a very nominal amount above your cash balance.

It's not about right now not having ample amount of cash to satisfy all of your customers. I get that. I get how bad the environment is. It's about driving accretion to your earnings model. There's no better way, I would think to do that than to invest in your own company, given how cheap the stock is, both I imagine in your mind given what you've said and all of your investors mind and I think the mind of the analysts that have been on this call. I really don't get it.

So if you could address again why over $1 billion of cash when you should be generating free cash flow in the future, why just having it sit in treasuries is actually the right use of cash? Doesn't make sense to me.

Tim Wiggins

Brett, thank you for your position. I know most if not all of our directors listen to the call. So I appreciate you're making that pitch for me. And we'll take it back to the Board. So I understand your position, perfectly, I appreciate your input, and we'll continue to look at that as a company.

Brett Miller - Dialathy Capital

Great. Thank you.

Tim Wiggins

You are welcome.

Operator

Your next question will come from the line of Todd Koffman with Raymond James.

Todd Koffman - Raymond James

Thank you very much. Just one more question on your Access business. Follow up to George Notter's question. As you deemphasize this what used to be cornerstone part of your business and you referenced that you think it will still be a several hundred million dollars Access business going forward.

Can you give more specificity as to how much of the business projects that you are currently serving that will be de-emphasized versus what is the sort of base level of business that will be an ongoing business for sometime versus I don't know it's 100 and something, little over $100 million a quarter today? Thank you.

Tim Wiggins

Okay. Well I think if you think about what are the key drivers of our Access business? So we have two businesses that are supporting fiber. One fiber-to-the-prem through the BPON application. Another business is supporting fiber-to-the-curb, and then we have a business that supports both of those in IOC customers, and we have a legacy copper business.

So, we have seen the legacy copper business declining as customers move to fiber architectures. We expect both two of our key customers, they will move to architectures different than what we are currently supporting. So you would expect over time, both our BPON business and our fiber-to-the-curb business would be impacted by those decisions.

So we think over time certainly the business is likely going to get smaller, unless we're able to continue to develop the customer relationships with some of these new platforms. But certainly as it relates to some of the big drivers of the business, these two fiber applications, I would expect that to decline as we go through '09 and into '10.

Todd Koffman - Raymond James

Just as a follow-on. Okay, so the Access business will decline going forward over the next 12, 18, 24 months. You have got some programs in fiber, then you are de-emphasizing clearly the legacy copper.

Can you give any sense as to what you think the base level of copper business will ultimately shake out and settle out at? I mean, there has been a number of legacy businesses in telecom that seem to ultimately hit a floor and then carry on indefinitely for a number of years. Do you want to take a wild guess as to what that may be within your Access segment?

Rob Pullen

No, because the market is very turbulent at this time, but I will tell you is this is all outside plant. Once it is deployed, it dominantly stays in place, and its evolution will take a long period of time. And so the tail will likely will longer versus shorter.

Todd Koffman - Raymond James

Thank you very much. Good luck.

Rob Pullen

Thanks.

Operator

There are no further questions at this time. Do you have any closing remarks?

Rob Pullen

Yes, thank you all for your participation. Tellabs, I believe executed successfully this quarter. And as you can see, we are repositioning for the future and improving our profitability. We are going to share more with you on November 13th in the investor conference for more of our strategic direction. Again, thanks a lot for your interest in Tellabs.

Operator

This will conclude today's conference call. You may now disconnect, and have a great day.

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Source: Tellabs Inc. Q3 2008 Earnings Call Transcript
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