Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

Tellabs, Inc. (TLAB)

Q3 2006 Earnings Call

October 24, 2006 8:00 am ET

Executives

Tom Scottino - Senior Investor Relations Manager

Krish Prabhu - President and CEO

Tim Wiggins - EVP and CFO

Analysts

Tim Long - Banc of America Securities

Tim Daubenspeck - Pacific Crest Securities

Tal Liani - Merrill Lynch

John Anthony - Cowen & Company

George Notter - Jefferies & Company

Ken Muth - Robert W. Baird

Ehud Gelblum - J.P. Morgan

Nikos Theodosopoulos - UBS

Brant Thompson - Goldman Sachs

Presentation

Operator

Good morning. My name is Tunisia 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 speakers' remarks, there will be a question-and-answer session. (Operator Instructions). Thank you.

Mr. Scottino, you may begin your conference.

Tom Scottino

Thank you Tunisia and welcome 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.

But before we will begin, I will remind you that certain statements made on the call today may be 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.

Having said that, I will turn the call over to Krish.

Krish Prabhu

Thanks, Tom. Good morning, everyone. As our news release said, our revenue for 3Q was $523 million, up 13% over last year's third quarter. As you'd recall, last time on our earnings call, we had guided between 510 and 535. We did see pretty strong revenue in some of our segments and as we had guided, revenue was somewhat affected by an inventory correction at one of our customers. Tim Wiggins will walk you through some more detail as he discusses both the revenue and the margin.

Year-to-date revenue growth compared to last year is 16%. We've seen good strong momentum in transport and data. We saw good data sales in 3Q. We were flat on access and managed access; and access, as we had said last time we are going through an inventory correction on our fiber-to-the-premise program.

Let me turn over to gross margins. Gross margins came in quite strong at 48.6%-48.7%. It's largely dependent on mix of products with fewer ONTs shipped in the quarter. Our margins look strong; of course, it's helped by the strength in transport and data products. We have also been working on supply chain efficiencies and cost of components and some of that’s playing through in the stronger margins.

For the last several quarters, we have held our OpEx very flat under tight control. That continued in the third quarter. OpEx came in pretty much where we had guided, flat and trending slightly down quarter-over-quarter. All in all, operating income at nearly 20% is very close to our stated target. Year-to-date, we are very happy with the progress we have made in operating income compared to the three quarters of last year. The first three quarters our year-to-date operating income is up 90% compared to what we had in 2005 and all of this is organic.

Let me talk a little bit about what we see on the horizon, I will then hand it over to Tim to give you a more detailed dive into the quarter and then we’ll come back and answer your questions. This year we have seen very strong wireless backhaul revenue growth for us. We have over the last several years made investments in enhancing our products especially the cross-connect as well as the managed access product to make them more efficient in wireless backhaul, and some of that is coming through.

We are also seeing, this year there was a lot of focus on trying to integrate our data products with our transport and managed access products for wireless backhaul. We did see some of that here in the last two quarters. The other area of revenue growth for us has been migration of traditional Frame/ATM networks to IP/MPLS. We now have our data products embedded in some rather large Frame/ATM backbones, where because of the obsolescence in that technology, the customers migrating to IP/MPLS and also carrying Ethernet on the same network, we are seeing good momentum there.

In the access area, as we have said in prior quarters, our FTTP, FTTC programs continue. We have had, as we said last quarter, a slight inventory correction on our FTTP program. We think as our customer gets their marketing campaign underway and signs some more of their end-customers, we will start seeing growth back in this program, might happen as early as next quarter.

We also have introduced new product, the 1150. This product is very versatile. It supports multiple configurations of fiber-to-the-prem, fiber-to-the-curb and fiber-to-the-node configuration; also has VDSL, ADSL 2 drops, as well as direct fiber drops. We think this product is ideal for not just domestic customers, but also international customers and we look at '07 as a big year to launching this product outside the US.

Lastly, let me talk a little about our 7100 program. We have just completed two comprehensive FOAs on rather large networks at one of our big customers successfully. We expect good revenue and good deployment of this product next year, especially as our customers look at revamping their metro and regional networks for IPTV backhaul, for Ethernet transport and for Lambda services.

All in all, we are very encouraged by the progress we saw in 3Q. We think we have very good momentum on several new platforms and good applications. We look forward to 2007 as another growth year for us. I will come back and answer your questions; and let me hand it over to Tim, who will give you a little more detail on 3Q.

Tim Wiggins

Thanks Krish. Good morning, everyone. Let's look at the numbers. Total revenue for the quarter was $523 million, that's up 13% compared with $464 million in the third quarter of 2005. On a sequential basis, 3Q '06 revenue was off approximately $27 million compared with Q2 '06. The sequential decline can primarily be attributed to the inventory adjustment at a major customer, which we talked about on last quarter's call. Year-over-year revenue growth, improved gross margins and our continuing focus on controlling operating expenses produced $102 million in non-GAAP operating income, up $68 million -- up from $68 million a year ago, that's just about 20% of revenue.

On a geographic basis, 3Q revenue from customers in North America amounted to 75% of the total versus 77% in the third quarter of 2005. Revenue from customers outside North America amounted to $129 million during the quarter, up 19% from $108 million in the comparable period of 2005.

Looking at the individual product segments, revenue for the Transport Product segment for the third quarter amounted to $203 million, that's up 30% from $156 million in the third quarter of 2005. Within Transport Product segment, wireless continues to be the prominent driver. For the quarter, North American wireless customers accounted for approximately 66% of all Transport Product segment revenue compared with 51% in the third quarter of 2005.

Looking at the Tellabs 5500 wideband cross-connect business specifically, we shipped approximately 2.8 million T1 equivalents in the third quarter of 2006, compared with 2.7 million in the second quarter of 2006 and 1.7 million in the third quarter of 2005. About 36% of this quarter’s 5500 system revenue came from new systems, systems expansions, and software upgrades with the balance of 64% consisting our port-card growth on our installed base.

The new system percentage is up from 30% in Q2 '06, and 20% in the third quarter of 2005. At the end of the quarter, 20% of the card slots in our installed base were open. This compares with 21% at the end of the second quarter of this year and 22% at the end of the third quarter of 2005. Segment profit for transport products was $110 million in Q3, up 45% from $76 million in the third quarter of 2005. The increase is primarily due to higher Tellabs 5500 revenue offset by slightly higher R&D.

Turning to the Broadband Product segment, the Broadband Product segment includes our access, managed access and data products. Overall revenue for this segment was $273 million, up 3% from $264 million in the third quarter of 2005. Revenue for our access products amounted to $161 million, which is down 3% compared with the $166 million we recorded in the third quarter of 2005. Excluding pass-through video revenue of $13 million in 3Q '05 and $2 million in 3Q '06, access revenue actually increased $7 million year-over-over.

On a sequential basis, access revenue for the third quarter of '06 declined 15% compared with the second quarter of '06. The $29 million sequential decline can primarily be attributed to an inventory alignment of one of our key customers. Excluding the $2 million and 3Q '06 pass-through revenue, we estimate that sales of fiber platform sets FTTP and FTTC amounted to approximately 56% of access product revenue in the quarter with the balance being copper access platforms. This compares with 53% in the third quarter of '05 and 58% in the second quarter of '06.

Revenue from managed access products came in at $80 million compared with $84 million in the third quarter of 2005. The year-over-year decline is primarily related to reduced Tellabs 2300 cable telephony and 8100 product revenue. On a sequential basis, Tellabs 8100 revenue increased 3% from 2Q '06 to 3Q '06. 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 $32 million, that’s more than double the $14 million we recorded in the second quarter of 2005. Year-to-date, revenue from these products was $76 million, again more than double the $29 million we reported in the first nine months of '05.

Segment profit for broadband products was $41 million in 3Q versus $49 million in the third quarter of 2005. The decline here is primarily due to higher variable manufacturing costs. For the third quarter of 2006 service segment revenue was $46 million, up 6% from $44 million in the third quarter of '05. Service segment profit was about $18 million

Service segment profit was about $18 million in 3Q; that compares with $10.5 million in the third quarter of '05. This improvement reflects an increase in revenue from higher value support agreements and professional services.

Looking at overall profitability, on a GAAP basis net income for the third quarter amounted to $59 million or $0.13 a share. That's up 41% from GAAP net income of $42 million or $0.09 per share in the third quarter of '05. Our non-GAAP net income for the third quarter of '06 amounted to $73 million or $0.16 a share on a fully diluted basis. That compares with non-GAAP net income of $68 million or $0.15 a share in the third quarter of last year but doesn't tell the whole story. Year-over-year net income comparisons are affected by changes in our tax provision.

As you may recall, in the third quarter of '05 we had operating loss carry-forwards that resulted in a non-GAAP 11% effective tax rate. For the third quarter of '06, our effective tax rate without the benefit of operating loss carry-forwards that sheltered us from tax on domestic income was 36.2%. Looking at the 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 third quarter of '06 non-GAAP operating income was $102 million or almost 20% of revenue; that’s up 50% from $68 million or just under 15% of revenue in the third quarter of last year.

For the first nine months of '06 non-GAAP operating income was $294 million, a 90% improvement compared with the $155 million we recorded in the first nine months of '05.

Turning back to net income, our non-GAAP net income calculation is adjusted to exclude deal-related stock compensation, amortization of purchase intangibles, equity-based compensation expense and other non-GAAP adjustments as described in this morning's news release.

The effect of equity-based compensation expense on 3Q was $9.5 million; this reduces our non-GAAP EPS by about $0.01. That way of looking at things is consistent with the way FirstCall and Reuters 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 margin at 48.9% compares with 46.6 in the second quarter of 2006 and 46.9 in the third quarter of 2005. As you know, our gross profit margin is dependent on product and customer mix, which was responsible for the shift between Q2 and Q3 of this year. Contributing to the shift was about 4 points of improvement from a more favorable product mix. We had fewer single family ONTs, more data products and higher 5500 content and a more favorable mix within access product lines. This was offset somewhat by fixed and higher variable manufacturing costs over the lower sales volume.

Turning to operating expenses, non-GAAP operating expense came in at $153 million, just less than 30% of revenue. That compares with $150 million in the third quarter of '05 when operating expenses amounted to 32% of revenue. The year-over-year increase here is primarily attributed to increased R&D investment in new platforms and feature enhancements.

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 17% of revenue. In the third quarter of 2005, R&D expenses were $82 million or just less than 18% of revenue.

Other income on a non-GAAP basis amounted to $12 million versus $9 million in the second quarter of '06. Our tax provision on non-GAAP pre-tax income for the quarter was $41 million or an effective rate of 36.2%. For the balance of '06, we expect our annual tax rate to be approximately 35%.

Turning to the balance sheet, day sales outstanding was 66 days versus 62 in Q2. The increase here is primarily related to the back-end loaded nature of revenue during the quarter. Inventory turns were 7.3 times versus 9 in Q2 '06. Inventory in terms of dollars increased to $156 million from $140 million in the second quarter '06. The increase here is primarily related to having more fiber-access equipment in inventory.

CapEx during the quarter was $15 million compared with $22 million in the second quarter of 2006.The decline here is primarily related to some facility projects that were completed in Q2. During the quarter, we purchased 7.6 million shares of our stock for $76 million. At quarter's end, the actual number of shares outstanding was 442 million compared with 448 million at the end of the second quarter. At the end of the quarter, our cash and investment balance stood at $1.231 billion, up $14 million from the second quarter of '06. This increase was largely driven by cash provided by operations of $86 million offset by cash used to repurchase our shares during the quarter. Headcount at the end of the quarter stood at approximately 3,700, consistent with the level at the end of the second quarter and book-to-bill was approximately 1.

Turning to our outlook for the fourth quarter, we expect 4Q revenues to be in a range between $525 million and $550 million. We expect gross margin to be about 46% plus or minus 1% or so, depending on products and services mix. We are looking for non-GAAP OpEx to be flat to slightly down, consistent with the target we have been working on throughout the year. In Q4 we expect the effect of expensing equity-based compensation as being approximately $10 million, split again between operating expense and cost of goods sold.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from the line of Tim Long.

Tim Long - Banc of America Securities

Thank you. Just a question on the access side, could you just talk a little bit about the pricing environment and any cuts that are needed for the BPON side and just your perception of what pricing will be like on the GPON business that you are looking to start next year? Thank you.

Krish Prabhu

Yeah. I will say a few things and Tim feel free to chime in. BPON pricing, when the GPON RFP came out, as we mentioned on the last call, we adjusted BPON prices. So, BPON pricing had been trending down especially for the ONTs and now there is no fundamental price differential between a BPON ONT and the GPON ONT. We have been very aggressive on cost reduction. We started a China design center. We are really going through a third generation design on our ONTs, which is highly cost optimized and it's also tightly integrated with our supply and manufacturing that all happens in China. So, I feel reasonably confident that Tellabs with having shipped more than 700,000 ONTs is best positioned to continue to ride the BPON to GPON transition. I do believe that there are competitors out there who want to get into this game and they will price aggressively, but we have experience and volumes under our belt and we now have a lot of field experience as it relates to labor costs and operational efficiencies of installation and of course monitoring a remote ONT, and I think all that will come true. There is a lot of synergy between BPON and GPON ONTs; in fact, a new chipset that supports both modes as a common chipset, most of the other elements in the ONT like the triplexer which triplexes video and downstream or upstream traffic is common. So we expect the BPON to GPON transition to be fairly smooth for us.

Tim Long - Banc of America Securities

And if there's any impact on OLTs at all on any of the price reduction?

Krish Prabhu

The OLT is largely stabilized, on the network side, pricing generally trends 7%, 10% down each year, especially in a steady state. I think the OLT is -- I'm not quite sure if it has reached there, but I think the biggest impact clearly is on the ONT side.

Tim Long - Banc of America Securities

Okay, thank you.

Operator

Your next question is from the line of Tim Daubenspeck.

Tim Daubenspeck - Pacific Crest Securities

Thank you. Just a question on the Q4 guidance, it doesn’t look like you're seeing maybe some normal seasonality, is -- going back to Krish's comments, the expected rebound in ONTs next quarter, did he mean the December quarter or the March quarter? And then can you kind of talk about the seasonal trend for the December quarter?

Krish Prabhu

Yes. On the ONTs, we get blanket orders from our customers and then they draw what they need based on the level of inventory in their warehouses. We did see an inventory buildup in their warehouses at the start of the third quarter, and that’s why we guided you to that level. Some of that inventory is being exhausted now for sure. Too early to tell whether the bounce is going to happen in 4Q or 1Q, and I did say in my opening comments it was dependent on the success they had in their marketing campaigns and the rate at which they were signing customers to their FTTP projects. So we'll have to watch and monitor that as we go through 4Q and 1Q. In terms of seasonality, 4Q typically is a stronger quarter than 3Q for us, and 4Q typically looks a lot like 2Q. But I think that's why our range is between 525 and 530, and I will certainly let Tim add, because he is closer to this than I am. But we have been careful with our guidance consistently over the last 8-10 quarters, and we have a good track record of delivering to the guidance. But I will let Tim explain if you have questions regarding the range and the seasonality, Tim may have more information on that.

Tim Wiggins

I think we have -- Tim, we have seen some caution on the part of our customers in terms of managing their CapEx, and I think we don't have great visibility to see if there is going to be a traditional wireless budget flush, but certainly we are going to this with a cautious view just given the kind of focus that carriers have been putting on CapEx this year.

Tim Daubenspeck - Pacific Crest Securities

Is this is part of the guide because of AT&T merger or are we expecting fiber-to-the-prem revenues to be down sequentially and that's a lot of the reason for the softness in the Q4.

Krish Prabhu

I don’t think sequentially there is going to be a downtrend, that’s because we did believe that inventory correction, the strongest correction happened in the third quarter. I think some of the factors we mentioned on the last call are still there. Wireless typically is a slower 4Q and wireless has been strong through first three quarters for this year. Last year, there was a significant Katrina build out at BellSouth, because of the lot of reconstruction most of that revenue came in, in the fourth quarter. So, I think seasonality has some other forces that have modulated it over the last four-five quarters. And as Tim mentioned, we have kind of looked at all the factors and we have given you what I think is a circumspect guidance for 4Q.

Tim Wiggins

I would just add that, I agree with Krish's comments on the fiber from a volume standpoint, but we also have some new pricing that will kick-in for one of our customers on the ONT in 4Q, and so that’s reflected both in our revenue and our margin guidance for 4Q.

Tim Daubenspeck - Pacific Crest Securities

I am sorry, can you just refresh. I didn’t catch the full margin guidance for Q4.

Tim Wiggins

It's similar to the guidance that we had prior to -- for Q1-Q2. It's 46%, plus or minus a point or so depending on mix.

Tim Daubenspeck - Pacific Crest Securities

And OpEx under control, same levels or up slightly?

Tim Wiggins

Absolutely.

Tim Daubenspeck - Pacific Crest Securities

I am sorry, I didn’t catch that.

Tim Wiggins

Absolutely.

Tim Daubenspeck - Pacific Crest Securities

Okay. Thank you.

Krish Prabhu

Okay, thanks. We have all the Tim's now on the call covered.

Operator

Your next question is from the line of Tal Liani.

Tal Liani - Merrill Lynch

Hi guys. I wanted to ask you about 2007. As we go into next year, what's your outlook, Krish, for the 5500? It looks like the strength is coming from wireless with year-over-year and sequential strength there. So, what's the outlook there? And also, if you can speak about GPON-BPON, what kind of mix you're expecting, and overall do you think that your unit shipment would be up next year versus this year? Thanks.

Krish Prabhu

Yes, thanks Tal. We believe that with our new FP11 release on the cross-connect, which has very high density configuration, has integrated data capability, also Ethernet aggregation. We did see a slight increase in the number of new systems deployed in 3Q. We think 2007 is going to be another strong year for us as far as cross-connect and wireless is concerned. On the last call, we gave you some data about minutes of use and the traffic hitting these networks and as long as that continues to grow, we see our customers continue to expand the network capacity pretty much in sync with the growth in minutes of use. We've seen that happen all through '06 and we anticipate, at least our projection is, it will continue at least in the first half of '07. We are also coupling a lot of our 5500 sales now with our 8800, because they all work under the same network manager and that does give us a very good smooth transition from voice to data in these wireless networks.

Let me talk a little bit about BPON-GPON. We have a true next generation GPON product, which goes into our customers lab for testing later this quarter. We can't really comment on what our customer is going to do and at what rate they are going to transition from BPON to GPON. We do believe with all the information we have currently that 2007 will be a strong BPON year. We think that unit shipments will continue to grow as long as the customer has marketing success. I think with over 700,000 ONT shipped, we are now talking about a fairly sizable deployment on FTTP. And just to give you a data point, in the days of ISDN, the total amount of ISDN terminations was in the range of 100,000. So, fiber has really taken off in a big way and we think our customer is going to continue to generate maximal revenue, especially video revenue off of this base that's been growing. We also have a full family of multi tenant units and multi- dwelling unit ONTs that are really ideal for any urban deployment they may do in their major metropolitan areas. So, I really can't comment, Tal, on at what point they go over from BPON to GPON but we do have from the visibility that we see, we have a pretty ambitious BPON program for 2007. What was your other question or did you have one?

Tal Liani - Merrill Lynch

No. I'll take the opportunity to ask a follow-up question but I did not have another question.

Krish Prabhu

Okay.

Tal Liani - Merrill Lynch

Can you comment about pricing, Krish you before going – before coming to Tellabs, you worked in Access in another company and you saw pricing going down on DSL as the market started to grow and companies outside of Alcatel struggled to maintain profitability. Going into this cycle, it looks exactly the same thing with now pricing going down in December and GPON, another hit the pricing next year. The question is, what is going to happen to profitability if unit shipment is going to grow? What’s going to profitability in this space? Can you bundle any of your products with access in order to improve the profitability of your overall access portfolio?

Krish Prabhu

There was some similarities between DSL rollout and the fiber rollout, because the characteristics are similar. You have a high density configuration at the network, and then you have a pretty high-performance, low-cost unit at the side of the house or inside the house. There is a big difference in that. For DSL the labor cost was not that big. At the end of the day, you could go and buy a DSL modem wherever you wanted and Alcatel was pretty aggressive in selling its chipset, so that the ODM market in Far East took off and the pricing of DSL terminations at the home came down dramatically. I think with the ONT, things are going to be a little bit different. Firstly, the labor cost in the home is a primary driver. That overwhelms the cost of the ONT. Our ONT is very, very intelligent in terms of self provisioning or can be continued to work closely with the customer to bring the labor cost down, labor time down. The ONT also does a lot more and could do a lot more depending on what happens in home networking, what happens in home gateways. So, I see, as I look at the next four or five years, while the ONT will commoditize in the context of hardware components and we already see very good chips and we also see system on a chip type solutions, I do believe that the ONT will also be far more software savvy than plain DSL modem, and depending on what portion of the home gateway gets integrated in the ONT, we might see a fairly complex device.

Now from our standpoint, we have invested a lot in staying ahead of the price decline on the cost side. We also in our new GPON OLT, we have a very high density configuration that gives us fairly good margins. And we have learned a lot from what happened in the DSL days, and yes, we are ready for the challenge. Time will tell, but I do believe it’s a very exciting business and it’s a business in which we can make good money and in the process, also be more strategic with our key customers.

Tal Liani - Merrill Lynch

Thank you.

Operator

Your next question is from the line of John Anthony.

John Anthony - Cowen & Company

Good morning, guys. Little confused here, so can we just go over the guidance relative to the comments you made, Krish, on Katrina. Is there anyway to factor that out and tell us what in apples-to-apples comp would have been?

Krish Prabhu

Compared to 4Q last year?

John Anthony - Cowen & Company

Yes.

Krish Prabhu

We said -- I don't really -- I mean, this is order of magnitude assessment, because we haven't really looked at it that way, that's an interesting question. But we said that at the start of the year revenue was growing. First half of the year revenue was growing year-on-year 19%, in the third quarter we think revenue grew 13%. We guided between 525 and 550. If you factor out Katrina and the impact of Katrina from 4Q of last year, I think revenue -- year-on-year revenue, if you come in at the higher end of the guidance, especially the inventory correction at one of our customers is complete and they order ONTs, I think we will still see year-on-year revenue growth similar to what we saw in the third quarter.

So, I think Tim Wiggins on the last call said, the growth rate was slowing down from 19% to between 10% and 15%. We grew 13% in 3Q and if you factor out Katrina, I think we will see a similar growth in the fourth quarter, especially if you come in at the higher end of our guidance range.

John Anthony - Cowen & Company

Okay. But on a sequential basis it seems that there are, even X-Katrina, it seems like the sequential comparison relative to last year is not as strong. Have you seen any sort of deterioration in the last few weeks or is this something that you'd seen consistently throughout the third quarter? And can you also address a couple of contracts that you had been shipping through throughout the year, including Telstra? Did you recognize any revenue from Telstra in the third quarter? And then along the same lines, did you recognize any Feature Pack 11 revenue in the third quarter?

Krish Prabhu

John, you have to realize that as I get older my memory stack gets smaller, so the four questions I am going to ask someone for help here. But let me address the last question first. Yes, we did recognize FP11 revenue that we shipped, in fact, quite a large number of new systems went out and we expect more of that as we go into the next two quarter. Of course, that's dependent on the budget that they have at the end of the year and how they would spend in a particular quarter, but FP11 will successfully ship, successfully deploy and the revenue recognized. We also recognize the revenue from Telstra, not all of it but a portion of the revenue. And as you know, especially for network gear revenue recognition rules under the new accounting schemes are very stringent. But we did recognize and we continue to deploy a lot of nodes in Telstra's network.

Now, the other question you had was ex-Katrina 3Q to 4Q sequential change.

John Anthony - Cowen & Company

Yes. It still looks like its slowing. So, my question is, have you seen a deterioration in the environment since September or how have things been trending since the close of the third quarter?

Krish Prabhu

Well, I think the -- no, we have not seen deterioration in the environment, but I do believe that historically the last two quarters of the year, wireless does slow down. So, we will see some of that. Now, if you look at 3Q to 4Q in '05 and compare it to 3Q to 4Q in '06, there was a significant ramp up in FTTP, especially going 3Q to 4Q last year and this year there is an inventory correction happening in FTTP. So, it is not just Katrina which was largely FTTC, but the other aspect is the inventory correction that happened -- that is happening in FTTP. Now, we think that will correct itself out here in this quarter. But, again, it's tied to our customer's marketing success.

John Anthony - Cowen & Company

Okay, and one last question. Given your comments on service provider budgets, are you getting any indication that there is going to be a snapback in demand in the first quarter or you just kind of -- do you not have any visibility in to the first quarter?

Krish Prabhu

Well, I think -- I didn’t make the comment that service providers are cautious about budget, I think that’s -- on the last quarter we talked about, Italy's BellSouth waiting for that merger at AT&T to be behind us. I do believe that we -- every product that we sell is sitting in a part of the network where the traffic is growing. I mean there is no doubt about that. We see that in wireless backhaul, a lot of people have forecasted wireless backhaul would dry out this year, but the minutes of usage go up, the traffic goes up and the customer has no choice but to increase the capacity and we see that. We have continued to transition that. Where there is a transition from voice to data happening, we have provided the customer with transition solutions that are still the customer's best option. So in fiber access we see that, any success our customer has in offering video services or competitive broadband services, which has a database above 3 meg their preferred path today is fiber as opposed to DSL or copper.

On the operating expense side for Access we have already seen rates of -- network reliability rates far greater in fiber than in copper. So I think there is compelling reasons for a customer to continue to deploy not only in these portions of the network where our products are embedded, but also to use these solutions. So I see no reason why things will slow down in '07.

John Anthony - Cowen & Company

Okay. Thanks a lot.

Operator

Your next question is from the line of George Notter.

George Notter - Jefferies & Company

Hi. Thanks very much guys. I had a question about your guidance looking into next year. I think you've commented recently that you should be able to go to grow the business 10-15% looking into next year on the top line. Is that still your guidance for next year and maybe you can talk a little bit about some of the swing factors that you see in terms of driving towards that kind of growth rate, if indeed that's the right number. Thanks.

Krish Prabhu

Let me ask Tim to address that question.

Tim Wiggins

Sure. George, I think the first thing we want to say is that we don't guide past the current quarter. We do have a model that has 15% growth as an objective and I was out on the street probably three or four weeks ago and talking about '07 and said we're working on strategies internally where we can see a path to get there. It's not easy but I think Krish's last comments were right on in the sense that we still feel very strongly that our products are lined up where our customer needs to fix bottlenecks in their networks. So as we look into '07, we are not sure what our customers are going to do in terms of CapEx. It's too early to tell but we like where we are positioned in the network. We've got the 7100 coming on next year. We've got the cross-connect business. So we think we'll continue to have a good solid year. So we see an avenue to get there; how it's going to exactly play out time will tell.

George Notter - Jefferies & Company

Got it. One quick follow up, just talking about the -- you have the cross-connect business you committed on the 5500 then you mentioned that there were about 20% of that installed base was empty slots. Any idea what that metric might look like for the Access Max product line?

Krish Prabhu

Yeah. That’s a good question and their deployment characteristics are different for Access and for core products like cross-connects, but we have seen -- someone was asking about trends in 3Q. Through 2Q and 3Q we have seen growing card slot demands for Access Max especially as we have introduced a new card that does six lines of voice and six lines of DSL on a card which is a very popular configuration that allows all copper-based Access Max platforms to continue to offer voice on day one, but pre-provision it for data so that when a customer calls for DSL you can just turn on a switch in software and they get DSL. So this is very popular, and we have seen an increase in card slots. You may recall George when we had acquired AFC there was a lot of concern about the copper piece of the business falling off, but over the last several quarters the copper to fiber ratio is pretty much held even as the overall business has grown, the access business. We also have a sizable deployment of Access Max in Telkom, South Africa and a little bit of the same phenomena is being seen there too.

So I think the issue with Access Max is not so much empty card slots, but more upgraded cards that go in the same slot and provide a variety of services and could provide additional services like Ethernet, backhaul or VDSL2 drops and we have a lot of them in the works as we continue to build on the deployed base.

George Notter - Jefferies & Company

Thanks.

Operator

Your next question is from the line of Ken Muth.

Ken Muth - Robert W. Baird

First of all, on the 8800, can you give us a little bit more color about just kind of the breakdown there of international versus US, and any kind of customer look into that as a wireless or cable market?

Krish Prabhu

Yeah. Okay. We have -- we'll try to get you a little spread between international and domestic. We don't really try to break it down at a product level for reasons you can understand. But just to give you a sense, we have the 8800 deployed in cable markets, but the cable application is limited and if cable enterprise services, which seems to be a new threat for cable operators takes off, the 8800 is likely going to see some growth in that sector. The 8800 is really not quite a router or we don't really use it as a router in cable applications because our sweet spot really is multi-service, where you need both Layer 2 and Layer 3 switching.

In the international applications, we have -- we saw a lot of that in 3Q. We are building out a couple of large international networks, one of them was mentioned on the call is Telstra and there the application really is transitioning frame/ATM to IP/MPLS and also being able to offer Ethernet services, offer the same platform. And we do believe that there is opportunity not just in Australia, but outside Australia, any place where there wasn’t large ATM network and the first generation DSLAMs, all were ATM DSLAMs, this is an excellent avenue to migrate those networks to an IP world. As far as wireless in North America, I mentioned earlier on the call we are positioning this as a companion product of the 5500. We have had good success at one customer. We've got good interest along with our 8600 at a couple of other wireless customers. So, a big thrust in '07 will be to see if we can get this combination of 8600, 8800, and 5500 all under one network manager widely deployed in wireless networks in North America.

Tim Wiggins

Okay. In terms of your question about the geographic mix, it shifts around quite a bit depending on which customer is deploying. For this particular quarter, more than half of it was international.

Ken Muth - Robert W. Baird

And then, one quick follow-up on the managed access side, I mean it looks to be trending down in negative 15 to 20% year-over-year. Can you just give us a sense of what's going on there, do you've to redo that product category or is there something you are looking for a shift in another product area or give us a little bit of sense how you're looking at the managed access business right now?

Krish Prabhu

Well, the managed access really consisted of three products, an SDH product, 6300 family, a managed access product 8100, and then also we had our cable telephony product 2300. I think Tim mentioned on the call that the 2300 is really winding down, we've clearly seen that. And year-on-year, the biggest difference in the overall category was with the 2300. But we do believe that both with the 8100 and with the 6300 because they are embedded in wireless networks and some of them are actually sold through channel partners, who offer larger wireless networks bundled with their RAN offerings, radio access network offerings, we do think that this product line has significant light looking into '07 and '08.

We are refreshing the product with data capability in almost all of these -- both these products and which carry Ethernet on it, but we also have positioned the 8600 as a companion product. So, the 8600 in those international applications works under the same network management umbrella, so when a customer has got a deployed network looking to migrate voice to data, the ease with which they can do it under the same network manger makes it very easy for them to deploy the 8600 product. So, I do expect the combination of 6300, 8100, and 8600 to have good success as wireless networks continue transition from 2G to 3G.

Ken Muth - Robert W. Baird

Okay. Thank you.

Operator

Your next question is from the line of Ehud Gelblum.

Ehud Gelblum - J.P. Morgan

Hi, good morning. Can you hear me?

Krish Prabhu

Yes. Good morning.

Ehud Gelblum - J.P. Morgan

Thank you, three questions quickly if I could. One is when you look at the 5500 now, 2.8 million T1 equivalent after 2.7 prior quarter, 2.8 prior quarter before that, numbers were much lower in prior years, are we sustainably in the high 2s, would you expect to see it dip back down to 2.0 or lower, do you think it looks sustainably in the 2.5 to 3.0 range and higher, that’s question number one? Question number two, when you do look at the guidance of only 3% basically sequentially into the fourth quarter, can you help us take that apart a little bit. What are the assumptions by product line, normally transport has been up in the past, but now you are saying, I think that wireless backhaul generally has a weaker fourth quarter, and so, perhaps that's not one of the areas that will be up 3%. But if you can help us with, is it transport that’s up a little bit, but access down or access up a little bit, but transport down to hit somewhere in the mid range, and how -- what has to happen to get to the top of the range versus the bottom, which is essentially flat? And if you can separate the impact of the ASP decline on the ONTs, what would the sequential number in the fourth quarter have been in your mind Tim, if you did not have this price decline on the ONTs happening in November. So what's the organic real volume growth that really is happening there besides net ASP declines?

Tim Wiggins

Bob, I'll answer the last one first. If I told you that, then I’d be giving you the price decline, right?

Ehud Gelblum - J.P. Morgan

Nothing wrong with that.

Tim Wiggins

I think our customer is sensitive as we are, but I'm not sure how I can answer that Ehud.

Ehud Gelblum - J.P. Morgan

Could you give a range perhaps that it may have impacted the -- price decline may have impacted by 5, 10, 15 20 --

Tim Wiggins

One thing, I think we need to bracket the problem so that you know what we’re talking about. We’re talking about a product line that’s in single digits in terms of the percentage of total revenue, so whatever price decline, however steep it was, it's impact, at least as we look from this quarter to next quarter, it's not going to be that big. The bigger issue though is the question that was asked earlier I think by Tal about what happens as you get into a market where these quantities go into millions, and then can we sustain it because Tellabs traditionally is a core player, and now in access you're talking about a trend where the price continues to decline. Let me say that the ASP decline does have an impact on the margin. We talked about that last time because our bar is pretty high, we want to be at 50% of revenue from a margin standpoint, and as you know historically the ASP has gone from really growth negative margins to breakeven to slightly positive margin and then now, and now we have a price decline and cost reduction has its own time constrains that take some time, especially as you look at system and chip solutions.

But we feel that this is a part of the business that’s essential for us, especially as we try to understand what opportunities there are in looking at software content in the ONT down the road as we learn more about the ONT business. Let me come to the two other questions that you asked, because I think they are relevant in terms in trying to understand if our business is slowing down or business is holding its own or is it just a seasonal effect here at the end of the quarter. It is true that transport is traditionally stronger in the fourth quarter, whether it's budget flush related or whatever, every year we have had good transport sales in 4Q on the wireline side. This year's wireless growth has simply been phenomenal. You have pointed out, we were averaging 1.8, 1.9 T1 lines all through '05, and we kind of stepped it up to 2.5, 2.8 million T1 lines here in '06, and that is clearly unsustainable. Part of that was a correction, couple of customers who hadn’t done much build out last year waiting for their pending mergers; part of this is really tracking increased traffic in the network. We do believe this will come down to normal levels and we have kind of factored that in our guidance and we think some of that will show up here in 4Q, because 4Q historically wireless guys don’t spend that much, especially after Thanksgiving. So, that’s part of the guidance in the range, we think that the Access products, we can be sure what level of inventory correction at one of our customers still persist in 4Q. So, we have factored that a little bit in our guidance.

We have mentioned that earlier on the call that especially BellSouth going through a merger, is cautious in terms of it's spending, waiting for the merger to finish. But we did have a fairly good 3Q relatively speaking with BellSouth, which is encouraging. So, we guide you to the best of our ability. We take our responsibility to meet or beat that guidance very seriously. We have a very good track record over the last 10 quarters and we have looked at all the factors and we feel comfortable with the 525 to 550 guidance. Sequentially, I think, yes, maybe I don’t know what the growth is, it can come in at the top-end of the range, maybe the growth is 5%. But, we don’t have any more information at this time to shed anymore light on this problem.

Ehud Gelblum - J.P. Morgan

Right. So, it seems as though we going forward in the future years, fourth quarter seasonality will not be as much as it has been historically. I mean, you basically had 10% to 15% or more fourth quarter historical seasonality. It seems as though from now on those trends will not be there, '07 through '09.

Krish Prabhu

Ehud, don't know, don’t know. We just don’t know what are the budgeting patterns in the fixed part of the network, we don’t know what international guys do with respect to their budget, we are shipping a lot of our data products internationally now in 4Q. We are going to ship some of our products through channel partners especially our 8600, 8100 products. We have a pretty large wireless channel partner, who has won some business in Asia and which will impact the rollout of those products. So, I think it's too early to tell. We do believe that the wireless will slow down in 4Q. That is clear. And that’s historical, that's been happening every year and the wireline growth in cross-connects two, three years ago, we used to ship a lot of cross-connects to the wireline segment and for almost five, six quarters, now that things has slowed down.

Ehud Gelblum - J.P. Morgan

And one last question, if I could. You used to mention that inventory turns were down this quarter, as you are building up fiber products going into the fourth quarter. Can you explain why that is or there's larger orders that are coming during the fourth quarter that you are preparing for?

Krish Prabhu

Ehud, that’s really a function of the inventory adjustment, one of our key customers that product was already in the pipeline and so it was built and received and it is sitting here.

Ehud Gelblum - J.P. Morgan

Okay. Thank you very much.

Krish Prabhu

Okay. Thanks.

Operator

Your next question is from the line of Nikos Theodosopoulos.

Nikos Theodosopoulos - UBS

Yes, thank you. Just some quick questions. Just for clarification, I just want to make sure I heard this right, did you say earlier that if you exclude the impact from Katrina that if you achieve revenues at the high-end of your guidance, total corporate revenue growth would be about 13% in the fourth quarter, is that what I heard?

Krish Prabhu

We don’t know exactly what the Katrina impact was last year. We do know that there was a significant spike in orders and revenue in our 1100 product, which is the product that we ship to BellSouth. We also had some 7100 shipments to BellSouth as they were looking at their regional network during that reconstruction and what we said earlier was our best assessment right now is if we looked at 4Q of last year, factor out some of that and if it come in at the high end of our range here, we would be more or like 10% to 13% rather than 13%. We haven’t done that precise math, Nikos, but that's our best guess at this time.

Nikos Theodosopoulos - UBS

Okay. And do you have an update on 10% customers this quarter, who they were?

Krish Prabhu

Three customers, yes, the question was of top 10 customers?

Nikos Theodosopoulos - UBS

10% customers.

Krish Prabhu

10% customers. Okay, yeah. So, we have three.

Nikos Theodosopoulos - UBS

Three. Okay. And just one last question, on the 8800, you had a very good quarter there and I am just trying to look at this business going forward. Do you think that customer base is broad enough now that will continue to see sequential improvements in revenues or is it going to continue to be lumpy, but still shows steady growth? What is your sense of how this business will do going forward?

Krish Prabhu

Yeah. This business actually is probably going to go through a few more quarters of lumpiness, as you called it, largely because these networks, while we have them embedded in large customers, we have NTT, we have Telstra, we have Cingular, we have Telecom Italia, and we have Verizon. So these are premier Tier 1 customers and as they get more comfortable in transitioning more applications on this product, because remember this product sits at a key node in the network and this product is really a multi-application, multi-service product. So, as they get comfortable, we will start seeing that steady rise in deployment and we will start seeing that growth in revenue much like what we did in the early days of the cross-connect.

So, we are not -- I'd say, we are not at that point yet. We continue seeing, this past quarter we had quite a lot of growth at Telstra; prior to that we had quite a lot of growth at Cingular, prior to that we had quite a lot of growth at Verizon and Telecom Italia. So, I would say it's too early to tell that we have hit the phase where sequential growth is more predictable.

Nikos Theodosopoulos - UBS

Okay.

Krish Prabhu

It is seasonal though. It does more towards the second half of the year than the first half of the year.

Nikos Theodosopoulos - UBS

Okay, thank you.

Krish Prabhu

We have time for one more question, operator.

Operator

Your next question is from the line of Brant Thompson.

Brant Thompson - Goldman Sachs

Thanks very much. You talked about being able to pull together or see a path to 10% to 15% revenue growth for 2007, and Krish, you also had referenced your 50% gross margin goals. Can you just -- when I look at the mix going forward in terms of the Access business over the next year, can you -- is it possible right now to have a lot of conviction in kind of the 50% gross margin goal or will next year be more of a mix of gross margins running below that, but OpEx being held? How should we think about that -- that cost outlook? From what you discussed it seems like your mix is still going to favor gross margin something below 50% for most of next year. Thank you.

Krish Prabhu

Yes. Now, I think Brant that's a good question. We have -- I think this management team has worked pretty to deliver good operating margins. I don't know, there are many players out there but we are comfortably at $2 billion in annual revenue and we are very close, tantalizing to be close to 20% operating margin, and I think that's a lot of hard work. Can we sustain 50% gross margin if Access, especially ONT is at 10%, 15% part of the business? No, I don't think so, because that's a very price competitive business and as was asked in an earlier question, the prices will continue to fall. They are nowhere near terminal velocity in terms of price decline. But I really believe that our goal of hitting 20% especially in an environment where we can grow the top line and where the mix is favorable, which is what we saw in the third quarter, we saw 13% growth year-on-year; we saw large transport in data component, and we saw a mix of other products, is very achievable.

Now if you looked at '07, it's too early to tell. I think if normal buying patterns come because customers want to upgrade their networks or want to take care of network capacity issues, want to continue to build Access so that they can pursue an aggressive video rollout plan. We have a little more success in wireless backhaul internationally. We have more success with Tier 1s internationally with our data products. We managed to launch one or two Access products in international markets and we have a pretty good rollout of 7100, which we fully expect next year at least as one big customer continues to revamp their metro and regional networks. Yes, I think that growth rate is very achievable and our plans -- our game plans are all based on that. Our sales guys are incented with that growth rate in mind. It's just that they're not fixed in there that we can't tell you with more conviction than what we have said up to this point.

Brant Thompson - Goldman Sachs

Okay, thank you.

Krish Prabhu

Alright, thanks everyone. We appreciate your interest in Tellabs and we will see you on the next call. Have a good day.

Operator

That concludes today's conference call, you may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Tellabs Q3 2006 Earnings Call Transcript
This Transcript
All Transcripts