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Tellabs, Inc. (NASDAQ:TLAB)

Q2 2009 Earnings Call

July 27, 2009 8:30 am ET

Executives

Robert W. Pullen - President and Chief Executive Officer

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Thomas Scottino - Senior Manager of Investor Relations

Analysts

Steven O’Brien - J.P. Morgan

Kenneth Muth - Robert W. Baird & Co.

Vivek Arya - Merrill Lynch

Asea Merchant - Citi

Simon Leopold - Morgan, Keegan & Co.

Nikos Theodosopoulos - UBS

George Notter - Jefferies & Co.

Jeffrey Kvaal - Barclays Capital

Todd Koffman - Raymond James

Lawrence Harris - C.L. King & Associates, Inc.

Operator

Good morning, my name is Alvis and I will be your conference operator today. At this time, I would like to welcome everyone to the Tellabs investor relations conference call. (Operator Instructions). You may begin your conference.

Thomas Scottino

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

Before we begin, I'd 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 recent SEC filings. The forward-looking statements made in this presentation are being made as of the time and date of its live presentation. If this presentation is reviewed after the time and date of its 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 will also include some non-GAAP financial measures. Reconciliations between non-GAAP financial measures and GAAP financial measures can be found at our tellabs.com website and in our SEC filings.

I will now turn the call over to Rob.

Robert W. Pullen

Good morning everyone. Let me start off by saying I’m proud of Tellabs’ results, particularly in this turbulent time. Tellabs has embraced change. Tellabs’ focus on innovative growth products is helping our customers and our company succeed. We’re helping our customers succeed by helping them generate service revenues, reducing their capital expenditures, cutting their operations expenses, and cutting their energy costs as part of their operations expenses.

We continue to implement our strategy. It’s the focus on our growth products, innovate and growth markets that are growing at greater than the capital expenditure rate and aspire to execute flawlessly.

Our second quarter turned out better than we initially expected. We came in toward the higher end of our revenue guidance. We had the strongest orders in more than a year and were encouraged by the underlying business trends. Our business appears to be stabilizing. I believe it’s probably too early right now to predict a recovery in the economy, but we are showing some stabilization. It manifests itself in our performance.

Our second quarter of 2009 revenue was $385 million. It was up 7% sequentially. This exhibits our revenue growth for the first time since the fourth quarter of ’07. Actually more than half of our second quarter of 2009 revenue or 52% came from our growth products. That was up from about 39% in the first quarter of 2009. We actually had the best revenue in four quarters for the Tellabs 7100 system, and we had record quarterly revenue for the 8600 and the 8800 systems.

Our broadband data segment grew by approximately 70%, and it grew because our first half of 2009 demand was greater than the first half of 2008, but it also increased because we had two customers accepting data projects. We actually had data growth year-over-year from 2009 to 2008 as I mentioned notwithstanding the two customers accepting our data projects.

On a bright note, some of our investments outside of North America, and our overall revenue was 40% of our second quarter of 2009, and that 40% mix was our highest international revenue percentage in more than 5 years; it was actually since the fourth quarter of 2003, and that 40% compares to about 32% in the first quarter of 2009.

Tellabs gross profit margins and operating expenses were in line with our guidance. Our non-GAAP gross profit margins were 43.7% compared with about 35% in the year ago quarter. That was up almost 8.6 points. This improvement resulted from higher data revenue, improved margins on access, and optical networking products.

Our non-GAAP operating expenses were about $128 million in the second quarter of 2009 which was down from $134 million in the first quarter of ’09, which was consistent with what we had shared with you in the last call. Our non-GAAP operating profits were $40 million which was about 10.5% of our overall revenue with our non-GAAP operating margin. That non-GAAP operating margin was the highest since the third quarter of 2006.

We delivered non-GAAP EPS of $0.08 which is about double of $0.04 in a year ago quarter, and that comparison excludes the tax benefit of around $0.09 in the year ago quarter. We generated cash and continued investing in R&D. We generated $64 million in cash from operations, and we added $58 million in cash and securities to our balance sheet in the second quarter. We now hold over $1.2 billion in cash and marketable securities and we have no debt.

We continue investing for the future to emerge stronger after downturn. Our solid cash flow enables us to invest 17% as a percent of sales in the second quarter back into research and development.

Earlier this month, we announced the restructuring plan that unfortunately will affect around 150 of our employees over the next year. This is the consequence of us intensifying our focus on growth markets and growth products.

I’ll also share with you and Tim will give you a little bit more color, we’re going to hire back some people, a majority of those, with different skill sets and around the world.

Focusing back on customers, customers are choosing our growth products and we’re reaching customers in adjacent markets. During the quarter, six new customers chose the Tellabs 8600 system and that was in all of our regions around the world including North America. In Latin America, Telecom Argentina was amongst our web. We received our first orders from a new 8800 customer in Japan as well as application 2 orders from an existing customer in Japan for high-speed Ethernet cords on our multi-service router, the 8800 system.

We won new 7100 customers in Latin America and in Asia this quarter. Last quarter we mentioned that we won business with the federal government here in the US. This quarter we actually received orders for our 1150 access system which is going to a major research facility and one of our new partners, General Dynamics Systems Integrator ordered the 7100 system for an army base modernization. These systems are going to be deployed at one of the biggest contiguous bases in US military installation both in White Sands Missile Range and Fort Bliss.

We also shared with you that we are investing more in expanding our market share in the cable or multiple services operator space and that’s paying off too. We received orders from two major cable companies for our 7100 and our 7300 system.

All in all, I’m pleased with Tellabs’ performance. We’re helping our customers and we’re focusing on innovative products, and our investments are paying off.

With that, I’m going to turn it over to Tim, and he’s going to give you a little bit more color and detail on some of our operations.

Timothy J. Wiggins

Good morning everyone. As Rob talked about, there are a number of very positive accomplishments during the quarter, and I’d like to make a few observations about those achievements from a CFO’s perspective.

First, our non-GAAP operating income at $40 million was the highest since 2Q of ’07. Second, our non-GAAP operating margin at 10.5% of revenue was the highest since the third quarter of ’06. Our quarterly operating expenses were $128 million, on a non-GAAP basis were solidly down compared with $134 million in Q1. Inventory, inventory turns, and DOS improved during the quarter. That generated solid cash flow, $64 million in cash from operations and orders were strong, our book to bill is greater than 1; in all, good performance in a tough environment.

Moving on, given all the changes we’ve made, to the business over the last year or so and the changes we’ve seen in the overall environment, we think that looking at the business on a sequential basis, it’s probably more relevant than year-over-year comparisons. Of course, year-over-year comps are contained in the press release we issued this morning.

With that in mind, let’s take a look at the numbers.

At $385 million, total revenue for the second quarter of 2009 increased by $23 million compared with Q1 ’09. Sequential growth in broadband and services segment was offset by a decline in transport segment. Growth in the data product category was driven by two customers who accepted deployments for which the equipment was shipped in prior quarters as Rob mentioned at the top of the call.

GAAP net income for the second quarter of 2009 amounted to about $16 million, more than double of the $6.5 million we recorded in the first quarter of the year. That equates to EPS of $0.04 per share, up from $0.02 per share in the first quarter. On a non-GAAP basis, net income excluding pre-tax charges for special items was $33 million or $0.08 a share in the second quarter of 2009, and that represents a 47% sequential increase in net income, up a 7% sequential increase in revenue. If you take a look at the $33 million and subtract $6 million or a penny a share for equity based comp to be consistent with first call and the result is $0.07 a share in non-GAAP EPS.

A quick note on the year-over-year comps in this morning’s press release, in the second quarter of 2008, net income was positively impacted by the tax benefit of $0.09 a share related to the successful completion of tax audits in prior years. This year, we have chosen to exclude the effect of the tax benefit from our net income comparison to give you a better feel for how the business actually performed in 2Q. As usually, you’ll find a complete reconciliation of our GAAP and non-GAAP results in this morning’s new release.

Revenue from customers in North America declined to $229 million and revenue from customers outside North America increased to $156 million compared with the first quarter in the year. Revenue from customers outside North America accounted for 40% of total sales, which is the highest percentage since the fourth quarter of 2003.

Let’s take a look at the segment data for the second quarter.

Broadband segment revenue was $210 million, up $32 million compared with $178 million in first quarter. On a sequential basis, growth in data and access product revenue was partially offset by lower managed access revenue. Specifically, data revenue totaled $107 million, up from $63 million in the prior quarter. The sequential increase in data revenue was primarily driven by two customers’ acceptance of deployments for which the equipment was shipped in earlier periods.

Even excluding the impact of these customer acceptances, we had record data revenue for the first six months of 2009 compared with all prior comparable periods. In all, data continues to be our fastest growing product category. For the first six months of 2009, data revenue totaled about $170 million, almost twice as much as the $88 million we recorded in the comparable period of 2008.

Access revenue was $68 million in the second quarter, up from $64 million in the prior quarter. The sequential increase was largely driven by higher sales of single family ONTs. Improving ONT profitability has been a priority for Tellabs, and we have done so in 7 of the lab’s 9 quarters.

Looking at the managed access category, revenue in the second quarter of 2009 came in at 435 million compared with $51 million in the prior quarter as we saw weakness in demand, particularly in Europe.

Taking all that into account, broadband segment profit for the second quarter of 2009 was $57 million, up $23 million from $34 million in the first quarter of the year. That represents 67% growth in segment profit, driven primarily by the higher level of data products and overall revenue growth of 18%.

Transport segment revenue was $119 million compared with $130 million in the prior quarter. Increased revenue from our 7100 optical networking system which grew to the highest level in four quarters was offset by lower cross-connect revenue. Optical networking is another area where we have been diligently working to improve profitability, and we have done so in 7 of the last 9 quarters.

Transport segment profit was $26 million in the second quarter of this year compared with $40 million in the first quarter. Transport segment profit declined as lower level of cross-connect revenue and higher level of optical networking system revenue was partially offset by lower R&D cost.

Services segment revenue was $56 million in Q2, up from $54 million in the first quarter of this year. Services segment profit amounted to $20 million, up from $19 million in Q1.

Non-GAAP gross margin for the second quarter of 2009 was 43.7% compared with 44.5% in the first quarter of 2009. As you know, our gross profit margin is dependent on product and customer mix. Contributing to the shift this quarter was about 3 points of improvement related to the higher level of data product revenue which was offset by about 4 points of decline related to the lower level of cross-connect revenue.

Turning to operating expenses for the quarter, non-GAAP R&D expenses came in at $65 million or nearly 17% of revenue. SG&A expenses for the quarter were $63 million. Other income on a non-GAAP basis amounted to $6 million in the second quarter of 2009, up from $5 million in the prior quarter.

Our tax provision on a non-GAAP pre-tax income for the quarter was $14 million for effective tax rate of 29.5%. We expect our effective non-GAAP tax rate for the balance of 2009 to be about 30% plus or minus, and nearly 49% our GAAP tax rate for Q2 reflects the impact of the valuation allowance maintained against our domestic deferred tax assets.

Turning to the balance sheet now, during the quarter, we generated $64 million in positive cash flow from operations and grew the cash, cash equivalents, and marketable securities and investments balance by $58 million. CapEx was about 6. DSO dropped to 64 days from 69 in Q1 and inventory turns were 5.4 times versus 4.4 in the first quarter. At the end of the second quarter, inventory in terms of dollars improved to $148 million compared with $171 million at the end of Q1.

During the quarter, we purchased about 4000 shares of our stock at a cost of about $19,000 under our 10b5 plan. The actual number of shares outstanding at quarter end was about $396 million consistent with the end of the first quarter.

Headcount at the end of the first quarter stood at approximately 3150 consistent with the first quarter level. Customer orders were the strongest in more than a year, book to bill for the quarter was greater than 1.

Turning to our outlook for the third quarter this year, based on everything we see in backlog and given the overall market uncertainty, we are guiding for third quarter revenue to be in the range from flat to up mid single digit percent compared with 2Q. As we told you last quarter, we expected product mix to negatively impact gross margin in Q3. Looking at things today, we expect data sales to moderate following strong 2Q performance and ONT sales to increase in 3Q. As a result, we expect gross margin in the third quarter to be about 40% plus or minus a point or two depending again on product mix.

Looking ahead to the fourth quarter, we anticipate gross margin improvement based on a more favorable product mix. We expect non-GAAP OpEx for the third quarter to be flat to slightly down. In addition, we expect the effect of expensing equity based compensation in 3Q will be about $4 million, split between operating expense and cost of goods sold.

So, to recap, we made good progress in the second quarter. Our non-GAAP operating income and operating margin were the highest in some time. Quarterly operating expenses reflected our cost control initiatives. Inventory, inventory turns, and DSO improved, we had solid cash flow, and book to bill is over 1.

At this time, I’d like to open the floor to your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Steven O’Brien - J.P. Morgan.

Steven O’Brien - J.P. Morgan

Can I ask first on the broadband data results and the revenue recognition this quarter; we understand there’s a bit of one-quarter impact here coming from customer acceptance; when you look out to the third quarter and fourth quarter, how should we consider? Does this category go back to a run rate that is similar to the Q1/Q4 levels? If you could just help quantify, what sort of a normalized level would have been without this customer acceptance? And then, on the same topic, you’ve talked about some broadband data category wins in China, what hit the numbers this quarter, are those wins still coming through the numbers?

Timothy J. Wiggins

Steve, I’ll take the first part of your question and Rob will handle the second part; so, on the data revenue, couple of things, certainly we did see some significant increase in the quarter, if you look at the sequential increase from $63 million to $107 million that was largely a result of these acceptances. If we exclude the acceptances and look at the business first half of this year to any of the first halves since we’ve been in the data business, it was still a record, so we saw solid improvement. If we think about the business in the second half, we expect to see continued growth, we’ve seen strong demand in orders; so, what we’re seeing here is that some longer terms projects where we’ve been shipping products for a number of periods, and as of course you know, there are many periods where you are shipping product, where you’re not able to recognize a revenue; other periods, particularly in cases like this where you get an acceptance but it tends to be a bit lumpy, but what we’re seeing is solid demand, we’re seeing record performance both with and without the revenue recognition and we see strong second half.

Robert W. Pullen

Like we were talking about earlier, we saw our corporate book to bill greater than 1 reinforcing some of that. Steve, for the second part of your question which is the impact of China, China actually also positively impacted our quarter, but the data revenue growth and the broadband revenue growth that Tim and I talked about was on a global basis; we had demand from all four regions of the world, whether it’s Asia, Latin America, North America, or Europe, the Middle East, and Africa and the two customer acceptances were actually in the Asia area and Latin American area, but it was not in China, it was in our Asia-Pacific region and separately in our Latin American region.

Steven O’Brien - J.P. Morgan

If I could ask a follow-on on the gross margin outlook, the timing next quarter of ONTs bringing down the gross margin, are there any other factors beyond the ONTs that are impacting the margin in Q3, pushing it down from the mid 40s that we should be aware of? And then, when we look out to Q4, you see North America carriers and carriers around the world with sort of at least discussing back-end loaded budgets this year for CapEx; if revenue mix normalizes and the CapEx budgets prove accurate, should we see sort of an unusual lift in the fourth quarter this year potentially?

Timothy J. Wiggins

A couple of thoughts; one, if you look at the guidance that we gave you in terms of the moving pieces this quarter, while our gross margins between 1Q and 2Q were fairly similar, we saw that there was 3 points of improvement related to the data increase and about 4 points of decline relative to a lower cross-connect; so, as we look out into the third quarter, we expect the data revenue while it will continue to increase, it would fall back to more of a run rate that we’ve seen in the past with growth which obviously would have a big impact on the margins, and then there’s other put and takes including expect increased ONT volume in 3Q, and we think about the fourth quarter, and we’ve mentioned that typically our practice has not been to provide guidance beyond the immediate coming quarter, and we thought it was important to say we do see some lift, and the kinds of things that we’d expect in the fourth quarter would be a continued strength in our data business, improvement in our optical products in terms of the 6300; we’d also expect some improvement in our cross-connect business in the fourth quarter which has a positive impact. We might see some moderation of the ONT. So, we’ll see how all that plays out. What we can see is that we’d expect based on our internal view some lift in the margin in the fourth quarter.

Robert W. Pullen

Yes, Tim. I agree. I would also add, I think, Steve, the second part of your question was the implication of carriers’ CapEx backend loaded. While we don’t get it custom to company and carrier CapEx, I hope that their forecast is correct. Based on our conversations and so on, there is a trend for more CapEx spend toward the end of the year particularly here in North America. I think you’ll see different spending patterns around the world. Western Europe may be a little bit more beleaguered by comparison, but we do see continued spending trends in emerging markets such as China, Brazil, South Africa, and to a lesser extent Russia, but we hope that those forecasts of CapEx are going to come through.

Operator

Your next question comes from the line of Kenneth Muth - Robert W. Baird & Co.

Kenneth Muth - Robert W. Baird & Co.

Could you give us a little bit more transparency on the book to bill; is that coming more from the data products category or do you expect some of the mix to change back, if we could just get a little bit more transparency to make sure we understand this; and then, the followon is, any expectations as you see in changing with the whole AT&T vendor consolidations, any highlights you could give us from your thoughts and how Tellabs would continue to supply there would be helpful.

Timothy J. Wiggins

A couple of thoughts on the book to bill and the data revenue recognition; one, I would have you think about is that to have a book to bill stronger than one in a period where you had some revenue recognition speaks of some significant underlying strength. So, if you think what a book to bill would mean to this, it was above our revenue that was recognized in the current period. To give guidance flat to up, mid single digits, it’s also a positive indicator given both the orders, and typically, we see the third quarter being one of our quieter quarters during the year. So, I think the way you need to think about it is that we had a good solid quarter with the metrics that we laid out, we have a book to bill that’s greater than one even though some of the revenue was from these customer acceptances. Of course, the book to bill and the orders are not impacted by revenue recognition. So, to have a solid over one and then to give what we think as reasonably good guidance in terms of revenue given the market conditions, I think, those are all positives.

Robert W. Pullen

I think the second part of your question was the recent announcements with AT&T in vendor consolidation. I just suffice it to say that AT&T is one of our top customers and we expect them to be one of our top customers going forward.

Operator

Your next question comes from the line of Vivek Arya - Merrill Lynch.

Vivek Arya - Merrill Lynch

A couple of question; first, I just wanted to take a step back and drill down into gross margins. In the second quarter you had a $40 million sequential growth in data products that gave you 3 points of gross margin uplift, but there was also a 4-point decline in gross margin from cross-connects where sales, I think, probably fell less than $40 million sequentially. In other words, it seems like the decline in the cross-connect gross margin dollars is not being offset by the increase in gross margin dollars from your broadband data product. Is that a correct perception and if it is what does that say about the longer-term gross margin trends at Tellabs?

Robert W. Pullen

First of all, it’s an incorrect perception. We grew revenue 7% from 1Q to 2Q of ’09, which as I mentioned, is the first time we had revenue growth since the fourth quarter of ’07. Secondly, we’re giving you guidance of flat to up by mid single-digit percentage from 2Q to 3Q, and so the offset of data growth was superior to the decline of some of our core products.

Vivek Arya - Merrill Lynch

Rob, my question is on gross margins. Even though you are guiding to sales growth in the third quarter, you’re also saying that your gross margins are going to fall almost 400 basis points, and when you look at the gross margin performance in the second quarter, the margin improvement from broadband data is being more than offset by declines in cross-connects?

Robert W. Pullen

Our second quarter 2009 gross margin was slightly below but approximate to the first quarter. If you remember, we gave you information here and gave you a comparison from last year, the same period in the year-ago quarter, we had 35% gross margin, we’re now up to approximately 44% or 43.7%, and we’re performing well. As Tim mentioned, our mix in the third quarter will likely give us a slight decline in gross margin, but we expect that to improve in the fourth quarter.

Vivek Arya - Merrill Lynch

Secondly, it seems that Nortel’s optical assets are up for sale and there is also a lot of vendor consolidation going on in the US market. Do you see the benefit of using your cash to gain scale in optical or do you think that you have the right scale?

Robert W. Pullen

We have the right scale. We’ll use our cash to do what’s right for our customers and our shareholders; that’s making my first point, but on the second point about consolidation, it doesn’t bother me. We’re a focused attacker, we focused in our core spaces and we believe we can differentiate on innovation. While we looked at the Nortel assets, we’re currently not pursuing that. We believe that our platform and our investments are the right ingredients for our customers going forward in areas that are growing faster than the overall CapEx.

Vivek Arya - Merrill Lynch

What is the right level of OpEx for your business? You’ve shown a very remarkable discipline in controlling costs, and I am wondering that as you see your business stabilize, at what level do you start growing on your R&D expenses, etc.?

Robert W. Pullen

I think you know from following the company that we set out for $100 million reduction which we’ve executed against and our commitment was to deliver 520 operating expense this year or less; we had a solid quarter reduction in Q2, our guidance was to see flat or maybe slightly down, but at this level, I think, as we look out the balance of the year, and you could run the math, this will get us to our commitment level, and I think, we’ll look at what are the opportunities for additional investment in the business, where do we see opportunities expand our customer relationships, deliver value, and take advantage of our strong balance sheet. So, that’s yet to be determined, but at this point I think we’re about at the level we can make our commitment and will evaluate whether we see up or down spending, I think, at this point look forward to be in the flat zone.

Operator

Your next question comes from the line of Asea Merchant - Citi.

Asea Merchant - Citi

Just very quickly, could you give us a little bit more detail on the managed access business that was down and obviously your optical networking was not as down as much as the overall segment. If you could drill a little bit into the optical networking segment, that would be great.

Robert W. Pullen

First of all, the managed access is later in its lifecycle and it will have a long tail to it, much like the 5500 program. At the same time, our optical networking is a category of a group of products, but notably, our 7100 system, our cornerstone product, was up substantially in 2Q of ’09 over 1Q of ’09.

Operator

Your next question comes from the line of Simon Leopold - Morgan, Keegan & Co.

Simon Leopold - Morgan, Keegan & Co.

I wanted to discuss a little bit about the 8600, 8800 successes here. If you could give us a little bit more color on the applications and competitive landscape of whom you beat out and what your customers are doing with your boxes?

Robert W. Pullen

Solutions you mean Simon?

Simon Leopold - Morgan, Keegan & Co.

Yes.

Robert W. Pullen

Maybe I’ll take that one. Tim’s comment is correct which is first of all we’re offering end-to-end solutions to our customers, and the 8600 and 8800 is both in the mobile backhaul space, as well as in business services delivery space, and it’s wide-ranging. As you know, there are different types of carriers in the world. Some are dominantly wireless building their own infrastructure; so their users are mobile backhaul. At the same time we deliver these products to wholesale customers that are delivering effectively wire line services for mobile backhaul applications. We mentioned BT in a previous announcement, they’re using our products to deliver business services or manage Ethernet aggregation services for the mobile application. Lastly, both the 8600 and 8800 are helping our customers generate revenue by delivering business services enterprise that could virtual private networks, it could be as I just gave you an example, mobile backhaul applications as a business service, and as I’ve mentioned on previous calls, we even have our 7100 system that’s delivering both wavelength and high-speed Ethernet services to enterprises as well, which is a slight departure from your question, but relevant in the whole business service delivery.

Simon Leopold - Morgan, Keegan & Co.

Who are you beating to win these deals?

Robert W. Pullen

We’re competing with the normal competitors, most of the big guys from the Chinese to now the French.

Simon Leopold - Morgan, Keegan & Co.

Going back to the managed access discussion, appreciate your comment, the maturity in comparing it to the cross-connects, but at least my sense is, this year we’ve had a pretty steep fall off in this June quarter, and I think with the high European exposure, I would imagine tough seasonality means that the managed access business will be equally depressed in the third quarter. I am just wondering how we should think about it; is this quarter kind of one-offish or is this the new level to think about?

Robert W. Pullen

That’s a good point Simon. The second half looks comparable to the first half even though we had a second quarter decline, and you’re right, we sell the managed access equipment all over the world, but it has a lot of Western European exposure, and Western Europe, the overall CapEx and markets are slightly down. I would expect to see a slight uptick in the third quarter.

Simon Leopold - Morgan, Keegan & Co.

One last one; you mentioned that you’re not pursuing the Nortel assets; so, are you investing R&D dollars internally to add 40 gigabit, 100 gigabit capabilities to 7100; how do you think about your internal investment strategies?

Robert W. Pullen

We actually have the 40 gigabit and we’re investing for higher speeds and more functionality in our 7100 platform, and our customers are validating that we’re in the right direction here by both our current customers buying more as well as winning new customers, Simon.

Simon Leopold - Morgan, Keegan & Co.

So, it’s fair to think of it as a high priority within your current R&D budget?

Robert W. Pullen

It’s a very high priority issue; Tim and I and the entire management are focused on certain areas. Optical networking is one of them, mobile backhaul certainly a second leg, the third leg is in business services delivery, and the fourth is in professional services.

Operator

Your next question comes from the line of Nikos Theodosopoulos - UBS.

Nikos Theodosopoulos - UBS

The data product; I think the perception on the results is that all the sequential growth were from these two contracts; when I look at the deferred revenue and inventory, in aggregate, it only fell like $23 million or $24 million and yet you have a $44 million sequential increase in that area, so would the data products have grown sequentially without these two projects or did the two projects lead to all the sequential growth?

Timothy J. Wiggins

No, if we exclude the revenue recognition and compare the first six months of this year to the first six months of last year, we grew.

Nikos Theodosopoulos - UBS

My question is second quarter versus first quarter, when I look at the change in inventory and deferred revenue, it doesn’t come close to the sequential growth in the data product.

Timothy J. Wiggins

Let’s talk about the accounting for a second on the revenue recognition. There are two components to our deferred revenue, Nikos; one is current and one is long-term. The current piece you can see on the face of the balance sheet, the long-term is in another liability section. So, that’s one data point. The second is, when you look at kinds of deferred revenue, there are two kinds at least; one of them is where you ship the product, you’ve invoiced for the product, but you’re not able to recognize the revenue. So, that would be a type that shows up in your deferred revenue because when you do the accounting for that, you’ve sent the bill and you’ve got to reverse it out. The other kind of deferred revenue results for when you’ve shipped the product, but you’re not able to invoice under the contractual terms, and then it remains an inventory at its cost, and then there would be some variations in between the two, but those are the two principal types; so, this was a combination of both, some of which where we were able to invoice, other parts of it where we were not. When you look at the change in our inventory, certainly, that was one of the impacts that allowed us to reduce our inventory. We also saw some reduction in the deferred balance as well.

Robert W. Pullen

Tim is right on target, but the only other thing I would add is, while demand is likely to be lumpy, our second half of this year will be comparable to the first half based on everything that we see from customer orders and demand.

Nikos Theodosopoulos - UBS

Okay, I’ll follow up later on the accounting and stuff, I still have a point of confusion there, but I’ll follow up later. A second question, wasn’t discussed I think, the broadband stimulus plan has pretty much been inactive now and there are a lot of estimates out there saying of the $7.5 billion, may be 15% or so is going to go towards active oriented access products which is the traditional AFT business you have, and I think the general perception is that you guys are not going to be a beneficiary of that because it’s not a business that people think you’re focused on; do you see incremental revenue and opportunities, are you going to be able to compete effectively for that spending in the next couple of years, and if so, how active are you in it?

Robert W. Pullen

In short, the answer is yes. We should be an active participant in there both in access and in transport by the way because some of the funding is not only for last-mile access but it’s also for the transport level which should have a positive impact on our both 1150 and 7100 and our 1000 program. Having said that, we’re actively involved with our customers and our partners now, and as you know, we are investing in 1150, in fact we’re investing in it for extensions with our carrier customers as well as into the federal government, and while the federal government spending is independent from the broadband stimulus, we’re already seeing positive results, and as I mentioned, the White Sands Missile Range and Fort Bliss complex as well. The million-dollar question is how much will we receive and so on, and that’s difficult to predict at this point in time, Nikos. I would treat it as a tail win for us, it should be positive for a group of companies including Tellabs.

Operator

You next question comes from the line of George Notter - Jefferies & Co.

George Notter - Jefferies & Co.

A housekeeping question, 10% customers, I didn’t see anything in the press release and I’m not sure if you made comments there, any 10% customer in the quarter?

Timothy J. Wiggins

We had three, George.

George Notter - Jefferies & Co.

Care to disclose who they are, how big they were, any details there?

Timothy J. Wiggins

No.

George Notter - Jefferies & Co.

I assume the usual guys are in there, the two usual guys.

Timothy J. Wiggins

Yes.

George Notter - Jefferies & Co.

And then on the cross-connect business, I’m trying to get a sense of what you think that business ought to do longer term, does it decline gracefully, long tail-ended, do you think it is more truncated, qualitatively how do you see that transition occurring over time?

Robert W. Pullen

I consider that later in the lifecycle product, it’s going to have a long tail to it and decline gracefully. Our customers are still buying new systems from us as well as extending their current systems. There’s a shift in North America over time from T1s to Ethernet, and we’re participating in both of those, both the T1 management as well as the Ethernet.

Operator

Your next question comes from the line of Jeffrey Kvaal - Barclays Capital.

Jeffrey Kvaal - Barclays Capital

I was wondering if I could post two questions; the first is on the growth products, could you perhaps decide for us where you think growth products might be as a percentage of the mix either in the third quarter or in the second half? And the second one would be, this may be analyzing it, but Rob, I think in your comments earlier in the quarter you were looking for sequential growth in the third quarter, the guidance range includes flattish; I just wanted to iron that issue out.

Timothy J. Wiggins

Jeff, let me talk about the growth products; on the strength of the data business which obviously was impacted by the customer acceptances in 2Q, the growth products actually exceeded our core products, so that was a solid sign. I think while we don’t expect that trend to continue at that strength, we do expect to see continuing improvement as a percent and we look at the growth product percent as a percent of the overall; so, I think we talked earlier where we’ve been out on the street about seeing a crossover late in the year that’s still possible, but I think we had a bit of a blip here, but we see that trend where the growth products continue to be a greater percentage of the overall business, in the mid 40s give or take depending on how the thing comes out as we look at the second half of the year.

Robert W. Pullen

Jeff, to answer the second part of your question, we actually see mid single digit growth from 2Q to 3Q. We gave you a range of flat to mid single digit growth, and that’s coming on the heels of growth from 1Q to 2Q as we explained earlier which is about 7% sequential growth, and that was the first time we registered growth since fourth quarter of ’07; again, hopefully, we’re going to see that same trend in the third quarter by comparison to the second quarter.

Jeffrey Kvaal - Barclays Capital

Okay, so it sounds like you’re thinking that it’s going to be mid single digits, but lets just be careful and include flattish then?

Robert W. Pullen

Yes, we’ve been giving you a range based on the macro uncertainty in the world.

Jeffrey Kvaal - Barclays Capital

Okay, makes sense.

Operator

Your next question comes from the line of Todd Koffman - Raymond James.

Todd Koffman - Raymond James

Just a followup to Nikos’ question about the broadband stimulus, within you access segment which I guess is around $68 million in the quarter, what percent of that is older AFC products versus the newer I guess ONT products?

Robert W. Pullen

First of all, as Tim mentioned, we had sequential growth in our access platforms, and it’s about a 50-50 mix of ONTs and current access equipment.

Operator

Your next question comes from the line of Lawrence Harris - C.L. King & Associates, Inc.

Lawrence Harris - C.L. King & Associates, Inc.

I noticed the last couple of quarters we haven’t had a material level of share repurchase and you indicated that you’re not interested in the Nortel business, are you keeping your options open for other activities, why the lack of share repurchase?

Timothy J. Wiggins

Larry, we’ve been through some very interesting times to say the least; I think our board rightfully have said, lets be careful, lets assess what we want to do with the business, how the growth products are going to perform, what other adjacencies we might want to do; so, I think it’s really been a period of, like many companies, lets get a sense of what the lay of the land is and decide, do we have excess capital, and if so, what’s the right way to return it; those are I think ongoing discussions with the board. I think at this point the board has made the right call in terms of being cautious and we’ll see how things play out.

Operator

Your next question comes from the line of Simon Leopold - Morgan, Keegan & Company, Inc.

Simon Leopold - Morgan, Keegan & Company, Inc.

A real quick followup, if you could just do a little hand-holding and let us know what’s included in your definition of growth products again?

Robert W. Pullen

The 8800, the 8600, the 7100, the 6300, and professional services. We broke out the component of our services business. We do a lot of services which are supported agreements, installations, turn-key, and we separated that from our consulting services where we are trying to both architect, design, and optimize our customers’ network where they’re paying us to do that.

Operator

There are no further questions at this time. Are there any closing remarks?

Robert W. Pullen

I just wanted to thank all of you for your participation and your good questions. As I mentioned at the top of the call, I’m proud of Tellabs’ results, particularly in this turbulent time, and as I mentioned, Tellabs has embraced change. I believe our focus on innovative growth products is helping our customers and our company succeed and we’re going to continue on this trend. So, thanks for your participation and we look forward to speaking to you again.

Operator

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

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Source: Tellabs, Inc., Q2 2009 Earnings Call Transcript
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