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Executives

Tom Scottino - IR

Rob Pullen - CEO and President

Tim Wiggins - EVP and CFO

Analysts

George Notter - Jefferies

Todd Koffman - Raymond James

Tal Liani - Merrill Lynch

Jeff Kvaal - Barclays Capital

Nikos Theodosopoulos - UBS

Simon Leopold - Morgan, Keegan

Ehud Gelblum - J.P. Morgan

Larry Harris - C.L. King

Scott Coleman - Morgan Stanley

Tellabs, Inc. (TLAB) Q4 2008 Earnings Call January 27, 2009 12:00 PM ET

Operator

Good morning, my name is Rachel and I will be your conference operator today. At this time I would like to welcome everyone to the Tellabs Investor Relations Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks there will be a question-and-answer session. (Operator Instructions). Thank you.

Mr. Tom Scottino, you may begin.

Tom Scottino

Thank you, Rachel, 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 our tellabs.com website. 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 management's 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, performance or achievements to be materially different.

A discussion of the factors that may affect future results is contained in Tellabs' most resent SEC filings. The forward-looking statements 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 live presentation it may not contain current or accurate information. Tellabs disclaims any obligation to update or revise any forward-looking statements based on new information, future events or otherwise. This presentation also includes non-GAAP financial measures. Reconciliations between non-GAAP financial measures and GAAP financial measures can be found at our website, www.tellabs.com, and in our SEC filings.

At this point I will turn the call over to our CEO, Rob.

Rob Pullen

Thanks, Tom, and good morning, everyone. As I reflect back on my first 10 months as Tellabs' CEO, despite our tough environment, Tellabs has performed well. As we shared with you in November at our analysts meeting and shareholder discussion, Tellabs is focused on improving profitability, both for our customers and for our company.

As you can see despite a slight sequential downturn in revenue, from 3Q of '08 to 4Q of '08, roughly 4%, our fourth quarter '08 earnings per share were $0.03, which were also positively impacted by a tax benefit in the quarter. When you look at our fourth quarter '08 non-GAAP earnings per share they were $0.09 versus $0.04 in previous year, fourth quarter of '07. If you focus on Tellabs, we help our customers succeed, both in generating new revenues, reducing their capital expense or reducing their operations expense.

As we shared with all of you we began by implementing a new strategy this past year, focusing our investments in growth products, innovating in growth markets, such as mobile backhaul, dynamic optical networking and business services. And we aspire to execute flawlessly. We added talent to the Tellabs leadership team. We added a new leader of sales and services, Roger Heinz. We added a new executive promoter from within for our marketing, Rizwan Khan, and we added a new Chief Technology Officer, Vikram Saksena.

We also improved Tellabs' profitability. When you look at our non-GAAP gross profit margins we improved them to roughly 42% from 34% a year ago. Our operating expenses decreased to approximately $135 million in the fourth quarter of '08, that's because we successfully completed our $100 million savings plan.

We achieved operating income in the fourth quarter of $36 million. That was up 102% from the fourth quarter of '07. We preserved our solid financial foundation so we can invest in research and development. Our cash position remains solid with $1.15 billion in cash, cash equivalents, and highly liquid financial instruments. Tim and his team did a good job preserving capital, and as you know we have no debt.

Our solid financial foundation in cash flow enabled us to invest approximately 17% of revenue in research and development. And what's the reward of that? It's working. We are winning customers. For example, in this quarter we received our first orders for the Tellabs 8600 from BT. BT now joins 95 other customers who have selected the Tellabs 8600 primarily from mobile backhaul. If you recall, Tim and I shared with you in a past call that we have roughly 80 or 81 customers, so we are improving our number of customers.

Likewise we just added a new cable TV company or multiple services operator. They selected the 7100 for their business services delivery and their optical networking. During the year we also recognized our first international revenue on the Tellabs 7100.

Our growth products, which are dominantly our 6300, 7100, 8600, 8800, and our professional services, are gaining traction. They are up 36% – or they equate to 36% of our 2008 revenue. Other examples that Tellabs is making positive strides, we had record revenue in the fourth quarter for our 8600, and it's up 96% year-over-year. Our combined data networking products or the 8800 and 8600 are up 34% from a year ago. And our dynamic optical networking products or 6300 and 7100 are up 27% year-over-year.

We also will share with you that our services revenue is up year-over-year, roughly 3%, and the professional services component of services is up 70% year-over-year.

As you can tell here from Tellabs, we're investing for the future to emerge stronger after this downturn, for the future to emerge stronger after this downturn, and with that summary, I will turn it over to Tim, and then we'll come back to answer your questions.

Tim Wiggins

Thanks, Rob, and good morning, everyone. Let's take a look at the numbers.

For the full year 2008, revenue amounted to $1.729 billion, down 10% from $1.913 billion in 2007. The year-over-year decline can be attributed to lower revenue in the transport broadband segments partially offset by increased revenue in the services segment.

Total revenue for the fourth quarter 2008 amounted to $408 million, compared with $424 million we reported in the third quarter of 2008. Sequential increases in transport and services segment revenue were offset by a decrease in broadband segment revenue.

GAAP net loss for the full year 2008, taking into an account a non-cash goodwill impairment of $998 million in 3Q was $930 million or $2.32 per share, compared with net income of $65 million or $0.15 per share in 2007. GAAP net income for the fourth quarter amounted to about $13 million or $0.03 a share compared with a net loss of $999 million in the third quarter of 2008 when GAAP earnings were reduced by a number of items, including the $998 million non-cash charge.

GAAP net income also included a benefit of $17 million or $0.04 per share in the fourth quarter of 2008. This benefit was the result of adjusting tax assets associated with the goodwill impairment charge in 3Q '08. On a non-GAAP basis net income for the full year 2008 increased 31% to $137 million or $0.34 a share in 2008, compared with $104 million or $0.24 a share in 2007. Non-GAAP net income for the fourth quarter of 2008, which excludes $39 million in pre-tax charges for special items increased to $35 million or $0.09 a share, compared with $19 million or $0.05 a share in the third quarter of '08.

The improvement in non-GAAP profitability in the quarter was driven primarily by margin improvements on the Tellabs' 7100 and 1600, which improved overall gross margin and lowering operating expenses as we executed on the $100 million cost-reduction plan we committed to last January.

Equity-based compensation expense for the fourth quarter of 2008 amounted to about $5 million or eight-tenths of a $0.01 a share. Taking equity comp into consideration as First Call and Reuters do when compiling mean EPS estimates for Tellabs gives you $0.08 in non-GAAP EPS.

As usual you'll find a complete reconciliation of GAAP and non-GAAP results in more detailed comparison in this morning's press release. Before we look at the numbers in more detail, I want to take a minute to reflect on a number of good things that we were able to accomplish in 2008, which I consider to be a transitional year for Tellabs.

In addition to forging new technology and market strategies, we laid the ground work for improved profitability going forward. As we exit 2008, we have the highest non-GAAP gross margins in a little more than two years at 41.9%, the lowest level of non-GAAP operating expenses in nearly four years at $135 million and the highest percentage of operating income to revenue in the last nine quarters at 8.8%. These improved operating metrics, and our solid balance sheet, give us the needed financial strength as we enter 2009.

Now, let's look at how the individual business segments performed in 2008. On a full-year basis, North American customers accounted for 68% of revenue in 2008, compared with 74% in 2007. Revenue from customers outside North America, which was partially benefited by favorable exchange rates, increased 12% to $560 million from $500 million in 2007. Revenue from customers in North America amounted to $268 million or 66% of the total in the fourth quarter of 2008, up slightly from the third quarter when North American revenue was $264 million. Revenue from customers outside North America, which was unfavorably affected by currency fluctuations during the quarter, amounted to $140 million in the fourth quarter in 2008, compared with a $160 million in the third quarter of 2008.

As you know, the broadband segment includes our access, managed access, and data products. On a full-year basis, broadband segment revenue totaled $920 million, down 10% from $1.18 billion in 2007. Growth and data product revenue was offset by lower access revenue and essentially flat managed access revenue. Specifically access revenue was $415 million in 2008, compared with $567 million in 2007. Revenue declined year-on-year as increased sales of single family ONTs were offset by lower sales of FTTP network equipment, FTTC platforms and copper-based access platforms. Managed access revenue was $290 million in 2008, compared with $291 million in 2007. While revenue from our 6300 SDH improved significantly, it was offset by lower revenue from the 8100 managed access system.

The Tellabs 8800 multi-service router series and the Tellabs 8600 managed edge system make up our data category. Data revenue for the full year totaled $215 million up 34% from $160 million in 2007. On a year-over-year basis, data continues to be our fastest growing product category. The increase in data revenues for 2008 was primarily driven by continuing acceptance of our NexGen 8600 platform for wireless backhaul.

Broadband segment profit in 2008 was $116 million compared with $39 million in 2007. This significant year-over-year improvement was driven by primarily higher data revenue, margin improvements associated with the Tellabs 6100 ONT and lower R&D expenses.

Turning to the fourth quarter of 2008, broadband segment revenue was $227 million, and that's down 12% from $260 million in the third quarter of '08. The sequential decrease in broadband segment revenue results from lower revenue levels across the entire segment. Within the broadband segment, access revenue was $98 million in the fourth quarter of '08, compared with $113 million in the third quarter of '08. The decline here is primarily related to lower sales of the Tellabs 1000 and 1100 platforms. Fiber platforms overall, both, fiber to the curve and fiber to the premise accounted for approximately 74% of access product revenue in the fourth quarter of 2008, and that percentage is consistent with the third quarter.

Managed access revenue in 4Q '08 driven primarily by lower sales of Tellabs 6300 system following a robust third quarter was $69 million, compared with $79 million in the third quarter. Revenue from data was $60 million in the fourth quarter of '08, compared with $68 million in the third quarter. In 4Q '08, broadband segment profit was $35 million compared with $48 million in 3Q. The decline here was primarily driven by lower revenue level and unfavorable product mix.

Looking at the transport segment for the full year, transport segment revenue was $580 million in 2008, compared with $673 million in 2007. The decline here primarily reflects lower levels of 5500 system and other cross-connect products partially offset by the growth in the 7100 [growth] revenue. Transport segment profit was $178 million in 2008, compared with $238 million in 2007. The decrease was driven by lower sales of 5500 and other cross-connect systems partially offset by improved customer mix and cost savings on the 7100. For the fourth quarter of 2008, transport segment revenue was $124 million, up 13% from $109 million in the third quarter of 2008. The improvement reflects sequentially higher sales of 5500 cross-connect systems, and 3000 voice quality enhancement products partially offset by lower 7100 revenue.

The North American wireless customers accounted for 48% of transport product sales in 4Q '08, up from 23% in 3Q '08. Looking at the Tellabs 5500 cross-connect business in the fourth quarter specifically, we shipped approximately 1.4 million T1 equivalents in the fourth quarter of '08 up from 943 million in the third quarter. About 48% of this quarter's 5500 system revenue came from new systems, system expansions, and system upgrades, compared with 17% in 3Q '08. The increase here was driven primarily by a significant increase in system upgrades.

The balance of the revenue in each quarter came from line card sales on the install base, which declined to 52% in the fourth quarter of '08 compared with 83% in 3Q. At the end of the quarter, 19% of the card slots in our install base were open, consistent with the level at the end of 3Q. Transport segment profit in 4Q '08 driven primarily by higher level of 5500 revenue was $46 million, up from $22 million in 3Q '08.

Turning to the services segment: For the full year, services segment revenue was $229 million in '08, up 3% from $222 million in '07. On a full-year basis, services segment profit was $76 million in '08 up 5% from $72 million in 2007. The increase here is attributable to increased revenue from higher marginal professional and support services.

For the fourth quarter of '08, services segment revenue was $57 million up 4% from $55 million in 3Q, and services segment profit amounted to $19 million, compared with $21 million in 3Q '08. On an annual basis non-GAAP gross profit margin was 38.5% in 2008, compared with 35.5% in 2007. As you know, our gross profit margin is dependent on product and customer mix. The increase here was primarily driven by nearly 5 points of improvement from margin improvements on the 1600 and 7100 products, and the higher level of data revenue, which was partially offset by lower revenue from the 5500 and other cross-connect products and access infrastructure equipment.

Non-GAAP gross margin for the fourth quarter of '08 was 41.9%, up from 38.5% in the third quarter. Contributing to the shift, this quarter was about 2.5 points of improvement, primarily related to the higher level of 5500 revenue, and nearly 3.5 points of improvement related to improved margins on the 7100 and 1600 products, which was offset by about 2.5 points of declines related to higher manufacturing costs and lowered managed access contribution.

Turning to operating expenses, on a full-year basis, non-GAAP OpEx was $556 million in 2008, down $38 million from $594 million in 2007. The decline in OpEx comes as we completed the $100 million COGS reduction plan we committed to in '08. Non-GAAP operating expenses for the fourth quarter of 2008 declined to $135 million or about 33% of revenue, compared with $137 million in 3Q '08. For the quarter, non-GAAP R&D expenses came in $70 million or a little more than 17% of revenue. SG&A expenses for the quarter were $65 million.

For the fourth quarter and the full year 2008, SG&A expenses included increased legal fees as a result of current lawsuits. Other income, on a non-GAAP basis amounted to $3 million in the fourth quarter, up from $1 million in the prior quarter. Our tax revision – our non-GAAP pretax income for the quarter was $3.9 million. The tax revision for the quarter reflects the benefit of reporting domestic R&D tax credits for 2008 that were recently re-established by Congress. We expect our non-GAAP effective tax rate for 2009 to be – to be about 30% plus or minus.

Turning to the balance sheet: Day sales outstanding were 57 days in 4Q, up from 54 in 3Q as more orders came in late in the quarter. Inventory turns were 5.1 times versus 5.7 in 3Q '08. At the end of the fourth quarter inventory in terms of dollars was $177 million, compared with $162 million at the end of the third quarter. The increase in inventory is primarily related to a lower-than-anticipated level of Tellabs 7100 revenue during the quarter.

CapEx during the quarter was about $17 million, compared with $15 million in the third quarter of '08. On a full-year basis CapEx was $50 million in '08, down from $58 million in 2007. During the quarter we purchased almost $3 million shares of our stock at a cost of a little more than $10 million.

The actual number of shares outstanding at quarter's end was $396 million, compared with $398 million at the end of the third quarter. In 2008, we purchased about 25 million shares of our stock at a cost of $154 million. At the end of the quarter, our cash and investment balance stood at $1.152 billion down 50 million from the third quarter of this year. This decline was primarily driven by our share buyback activities during the quarter.

During the full year 2008, we generated $131 million of positive cash from operations. Headcount at the end of the quarter stood at 3,230, down from 3,480 at the end of the third quarter. Book-to-bill for the quarter was less than one.

Turning to our outlook for the first quarter of this year, as we look to the first quarter, we expect that seasonality and the overall difficult economic environment will continue to pressure revenue. Based on what we see today, we expect revenue for the first quarter to be in a range between $345 million, and $375 million. We achieved sequential gross margin improvement this quarter as we benefited from cost-reduction activities, and a favorable product mix.

Looking ahead, we expect gross margin in the first quarter to be flat, plus or minus a point or two depending on product mix. We expect non-GAAP OpEx for the first quarter to be flat to slightly down, including some near-term increases for parts and prototypes. Over the course of 2008, we expect OpEx to trend down.

In addition, we expect the effective expensing equity-based compensation in Q1 will be about $5 million split between operating expense and cost of goods sold. 2009 looks to be a year of significant challenges and significant opportunities. We entered the year with a solid balance sheet, improved gross margins and reduced operating expenses. That gives us the financial strength and flexibility needed to meet the challenges and opportunities 2009 presents.

At this point we'll open the floor to your questions. Rachel, we're ready for the first question.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from George Notter with Jefferies.

George Notter - Jefferies

Hi. I wanted to ask about the Q1 guidance. It's little bit below where we are and where the street expects. I'm trying to get a better handle on where you are coming from in terms of the guidance. I hear your comments about seasonality and the economy. You know, one of your competitors – or I guess, another company in the space, commented that they saw reasonably stronger order trends in Q1. It appears in the first two, three weeks of the quarter. But I am trying to figure out what you are seeing right now and what's driving that guidance in more detail? Thanks.

Rob Pullen

Well, George, you know, we're taking into consideration, the economy, You know, I have been talking to our customers, and we're getting mixed feedback. Some are saying they will be flat year-over-year in expenses more in developing countries and emerging countries, and more of the developed countries are saying that they are going to be cautious in the first half of the year, and then evaluate the second half of the year. So we are taking that in to consideration in our view. We also want to give guidance in a range where we believe we can hit it and we don't have as much visibility as we would like, therefore, giving you, you know, insight into this range.

George Notter - Jefferies

Then separately on the 7100, it was a little softer than you thought in Q4. Any commentary there? Thanks?

Rob Pullen

I actually expected it to be somewhat soft in Q4. We – our customers billed out their networks in the first half of the year. We're adding on new customers in the 7100, and would expect that to have more of a positive impact in the first half of the year.

George Notter - Jefferies

Great. Thanks.

Operator

Your next question comes from Todd Koffman with Raymond James.

Todd Koffman - Raymond James

Thank you very much. I wanted to ask about the access segment. You know, it has gone through, a year ago, doing around $150 million a quarter. It's down about 100. Where does that segment likely shake now out in '09, qualitatively, given factors in the real estate market and what not? Thank you.

Rob Pullen

First of all, access is not a segment for us. It's part of our broadband segment, Todd. Next, as you know earlier this year, we exited an unprofitable business in one of our platforms, the 8865. We continue to be in the access space. There's also a macroeconomic impact as well. With the economy slowing down, both housing starts, turn of people, changing from one house to another is down as well Therefore, it also is negatively impacting our access business. We do expect that there could be some positive, though. With the stimulus package, there may be a positive note, of, you know, the government promoting broadband in more rural areas, and Tellabs could be a beneficiary of that as well.

Todd Koffman - Raymond James

Thank you.

Operator

Your next question comes from Tal Liani with Merrill Lynch.

Tal Liani - Merrill Lynch

I have a follow-up on your last answer, but I have another question. Can you elaborate how would you benefit from broadband? What are the products and at the high level, if the government does try to help broadband penetration, how do you think it will happen and benefit you? And second, going back to the previous question also, the guidance for next quarter is pretty weak, the question is, when you look at your 8600, 8800, and the outlook for cross-connect for the 5500. Do you think that in the second half of the year, when we come back from slowdown, you are already going to see a shift from legacy to new, or you are going to continue to see the carriers buying – mainly in the U.S. continuing to buy the cross-connect capacity? I'm trying to view the timing of this migration to new architecture. Thanks.

Rob Pullen

Okay. Tal, you asked a lot of questions in there. Let me see if I can answer your question. So, first of all, the broadband issue. I don't know exactly how the government is going to shake that out. My personal preference is that they are going to be give the service providers tax credits to deploy broadband both in wire line and wireless. If that proves to be true, which the indications are consistent with that direction, our products that would benefit are dominantly, all of our growth products. Part of that group are the access products for deploying broadband DSL which would benefit, notwithstanding the fact that access is down year-over-year as Todd pointed out earlier.

Next, it should benefit our other products as well, because when you deploy bandwidth in the access part of the network it aggregates in the optic – the dynamic optical plane which is 6300 and 7100 products. Additionally when you have wireless broadband, with our 8800 and 8600 products would benefit from that as well. And so the deployment of wire line or wireless broadband data would benefit our growth products as I had mentioned earlier.

Now, I think your second part of your question was what is going on with cross-connects versus new growth products. Tal, we have had diverse customer feedback. Some have said we're going to sweat our assets, which is saying they are going to get more out of our existing core products, the cross-connects and so and you saw an uptick in the fourth quarter. By the way, at the same time, let's be realistic, these products are more toward the end of their life cycle and will gracefully decline over time.

On the other hand, we have seen customers say, 'hey, look, I'm going to leave in my existing assets, and I'm going to switch to new technologies, thereby benefiting our growth products'. And so we have seen a mixed response on the sweating the assets versus focusing on our new growth products.

Tal Liani - Merrill Lynch

Were there RFPs in the U.S. where carriers already selected their vendors, and were you selected within in your customers? What is your success rate for the new architecture?

Rob Pullen

Well, we haven't broken out specific customer feedback, but we have – as I said we were selected in 7100 new RFP for a North American cable company for both delivering business services and their optical networking products. I also shared with you that we won approximately 14 or 15 new mobile backhaul customers, which included our 8600 and a combined solution of 8800, 8600, and our integrated network management system.

Tal Liani - Merrill Lynch

Thank you very much.

Operator

Your next question comes from Jeff Kvaal with Barclays Capital.

Jeff Kvaal - Barclays Capital

Yes. Thanks very much. Would you folks mind help taking apart the gross margin improvement for us. Which were the bigger factors, and which were the smaller ones? And then that leads in to the next question, which is, what gives you the comfort in the relative stability in the gross margin structure in March? Thank you.

Tim Wiggins

Okay. Well, I think if we look at what happened in the fourth quarter – let me find the right thing, hang on a second. Let me get to the right spot. We gave you some of that detail both for the year and for the quarter. Okay. Here we go. So in 4Q, we went from 38.5 in the third quarter to 41.9, and so if you think about that, there are really three pieces that we laid out.

One is about 2.5 points of improvement come from higher levels of our 5500, so we saw an uptick in that revenue in 4Q, and it drove about 2.5 points. Nearly 3.5 points improvement related to improved margins on our 7100 and 1600. We have a long string of quarters of improvements on both of those products, you know, six and seven quarters in a row we have been working hard to improve them. It was a positive impact in the 3Q to 4Q. You know, that's a function both of volume and of improved pricing.

And the third component was 2.5 points of decline, and this related to somewhat higher manufacturing costs in 4Q, and lower managed access contribution. If you think about the full year, we went from 35.5 to 38.5, and so we tried to help you think about that along these lines. About 5 points of improvement came from improved performance of the 1600 and 7100 products, the higher level of data revenue. So those two areas combined, and that was partially offset by lower revenue for the full year on the 5500, other cross-connect products and the access infrastructure.

So now, thinking about, you know, how do we see this going forward, and why are we giving the guidance we are? We're looking for essentially a flat margin performance. Now it will vary a point or two based on mix, but as we see it today, I would say that the – if you look at our 7100 and 1600, we're going to likely have increased volume as Rob alluded to in our 7100 and likely lower volume in our 1600. That in my mind comes out to about a wash.

If you think about our managed access business, I see that as about a wash in terms of first – fourth quarter to first quarter. And if you think about our transport segment, I think the 5500 will be improvement -- will be offset by lower BQE. We had a very strong BQE. So there's a number of puts and takes, but based on what we see today, and the volume that we're forecasting, we think we can carry the kind of margin that we saw in 4Q and into the first quarter, and depending on how the mix goes for the balance of the year we are hopeful we will stay above that 40% for the full year.

Rob Pullen

I would also add, Jeff, that two of our teammates, Dan Kelly, who runs our product businesses units and engineering group, and John Brots, who runs our supply chain are now focused on cost reductions on a continuum. Both in getting costs out of our supply chain by reducing complexity and of course negotiation, as well as engineering value-add redesign, including getting more features or higher density at lower energy for lower cost structure.

Jeff Kvaal - Barclays Capital

Okay. Now it makes sense. So, one element of the gross margin guidance for the first quarter then is ongoing strength in the 5500?

Rob Pullen

That's correct.

Jeff Kvaal - Barclays Capital

Okay. All right. So then a prudent way to go would to be think that it would not persist through the balance of the year?

Tim Wiggins

Yes, but we see continued growth in our data products which have good solid margins.

Jeff Kvaal - Barclays Capital

Okay. Thank you very much.

Rob Pullen

Okay.

Operator

Your next question comes from Nikos Theodosopoulos with UBS.

Nikos Theodosopoulos - UBS

Hello?

Rob Pullen

Hello, Nikos.

Nikos Theodosopoulos - UBS

I had a couple of questions. Can you give some additional information on how the 5500 did for the full year in terms of revenue? I mean, in this quarter the uptick looked to be quite extreme sequentially. So I'm trying to get a little bit more insight as to how much it declined for the year, and what kind of uptick you saw sequentially in the fourth quarter?

Rob Pullen

Okay. Nikos, you know, when you compare year-over-year, '07 to '08, we're down about 20% in the 5500 product line.

Nikos Theodosopoulos - UBS

Okay.

Rob Pullen

So when you compare 4Q '08 to 4Q '07, we're up 12%, and when you compare 4Q '08 to 3Q '08, we're up over 30%.

Nikos Theodosopoulos - UBS

Okay.

Rob Pullen

And so we saw some strength here in the fourth quarter, and it was driven by the wireless carriers, as well as T1 business services delivery. As you know while we're helping the carriers transition to ethernet and IP for mobile backhaul, the dominant delivery mechanism to connect the base transceiver station to a mobile switching standard is still T1s today and we saw growth there.

Nikos Theodosopoulos - UBS

Okay. Okay. And typically the seasonality – now that this business is predominantly wireless the seasonality has been, I think in the last two years, if I'm not mistaken, maybe actually last three years. The first quarter was the highest for the year, and then it kind of the other three quarters are lower. Is that kind of like what you see again for '09? Or is that normal seasonality for that business?

Rob Pullen

Well, first, yes, it is short of it, Nikos. We see normal seasonality in the 5500 business, and Q1 should be positive for us as well. But I would also qualify something. The 5500 was dominantly driven by mobile backhaul and wireless data growth. But it was deployed both in wireless and wire line customers, including the wire line customers delivering the business service of T1 for mobile backhaul.

Nikos Theodosopoulos - UBS

Okay. One last question. On the cash flow generation, the last two quarters, the company hasn't generated, if I combine them, hasn't generated operating cash flow. Can you give us a sense as to, how important that is going to be, and how you are measuring that going forward? Thank you.

Rob Pullen

Yes, it's absolutely very important. You know, we had particularly in the fourth quarter some working capital issues around inventory. We have some very focused programs on that. We believe as we look in to '09, that it's important that we have another strong cash flow generation for the full year, and it is an area of high focus. I'm highly confident we'll be able to continue to produce solid cash flows in '09. And really, Nikos, it's on the strength of improved margins, lower cost, and we'll continue to focus on working capital.

Nikos Theodosopoulos - UBS

Okay. Great. Thanks a lot.

Operator

Your next question comes from Simon Leopold with Morgan, Keegan.

Simon Leopold - Morgan, Keegan

First, two quick housekeeping questions. I know you mentioned in the access business the usual split between the fiber and copper, if you could remind us of that number?

Rob Pullen

74% fiber.

Simon Leopold - Morgan, Keegan

Great.

Rob Pullen

Right.

Simon Leopold - Morgan, Keegan

And 10% customers for the year in the quarter?

Rob Pullen

2.

Simon Leopold - Morgan, Keegan

And they were the usual suspects?

Rob Pullen

I think that's correct.

Simon Leopold - Morgan, Keegan

And how significant were they over all?

Rob Pullen

I would say they were 10% customers, and I would stop there.

Simon Leopold - Morgan, Keegan

Okay. Now in terms of sort of the overall trends –

Rob Pullen

Simon, just as a data point –

Simon Leopold - Morgan, Keegan

Sure.

Rob Pullen

As you can tell there are two 10% customers, but based on the information I will share with you we're greatly diversifying our customer base, including when you look just at the fourth quarter of '08. Revenue outside of North America is now more than one-third of our business, so roughly 34% of our business.

Simon Leopold - Morgan, Keegan

Right. I guess what I am trying to figure out is historically Verizon has been a very significant percent of the business and we would imagine that the coming down with the shifts in the access just trying to quantify how that is sort of shaking out today.

Tim Wiggins

We'll have some more data on that in a couple of weeks when we file our K.

Rob Pullen

Our K.

Simon Leopold - Morgan, Keegan

Okay. So just rather than dwelling on that, I would like to see if you could maybe give us an update on how your prospects and thoughts about the growth have shifted since you hosted the analysts meeting a couple of months ago. If you could do a compare and contrast about what you feel better about, what you feel worse about, given sort of what has transpired?

Tim Wiggins

Well I actually, I believe the strategy we gave at the analysts' meeting, Simon is still very solid. When I'm visiting customers, they are telling us they are going to spend in their services where they make money, whether its business services delivery, or the mobile backhaul space, or the capability to handle all of that data and video traffic, which is manifesting itself in dynamic optical networking. I believe it was consistent with the message we gave you before, which is in developed countries, we see 5% plus to 10% CapEx decline, and in developing countries or emerging countries, they could be flat year-over-year and the major risk there is probably the foreign exchange conversion. And so that's still consistent with what we have seen before. You know, and as we also said, we expect the economic climate, unfortunately to continue throughout 2009 as well.

Simon Leopold - Morgan, Keegan

So one of the things I think many of us are struggling with is the midpoint of your March guidance would imply, I think, a 20% plus year-over-year decline, which is a little bit out of whack with this CapEx sense that you are picking up of maybe 5% to 10% down in developed markets, flat in emerging markets. So that's where disconnect is, I was just trying to say, okay, is this about share loss, about the transitions? Help us understand why your view on your own business is so different from your view on carrier spending?

Rob Pullen

It's a complex answer, Simon, but the simple answer is we're in the midst of transformation and transition. Our core products are later in their life cycle, and in decline, and our growth products haven't usurped them yet. But we are moving in the right direction.

Simon Leopold - Morgan, Keegan

Great. Thank you.

Tim Wiggins

By the way, Simon, check your math on that 20%. I think it's a lot closer to 10.

Simon Leopold - Morgan, Keegan

Okay. Will do.

Tim Wiggins

All right.

Operator

Your next question comes from Ehud Gelblum with J.P. Morgan.

Ehud Gelblum - J.P. Morgan

Hi. Thanks. A couple of questions. First of all, I appreciate the part of the explanation that you gave us on the gross margin for Q1. If I could just go over that again, I'm trying to understand why revenue is down so much. You basically said the 7100 is up, the ONTs are down. Managed access is sort of you said a wash, I assume relatively constant at that mid-to-high 60s number, and the 5500 up a little bit, lower BQE, it popped up out of nowhere, but that's not what is going to make it different. So are we down from 408 down into the mid-to-high 300s if – if you can help us with in terms of revenue mix. What really is falling off hard in Q1?

Tim Wiggins

When I was giving you the puts and takes, Ehud, it was around gross margin, but inside the 7100, 1600 wash is that the revenues will be up for 7100, but not as much as the ONTs are going to be down. So that's probably the biggest single mover down in Q1.

Ehud Gelblum - J.P. Morgan

Okay. And that takes us all the way down –

Tim Wiggins

Takes us a long way.

Ehud Gelblum - J.P. Morgan

Okay. Now, is that the secular decline. Do we have to get down to 360 from 408 and lose $40 million to $45 million? You said your fiber access for this quarter was 74% of your of your total access I calculate $73 million, so should we be looking for your fiber number to fall from $73ish million in Q4 down to something closer to $30 million?

Tim Wiggins

Well, I think what we want to say to you is that, you know, we're looking for a significant decline in the ONTs in Q1, and, the other businesses – I think the – and the other area I mentioned is that the BQE, which we had a big shipment of a Next-Gen product in 4Q will be down as well. I think the sum of those two describe most of the decline that we're seeing. There are other puts and takes, but that's largely what is happening.

Ehud Gelblum - J.P. Morgan

Okay. That's helpful. Now this decline in the ONT in the fiber business; is that something that is seasonal or cyclical, or is that what we what we have always been expecting, which is the Verizon move from BPON to GPON? Which means that once it moves to GPON it never comes back to BPON and so whatever mark we see in this fiber in Q1 basically becomes the new high and we keep either things flat or down from there going forward? Or is there any chance for it to bump back up again?

Rob Pullen

Well there's some chance for it to bump back up, Ehud. Its really – it will be in decline for the customers transitioning from BPON to GPON. At the same time they'll fill out all of their slots on BPON to deliver a great broadband service to the consumer. And so it will transition over time. Like I shared with you on the last call, you know, at least one of our top customers is already in transition from BPON to GPON.

Ehud Gelblum - J.P. Morgan

So it's not incorrect to take that down to a very, very low number over the course of the next year or two?

Rob Pullen

It will transition in its life cycle as the growth of the BPON declines over time.

Ehud Gelblum - J.P. Morgan

Okay.

Tim Wiggin

But – but very low number is probably not accurate. It is still meaningful revenue as we look out over '09, Ehud.

Ehud Gelblum - J.P. Morgan

Okay. Especially when you sum up the four quarters, understandable.

Tim Wiggins

Yes.

Ehud Gelblum - J.P. Morgan

Managed access was weak. It suddenly became strong out of nowhere earlier this year, and became a focus for you. Now it seems to be weak. What drove that in Q4? Is that – it sounded like you said it would be flat in Q1 at this new level? Does that pop back up again in Q2, Q3 or is that depending on carrier spending or does that go back down again kind of where it was in the 60s?

Rob Pullen

It will depend on carrier spending. We had a pop in 2Q and 3Q of '08, Ehud, dominantly in developed emerging countries, where it was – the mobile backhaul application, but it was over E1s over dense wave and the [SDH] environment. 4Q just saw a slight decline, and depending on carrier CapEx, could see another pop in '09 as well.

Ehud Gelblum - J.P. Morgan

So that we have to count on carrier CapEx popping up, otherwise it will probably stay in the 60s?

Tim Wiggins

Well, there are two things going on there. We have the 6300 which has a number of features that are very desirable for the mobile backhaul and has seen growth in 2008, and we would expect, depending on how things play out, we could see growth again in 2009. But also in that category is our 8100 managed access system which is I think like getting late in its life cycle and we have the 8600 as our Next-Gen product. So what you are seeing is growth in the 6300, and later life cycle behavior out of the 8100 and I think that would be the case again next year.

Rob Pullen

I agree.

Ehud Gelblum - J.P. Morgan

Okay. Two last quick questions. Would the BPON business continuing to decline, I haven't taken a look at the balance sheet on the book value but is there a need for another write down of the AFC goodwill? I actually haven't looked at it. I don't know how much is left. And the second is as you look at your carrier customers, have they given you a hint at all as to clearly they pulled off from spending at the end of 2008. Have they given you a hint as to they are going to start off slow, but if things stay stable, they will pick up their spending to the end of the year, or are they going to – have they said, look, this is our level that we are going to have for the whole year and maybe we'll look again at 2010 before we start spending again.

Tim Wiggins

Well let me just give you a bit of perspective, particularly on the ONTs, Ehud, that we saw strength in the ONTs through the back half of the year. In fact, you know, the third and fourth quarters were the highest two quarters of the year. So, you know, what we're seeing is that the product works very well for our customers, and there's a lot of our chassis and slots out there that are being deployed as we move in to 2009 and maybe this is 12 to 18 months behind some of their early speculation as that some of the GPON products are getting more traction, and we expect it overtime that this product would begin to decline and that's what we're seeing.

Rob Pullen

At the same time, we're having customers upgrade our current 1100 family to GPON, and the stimulus package could help us. But Tim, I think Ehud was asking about the balance sheet and as a risk of writing down any goodwill and the answer is no.

Tim Wiggins

No.

Ehud Gelblum - J.P. Morgan

Okay.

Tim Wiggins

The goodwill is gone for both our transport and broadband segments, and we carry about, a little over $100 million of goodwill that relates to our service segment.

Rob Pullen

And so, Ehud, there's no risk of us taking additional write down attributable to access. The second part of your question was customer feedback, and I tried to share some of that. We have had customer feedback vary, Ehud. On one hand in emerging countries, they have said I'm going to behave flat spending year-over-year, and the only impact will be foreign exchange monetary risk. The developed countries, particularly in North America, said I could be down 5% to 10%, and what I'm going to do is have cautious first half spending and see how the economy and consumer spending continues on, which I don't believe carriers are in as bad as shape as they were in the year 2001.

Ehud Gelblum - J.P. Morgan

Right. (inaudible). So what you are saying is – what they are saying is the first half less – is worse than 5% to 10%, and they are expecting to come back in the second half to end up at 5% to 10% for the year is that what you are saying.

Rob Pullen

No, I'm not saying that. I think its 5% to 10% for the whole year, and they are going to be cautious in the first half of the year.

Ehud Gelblum - J.P. Morgan

You mean less than 5% to 10%.

Rob Pullen

Including in developed countries here in North America that said in my optical networking, I'm going to spend similar as I did last year, and it will be front-end loaded. But the general sentiment – the general sentiment is they will be cautious in the first half of the year and wait to see what consumer spending will be for the second half.

Ehud Gelblum - J.P. Morgan

Okay. I will take that offline. You just sounded as though you are saying worse than 5% to 10% in the first half that's what the cautious is, but I'll take it offline. I appreciate it.

Rob Pullen

Thanks, Ehud.

Operator

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

Larry Harris - C.L. King

Yes. Thank you. I wanted to ask about the 7100. As I recall you indicated you anticipate a bounce back in revenues in the first half of 2009, and is that related to your traditional customer or customers, or do you anticipate additional shipments as a result of this new cable order, and is there a potential for orders from other cable customers?

Rob Pullen

It – we're trying to enhance our number of customers, Larry, which we – we have done that, and we'll continue to do that, all throughout '09, and so it will be a mix of growth on the embedded base as well as new customer growth. And, by the way, year-over-year, '08 to '09, we could see, you know, flat to slightly down in 7100 depending on what the spend is going to be.

Operator

Your next question comes from Scott Coleman with Morgan Stanley.

Scott Coleman - Morgan Stanley

Thanks and good morning. Just a couple of follow-ups here. Tim, first on gross margin, I think you called out 2.5 points this quarter on higher manufacturing costs. Could you give a little more detail there? And if you expect that to be repeated in Q1, and my assumption is that that comes off of the books as you go into Q1, and so you might get offset elsewhere.

Tim Wiggins

Yeah, Scott, it was really a combination of two things. It was manufacturing costs and lower contribution from our managed access, so you'll recall our managed access business in 4Q was down. In terms of manufacturing costs, it really centered around reserves for E&O and some – essentially warranty and royalty stuff. So it's peculiar to what we see in terms of our inventory position at the time, and I wouldn't expect them to continue, but they were things that we felt that were important to accrue at then of the year.

Scott Coleman - Morgan Stanley

And so then from a product-mix perspective, with transport up, the ONT business down, you make up that 2.5 points on product mix. Is that the expectation?

Tim Wiggins

Well, I think it's within the kind of the level of air, but what we're seeing in transport is, some strength are flat to some strength in the 5500, but we did have a very strong BQE in 4Q where we had significant shipments. So I think what we're trying to say is that, look for – to me from a gross margin standpoint, the 7100 and 1600 to wash from a margin standpoint. And the transport, the BQE and the 5500 is pretty much wash, and the managed access was kind of a wash, so I mean what we're saying is, when you look at 4Q to 1Q is that there's not a ton of movement, but I think within the balance of a point or two on any particular movement we'll have to wait and see. But when we take it all together and tell you what our best thinking is at this point, we're looking at a flat gross margin in Q1, and then we'll see what the mix actually comes in at, and that's why we give the plus or minus a point or two.

Scott Coleman - Morgan Stanley

Sounds good. And then you also talked about OpEx trends down over the course of the year from the Q1 levels. Where do you expect incremental savings or cost takeouts from [an incremental] perspective?

Tim Wiggins

I am sorry. Would you ask me again?

Scott Coleman - Morgan Stanley

Sure. I thought what you said in your prepared remarks Tim, is that you expect OpEx to trend down over the course of the year from Q1?

Tim Wiggins

Yeah.

Scott Coleman - Morgan Stanley

Where do you expect to be able your incremental costs down?

Tim Wiggins

Sure. Okay.

Scott Coleman - Morgan Stanley

And that was on a dollar basis if I remember.

Tim Wiggins

Yes. Scott what happens for us in Q1 is that we have -- Q1 is kind of a heavy spend for us in some of our areas. We have trade shows and some other expenses that tend to be lumped in Q1. So that's part of the challenge, and the second thing is we have some developments that will affect our parts and [pro-toes]. So I think what we're looking for is that we're going to continue to manage it very aggressively. We have given guidance in the past that we expect our $100 million plan to deliver about $75 million of savings to the OpEx line when compared to 2007 spend. And so that really points in the direction of $520 million OpEx, and that's the direction that we're taking. So we're going to continue to manage this. We'll get past some of the front-end loaded first quarter expenses. In addition we have some legal fees which we think will mitigate through the year. So I think we'll also continue to aggressively manage costs. We'll see how the year progresses to see how aggressive we have to be on that front.

Scott Coleman - Morgan Stanley

All right, guys, thank you very much.

Tim Wiggins

Thank you.

Operator

Thank you. At this time you have no further questions. Are there any closing remarks?

Rob Pullen

Yeah, I'll just summarize. Thanks everyone for participating this morning. Despite the economic headwinds at Tellabs we're focused on improving our profitability and of course our customers along the way. Our strategy is moving in the right direction, and paying off, and as I reflect back on my 10 months on the job, I think Tellabs is successfully executing in this tough environment. And so, again, we thank you for your support, and we'll look forward to communicating with you as the days and months go on. Thank you.

Operator

Thank you for participating in today's Tellabs investor relations call. You may now disconnect.

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Source: Tellabs, Inc. Q4 2008 Earnings Call Transcript
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