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Tellabs, Inc., (NASDAQ:TLAB)

Q2 2006 Earnings Conference Call

July 27, 2006, 8:30 a.m. EST

Executives:

Krish A. Prabhu, President and CEO

Timothy J. Wiggins, Executive Vice President and CFO

Tom Scottino, Investor Relations

Analysts:

Michael Genevieve, Citigroup

George Notter, Jefferies & Co

John Anthony, Cowen & Co

Markus Coopersmith, Lehman Brothers

Ehud Gelblum, JP Morgan

Tim Daubenspeck, Pacific Crest Securities

Kenneth Muth, Robert W. Baird

Operator

Good morning, my name is Constance and I will be your conference operator today. At this time, I would like to welcome everyone to the Tellabs Investor Relations Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks there will be a question and answer session. If you would like to ask a question during this time, simply press * then the number 1 on you telephone keypad. If you would like to withdraw your question, press the # key. Thank you. Mr. Scottino, Sr. Manager of Investor Relations, you may begin your conference.

Tom Scottino, Investor Relations

Thank you Constance and good morning everyone. With me today are Tellabs’ President and CEO, Krish Prabhu; and our CFO, Tim Wiggins. If you haven’t seen the news release we issued this morning, you can access it at tellabs.com.

Before we begin, I will remind you that certain statements made on the call today maybe considered forward looking. I direct you to the risk factors contained in today’s news release and in the reports filed by Tellabs with the Securities and Exchange Commission. At the same time we will be presenting GAAP and non-GAAP financial information this morning, a complete reconciliation of that information can be found in today’s news release. Okay, I’ll turn it over to Krish now.

Krish A. Prabhu, President and CEO

Thanks Tom. Good morning everyone, welcome to our earnings call. We had a really good quarter, strong revenues, strong earnings. Tim Wiggins will give you details. We do report as you know from the start of this year in two segments where you give you segment profit, which is gross margin minus R&D, and we also give you revenue in multiple product lines just so that you can track what the growth or the changes have been year on year.

As I look at the first half the thing that I’m proudest about is the fact that our operating income through the first two quarters is nearly $192 million, and if you compare that with the first half of 2005 it was $81 million. So, we more than doubled the operating income at a time when we’ve tried to get into a highly priced competitive market, Fiber Access, which has year on year been growing very strongly. I’m very pleased that the revenue and the operating income are both simultaneously up. Our margins are holding steady as Tim will walk you through it, and of course for several quarters now we’ve held our OpEx within a very tight range and that continues in this quarter. From an operating income standpoint, it is our best quarter in five years. I’ve got to back to the first quarter of ’01 before the bubble burst when we had this level of operating income.

Cross-Connect and Fiber Access sales were strong. Our customers are spending for network upgrades that they need so that they position themselves for both broadband fixed and mobile services, and we are benefiting from that. I will not get into a lot of commentary on the numbers; Tim has a pretty comprehensive presentation, he’ll come back and answer that in more detail, but I’ll take about 5 minutes to address a few topics that consistently keep coming up in some of the reports that we see from analysts or some of the questions that we get directly, and I felt it was important that we address them on this call.

The first one is about our Cross-Connect sales, the question keeps up coming up, “are the Cross-Connect sales sustainable?” We have done a very detailed analysis about our T1 equivalent lines shipped, which is a strong measure of what’s happening to the T1 network out there both on the fixed and the mobile side and how it is growing as traffic continues to grow in the T1 network. Going back to the first quarter of ’03 and plodding it forward to date, we’ve seen that Cross-Connects have been sold into three segments -- wireless carriers, regional bell operating companies, and other local exchange carriers.

The amount of T1 equivalents shipped into other local exchange carriers has been steady; no decline but flat and very little growth. The amount of T1 equivalents shipped to RBOCs going back to the first quarter of ’03 has been steady, a very slight growth but nothing significant or appreciable. The amount of T1 equivalents shipped into the wireless segment has very closely tracked the wireless network minutes of usage that the CPIA publishes every year. You may recall that between 2003 and 2006 the minutes of use is expected to go from 800 billion minutes to 1.6 trillion minutes in the U.S., and of course our T1 equivalents shipped over that period has doubled tracking that very closely.

In projecting this forward, as we look at what we can expect in ’07 and ’08 as we study how many T1 lines go to the various base station sites, how many of them are copper, how many of them are fiber connected, we feel fairly confident at this time that the continued strength in Cross-Connects will last at least for a couple of years and possibly into 2009. Of course, I make this statement based on the study we’ve done and there can always be something that comes in from a field that we didn’t look at, but considering that this is a very big network, this network continues to accommodate all the minutes of use, the T1 equivalents continue to grow at a steady rate, we feel fairly confident that our Cross-Connect sales are sustainable for several quarters looking into the next few years.

We are working very closely with our customers to understand the TDM to Ethernet migration. We think mobile voice will shift to Voice-over-IP over the next few years and we have a family of products, the 8600, the 8800 plus an alliance with suppliers who have Ethernet aggregation products, and we feel confident that we will be able to ride the technology transition from TDM to Ethernet.

Let me switch to the next topic of interest, which is fiber-op Access, especially the BPON to GPON conversion that people have talked about. We did ship a record number of ONTs this past quarter. Our BPON platform is very solid, wide reaching. We are in hundreds of central offices with our primary customer and we believe that this network will continue to expand especially if our customer has plans to continue to reach out to more of their customers. We feel we will benefit from this very well next year.

We have a very competitive GPON product as you know. We chose to go to a next generation architecture which looks at GPON not just as an aggregation node but also as a service node. As part of the service node we’ve introduce Layer2, Layer 3 capabilities in the GPON OLT. We have done preliminary lab testing in our lab with our primary customer. We have bid this particular product in their pending RSP. We are fairly confident that the customer has endorsed the architecture, and it’s being said that there would be an announcement soon and we feel confident that we will be in a position to be a GPON supplier to our customer as they look at BPON to GPON over the next several years. Our GPON product is ready for customer lab testing in the fourth quarter of this year and pending successful lab tests it would be ready for field deployment sometime in 2007.

Let me talk about another topic, this is the next-generation optical transport platforms. We have announced a win with Verizon last week for our ROADM Optical Transport Platform. We are very confident that this platform is an industry leading platform. Our understanding is that SONNET/SDH networks have a problem with handling video, especially video in the form of Ethernet transport, and as you all know the primary mode of transport for video in public networks is going to be Ethernet. ROADM is the right architecture. It accommodates not only the growth in bandwidth that is needed for video but also the ability to simultaneously transport SONNET as well as Ethernet broadband signals on the same fiber. With this win at Verizon, we are engaged in very elaborate, extensive, several hundreds of miles spanning networks. We have two FOAs that will complete this year, and pending successful completion of these FOAs we expect sales ramp up that will kick off here in 2007, especially if the customer continues to advance their transport network per their announced plans.

Let me talk a little bit about data traction, which has been another question that has come up. Year-on-year through the first half, the growth in our data business, which is our 8600 and our 8800 family of products, has been three times what it was last year. We have had several new customers and new applications. The primary application that seems to be particularly hot this year is Wireless Backhaul. We now have nearly 30 networks; half a dozen of them are with Tier 1 customers. Traditionally, the third quarter and fourth quarter have been stronger for us over the last two years, so we do expect a pretty robust data business for the second half of the year.

Lastly, I want to address two more topics quickly and I’ll hand it over to Tim. One, in terms of guidance over the last several quarters you will agree with me that we’ve been pretty good on guidance, sometimes conservative as some of you have pointed out and have delivered at or above guidance. I think it is better in terms of hitting our guidance. We continue to look at all factors that tell us what the plot is going to shape up like. We look at backlog, we look at book to bill, we look at accuracy of converting letters of intent, we look at completion of tests especially for new opportunities because we have pretty rigid revenue recognition that’s tied to success with test completion, etc. So, as we look at the third quarter, we do have a couple of items, especially in our Fiber Access area that would mean that our guidance range would be broader than normal. This is specially tied to two particular things. In the FTTP areas as our customer ramps up, as they look at their customer take rates, we will have to watch how their inventories grow and how their inventories are exhausted, so that may have an impact on our ONT sales in the third quarter.

Our FTTC program with another large RBOC, the timing of their capital expenditures maybe dependent on the pending merger that they have with another RBOC. As you recall, whenever RBOCs go through mergers capital expenditure is always a constraint and only what is needed is procured.

Lastly, in consolidation, our acquisition and merger strategy has been to make us more strategic with our key customers and that was what led to the AFC acquisition back in 2004. We will continue to do that as we look at other opportunities for us to be more strategic with our key customers.

For the time being we feel very confident that the waves of network upgrades, largely driven by MPLS, by ROADM, our optical transport platform, and by FTTX will more or less replace the waves that we saw in the 90’s, the ATM, BSPH, and the DSL and we feel very confident that we have the right platforms, the right customer relationships, the right incumbency position to be able to ride out these waves. We also recognize that our domestic sales continue to grow at a rate faster than our international sales and we continue to work with international partners to see if we can find more channel opportunities to sell these key next-generation platforms internationally.

We are not opposed to consolidation or merger with a bigger player, nor are we opposed to consolidation or merger with another like sized player, but we are not looking to do consolidation so that the synergies extracted can exceed our combined operating profits. Our operating profit is very healthy. We have, as I pointed out, are now at almost 19% of revenue for our operating profit and we have 3700 employees, the best in the business; any consolidation or merger that we do will really be driven by our need to be more strategic with our key customers.

With that I will hand it over to Tim Wiggins, our CFO, and I’ll come back to answer some of your questions.

Timothy J. Wiggins, Executive Vice President and CFO

Thanks Krish and good morning everyone. Let’s take a look at the numbers. Total revenue for the quarter was $549 million; that’s up a robust 19% compared with $463 million in the second quarter of 2005 and slightly higher than the guidance we provided in our April earnings call. Broad customer demands drove strong revenue growth across our transport, broadband, and services segments. The revenue momentum and our continuing focus on reducing operating expenses produced $103 million in non-GAAP operating income. That’s almost 19% of revenue, up from 17% in the first quarter of this year and 13% in the second quarter of last year. On a geographic basis, the second quarter revenues from customers in North America amounted to 77% of the total; that’s versus 74% in the second quarter of 2005.

Looking at the individual product segments, revenue for the transport product segment of the second quarter of 2006 amounted to $202 million. That’s up 19% from $170 million in the second quarter of 2005. Within the transport product segment, wireless continues to be the prominent driver. For the quarter, North American wireless customers accounted for approximately 63% of all transport products segment revenue, compared with 66% in the first quarter of 2006 and 55% in the second quarter of 2005.

Looking at the Tellabs 5500 Wideband Cross-Connect business specifically, we shipped approximately 2.7 million T1 equivalents in the second quarter of 2006, compared with 2.8 million in the first quarter of 2006. About 70% of this quarter’s 5500 system revenue came from port card growth on our install base with the balance of 30% consisting of new systems, systems expansions, and software upgrades. That’s consistent with the first quarter 2006 levels and can be compared with 66% in the second quarter of 2005. At the end of quarter the percentage of open card slots on our install base was in the low 20’s range. That’s consistent with the percentage of open card slots at the end of the second quarter of 2005.

Segment profit for transport products was $112 million, up from $74 million in the second quarter of 2005. The increase is primarily due to higher revenue levels, improved gross profit margins, and flat R&D expenses.

Turning to the broadband product segment, the broadband products segment includes our Managed Access and data products. Overall revenue for this segment was $298 million, up 21% from $248 million in the second quarter of 2005. Revenue from our Access products amounted to $190 million, which is up 32% when compared with $143 million we recorded in the second quarter of 2005. We estimate that sales of fiber platforms, both FTTP and FTTC, amounted to 58% of Access product revenue in the quarter with the balance being copper Access platforms. This compares with 56% in the first quarter of 2006 and 49% in the second quarter of 2005. When you do the math, you’ll see that sequential and year-over-year revenue improvements for both our fiber and copper Access products. On the fiber side, we see continue ramp up of sales of single family ONTs. Our copper business saw strength related to DSL build outs.

Revenue for Managed Access products came in at $86 million compared with $96 million in the second quarter of 2005. We saw a strong 17% sequential increase from the first quarter ’06 to the second quarter’06 driven by increase Tellabs 6300 and 8100 product revenue. The year-over-year decline is related to reduced Tellabs’ 2300 and 8100 product revenues.

The Tellabs’ 8800 Multi-Service Router Series and the Tellabs’ 8600 Managed Edge System make up our data category. For the quarter, revenue from data was $22 million. That’s up from $9 million in the second quarter of 2005. Year-to-date data revenue was at $44 million compared to $50 million in the fist half of ’05. Segment profits for broadband products were $38 million in the second quarter versus $37 million in the second quarter of 2005. Cost reduction on our ONT product were offset by slightly less favorable product mix and increased R&D expenses related to new product development.

For the second quarter of 2006 services segment revenue was $49 million, up 8% from the second quarter of 2005. Services segment profit was about $19 million in the second quarter. That’s up 27% compared with $15 million in the second quarter of 2005. The increase here is driven largely by higher revenue and a more favorable mix of services delivered.

Turning to overall profitability, on a GAAP basis net income for the second quarter amounted to $54 million or $0.12 per share. That’s up 30% from GAAP net income of $41 million or $0.09 per share in the second quarter of 2005. Our non-GAAP net income for the second quarter of 2006 amounted to $73 million or $0.16 per share on a fully diluted basis. That’s a 20% year-on-year increase when compared with non-GAAP net income of $58 million or $0.13 per share in the second quarter of last year.

The year-over-year net income comparisons are affected by changes in our tax provision. As you may recall, in the second quarter of 2005 we had operating loss carry forwards that resulted in a 14.6 effective tax rate. For the second quarter of 2006 our effective tax rate without the benefit of operating loss carry forwards that sheltered us from tax on domestic income stood at 34.2%.

Looking at non-GAAP operating income line gives you another view of how the business performed. As I mentioned at the top of the call, for the second quarter of 2006, non-GAAP operating income was $103 million or almost 19% of revenue, up from $59 million or 13% of revenue in the second quarter of 2005. As Krish mentioned, that’s our highest level of non-GAAP operating income since the first quarter of 2001 just before the industry turned down.

For the first six months of 2006 non-GAAP operating income was $192 million, more than double the $87 million we had in the first half of ’05. Turning back to net income, our non-GAAP net income calculation is adjusted to exclude the relative stock compensation and amortization and purchase intangibles, restructuring charges, write down of a long-term equity investment and stock option expense. The restructuring charge, which amounts to $2 million, is being taken in connection with the workforce reduction we initiated during the quarter. You can expect another $10 million to $12 million of additional charges related to this restructuring in the back half of the year. The bulk of those charges which are related to exiting leased facilities will hit in the fourth quarter.

The effect of stock option expense in the second quarter was $11.5 million. This reduces our non-GAAP EPS by $0.017. That way of looking at things is consistent with the way Firstcall and Writers compile mean EPS estimates for Tellabs. As usual, you’ll find a complete reconciliation of our GAAP and non-GAAP results in this morning’s press release.

Non-GAAP gross profit at 46.6% was within the guidance we provided in April and compares with 47.3% in the first quarter of 2006 and 44.8% in the second quarter of 2005. As you know, our gross profit margin is dependent on customer and product mix, which was responsible for the shift between the first quarter and second quarter. Contributing to the shift was a higher volume of Access products which resulted in about 1.5 of decline, which was partially offset by just about 0.75 worth of improvement coming from services margin. Looking forward to the third quarter, our gross profit margin guidance is the same as it was in the second quarter, in the range between 46% and 47%, of course depending on products and services mix.

Turning to operating expenses, non-GAAP operating expenses came in at $153 million or just less than 28% of revenue. That’s consistent with our guidance and compares with $148 million in the second quarter of 2005 when operating expenses amounted to 32% of revenue. For the quarter, R&D expenses came in at $86 million and SG&A expenses were $67 million. At $86 million R&D equals less than 16% of revenue. That compares with the second quarter of 2005 when R&D expenses were $80 million or just more than 17% of revenue.

For the third quarter 2006, we’re looking for non-GAAP OpEx to be flat to slightly down, consistent with our targets to have quarterly operating expenses trend modestly down through the course of ‘06. In the third quarter, we expect that the effect of expensing equity based compensation will be approximately $11 million, split between operating expenses and cost of goods sold.

Other income on a non-GAAP basis amounted to $9 million versus $12 million in the first quarter of ’06. The decline here was related to foreign exchange losses experienced during the quarter. Our tax provision, our non-GAAP pretax income for the quarter was $38 million for an effective tax rate of 34.2%. This is slightly below our guidance due to changes in our state tax estimates and an increase in non-taxable investment income. For the balance of ’06, we expect our annual tax rate to be approximately 35%.

Looking at the balance sheet, day sales outstanding was 62 days, down slightly from 64 days in the first quarter, our inventory terms were 9 times versus 9.4 in the first quarter 2005, and inventory in terms of dollars increased to $140 million from $124 million in the first quarter of 2006. CapEx during the quarter was $22 million compared with $13 million in the first quarter of this year. The increase here is primarily related to equipment for new product development and cost related to R&D facility enhancements.

During the quarter, we purchased 2.5 million shares of our stock for $37 million. At quarter’s end, the actual number of shares outstanding was $448 million, essentially the same as the first quarter.

At the end of the quarter, our cash and investment balance stood at $1.280 billion, that’s up $73 million from the first quarter. This increase was largely driven by strong cash flow provided by operations of $107 million, which was offset by the cash used to repurchase our shares during the quarter. Head count at the end of the quarter stood at approximately 3700, consistent with the end of the first quarter, and our book to bill was less than 1.

As Krish mentioned at the top of the call, as we look forward to the third quarter, we expect the growth momentum we’ve been experiencing to continue, albeit at a somewhat slower rate. Looking at backlog which has returned to more historically normal levels, early third quarter order rates, uncertainty about the timing of capital spending at Bellsouth prior to its merger, and some indications of key customers selectively managing inventories contributes to a lower level of visibility than we’ve had in prior quarters. As a result, we are providing a somewhat wider range for revenue guidance. For the third quarter, we expect revenues to be up between 10% and 15% of our third quarter revenue in ’05. That would put the third quarter ’06 revenue in the range of $510 million and $535 million.

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

Question-and-Answer Session

Operator

At this time, I would like to remind everyone, if you would like to ask a question, please press * then the number 1 on your telephone keypad. We’ll pause for just a moment to compile the Q&A roster. Your first question comes from Michael Genevieve of Citigroup.

Michael Genevieve, Citigroup

Thanks a lot. I just wanted to touch on BellSouth, you talk about the uncertainty of timing related to the consolidation, are you fairly confident that you’re going to remain the key vendor for the Fiber-To-The-Curb sales once the merger there is closed, or is there a possibility that that could change going forward?

Krish A. Prabhu, President and CEO

Mike, thanks for the question. We have touched base with all the contacts that AT&T as well as BellSouth with their technical staff. The sense we get is that — again I want to be very clear I’m not speaking for our customer, I’m just giving you my personal opinion, and it maybe biased — the sense we get is that Fiber Access architectures at least over the next several years, maybe two, three, four, five years, will be quite regional; meaning, if in certain parts of their broad network they’ve been using broadband copper for broadband service, BSL or DSL extensions, in certain parts if they are using FTTN and in certain parts they are using FTTC, and if they want to launch FTTP, all these options will prevail especially where they’ve got some current momentum. Coming to BellSouth, our FTTC platform, we have deployed 1.5 million lines, we have worked with the customer to transition some of the earlier lines from competitive broadband service to full IPTV service, which essentially means we go from 8 meg to a home to 80 meg to a home. We have plans for upgrades. We have bits in proposals in parts of the network where these upgrades will be kicked off. We’ve also shown them how the current platform supports FTTP. We have a roadmap commitment to get that to BellSouth. So, we are certainly acting on the premise that for the next several years, at least in the BellSouth part of AT&T, this in platforms will continue to thrive. We also hope to be able to convince the non-BellSouth part of AT&T that this is a very competitive architecture at 1.5 million lines deployed, the economics are well understood and that our R&D commitments will give them significant payoffs as they try to get 80 meg to every home and provide a wide range of services. Just to be clear, the guidance that we provided for third quarter is not influenced by any of this, because these are all issues that will come into play if they do in outer years. The guidance that we provided is largely driven by looking at last year at this quarter when we had historically high levels because of hurricane activity and because of the start that BellSouth was hitting in the fiber rollouts, and this year same time I think BellSouth is being cautious in their CapEx spending, which Ameritech did and which Pacific Telesys did before they were acquired by AT&T, and that was our point that the guidance is somewhat hazy because we don’t really have better visibility into the BellSouth deployment plans for this quarter.

Michael Genevieve, Citigroup

Thanks for that detail. One quick followup; with Verizon right now clearly you’re the primary vendor. They do have a secondary vendor name but it seems like you’re getting the vast majority of the business, any thoughts you can give us on the expectations for GPON, do you think that they will choose two vendors, three vendors; what do you think the mix will be between a primary and a secondary there?

Krish A. Prabhu, President and CEO

I can’t comment for our customer and I don’t know what they will do frankly. We’ve put our best foot forward. We’ve done very well, we’ve earned the primary vendor status at Verizon through execution, and we understand their fiber rollout. We have a very comprehensive product portfolio for the home. We solved and we continue to solve a lot of issues that are related to labor, deployment, turn up of service, provisioning, and all that plays out when you transition the PON protocol from BPON to GPON. At the end of the day the transition from BPON to GPON is just a change in PON protocol so that you can get more bandwidth to the homes on the same fiber network. So, I feel very confident at this time that we will be a supplier as they transition from BPON to GPON. I also feel very confident that BPON momentum will accelerate next year, but these are questions that our customer must essentially answer, and I for one don’t want to answer on their behalf.

Michael Genevieve, Citigroup

Thanks, Krish.

Operator

Your next question comes from George Notter of Jefferies.

George Notter, Jefferies & Co

Hi, thanks very much guys. I heard your commentary on the long run outlook on the 5500 Cross-Connect business earlier in the monologue and certainly understand the comments about the growth in that business historically kind of matching growth in wireless minutes of use. But, for the wireless piece of your business it seems that I really took at huge step function up in the first quarter; I think we calculated about 49% sequential growth in T1 equivalents in the first quarter versus prior fourth quarter and now here you are again in the second quarter at about the same level, 2.7 million T1 equivalents. Certainly that trajectory in the wireless piece of your business I guess would not match the trajectory of minutes of use growth that we’ve seen going from last year into this year, so I would imagine that 3G deployment kind of played in there. The question here, how do you reconcile the performance of your business from last year to this year, the fourth quarter to the first quarter into the second quarter, what you’re seeing in wireless demand trends in 3G and what is that boat for the outlook of the business going forward?

Krish A. Prabhu, President and CEO

Okay, George. The fourth quarter was 1.9 million T1 equivalents, first quarter was 2.8 million, and the second quarter was 2.7 million. So, I would characterize it as a step function but not a ramp. So, we’re not growing sequentially but I guess you’re right, prior to this year, last year, going back another quarter, the third quarter was 1.7 million and the second quarter of ’05 was 1.9 million. So, we were at the 1.7 million to 1.9 million range, we stepped up to 2.7 million to 2.8 million range when we went into ’06. I think we explained this on the last call, on the last monologue, we explained it as print coming back this year and doing significant build out, and that’s out explanation of the step part of that function. But when we go back and look at he trend lines, the trend line going back to the first quarter ’03, just to give you a sense, in the first quarter ’03 we were shipping less to the wireless account T1 equivalent than to the RBOCs. And in the second quarter of ’05, the last quarter, we shipped three times as much into the wireless accounts as we shipped to the RBOCs, and the RBOCs have held steady but slightly ground and these are all T1 equivalents, so we are not playing with numbers of revenue. Whereas the wireless continues to go on this ramp, there was this slow step function…step function is largely Spring Nextel coming back after they hadn’t spent much in the second half of last year.

George Notter, Jefferies & Co

Got it, thanks.

Operator

Your next question comes from John Anthony of Cowen & Company.

John Anthony, Cowen & Co

Good morning guys, a few questions. One, could you just kind of give us the sense and update us on the 612; I apologize if that’s already been asked.

Krish A. Prabhu, President and CEO

The 612 is an ONT that has MoCA, Multimedia over Cable. MoCA allows the operator to come near the fiber at the site of the home, take the data signal — not the video, we’re talking about the data part of the signal — and send it over existing co-apps in the home to the computer or the router that sits next to the computer. So, this saves them in terms of labor in the home. We have this product going through on acceptance test that the customer may have already completed testing and we are scheduled to ship quantities of this product in the fourth quarter. Again, it all depends on when the customer orders and when they start their rollout and it’s tied to their operational procedures for deployment of this type of ONT. But if things go per plan, we will see sizeable 612 shipments in the fourth quarter of ’06.

John Anthony, Cowen & Co

And do you still expect the 612 margins to be better than the 611 margins?

Krish A. Prabhu, President and CEO

Well, there were two things to the 612 -- one was margin improvement which was planned, and then the other thing was capability improvement, which is the MoCA that I just explained. We will have to look at the margins more carefully because we have negotiated a slightly different pricing structure with the customer.

John Anthony, Cowen & Co

Okay, and on the 8800 business, you said that you’re expected to ramp in the back half, is that relative to new customers or is that relative to existing customer programs that are just increasing themselves?

Krish A. Prabhu, President and CEO

A combination of both. We have some shipped to a new customer for an application and our revenue recognition prevents us from recognizing until we get the customer’s final acceptance. If we get that we will have one sizeable new customer, a Tier 1 customer, with one sizeable deployment here in the third quarter or the fourth quarter. Existing customers, Tier 1s, continue to buy. We have announced NTT Verizon, we have a major Tier 1 in Europe that we sell through a channel partner, we have Vodacom, and these continue to deploy, so I expect that to happen also. As well as, we have a large wireless carrier in the U.S. who has done significant deployment in the first half of this year and I think that will continue in the second half.

John Anthony, Cowen & Co

Okay, and lastly, on the 7100 can you give us a sense how that market is evolving right now? Do you see other domestic carriers adopting that type of platform quickly or is this something where it’s going to be Verizon and it’s going to take a while before other customers come on quickly?

Krish A. Prabhu, President and CEO

Our premise in launching the 7100 and repositioning the 7100 over the last two years; the 7100 started as a metro DWDM product and as you know there were quite a few in the race at various times, ONI, Ciena, Lucent, Nortel. We kind of launched a next-generation effort because we felt that it was not just about DWDM in the metro but we felt it also had to handle Ethernet in a more efficient way, because SONNET has a basic limitation in the way kind of Ethernet and we also felt that it may have to do some select MPLS grooming capability on the line card, especially if you have a lot of video signals that come in and need guaranteed circuit like transport capabilities end-to-end so that you don’t run into service delays. So, our architecture has been endorsed by Verizon, we’re very happy about the win that we announced. Verizon we feel is ready as they launch they video effort; I think that’s what the press release said. As they launched, they are ready to roll out a lot of video transport in their core and regional networks and it’s going to be on this platform, but this platform can also be a platform that taps SONNET without giving up any capabilities and gives you a chance to get bandwidth gain through DWDM. I think it’s a really slick NextGen transport architecture and I really believe the opportunity is for all existing SONNET/SDH networks to find a way to grow to NextGen transport using a platform of this type without having to retire their existing SONNET/SDH networks, because we do have a SONNET blade that does a full ADM on a card. So, I’m very bullish about it. We’ve been selling it to other large U.S. carriers and because of customer consolidation we do have a strong network of nearly 1000 nodes in BellSouth, but it primarily includes AT&T, Quest, Sprint, so there’s a small list of carriers in the U.S. who would find this kind of an optical transport platform as part of their network upgrade plans, but I think the platform is truly global. It can go even into an existing SDH network, because all you have to do is develop and SDH blade and you get all the capabilities. So, I’m very bullish. Again, like I said that’s a personal opinion and we certainly will work very hard to make sure that it gets its maximum channeled reach through channel partners and others outside the U.S.

John Anthony, Cowen & Co

Great, thanks guys.

Operator

Your next question comes from Markus Coopersmith of Lehman Brothers.

Markus Coopersmith, Lehman Brothers

Hey, good morning everyone. I wanted to kind of spend a couple of minutes just going over the Cross-Connect. One of the things that I spent a lot of time talking to my clients about is the increase this year and how much that has to with potential integration of some of the mergers we’ve seen — well maybe that’s not necessarily a function of specifically MOU growth but maybe migrating base stations around from one area to another, just adding some extra coverage. Could you maybe help us understand if you think that is a meaningful driver in the business and how you think the outlook for that is?

Krish A. Prabhu, President and CEO

That’s a good question and this question has been coming on as you know over the last two to three years, and we’ve talked about middle innings, thirdly innings, late innings, over time, extra innings, but one of the questions we answered and it was a very comprehensive study because we looked at what we shipped to all the customers over the last three years was the close tracking of the T1 equivalents shipped, 2 minutes of use, and of course there have been spikes as George pointed out in his question, we did have a step function and the cause of that was really Sprint. So, there have been a few of those. AT&T Wireless, Cingular before their merger suppressed some expenditure and of course Verizon Wireless had a big spike when they launched their 3G back in ’04. We have never studied network consolidation for spectrum, moving base stations around in more detail or at the second level of detail. We do feel fairly confident that given the 1990 product where some people have talked about as high as 95%, some have said 85% of the 200,000 base station sites in the U.S. — and by the way this is just a U.S. product, we don’t sell this product outside the U.S. — the 200,000 base stations given that 90% of them are connected by copper, and once you say copper most of the technologies are T1 based even if it is copper Ethernet through inverse multiplexing. We feel fairly confident that even if they do base station consolidation, in terms of backhaul there is a significant opportunity especially if they launch data services — and by the way the CTIA data suggested only 6% of current revenue is derived from NextGen data services, so we still have a lot of head room for growth — we feel fairly confident that T1 equivalent build is largely driven still by basic backhaul needs. I don’t think base station consolidation is going to have a big impact, but let me ask our experts to take a look at it and maybe on the next call we’ll probably have a better answer to your question.

Mark Coppersmith, Lehman Brothers

Just to kind of wrap that up, you have one of your bigger customers saying they’re cutting capital spending materially next year because of less integration of the AT&T Wireless Cingular merger and maybe less rebuilding in the West Coast where they had a JV. You’re not specifically reading into that as saying that there’s a bunch of extra T1 capacity being shipped to support that, which is disappearing next year?

Krish A. Prabhu, President and CEO

I don’t think it is T1, I really don’t. I think spectrum consolidation I think they were looking at radio access in more detail, they maybe looking at circuit switch capacity, but T1 growth going forward, even in a consolidated network, will be propelled by data service growth. And we’ve had a look even at some of the more aggressive wireless customers who launched their 3G almost two years ago. We’ve gone and looked at how many T1s we have reaching to their base stations and in most cases it’s two or three. It’s not seven or ten T1s per base station that we thought a normal-sized 3G deployment would need for data services. This particular customer that you referred to, yes, I think that they have done a lot of network consolidation, they’ve moved spectrum around, and they continued to buy Cross-Connects at a pretty good clip in the first half. I’ve read that they will spend much less next year. It may affect us, it’s too early to tell, but we also have other opportunities coming up because you do have other wireless operators who are awaiting more spectrum awards in August and September and who will be more aggressive in their build out. So, being very well positioned in all four wireless operators in the U.S., we feel fairly confident that the Cross-Connect business has legs at least for the next two or two and half years.

Mark Coppersmith, Lehman Brothers

Okay, thanks very much.

Operator

Your next question comes from Ehud Gelblum, JP Morgan.

Ehud Gelblum, JP Morgan

Thank you. I had a couple of questions if I could. The first one was trying to get a little handle on the components for your new guidance. I understand the size of the range I fell are largely due to the topics that you talked about, but if we look at it from a sequential basis, from the revenue that you gave this quarter, are you expect the transport side to decline some, is it more the data side, is it more the 8800, is it more on the fiber of the node or the copper of it that seemed to do very well this quarter? Can you give us a little bit of a sense on a sequential basis as to whether the drivers are particularly midpoint versus where we are now, not the range but the midpoint of the guidance versus the second quarter results that you had?

Krish A. Prabhu, President and CEO

Okay, Ehud, we don’t like to go down into great detail, because smart guys like you will not stop at one level of detail and will get down to the next detail, but I will give you more color because these are unusual times. We have lots of our competitors and fellow suppliers give you confused information on guidance or at least disappoint on guidance, and in the spirit of being completely transparent without getting into a level of detail that we don’t want to get into I will give you more guidance. If you look at the second quarter to third quarter in ’05 we were essentially flat, but you have to factor out of that that second quarter to three quarter flatness for last year about $13 million of sales of passthrough equipment, primarily harmonic. We don’t have that this year, so right after that if you say “Okay, the second quarter to the third quarter ought to be flat year on year,” you would expect $545 million to $549 million revenue for the third quarter, but right after take the $13 million to $15 million Op which was primarily harmonic from last year and so you’ve come to the upper end of our range, which is $530 million. In that is factored the fact that Managed Access business, our data business, our Cross-Connect business will all hold steady; year on year they showed an 18% to 19% growth, and that was an aggregate growth, and that the ONTs and the Fiber Access that we shipped into BellSouth will hold steady. In looking at what’s happening in terms of ONT deployment, considering that we shipped a lot number of ONTs in the second quarter and personally having looked through the early days of DSL with another supplier, I do know there are ups and downs especially as they manage their warehouse inventory when it comes to customer premise equipment. We feel it’s a little too aggressive to tell you that the ONTs will continue at the same place as they did in the second quarter. So, you factor out the risk in ONTs and you factor out the market risk — last year BellSouth was hitting stride as I said, they were very happy with what we had done for them in the first half, they were getting ready for the hurricane season, they launched for accelerated deployment because they had suppressed their spending in ’04 awaiting AFC’s acquisition with Tellabs — this year we think the situation is a little bit different at BellSouth and that is largely related to the fact that they are going through a spending merger and in every spending merger that I’ve seen before there are incentives to rein in capital expenditures. So, we do believe that they will spend because Access doesn’t stop, you have to keep spending because the economy continues and you have new lines to sell, etc. etc., but we also believe that it would be risky to factor in the same level of access deployment as what we saw historically. If you take those two elements out that largely brings you from $530 million down to $515 million, and that’s really the gist of the guidance we are giving you at this time.

Ehud Gelblum, JP Morgan

That’s very helpful. Was there some Katrina build this quarter that may also fall out and is BellSouth…those positions and what’s happening with FTTC BellSouth or has BellSouth actually began cautioning on what they are spending might look like in the second half?

Krish A. Prabhu, President and CEO

Unfortunately, we don’t get the same level of guidance that you get from our customers. So, we have looked at historic trend patterns at least in the first and the second quarter. Let me answer the first question first. The Katrina build largely we shipped product to a third party, a minority bar, who then does the warehousing and the distribution that goes into BellSouth, and we’ve looked at inventory levels at that bar and I think the first and the second quarter whatever Katrina rebuild was there was pulled from that. Will there be more rebuild, are people returning to New Orleans, is the rebuild over? I have no idea and I just look at the inventory levels at our bar are, I look at the direct orders from our customers, and I look at the trend over the last four to five months, and we’ve exercised a little caution as we go into the third quarter, but I must say the third quarter historically is a strong quarter for Access; it has been for AFC. We do see growth in BSL plugs on the copper side and I think that’s why our copper content has stayed strong. All the reports that said that we would lose key customers in IOCs and the copper business is going to go down have been proven somewhat excessive in my opinion, because the copper business continues to hum along and a lot of it is BSL plugs going in and also some new platforms. We are working very hard to convert those platforms into our NextGen Access platform, which is primarily the Access platform that we ship into BellSouth today with the Multi-Serviced Access platform.

Ehud Gelblum, JP Morgan

Very helpful; one last thing if I could. You mentioned the modified pricing structure you have with your Fiber-To-The-Trend customer, how did that come about, was that in relation to your negotiations for the next-generation GPON, can we read into that the fact that you actually the modified pricing structure means that you will be part of the next-generation GPON, how did you get into that contract?

Krish A. Prabhu, President and CEO

You’ve asked all the questions and you’ve also answered all the questions. I don’t know if I can amplify that or add anything else to it. It’s a very competitive world out there, other suppliers who are not part of BPON are working very hard to get in, we expect the prices to come down, we think this is what it takes to be in the major league and play with the big boys. So, we’ve done what is necessary to make sure that we are a key supplier in the GPON race, and I feel that our customer will do an announcement as to who they’ve picked very soon, so hopefully all these questions will be answered. But, the answer to your question about modified BPON pricing is a part of being competitive especially as they look at GPON technology pricing and they look at BPON and how do they transition from BPON to GPON, and we’ve done everything to make sure that we continue to have the momentum that we have worked so hard for through ’05.

Ehud Gelblum, JP Morgan

Thanks so much, Kris.

Operator

Your next question comes from Tim Daubenspeck of Pacific Crest Securities.

Tim Daubenspeck, Pacific Crest Securities

Thank you very much. Everyone is focused on the guidance here with the stock and the pre-market, with BellSouth do you see this as temporary, would you expect some type of snap back down the road whenever the AT&T merger completes as they near term keep an eye on inventory? In terms of the fourth quarter on the Verizon side, can you talk a little bit about expectations as they’ve run through some inventory, would you expect some type of snap back at some point in each of those businesses?

Krish A. Prabhu, President and CEO

Good question. I have talked to everybody at BellSouth and I have talked to everybody at AT&T that I know of and who would give me a meeting. So, I have assurance from everyone that there’s absolutely no reason to believe that whatever has worked for BellSouth, the FTTC effort in their nine-state territory and I think now in six out of nine, I don’t know exactly the number, when they go into Greenfield they go FTTC over copper just for basic voice service. I have assurances that the economics are compelling, the operational procedures and the engineering procedures are well entrenched, and that we have no reason to believe that all that would be stopped overnight and that the idea would be an FTTN or a broadband DSL deployment, and that’s the competitive threat about being part of AT&T; would AT&T take whatever they’re doing in their other regions? The other question that has been raised is…we become a very critical supplier to AT&T through this merger. If you look at what we do at Cingular and what we do at BellSouth and what we do at SBC today — by the way a lot of our DSL growth on the copper is also coming from the SBC part of the network — what we do in Cross-Connect, what we do in ROADM at BellSouth, we’ve become a major supplier to the new AT&T. So, I feel fairly confident that if indeed there is an architectural change in the BellSouth part of the network and the reason for that architectural change is driven by a different understanding on economics and service offerings, our existing platform that we have well deployed at BellSouth, the 1150, it supports an FTTN configuration, it supports an FTTP configuration, but it’s primary application at BellSouth today is FTTC, because that’s what BellSouth chooses to deploy. So, we are working under the assumption that this is an opportunity for us to expand into other parts of the AT&T and frankly I haven’t heard from anybody that that opportunity is going to be denied, or on the contrary that what we have at BellSouth is…what I’ve heard is, if our roadmap continues to evolve to the roadmap that we have to the customer, that makes us a very competitive offering. So, I’m not too worried about the BellSouth part of the business. The guidance that we provided — just so that we are clear and we address this in the form of a question — is solely tied to one thing, which is when an RBOC gets acquired by an RBOC and you saw that with Ameritech and we saw at Pacific Telesys, their spending kind of stops for a while or slows down for a while as they look at what their spending profile is going to be in the new company, and that’s the risk that we have factored in our third quarter. It doesn’t mean that we will come on to the third quarter and we won’t have good strong BellSouth sales. We may get a couple of bad hurricanes, we may find that they are going out there and their inventory has been depleted, that they can’t afford not to spend, who knows? We just gave the guidance because we felt it was our responsibility to tell you that this risk means we can’t be sure that the third quarter is going to be as strong as the second quarter. And lastly, year on year, we are still growing at 10% to 15% in spite of our new guidance.

Unfortunately, I have a flight to catch and we’ve got time for one more question.

Operator

Your next question comes from Ken Muth of Robert Baird.

Kenneth Muth, Robert W. Baird

Hi, good morning. On the GPON just one more time here, you have products going into the Verizon lab in the fourth quarter ’06 and it sounds like Verizon really wants to be shipping their GPON in early ’07, do you feel that you’ll be a little bit late with that and miss some of the first half ’07 revenue opportunity at Verizon?

Krish A. Prabhu, President and CEO

I can’t speak for how much Verizon is going to do by means of revenue or deployment in the first half ’07 with GPON. I can only talk about historically what are the steps. You go into the lab, they do a lab evaluation, which is a couple of months, they have to develop OSS capabilities so the new platform can integrate with their existing OSS systems. We don’t have that issue because we are an existing BPON supplier so we are well integrated into their existing OSS. Then they do an FOA to make sure that the field issues are all covered. As part of that they will be looking at deployment issues in the home, turn off issues in the home, they’ll be testing the PON protocol, we’ve gone through all that with BPON we and know from GPON standpoint what the changes in the protocol are and we’ve covered for it. So, I don’t look at the fact that we are a few months late into the lab as slowing us down because we do have lead in certain other areas because of being an incumbent supplier. So, we are planning with our current schedule that we will have a shot at their early deployment whenever that deployment happens.

Kenneth Muth, Robert W. Baird

Okay, and then a quick followup on the BPON side, now that Verizon has passed a lot of communities, it’s over 700, do you feel that they’re mostly done passing the central offices, and as you alluded to they’re going to be more fixed on getting the penetration rates up, which would be the ONT, and that maybe a little bit less of the visibility that you’ve got now?

Krish A. Prabhu, President and CEO

I said that several hundred offices; I think it’s more than 700 but I can’t speak for how much they’ve done, but your question nevertheless is very valid. No, we think there are a lot of our home stats that they still will continue…I think their published numbers say 6 million at the end of this year and I feel that they will continue to do more BPON deployment both in central offices as well as ONTs when homes connect. I also feel that they’ll continue to transition from BPON to GPON and do GPON deployments. We have a family of multi-tenant, multi-dwelling ONTs which will mean that they will go into dense urban areas, the so called urban assault for their…program. I think all of this will play out in the second half of ’06 going into ’07. We believe that the moment on the BPON side will continue to accelerate through the end of ’07, that’s our best understanding today. We don’t have any guarantees from the customer, but believe me we try to read the tea leaves much more than anyone of the analysts out there…well this is our future and we want to make sure that we control our future.

Kenneth Muth, Robert W. Baird

Okay, thank you.

Krish A. Prabhu, President and CEO

Alright, thanks very much. I appreciate your interest in Tellabs and we will get back at the end of next quarter, and we do know that there are one or two questions that were raised on the wireless backhaul; we’ll try to get a little more clarity on that at that time. Thanks everyone, have a good day.

Operator

This concludes today’s Tellabs investor relations conference call, you may now disconnect.

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Source: Tellabs Q2 2006 Earnings Conference Call Transcript (TLAB)
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