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Tekelec (NASDAQ:TKLC)

Q3 2008 Earnings Call

November 3, 2008 4:45 pm ET

Executives

Penny St. Clair-Holmes - Vice President of Corporate Marketing

Frank Plastina - President and Chief Executive Officer

William Everett - Chief Financial Officer

Analysts

George Notter - Jefferies & Company

Larry Harris - C.L. King

Scott Coleman - Morgan Stanley

Todd Kaufman - Raymond James

Amir Rozwadowski - Barclays Capital

Kenneth Muth - Robert Baird

Brian Modoff - Deutsche Bank

Operator

Good afternoon. And welcome to Tekelec Third Quarter 2008 Earnings Release Conference Call. At this time, all participants are in a listen- only mode. [Operator Instructions]. It is now my pleasure to turn the call over to Penny St. Clair-Holmes. You may begin.

Penny St. Clair-Holmes - Vice President of Corporate Marketing

Thank you. I am joined today by Frank Plastina, President and Chief Executive Officer and Bill Everett, Chief Financial Officer of Tekelec. Hopefully by now, you have access to a copy of the slides of supplemental material posted to our website, at tekelec.com. You can access the slides by hitting the link labeled "Investors”, and then clicking on the "Investor Relations" homepage. From that location, you can also access the press release issued earlier today. As a reminder, there will be a telephone replay of this conference call available for seven days following the call. You may also listen to a rebroadcast on our website at any time during the next 90 days. All of this replay and rebroadcast information can be found in the "Investor Relations" section of Tekelec's website.

I would also remind you that during the course of this conference call, we will make projections or other forward-looking statements regarding future events or the future financial performance of the Company. The actual events or results of the Company may differ materially from these forward-looking statements as a result of important risk factors, including those discussed in our 2007 Form 10-K filed on February 27, 2008, the First Quarter Form 10-Q filed on May 8, 2008, the Second Quarter Form 10-Q filed on August 6, 2008, the press release issued earlier today, and other documents the Company periodically files with the Securities and Exchange Commission.

Also, unless explicitly noted, all financial results and metrics during our call today are non-GAAP results from continuing operations. Please see the slides of supplemental material posted to our website for information reconciling non-GAAP to GAAP measures. We will also post the actual transcript of this call on the investor section of our website.

With that said, I would like to turn the call over to Frank Plastina. Frank?

Frank Plastina - President and Chief Executive Officer

Thanks, Penny and good afternoon to everyone on the call. We were very pleased with our strong operating performance for the third quarter and for the first nine months of the year. Our revenues and operating margins continued to be very strong and our operating cash flows for the third quarter were exceptional. Although our third quarter orders were below last year’s and somewhat lower than our expectations, our year-to-date orders were 7% ahead of last year’s. We believe that order input for the first nine months is the best measure of orders performance given the volatility of order input from quarter to quarter. Bill will provide our outlook for orders later in the call.

With regard to our Q3 performance, revenues and operating margins were particularly strong for the quarter and year-to-date. Revenues were up 8% year-over-year both in the third quarter and year-to-date and we generated operating margins of 19% for the first nine months of the year. These margins were just shy of our stated long term goal of 20% operating margins. Our gross margin performance of 68% for the quarter and 66% year-to-date was also very strong on an absolute basis and when compared to other companies in our sector. Cash flows from continuing operations for the first nine months of 2008 were $87.9 million compared to $26.7 million for the first nine months of last year. This is especially noteworthy given the liquidity constraints faced by many in the telecom equipment sector and in the economy as a whole.

Our strong balance sheet and liquidity continue to provide us with financial resources and flexibility to help address the potential impact of the current economic environment and to further invest in our portfolio. Simply put, our objective is to translate this financial strength into future market share gains. Bill will provide more detail on our cash performance and strong balance sheet later in the call.

I will now review several business highlights from the third quarter. We added three new customers in the quarter, all of which purchased our EAGLE product together with our number portability solution.

We are a market leader in number portability solutions worldwide and we now have 76 service providers in 25 countries using our software. Our solutions are attractive because we integrate number portability into the session management of voice calls as well as short messages, and multimedia messages in both prepaid and postpaid environments. Our solution simplifies number portability deployments and provides the ability to handle enhanced multimedia.

Looking forward, we are pleased with increasing TekCore customer interest. We are currently working with a number of service providers on use cases for TekCore. Although we do not know if our customers’ 2009 CapEx plans will include some of these solutions, it is encouraging to know that TekCore is attracting interest by providing a cost effective solution to today’s problems. I would like to highlight several use cases.

One solution provided by the TekCore SIP Signaling Router is lower cost routing in a Next-Gen Network. Because of the lack of a strong business case for a large scale move to IMS, operators are investing capital in their existing Next-Gen Networks. Since these networks are not necessarily standards based, SIP routing information must be replicated and provisioned in each and every node in the network. We offer a routing approach that delivers OpEx savings through simplified routing and configuration, network routing efficiency and increased capacity. The “best efforts” nature of IP makes this capability even more essential than it was in the circuit switched world.

Another use case is how best to deploy number portability in a SIP environment. Operators need to support number portability for VoIP subscribers and leverage their existing number portability infrastructure for all of their subscribers, regardless of technology. That means having access to their existing legacy databases as networks migrate from TDM to IP. This requires a SIP to SS7 inter-working solution. This solution can be used to access existing databases, such as home location registers, 800 databases, calling name, and service platforms like voicemail and customer care.

As you can see, handling the complexity created by network technology evolution will continue to provide Tekelec with market opportunities. The reality is that operators must deal with the complexity that has resulted from deploying several generations of wireless radio networks as well as TDM and VoIP exchanges. All these technologies employ different or enhanced signaling protocols and overlapping technologies. The result is OpEx and CapEx inefficiency and we believe solutions that help operators’ deal with this complexity will continue to gain traction.

The fact that Tekelec enjoys a diverse customer base in 68 countries will continue to provide us with tremendous insight as to how networks are evolving and how we can help scale them cost effectively.

I will now turn it over to Bill who will go into more details on the results for this past quarter. Bill?

William Everett - Chief Financial Officer

Thanks Frank. I will provide further insight into our third quarter results and update our annual guidance for 2008. Please refer to slides 5 to 12 which provide both our GAAP and non-GAAP results for the three and nine months ended September 30, 2008 and 2007 along with the associated reconciliations. As Penny mentioned earlier, unless otherwise stated, all of the financial metrics presented herein are on a non-GAAP basis from continuing operations.

Revenue for the third quarter of 2008 was $106.0 million, up 8% compared to $97.8 million for the third quarter of 2007. We generated consolidated gross margins of 68% and net income from continuing operations of $12.5 million, or 19 cents per diluted share for the third quarter of 2008. This compares to gross margins of 66% and net income from continuing operations of $13.8 million, or 18 cents per diluted share, for the third quarter of 2007. Operating margin from continuing operations for the third quarter of 2008 was 18%, up from 16% in Q3 of last year. The increase in earnings per share from continuing operations compared to the third quarter a year ago reflects in part the lower number of shares outstanding as a result of redeeming the convertible debentures in June 2008 and the stock repurchase programs the company has undertaken.

Revenue for the first nine months of 2008 was $340.7 million, up 8% compared to $316.6 million for the first nine months of last year. For the nine months ended September 30, 2008, we generated consolidated gross margins of 66% and net income from continuing operations of $46.4 million, or 67 cents per diluted share. This compares to gross margins of 60% and net income from continuing operations of $33.4 million, or 45 cents per diluted share, for the first nine months of 2007. Operating margin from continuing operations for the first nine months of 2008 was 19% compared to 12% for the first nine months a year ago.

Orders for the third quarter of 2008 were $87.4 million, down 20% compared to $109.2 million for the third quarter of 2007. However, orders for the first three quarters of 2008 were $292.7 million, up 7% compared to $273.0 million for the first nine months a year ago. We believe that the year-to-date comparison is more meaningful because we experience volatility in the timing of our quarterly orders. The increase in orders on a year-to-date basis was primarily due to increased signaling requirements within our customers’ networks as well as new customer wins. It is, however, difficult for us to determine the extent to which the current economic environment has affected or will affect the timing or size of our customers’ orders. I will comment more on the impact of the current economic environment when we discuss our guidance for the remainder of the year.

Please refer to slides 21 and 22 for a breakdown of our revenue by product and service categories for the three and nine months ended September 30, 2007 and 2008. For the third quarter of 2008, total product revenue was $75.5 million up 7% compared to $70.5 million in Q3 of last year. This quarterly increase was driven by growth in Eagle and other signaling products as well as number portability products. The increase in number portability revenue in Q3 compared to the third quarter last year is due primarily to our new LNP release which supports 384 million ported numbers in North America. Total services revenue in the third quarter of 2008 was $30.5 million, up 12% from $27.3 million in the third quarter last year. Our increase in total services was due primarily to the increase in professional services revenue associated with signaling and number portability installations internationally.

For the first nine months of the year, overall product revenue was up 8% driven by our continued success with our signaling product line along with the increases in our number portability revenue discussed previously. Partially offsetting the increase in these product revenues was a significant decline in our performance management and monitoring product revenue. The decline was due to lower orders during the first nine months of this year compared to a year ago and to a longer revenue recognition cycle for these products. While we experienced a significant decline in revenue from these products in the first nine months of 2008, our backlog for these products and services as of the end of Q3 2008 has increased significantly when compared to a year ago.

Next, I would like to comment on the geographic breakdown of revenue and our continued strong international performance. Slides 18 through 20 provide a breakdown of revenue by region. During the third quarter of 2008, revenue outside North America represented 68% of our total revenues compared with 49% in the same quarter last year. For the first nine months of 2008, revenue outside North America represented 59% of our total revenue compared with 56% in the first nine months of last year. We expect that international orders and revenue will continue to represent more than 50% of our consolidated total on an ongoing basis as we continue to expand our global footprint.

As we mentioned last quarter, we continue to diversify our customer base and are not overly dependent on any specific customer. In the third quarter of 2008, we had two customers that represented 10% or more of our total revenue, with the Orange Group and Telecom Italia Group each representing 11%.

Now let me turn to consolidated gross margins. Our consolidated gross margins were 68% for Q3 of 2008, compared to 66% in Q3 of 2007 and 64% in the second quarter of this year. Year-to-date gross margins are 66% compared to 60% for the same period in 2007. While we did not achieve the same level of extension and upgrade business that we achieved in the first two quarters of this year, our third quarter gross margins benefited from a number of other factors, including better than expected performance related to certain contract and warranty provisions, our ability to reduce our manufacturing and inventory costs and a favorable contract mix during the quarter.

R&D expenses for Q3 of 2008 were $24.5 million up 10% compared to $22.3 million in Q3 of 2007 but down from $25.4 million in Q2 of this year. The year over year increase in R&D spending was due in part to investments in developing SIP based products to help our customers migrate to IP networks including the acquisition of the SIP-focused Estacado team earlier this year. In addition, our success in continuing to win new customers and new number portability orders outside North America has required continued investment in ITU and local feature development to respond to customer requirements.

Sales and Marketing expenses were $17.4 million in Q3 of 2008, up 10% from $15.8 million in Q3 of 2007 but down from $18.2 million in Q2 of this year. Sales commissions in Q3 2008 were up over the same period a year ago reflecting higher revenue on a year-to-date basis. Further, marketing and web media costs were also up as we continue to promote our newer products.

G&A expenses were $11.5 million in Q3 2008, up 7% from $10.7 million in Q3 of 2007 and up from $11.1 million in Q2 of this year. The increase in spending from the prior year was due to a combination of slightly higher bad debt expense as well as IT and finance expenditures due in part to the consolidation of our international accounting and reporting functions.

Our non-GAAP effective tax rate for Q3 2008 was 33% compared to 25% in Q3 of last year due primarily to Congress’ delay in extending the research and development tax credit until October of 2008. I will address the impact of the recent renewal of the R&D Credit on Q4 and the full year tax rate when we address our updated guidance.

Our GAAP financial results for the quarter include the impact of stock-based compensation under FAS 123R. Pre-tax stock-based compensation from continuing operations for the third quarter of 2008 was $3.3 million essentially unchanged from $3.4 million in Q3 of 2007 and $3.4 million in Q2 of this year. Pre-tax stock-based compensation from continuing operations for the first nine months of 2008 decreased 19% to $9.8 million compared to $12.1 million in the first nine months of 2007 due primarily to changes in our equity compensation policies. We have provided a summary of the impact of stock-based compensation from continuing operations by line item on slides 23 and 24.

Before I comment on our balance sheet and cash flows, let me address the impact of changes in foreign exchange rates on our operating results for the third quarter. Other expense net, for the third quarter of 2008 of $2.2 million consists primarily of net realized foreign exchange losses and associated hedging costs as well as non cash translation losses, due in part to the devaluation of the Brazilian Real.

We exited the third quarter with a very strong balance sheet. We had cash and short term investments of $228.6 million as of September 30, 2008 compared to $190.1 million as of June 30 of this year. This increase is attributable primarily to the $30.9 million of cash flow from operations generated during the quarter. Our working capital balance at September 30, 2008 was $227.7 million, up from $201.8 million at the end of June 2008. Please refer to slide 25 for certain key balance sheet metrics.

At the end of the quarter, we held $105.8 million of Student Loan Auction Rate Securities measured at fair value. All of these securities are either AAA or AA rated by one or more rating agencies. We continue to classify these securities as long-term investments as a result of the ongoing liquidity issues in the credit market. We currently believe that the $5.0 million reduction in market value (or $3.0 million after tax) is temporary and we expect to recover the face amount of these securities, either under the terms of the UBS settlement agreement, which I will discuss in a moment, or when liquidity is restored. Accordingly, the adjustment has been recorded through shareholders equity and not the income statement.

As announced in our press release earlier today, Tekelec accepted an offer from UBS for auction rate securities rights related to our portfolio of Student Loan Auction Rate Securities. Under the terms of the agreement, UBS has the right, at its discretion, to purchase these securities, at par plus accrued interest, at any time until July 2, 2012 and Tekelec has the right to require UBS to purchase the securities at par plus accrued interest at its election at any time between June 30, 2010 and July 2, 2012. We will continue to classify these Auction Rate Securities as long-term investments until we believe that we are within twelve months of a liquidity event.

For the first nine months of 2008, we generated positive cash flows from continuing operations of $87.9 million compared to $26.7 million for the first nine months of last year. The strong cash flows for the first nine months of 2008 compared to the same period a year ago are due primarily to the increase in earnings from continuing operations, the strong orders and billings during the last four quarters and to the receipt of a tax refund of $18.9 million from the IRS in the third quarter of 2008. The refund is attributable to the carryback of net operating losses and capital losses generated from the sale of SSG in 2007 to prior years’ tax returns. We also solidified our capital structure in early October by entering into a three year $50 million revolving credit facility with Wachovia Bank to provide additional financial resources and flexibility. We expect this line of credit will remain in place under the same terms and conditions upon the completion of Wells Fargo’s acquisition of Wachovia.

We are updating our guidance for the full year of 2008. Please refer to slide 26 for a comparison of our previous guidance and today’s updated guidance. Our revenue estimate for full year 2008 is unchanged and continues to range from $460 million to $470 million. This forecasted revenue represents year over year revenue growth of approximately 7% to 9%. We expect non-GAAP consolidated gross margins for the full year will be 65% to 66% and non-GAAP EPS will range from 86 to 92 cents per diluted share for 2008. This represents non-GAAP EPS growth of approximately 30% to 39% on a year over year basis. We expect our non-GAAP annualized effective tax rate for 2008 will be approximately 28% to 30% given that Congress has now renewed the R&D tax credit. The full year impact of the R&D Credit of approximately $1.5 to $2.0 million will be recorded in the fourth quarter which we expect will reduce our Q4 non-GAAP effective tax rate to approximately 25% to 27%. We further expect that the share count used to calculate diluted non-GAAP EPS for the year will be approximately 70 million shares. We also expect that our 2008 GAAP EPS will range between 65 and 71 cents per diluted share.

Visibility to order inflow has been reduced as a result of the difficult economic conditions worldwide, and thus, fourth quarter orders are increasingly difficult to predict. We believe that our order input for Q4, and perhaps the next several quarters, may be impacted by, among other things, the availability of credit in the developing world and the appreciation of the US dollar verses currencies in developing countries. Given our current information, we now expect that our orders for the full year will range between $425 and $460 million compared to $460 to $470 million (or slightly above) which our guidance implied at the end of Q2. This translates into Q4 orders of approximately $130 to $170 million. Frank?

Frank Plastina - President and Chief Executive Officer

Thanks, Bill. Our portfolio is focused on addressing what our customers’ need now to address the challenge of handling complexity in their networks. Tekelec provides solutions that customers know will evolve as their business needs dictate and at a pace they manage. We believe that is why we have won thirty-seven new customers over the last seven quarters and why we have product operating in 68 countries around the world.

In closing, our portfolio of session management, messaging and performance management solutions is focused on our customers’ essential CapEx spending. Understandably, our customers are being cautious with their capital budgets and they typically spend with an objective to drive additional traffic onto their network and to offer incremental services. The 3G rollout is a good example. The small percentage of their overall capital budgets that is spent with us goes toward servicing and monitoring that incremental traffic once it is on the network. Going forward, we expect to continue to leverage our global installed base of customers and financial strength into opportunities to gain market share. We are financially strong and we have an experienced and disciplined management team.

I thank you for your time today and will now open up the call for any questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions]. Your first question comes from George Notter with Jefferies & Company.

George Notter

Hi, thanks very much. I guess I wanted to ask about the order guidance for Q4 and thereafter if you think about your signaling products, where do you think you kind of reside in the hierarchy of discretionary versus non-discretionary spending for operators, and what's your thoughts about how that impacts your order rates going forward?

William Everett

Yeah, I think from a discretionary or non-discretionary, we very high up the chain in terms of non-discretionary. So the signaling network essentially is the brain or the central nervous system of the network and any kind of weakness there does significantly degrade the operation of the network. So, it really is a non-discretionary item. We feel as a result we have given a very wide range because we do think that if anything is delayed, it eventually does come back to us because a lot of what we are seeing in the pipeline is essentially extension business. So if you look at the midpoint of range that we've guided to, it would still represent third highest fourth quarter and the second highest year overall that we've ever had as a company. And we may see some delays because of this economic slowdown, based on letters of credit and lines of credit not being able to be secured by some of the emerging market players or potentially a budget flush not occurring this year as we saw last year. So that’s why we gave a very wide range. Obviously, if the budget flush occurs, it will be at the higher end of the range, if there is more issues with either dollar appreciation or lines of credit not being able to be accessed or being taken down, then we'll see it at the lower range. So it’s the midpoint that really matters.

George Notter

Have you seen any order cancellations from customers or push outs on timing of delivery or timing of orders from customers?

Frank Plastina

We have not seen that. And what we're doing is just watching it day to day to see if that happens. And I think the fact that we haven’t seen it really lends credibility back to the point that signaling and core extensions are really non-discretionary.

George Notter

Got it. I will turn out. Thanks very much.

Operator

Your next question comes from Larry Harris with C.L. King.

Larry Harris

Yes, thank you. I noticed that there is -- you didn’t see the pick up in upgrades and extensions this quarter in the signaling area. Was there any particular reason why you didn't see it this quarter?

Frank Plastina

Well, we had a very healthy first half year as you know, Larry, in terms of extensions and what we call book shift business. So some capacity was built there. But we did have pretty healthy number and the margins in Q3 that we booked very slightly flat. And then we had a high 60s margin, 68% essentially on a non-GAAP basis, that’s a very healthy margin for us. For us which means that there was a pretty good size of business for book shift. Going forward, we are still seeing see some healthy book shift business in the fourth quarter and that has been factored into our guidance. When we took our earnings up again and it’s now sitting at 86 to $0.92 EPS and we took our guidance to gross margins up again and now it’s in the range of 65 to 66%. So those trends are still percolating along; they certainly aren't as strong as they were in the first half of the year. But we are still benefiting from them.

Larry Harris

Understand. There aren’t many companies these days that are raising earnings guidance. So congratulations on that. I know you break out revenues on three geographic classes. Is there any way you can size up, say, what emerging markets are versus developed markets? Because I think that's where people are, right now, have a greater amount of focus?

Frank Plastina

Yeah, emerging market for us are essentially anything other than North America and Western Europe. So, Asia-PAC, CALA, Eastern Europe, Middle East, are all emerging markets.

Larry Harris

Okay. And then what percentage of revenues would that be?

William Everett

Yes, Larry, this is Bill. For the year-to-date -- I don't know if I have the number for the third quarter by itself but.

Larry Harris

Sure.

William Everett

Year-to-date is probably a little bit over a third of our revenues year-to-date have come from what would generally characterized as emerging markets.

Larry Harris

Understood. All right. Well, great and congratulations on the results and the guidance.

William Everett

Thank you.

Frank Plastina

Thanks.

Operator

Your next question comes from Scott Coleman with Morgan Stanley.

Scott Coleman

Hi, thanks guys. Good afternoon. A couple of question on my end. First in terms of your North American business, is sell off more than 30% sequentially and year-over-year, can you talk about whether that was driven by your broad base of customers here? Or was it driven by one or two customers?

Frank Plastina

That was essentially driven by all of the customers, because the drop from Q2 to Q3 was essentially just the book shift business. Book shift business is predominantly North American focus where as our backlog business tends to be more skewed towards international. It will come in waves, but that was broad-based. And what we see going forward is really a continuing business with our North American customers based on capacity requirements and essentially ordering as they need it versus really building out capacity ahead of expectations.

Scott Coleman

Okay. Have the depressed order trends persisted through Q4 to-date?

Frank Plastina

No, the Q3 was lower than we had thought. But Q4 as you know, we get in a pretty wide range, we are comfortable with that and as I said earlier the midpoint of that range still gives us one of the best quarters we've had, in fact third highest fourth quarter we've ever had. So all of that is factored into that Q4, 130 to 170 range for orders.

Scott Coleman

Okay. I choose just to be a little more specific, Frank. The current book shift business within North American customers, I am assuming given the range that you have provided for Q4 here that you haven’t seen a change in pattern from them over the last month or so?

Frank Plastina

No, we have not seen a change other than the regular pattern of them building out their core capacity as they needed.

Scott Coleman

Okay.

Frank Plastina

So we haven’t seen anything significantly different from that. Obviously, as we look into 2009 CapEx planning, that’s something that we are going to watch very closely.

Scott Coleman

Okay. And then if I take you -- what your revenue guidance and your order guidance together, no change to full year revenue, orders coming down, is the way that we should interpret that is lower expected growth in 2009?

Frank Plastina

I think it’s too early to tell. It really depends on where we finish on the range in order input and we are going to make that call in February when we give our Q4 results. One thing I would like to note on the US customers in particular our business really depends on traffic growth as opposed to subscriber ads and other things. So we haven’t seen any slowdown in traffic growth even with the economic downturn.

Scott Coleman

Okay. Bill, in terms of the lower order number, is there a way you can parse out the concerns about credit availability in developing markets versus FX? Is there a certain dollar figure that you are thinking about there that is FX related?

William Everett

No, I think that’s one of the risk factors, Scott than a definitive number. And one of the things that, you know we is, we have major customers in Mexico and Brazil in particular and in India and so those currencies have devalued relative to the dollar in the last say 90 days in Q3 and since the end of Q3 as well. So, since those are major areas where we have major customers’ install base, we are concerned about the fact that that will make it more difficult from a pricing point of view. So, I would say it’s more of a concern about where some of the growths are -- the wireless networks than it is specifically about the individual customers. On the credit side of it, again, as I would say, it’s more macro concern. Again, in those areas and in other developing countries as well, there is a lot of uncertainty about the ability to finance the growth in those networks. And whether that will turn out to be a real problem or not remains to be seen. We've identified it because we think those two factors taken together represent risk factors for the business. So I -- there isn’t a specific number that we can parse to either one of those categories, and we will see at end of quarter whether or not it really does or does not affect our entry for the quarter.

Scott Coleman

Just to make sure I understand. If the dollar real exchange rate stays where it is and there is no other swing factor, do think you are more or less at the mid point of your older guidance. Is that – how am I supposed to interpret that?

William Everett

Well, I would say it’s difficult to answer the question specifically because we have contracts with customers. We have orders and quotes that are already in the field. And so it may or may not impact Q4 specifically. But just generally speaking, if the areas where there has been strong growth on the wireless side in particular are the areas where the currencies are devaluing significantly. If we sell to them in dollars, it makes our products relatively speaking more expensive. So, I think that either the -- potential impact could be either on orders or margin if it turns out that we reduce our prices. But at the moment, that has not been an issue in any significant way. So we are just identifying the fact that emerging currencies, countries and currencies in general, are areas where particularly India and Latin America and Mexico, where there's been a significant change in the valuation of the currencies and we have major customers in those countries.

Scott Coleman

Alright. And then maybe one last one on the product side. This is at least the second quarter in a row that the performance management products have been disappointing but you have called out the longer revenue recognition cycle and a very strong backlog for these products. When do we start to see that come through on the revenue line?

William Everett

I mean you will start seeing that frankly partially in Q4 and then the early part of ’09. And the reason for that is a lot of orders that we booked primarily in the second half of last year in Q4 in particular in ’07, the new customers and getting these new customers up and running has been a much longer task than we had budgeted for. So that’s taking longer. The good news, though, is, once they are up and running, then we got that installed base of customers to sell into and upgrade. And we will be GA on IAS 4.0 this particular quarter and sometime this quarter, by the end of the year, and that will support 100 different protocols. I mean the product has been significantly improved in the last 12 months in terms of scalability and performance and just the amount of different types of network traffic you can address and once those new customers installations are finished and we have a customer acceptance, we then have a ready base to upsell to the new features.

Scott Coleman

Okay. And Frank, you referenced that these products comprise a good percentage of the backlog. Can you just give us an idea as the performance monitoring management, is that 10% of backlog, is it 20% of backlog, just trying to understand what type of growth you expect over the next couple of quarters?

Frank Plastina

Yeah, what I was referring to was that new customers within the backlog of IAS orders was a big percentage of total of IAS as opposed to ISP being a big percentage of the overall backlog. A vast majority of our backlog is still traditional Eagle and Eagle based products such as number portability and others.

Scott Coleman

Okay. Alright guys. Thanks a lot.

Frank Plastina

Thanks.

Operator

Your next question comes from the line of Todd Kaufman with Raymond James.

Todd Kaufman

Thank you. With regard to your North American Q3 revenues, I wouldn’t think that that was impacted by very recent macro economic development and historically the Q3 for North American customers actually quite strong. What transpired during the quarter that led to the revenues that you recognized from your North American customers? And then I have a follow-up on the North American order weakness that you have been talking about?

Frank Plastina

Yeah, I think North America in absolute terms was strong and we generated very healthy booked ship business in Q3 of ’08. I mean when you compare to Q3 of ’07 there are items that have revenue recognition, there were obviously some projects that have been recognized in ’07 that didn’t replicate in ’08. But in terms of the actual flow of business, you are right, there was no impact in Q3 from an economic slowdown and I agree with that. We had a pretty booked ship quarter. We essentially hit the overall revenue plans for the company, which is why we have not changed the guidance for the year. We are still in the same range of 460 to 470 and we did better on margins. So overall the quarter from a historical perspective played out the way we had expected.

Todd Kaufman

Okay. And just a follow-up and moving to orders now someone earlier in the queue asked a question as it relates to your Q4 orders, the first four weeks into your fourth quarter, have your North American orders come back at all, someone asked that question and I couldn’t understand what your explanation or what your response was to that question?

Frank Plastina

The question was have they come back? They never went away. We had a steady booked ship component in our third quarter and we are expecting the same in the fourth quarter and that’s been factored into our guidance. As you can see, we have increased both our margins and earnings guidance which does reflect a healthy booked ship business. So our gross margin guidance is now 65 to 66% and we have up the EPS guidance to a range of $0.86 to $0.90.

Todd Kaufman

And just one quick follow-up. Historically amongst these North American customers, is it fair to say that the order level in the first calendar quarter starts off a little bit sluggish or historically have you not seen that pattern amongst your North American customers? Thank you.

Frank Plastina

Yeah that’s typically the pattern, Todd, frankly most of the companies in North America follow a very rigid budget process that does not end until February in most cases. So we do have CapEx plans that typically are skewed towards the end of the year. What we also don’t know at this stage is, are we going to have a budget flush that has occurred in past fourth quarters and that’s also predominantly North American phenomenon. So to the extent that there is one, we will trend towards the higher end of the orders range. If there isn’t then it’s the lower end. And which is why that’s one of the factors that we are providing such a wide range for the fourth quarter in order input.

Todd Kaufman

Thank you very much. Good luck.

Frank Plastina

Thank you.

Operator

Your next question comes from the line of Amir Rozwadowski with Barclays Capital.

Amir Rozwadowski

Thank you very much for taking the question gentlemen. Frank, I just wanted to touch upon your commentary during the call about potentially being able to gain share in the current environment. Could you give us a little bit of a color there in terms of a – is that a strategy that we should equate with how you are approaching pricing given the current environment or health of some of your competitors?

Frank Plastina

I think it’s more of the latter. I think that the former, we have no interest in using our balance sheet to finance any business or anything like that. We are a niche provider. It doesn’t make sense for us to do that. Some of the larger providers may do that because they are essentially backstopping the entire network builds. But frankly, we are too small and it really doesn’t make sense given the specialty of our products. In terms of the latter point, I think there is weakness across the telecom equipment sector. There is no question that some of the larger players are struggling in certain areas. And the question for us is can we be more aggressive in getting into some of the adjacent spaces where they have potentially had product in the past or potentially are actually developing product that may not seem so core anymore. One example is the larger players that had a portfolio of IMS products that largely have not gain traction anywhere. The transition story of improving the scalability and essentially the reliability of NextGen networks and allowing them to scale effectively and getting into a SIP environment without having to go through a full blown IMS architecture is something we are seeing. And I mentioned TekCore as an example of that. Basic SIP signaling routing, basic SIP to SS7 handling and number portability and not having to replicate all these databases in every network element and more elegantly using layer five capabilities such as TekCore brings to the table is a better way to do it. It’s more efficient, it’s most cost effective and we are getting traction from just a pure business case perspective on deploying those kinds of solutions.

Amir Rozwadowski

Okay, that’s very helpful. And then if I may just a clarification on the traffic growth side. You commented the traffic growth remains robust in regions like the US. Are you seeing similar patterns in some of your international and particularly in emerging markets, in that if we start to see some relief in terms of the credit issues for some of those carriers, should we then start to see some further stronger visibility when it comes to your orders?

Frank Plastina

I agree and I think we will see stronger visibility and we are not seeing any let up in traffic either. I mean, one of the reasons that the emerging market players are tapping into lines of credit because they are trying keep up with traffic growth. As you know, in all of those countries frankly in the emerging markets, wireless networks is really the only network structure that has any kind of reliability and any kind of new features on it. The wireline networks leave a lot to be desired and frankly they are not investing in wire line network. So the ability for them to scale wireless networks and actually do business applications on them unlike some the developed world network, we will become essential to those economies continuing to grow. So we see a situation where they will need to continue to tap into their lines of credit to keep up with growth and build the infrastructure because that’s the only way that the overall economy is going to continue growing. And so, I think the conclusion for us is we see really more of a delay as being sort out in the financial sectors, banks get sorted out, who has the counterparty risk on letters of credit all of that stuff get sorted out, and then we see much more macroeconomic driven traffic handling purchases from so many of these emerging market service providers.

Amir Rozwadowski

Great. Thanks for the incremental color.

Operator

[Operator Instruction]. Your next question comes from Ken Muth with Robert Baird.

Kenneth Muth

Hi Bill. On the foreign currency hedge loss in Q3, would you expect something similar in Q4 or how should kind of factor that in?

William Everett

Yeah, hi Ken. We don’t necessarily expect the same loss in Q4 as we have in Q3, probably because we changed our hedging program partway through the third quarter. Even though the currencies particularly in Brazil where incur most of the FX losses, the Real continue to devalue during the month of October. We think we are better positioned to handle that, so we wouldn’t expect the same magnitude of the FX losses in Q4 at this time.

Kenneth Muth

Okay. And then, I think I might have miss this, Frank, was talking about the TekCore, how many customers you have for that, are you still in trials or when will that be available as kind of a CSCF that you were talking about a couple of quarters ago?

Frank Plastina

Yeah, we’re in trials now Ken and what’s available is some of the basics CSCF functionality is available, primarily the interest and the traction has made on the SIP signaling routing capability of TekCore. So, the traction that we had with several Tier 1s around the world has been all around handling a lot of their SIP traffic and essentially putting in a SIP STP capability in between either their IP based MSEs or between IP PBXs and IP spigots going into MSCs. That's really been the main reason to look at deploying this. We're also seeing some evolution of SPC kind of functionality being put into TekCore and higher up in the network, because we're seeing the edge not being able to keep up with some of the scalability particularly in wireless networks. SPC that have been deployed out there in the industry in the last couple of years have been predominantly wireline VoIP based and what we see now in the wireless side is a need to scale as a much higher capability and capacity and TekCore is well-suited for that.

Kenneth Muth

Okay. And then, on the geography side, clearly the -- you know, EAA, as you guys categorize it here, just continues to have an exceptional year here. Do you worry that some of the major buildups are done? Or kind of what's going on? I would not assume too much here that being China and India, but any kind of -- a little bit more clarity and transparency on the geography front would be maybe helpful, what's kind of going on?

Frank Plastina

Yes. In E-AAA -- there's no China. We do not have sales into China at this time. It’s primarily been driven by India and a lot of the emerging economies, in addition to India. So, places like Russia and Vietnam and Nigeria, the other larger economies around the world. We also have a pretty healthy business that's growing in all of Europe, both Western and Eastern Europe. In Eastern Europe in particular, we've done quite well with our Eagle products because of the number portability mandate by the EU. We're now seeing the replacement cycle in Western Europe start. We've actually done five separate replacements of number portability solutions in Western European carriers in the past few quarters. We've booked orders on them -- we haven't completed all of the work yet. That is a nice trend that is starting. And the reason for that is, the early part of number portability or the early days of number portability were all SCP or IN-based solutions that are now starting to topple over because they can't scale to higher numbers ported of being one point, and then they can't evolve to a SIP capability. So we're seeing a lot of Western European service providers look at alternatives to handle number portability and really looking at integrating that with Eagle as the most efficient way to go.

Kenneth Muth

Okay. And then Bill on the gross margins, obviously, great progress there. Is some of this just because you -- a while ago, you guys had these very low margin, almost zero gross margin contracts. Are we through all of those contracts now? Or do we still have some of these very low gross margin contracts remaining?

William Everett

No. Actually, we have completed all of those or brought all of those to conclusion, Ken. And I think that more than anything else this quarter was really the question of mix of that business and some other very favorable operating results for us, purchase price variances and overhead variances, and we really had good quarter in terms of the operation of our business, together with a mix of LNP and a lot of traditional Eagle business. So all of those factors together really helped the margins. And it really was in some contract provisions that we’d set up earlier for things like warrant issues and things change-outs in the field and all of that turned out very favorably for us. So we were benefited from that for sure and then Frank earlier said or maybe commented about book-ship business and expansion business and I think just to make sure it’s crystal clear we had what I would consider a normal quarter with respect to book-ship business, we didn’t see any drop offs than what has been sort of the traditional norm. We had exceptionally good book-ship strong business in the first and second quarter of the year driven by what we believe is largely by text messaging and some other things that really drove the requirements up particularly for North American customers. We didn’t see that same bubble of book-ship orders during the quarter for line card expansions and things like that but we had other kind of expansion business like LNP expansion two to three 84 number portability in North America and other things. So it wasn’t the same kind of business. It wasn’t driven by inventory purchases but it was good growth and good business in North America nonetheless.

Kenneth Muth

Great. Thank you.

William Everett

Okay.

Operator

Your final question today comes from the line of Brian Modoff with Deutsche Bank.

Brian Modoff

Hi guys. Couple of questions for you. First off in terms of the low end of your range of guidance for the current quarter, how much of that is backlog business?

Frank Plastina

Are you referring to revenue?

Brian Modoff

Yeah, low end of your revenue, how much of that is backlog business?

Frank Plastina

We never break it up between book-ship and backlog. But we're not expecting book-ship quarter to the extent that we had in the first half of this year. So I would say that we're probably trending back to more normal Q4 trends.

Brian Modoff

So, this will have a heavier portion of backlog business?

William Everett

Just, Brian in general, in any given year, when we start a year or any period generally, on average, probably 75% of the revenues in any period come from the beginning backlog. I can't say specifically whether it is higher or lower when compared to Q4 but general that’s not a bad rule of thumb.

Brian Modoff

Okay, good. And then looking at TekCore, you talked about SIP signaling being one of the biggest drivers of that. Can you kind of talk about what you see that as opportunity on the revenue side in '09? And the interoperatability that you allow, can you kind of compare kind of your backlog of protocol facts and capabilities across multiple languages, can you kind of backlog that backstop that against your competitors in terms of their ability to offer similar capability?

Frank Plastina

Yeah. I think we got a tremendous advantage just by virtue of the fact that we've been at this thing for 20 years or so. Handling some of the specific protocols in the IN or circuit world is really competitive advantage. It is already built into our software. It is something we can already handle and obviously we can also handle SIP on top of that and go back and forth. I mentioned in the prepared remarks that things like 800 calls and HLRs and all of the things that are still working on SS7 basis need to interwork with all of the SIP flavored applications servers and all the other SIP trunking offers that are being provided out there. And unless there is a very efficient way to make the actual call or session connection, it’s going to bog down the network pretty quickly.

Brian Modoff

And can you talk about on a regional basis, is that a more of a -- that advantage more of a North American switching fabric kind of advantage or would you consider that global advantage? What regions would you say really stands out?

Frank Plastina

It is interesting you say that because I think it’s been a bit of both. The North American folks are very aggressively starting to sell SIP trunking and direct Ethernet connections into enterprises and we see that from the wireline guys as opposed to the wireless guys predominantly. Once you take that outside of the US, there really isn’t much of a wireline infrastructure. So what we are seeing is the wireless service providers actually offering enterprise-like services directly into enterprises and, therefore, requiring some of the SIP trunking capability earlier than we see in North America. For example, one of the initial deployments of our TekCore products was direct connection or essentially SIP signaling routing in between IPPBXs and MSCs, IPMSCs, so that was a wireless offer into an enterprise network for IPPBXs, so we are seeing a bit of both.

Brian Modoff

And if you were to look at say Q4 of next year, would you venture to guess what percentage of revenue might be TekCore a year from now?

Frank Plastina

I wouldn't venture to guess. To guess I’d hope it’s a whole bunch. I think the important thing is the market size is starting to bubble. We are seeing that in the pipeline and we are seeing traction. Last call we talked about our market size by 2010 of anywhere from 100 to $300 million and we think we're very well-positioned to get a good chunk of that share.

Operator

Ladies and gentlemen, thank you for participating in today's Tekelec third quarter 2008 earnings release conference call. This does conclude today's conference. You may now disconnect.

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