Lucent Technologies F4Q06 (Qtr End 9/30/06) Earnings Call Transcript

| About: Lucent Technologies (LU)

Lucent Technologies Inc. (LU)

F4Q06 Earnings Call

October 24, 2006 8:30 am ET

Executives

John DeBono - Vice President, Investor Relations

Patricia F. Russo - Chairman, Chief Executive Officer

John Kritzmacher - Chief Financial Officer

Frank A. D'Amelio - Chief Operating Officer

Analysts

Inder Singh - Prudential Equity Group

Jiong Shao - Lehman Brothers

Tim Long - Banc of America Securities

Paul Sagawa - Sanford C. Bernstein & Co.

Paras Bhargava - BMO Capital Markets

Simon Leopold - Morgan, Keegan & Company

Ken Muth - Robert W. Baird & Co.

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Lucent Technologies investor relations conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time.

(Operator Instructions)

As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, John DeBono, Vice President of Investor Relations. Please go ahead.

John DeBono

Good morning, everyone. With me today are: Pat Russo, Chairman and CEO; Frank D'Amelio, Chief Operating Officer; and John Kritzmacher, our Chief Financial Officer. We will begin with Pat and John providing an overview of Lucent’s results for the quarter and fiscal year, and then we will open the call up for your questions.

If anyone has not yet seen a copy of our earnings release, it is available on Lucent’s
website.

Before we begin, let me remind everyone that this conference call is open to the media and we are providing a simultaneous webcast of the call for the public. A replay of the call is expected to be available on the company’s website beginning this afternoon, and running through October 31st.

The PDF version of the slides we are presenting on this call will also be posted to our website for your reference.

I also want to remind you that today’s remarks contain statements that constitute forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. These forward-looking statements are not guarantees of future performance and involve certain risks, uncertainties, and assumptions that are difficult to assess. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted. For a list and descriptions of certain of these risks and uncertainties, I would like to refer you to the forward-looking statement disclosure in today’s press release and other information provided in our SEC filings.

Now, at this point, I will turn the call over to Pat.

Patricia F. Russo

Thanks, John. Good morning, and thanks for joining us. As we announced earlier this morning, while our performance for the full year of 2006 fell short of all of our expectations on the top line, we finished the year with a strong fourth quarter. Revenues were up 25% sequentially, due primarily to customer acceptance of our new EV-DO Rev A software and, as we previously suggested, this past quarter turned out to be our highest revenue quarter for the year.

For the full year, revenues were down 7% to $8.8 billion, compared with $9.4 billion in the previous year. That said, we were still able to maintain financial discipline across the business. We achieved a gross margin rate of 42%, and reported earnings of $0.11 per diluted share, and that of course includes some negative significant items of about $0.05 John will talk about.

He will provide you with the additional details on the overall financial results in just a minute, but let me just make a few comments at the macro level about the trends that we saw in this past year and give you an update on our pending merger with Alcatel.

First of all, if you recall, during last year’s year-end call, I referenced that we saw five macro expectations as we went into ’06. We said that:

  • We expected to see more IMS trials converting into deployments;
  • We expected that IPTV would begin to make more serious in-roads, and that video would play an increasingly important role in driving bandwidth demand;
  • We said that we believe 3G mobile deployments would continue to be driven by capacity demands, and that we would start to see a migration to Rev A and HSDPA;
  • We said that we expected to see Ethernet and its role, particularly in Ethernet-over-optical services, to be important; and that
  • We expected managed and professional services would become more important to our customers looking to reduce their operating expense and complexity in their networks.

From our perspective, these trends all played out in fiscal 2006. However, some of them did not play out as quickly as we had expected. Let me just provide a couple of comments on each.

First of all, in the area of IMS, certainly the IMS market opportunity did accelerate during the past year. We established ourselves as a thought leader in fiscal 2005, and we started ’06 by announcing IMS wins with Cingular and SBC. We finished the year by making in-roads in Europe with IMS service and solution wins at KPN, and by booking our first IMS revenues in Q4. Though the amount of revenue was relatively small, it was spread across the portfolio and has given us a base from which to continue to grow our IMS business.

We now have contracts with 10 significant customers. We continue to conduct many trials around the world, and these trials, as I have noted before, prove to be a key part of what is a lengthy and complex sales process. The work we are now doing with customers as they begin to deploy IMS-based services supports our view of the strategic opportunity this represents for new applications, expanded service opportunities, along with the IMS portfolio elements themselves. We continue to see this as an important segment for the future.

In the IPTV space, we believe that our support of Telefonica and PCCW has placed us among the leading IPTV vendors. With almost 300,000 commercial subscribers, Telefonica’s Imagenio service is among the largest deployments to date, and we are helping this customer now launch IPTV service in the Czech Republic and other countries.

You may recall in April we entered into a unique partnership with Telefonica, where we assumed responsibility for the management and evolution of their IPTV software solution, which now has been further enhanced with some Bell labs developed content management customization and quality of service features. We are now offering this platform, called MiViewTV, along with the IPTV network and business services, to all of our customers.

In mobility, fiscal 2006 was the transition year we talked about, and we began to see the migration to Rev A and HSDPA late in the year. Our Rev A software achieved commercial availability during the fourth quarter, and the sales of this software, which is associated with the circuit packs we had been deploying all year, were a significant contributor to our revenue increase this past quarter.

We expect to issue further Rev A enhancements in the spring and the fall of 2007 to enable our customers to offer enhanced high bandwidth data and multimedia services, such as push-to-talk and video telephony. Last week, we announced we would develop the software and infrastructure to support the rollout of push-to-talk services on Sprint’s Rev A network. However, it is important to note that we do not expect that these future releases will have the same degree of impact on our top-line as we saw in this particular quarter with the initial release of Rev A.

While our quarterly revenues for the mobility access and applications business were up 54% sequentially, on an annual basis, this segment declined 13%. As we have said on previous calls, this decline was primarily driven by the delays in the 3G licenses in China, to a lesser extent by more selective participation in some very highly competitive bids in India and, as we have noted previously, wireless deployments in North America were slower than anticipated, affected in part by the carrier consolidation activity that was underway in ’06.

In our applications business, we posted year-over-year growth, and our pending acquisition of Mobilitec will really help our ability there to help mobile service providers deliver and manage multimedia content.

In the Ethernet-Over-Optical space, which is part of our optical business, in which our product sales grew 7% year over year, which was faster than the overall market, we see a continuing trend toward deployment of ethernet over SONET and SVH made of ethernet.

Enterprises and government agencies are deploying these networks for IT and business operations to increase bandwidth and cut their leased line costs. Increasingly, wireless operators are using optical ethernet architectures to support back-haul requirements, so they can reduce their lease capacity and their overall expenses, and to help simplify their migration to 3G networks. Of course, a growing number of carriers are using ethernet to support their IPTV deployments.

As each of these developments indicates, this is an important space, and one in which we believe we have made some good progress. Since closing our Riverstone transaction, we have expanded our customer base and launched two new cost-effective edge platforms, Lucent ethernet routers, the 15100 and the 15800, as we continue to position ourselves to address these opportunities going forward.

Lastly, let me just comment on services. As you know, services has been an important business for us, both in support of our products business and independent of our products business, and we made some progress in fiscal ’06.

We were able to grow our services business in spite of the decline in our products business. The revenues were up 4% year over year, driven largely by network integration and deployment solutions due to increased UMTS 3G mobile, multi-vendor services and broadband customer deployments.

We continue to believe that demand for professional services will be driven by increased network complexity and the need for multi-vendor skills. Our efforts in some of the newer areas we targeted, such as network transformation, are beginning to pay off. We announced our prime integrator win at KPN and Manx Telecom, which I think begins to demonstrate growing acceptance of our ability to help customers manage the migration from legacy to IP networks.

In ’06, we also made good progress in signing new managed services agreement, many of them multi-year, and our managed services revenues almost doubled year over year, albeit on a smaller base.

In summary, while our results were impacted by a slower pace and scale of adoption, the broader trends that we had identified, we believe remain valid. While we are certainly disappointed in the overall decline on the top-line for the year, I think it is important to note that we did see growth in some of the strategic areas in which we had been investing, and that would be growth in our optical, professional services, managed services, applications, UMTS, IMS, and data businesses.

While growth in these was not enough to offset the declines, particularly in the Asia-Pacific region, we believe that these are the strategic areas that will continue to contribute to growth in the coming years.

I think our decisions and our actions position us well as we approach the closing of our pending merger with Alcatel, and I think we have pointed out previously, and I would reaffirm, that the combined company will have leading positions in every relevant area to the network evolution that is currently underway.

Let me close with a few comments on the merger. We are working hard on our integration planning. The teams are making excellent progress. During this past quarter, we continued to fill out the company’s leadership team with further organizational announcements, so that our integration planning could progress with further detail. We will be ready to begin operations as a new company once the deal is closed, and we remain confident that we can achieve the identified synergy targets of $1.7 billion within three years.

The fact that the deal has not yet closed has introduced some uncertainty in customer buying decisions, especially in areas where there is anticipated product overlap. This is a short-lived condition, and we believe temporary, but we are seeing some impact as customers are pausing and seeking clarity about our decisions with respect to our product portfolio. These plans are obviously being worked and are very far along, but until the merger is complete, we are limited in our ability to answer our customers’ questions to the fullest extent that they want and we will be able to, once we close.

Last quarter, Lucent and Alcatel received shareholder approval of the merger, and we have completed most of the regulatory reviews. We have submitted our formal notice to CFIUS, and as we have said, that process can take up to 90 days. The application we submitted was comprehensive. We have been engaged in ongoing and productive discussions with the government officials, and we are hopeful that we will be able to move to a successful conclusion of this important process. Therefore, I remain confident that we are on track to complete the merger by the end of this calendar year.

At this time, I will turn it over to John Kritzmacher, who will provide you more financial detail.

John Kritzmacher

Thank you, Pat. Good morning, everyone. Today we reported revenues for the fourth fiscal quarter of 2006 of $2.56 billion, an increase of $511 million, or 25% sequentially, and an increase of 5% as compared to the year ago quarter.

Similar to the patterns exhibited in fiscal years 2005 and 2004, the fourth quarter was the highest revenue quarter in fiscal 2006.

Sequentially, revenues in the U.S. increased 40% to $1.8 billion, while non-U.S. revenues increased 1% to $789 million. This resulted in a geographic mix of 69% in the U.S., and 31% outside the U.S. As Pat mentioned, the sequential increase in revenues was driven largely by an increase in sales to our North America mobility customers. As anticipated, these incremental sales were primarily related to the rollout of our EV-DO Rev A and HSDPA solutions in the fourth quarter.

For fiscal year 2006, revenues decreased 7% to $8.8 billion. In the U.S., revenues decreased 1% to $5.9 billion, while non-U.S. revenues decreased 17% to $2.9 billion. Most of the year-over-year decline in non-U.S. revenues was related to China and, to a lesser extent, India, where combined revenues declined by about $500 million.

We reported net income of $371 million, or $0.07 per diluted share for the fourth fiscal quarter of 2006. These results compare with net income of $79 million, or $0.02 per diluted share in the third quarter of fiscal 2006, and net income of $372 million, or $0.07 per diluted share in the year-ago quarter.

Fourth quarter results included approximately $73 million, or about $0.01 per diluted share in favorable tax impacts, including a $42 million reversal of U.S. deferred taxes, previously provided for during the nine months ended June 30, and $31 million in certain other discreet tax items, including the reversal of certain non-U.S. tax evaluation allowances.

Please note that the average number of shares outstanding used to calculate diluted EPS for the fourth quarter was about 5.5 billion, which includes the dilutive effects of in-the-money stock options and our 2.75% and 8% convertible securities. The 7.75% convertible securities were excluded from the calculation, as the effect of adding back the related interest to net income and increasing the total share count to include the impact of their conversion was anti-dilutive.

The gross margin rate for the fourth quarter was 44% of revenue, as compared to 41% in the third quarter. The sequential increase was due to the favorable impact of increased sales volume and a favorable shift in product and geographic mix, which were partially offset by higher inventory and warranty charges, and higher accruals for employee incentive awards.

Operating expenses for the fourth quarter were $739 million, as compared with $665 million for the third quarter, and the operating margin rate was 15%, as compared to 8% in the third quarter.

Despite the annual revenue decline, we reported a gross margin rate for fiscal 2006 of 42%, as compared to 44% for fiscal 2005. The decrease in the annual gross margin rate was largely the result of lower volume and an unfavorable shift in product mix.

For the fiscal year, operating expenses were $3.02 billion, as compared with $2.86 billion for fiscal 2005. Gross margin and operating expenses for fiscal 2006 reflect a total reduction of approximately $300 million in annual and long-term employee incentive awards, as compared with fiscal 2005.

In the net pension and post-retirement benefit credit for the fourth quarter was $107 million, an increase of $3 million as compared to our third quarter. The net credit includes a gross pension benefit of $167 million, partially offset by a cost of $60 million for post-retirement benefits, primarily retiree healthcare.

Consistent with prior periods, about two-thirds of the net credit is reflected in operating expenses, and the remainder impacts our gross margin. The net pension and post retirement benefit credit for fiscal 2006 was $429 million, a decrease of $289 million, as compared to fiscal 2005.

For Lucent on a standalone basis, we currently expect a reduction in the annual net pension credit of approximately $250 million for fiscal 2007. The reduction is primarily due to a decrease in the assumed rate of return on pension assets as a consequence of the change in asset allocation for our represented retiree trust, which we disclosed on our last earnings call.

Please note that upon closing of the pending merger with Alcatel, the amount of the net pension credit may change materially due to many factors, including purchase accounting adjustments and differences in accounting standards under IFRS.

I would also like to call your attention to another important matter related to accounting for pension and retiree benefits. During the fourth quarter, we elected to early adopt financial accounting standard, or FAS-158, which governs accounting for defined benefit pensions and other post-retirement benefit plans. The standard requires recognition of the funded status of these plans as measured under GAAP in the financial statements. Previously this information was only required in footnotes. With the adoption of FAS-158, the net assets and liabilities associated with our pension and retiree benefit plans were adjusted, resulting in a direct charge to equity of approximately $500 million, based on the annual measurement completed on September 30, 2006.

I will provide further information on the improved funded status of our pension and retiree benefit plans later in my presentation. For now, let me provide further detail on our operating expenses.

Operating expenses for the fourth quarter of fiscal 2006 increased by $74 million sequentially to $739 million. Total SG&A increased by $48 million to $418 million, and R&D increased by $45 million to $321 million.

The R&D amount excludes $52 million for certain software development costs that were capitalized in the quarter, as required under U.S. GAAP.

The $48 million sequential increase in SG&A was primarily the result of $27 million in higher accruals for employee incentive awards, $25 million in charges for a dispute related to economic incentives provided in prior periods by a non-U.S. jurisdiction, and $11 million in bad debt and customer financing charges, as compared to a reversal of $2 million in the third quarter. These were partially offset by $17 million of reduced spending, related primarily to general corporate support functions.

The $45 million sequential increase in R&D was related largely to $22 million in higher accruals for employee incentive awards, and $19 million, related largely to higher spending in the multimedia network solutions segment.

With respect to stock-based compensation, fourth quarter results included the recognition of $22 million in stock compensation expense, of which $19 million was reflected in operating expenses. Merger-related expenses of $34 million, which included items such as the printing and mailing of our proxy materials, are included in other income.

As I mentioned a moment ago, during the fourth quarter, we recognized an income tax benefit of $45 million. This benefit was driven largely by a $42 million reversal of previously recorded U.S. deferred taxes, and $31 million in certain other discreet tax items, including reversal of certain non-U.S. tax evaluation allowances. These more than offset our non-U.S. tax expense of $28 million for the quarter.

As you may recall, we began to recognize U.S. deferred tax expenses in fiscal 2006, based on the relationship between deferred tax liabilities associated with the pension credit and deferred tax assets related to other post-retirement benefit expenses, primarily retiree health care. We expected that during fiscal 2006, these liabilities would exceed the assets, requiring us to tax affect some earnings related to the pension credit. As a consequence of implementing FAS-158, this shift did not occur, and we reversed previously recorded U.S. deferred income taxes.

Now, let me turn to the performance of our operating segments.

For mobility access and application solutions, revenues for the fourth quarter were $1.3 billion, an increase of $450 million, or 54% sequentially. U.S. revenues increased by $452 million, or 69%. As previously mentioned, the sequential increase was driven largely by EV-DO Rev A and HSDPA sales. Non-U.S. revenues decreased by $2 million, or 1%.

Segment income for the fourth quarter of $506 million increased by $278 million. The increase was due primarily to higher sales volume and a higher gross margin rate. The higher gross margin rate was largely the result of the higher sales volume and, to a lesser extent, a favorable shift in product and geographic mix.

Fourth quarter revenues for multimedia network solutions were $440 million, a decrease of $14 million, or 3% sequentially.

Access and data networking revenues decreased sequentially by $37 million, or 15%, while optical revenues increased sequentially by $23 million, or 11%.

U.S. revenues for multimedia network solutions increased by $11 million, or 7%, due primarily to higher sales of optical products. Our non-U.S. revenues decreased by $25 million, or 9%, largely as a results of lower access and data networking sales, primarily in Europe.

Segment income of $14 million decreased by $12 million sequentially, primarily due to an increase in expenses. The sequential increase in expenses was largely related to incremental investments and our next generation optical technologies, and investments in access technologies under a recently announced joint development agreement.

Our converged core solutions, revenues for the fourth quarter were $157 million, a sequential increase of $10 million, or 7%. U.S. revenues increased $1 million, or 1%, and non-U.S. revenues increased by $9 million, or 14%. Circuit switching and PHS revenues of approximately $110 million in the aggregate accounted for 53% and 19% of the total converged core solutions revenues, respectively.

Segment income of $34 million increased by $14 million sequentially, due primarily to higher sales volume and an increase in the gross margin rate. The increase in the gross margin rate was largely due to higher sales volume and a favorable shift in product mix.

Finally, for the services segment, revenues were $644 million in the fourth quarter, an increase of $63 million, or 11% sequentially. The sequential increase was driven primarily by an increase in professional services sales in the U.S. and Asia-Pacific regions.

On a sequential basis, U.S. revenues increased by $38 million, or 12%, and non-U.S. revenues increased by $25 million, or 10%.

Sequentially, segment income increased by $11 million to $95 million, due primarily to the increase in sales volume, which more than offset a lower gross margin rate. The gross margin rate for the fourth quarter decreased by one point sequentially, 25% as a result of an unfavorable shift in services mix.

Cash generated from operating activities in the fourth quarter was $123 million. Increased use of cash for working capital was primarily driven by higher accounts receivable, consistent with our revenue growth in the quarter. Capital spending, which includes expenditures for internal use software, was $64 million in the fourth quarter. During the fourth quarter, we applied $62 million of operating cash to fund retiree health care and other post-retirement benefits. This amount excludes the reimbursement of $25 million funded in the year-ago quarter.

While we are on this point, I would like to provide some additional information on our pension and post-retirement benefit plans.

As of September 30, 2006, the aggregate fair market value of pension and other post-retirement benefit assets was $35.9 billion, as compared to obligations of $35.8 billion. Aggregate funding status of these plans improved by $2.5 billion during fiscal 2006, primarily due to plan asset performance and, to a lesser extent, a 25 basis point increase in the discount rate for measuring pension and post-retirement health care liabilities.

Our U.S. pension plans meet the requirements of ARISA’s current funding rules, and we do not expect to make any contributions to the qualified U.S. pension plans through 2007. We also currently believe it is unlikely that any required contributions would have a material effect on our liquidity through 2010.

The fair market value of assets held in pension trust was approximately $35 billion as of September 30, 2006, as compared to approximately $34 billion as of June 30, 2006. Almost all of these assets are related to the U.S. pension plans.

On August 17th, President Bush signed into law Pension Protection Act of 2006. The principle changes under this legislation relate to the way assets and liabilities are valued to determine required pension contributions.

Although section 420 legislative changes were included in the Act, additional changes that we were seeking are still being pursued as technical corrections. We continue to work with our unions to seek these legislative changes, which would give us greater flexibility when using excess pension assets to fund retiree health care.

The Act does provide for what is called a collectively bargained transfer. Under this new type of transfer, pension assets in excess of 120% of obligations would be available to fund retiree health care costs. Under a conventional transfer, the threshold was 125%.

As of the January 1, 2006 valuation date, there were approximately $2.8 billion of pension assets that would be eligible for collectively bargained transfers to fund retiree health care costs for our formerly represented retirees. $2.2 billion would be available for conventional transfers.

We currently expect to make a collectively bargained for transfer of about $550 million in December, 2006. This transfer will cover formerly represented retiree health care costs from October 2006 through December 2007.

Together with our unions, we have amended our collective bargaining agreement to extend the deadline for technical corrections to the acts to June 30, 2007. If, by that date, the legislation imposes constraints that would significantly impair the company’s ability to pre-fund retiree health care costs using excess pension assets, Lucent would have the ability, at its sole discretion beginning on January 1, 2008, to adjust the level of subsidy it provides for formerly represented retiree health care.

Next, I will provide some details on working capital and other metrics.

Inventory turns increased from 6.3 to 7.9 turns, due largely to the sequential increase in sales volume, while DSOs decreased from 68 to 57 days. The decrease in DSOs were driven primarily by the timing of billings and collections in North America during the fourth quarter, and our headcount as of September 30, 2006, was approximately 29,800, a net decrease of 400 from June 30, 2006.

Including the impact of the Riverstone acquisition, our headcount is down about 800 over the fiscal year, reflecting a net decline of about 1100 in the U.S. and net adds of about 300 in non-U.S. regions.

Now, let’s turn to the balance sheet. More specifically, our cash, marketable securities, and debt profile.

As of September 30, 3006, Lucent had cash and marketable securities of $3.4 billion, down approximately $250 million as compared to June 30, 2006. The sequential decrease was driven largely by the use of $368 million in cash in July to redeem the remaining outstanding 7.25% notes. As noted earlier, we generated cash from operating activities of $123 million during the quarter. Total debt and convertible securities decreased in the fourth quarter to $5.1 billion, and as a result, our net debt position decreased by about $100 million to $1.6 billion.

If we continue to have the right call, the 8% convertible security is at par. Approximately $486 million of these securities were outstanding as of September 30, 2006, and we are continuing to evaluate our options, relative to the retirement of these securities.

From a maturity perspective, our debt portfolio continues to remain relatively long-dated. As of September 30, 2006, about 85% of our debt in convertible securities mature in or after 2010, assuming the 8% convertible is put back to us.

With that, let me summarize today’s report on Lucent’s financial results for the fourth fiscal quarter. We reported revenues of $2.56 billion, a gross margin rate of 44%, an operating margin rate of 15%, and earnings per diluted share of $0.07.

As Pat mentioned, we continue to expect our pending merger with Alcatel to close by the end of the calendar year. As such, and as we have previously announced, we will not be providing any guidance on future results at this time.

Now, I will turn it over to John DeBono to open our Q&A session.

John DeBono

Thank you, John. We are now ready to begin the Q&A session. As soon as you have finished asking your question, you will be removed from the queue so that we can get to as many questions as possible. Operator, can we have the first question, please?

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question is from Inder Singh with Prudential.

Inder Singh - Prudential Equity Group

One of the bright spots I think in the results that you reported this morning was obviously strength in your CDMA wireless business. That market seems to be continuing to be strong, at least for you. It is a market I think there have been some questions about, in terms of growth and so on.

Can you talk in the context of carrier consolidation that you just talked about earlier, how you see this market playing out, and whether you see it remaining strong. I think you mentioned some future releases of EV-DO Rev A into 2007 as well.

Patricia F. Russo

Thanks, Inder. First of all, I commented in North America, I think it is fair to say that our CDMA business in North America was impacted to some extent as a result of some of the consolidation activity. We will not specifically quantify it, but I think there is no question that that occurred.

With respect to the CDMA market, what we have said and what we continue to believe, first of all, it is a large market, and obviously Lucent has a large business. We see this market as being stable. We think there will be areas of growth. We think there will be areas where it may decline a little bit, but fundamentally, we see this as a large and stable market for clearly a few years out. We have, as I have noted many times previously, further technology upgrades with respect to Rev A on to Rev C, as the work continues, as the whole industry moves towards “4G”, but I think we would all agree that is some time out.

We have not yet seen the impact of the all IP core associated with CDMA or some of the next generation services, so we continue to see it as a large, stable market, one which offers opportunity for us and one that we are continuing to invest in.

John DeBono

Next question, please.

Operator

Your next question comes from the line of Jiong Shao with Lehman Brothers.

Jiong Shao - Lehman Brothers

Thank you very much. My question is about the converged core segment. It looks like it has not shown as much growth as I expected, say last year. Could you just talk about the dynamics going on there, and how much of your converged core business today still comes from the legacy business, and how much from the next-gen type of products?

Also, any color you can provide on the IMS, like how much of the revenue from the converged core now from IMS? Thank you.

Frank A. D'Amelio

In terms of the rhythm of the business, what is going on there is I will call it the legacy revenues continue to decline at a rate that exceeds the pick-up in revenue for the new next generation products and solutions. At a macro level, that is what is going on.

If you look at the percentages there, circuit switching is, give or take, about 50% of the number. PHS is about 20% of the number, and those two product lines continue to decline, as I mentioned.

We still see IMS as clearly an opportunity for growth going forward, but the uptake on that, the revenues we are looking from that, the market opportunities for that, from a revenue perspective, are building. That is still very much -- I will call it an invest type of opportunity. We see future opportunity there, but from a revenue perspective, that is relatively small from an overall scheme, and we see that as a big opportunity going forward. That is what is going on.

Patricia F. Russo

Let me just punctuate something I said previously, because I think it is important to understand about this sort of IMS space, because as we all know, it is pretty large and for some, it may seem a bit nebulous, and for all of us, it has been a long time coming.

Our learnings are this is the next generation transformation in the core of networks, and it will play out for many, many years to come, and so these kinds of changes do not occur as quickly as any of us hope or expect when we get started.

We can see that by the trial work we are doing and the time it takes to actually get these new services up, get them tested, and then get them deployed on a massive enough scale that you really start to see the numbers.

This was the first quarter we actually recorded real IMS revenue in the IMS portfolio, so that is point one, and we expect that will continue going forward.

The second thing I think you have to look at is where else do you see evidence of the IMS position, and there is two places additionally to look. One is applications and the second is services. If you look at our applications business, we had very good growth in our applications business in this same quarter, not totally all related to IMS, but certainly there is a relationship between our IMS position in these accounts and our ability to grow our applications business.

The second place you look is in services, and if you look at our professional services business, which is a lot of the integration work and the complex work that make up a good piece of these “IMS contracts”, you also have to look there for the opportunity, so we have said for some time that there clearly is volume to be had in the core IMS portfolio element -- gateways, soft switches, et cetera -- but it is really a more expansive opportunity for us over time. While all of us would hope it would come more rapidly and in a more accelerated way, we are still in the relatively early days. We think ’07, as we said, late ’06 and into ’07 is when we think this will start to actually register from a numbers standpoint.

Frank A. D'Amelio

If I could just add one thing, if you look at this from a footprint perspective, we clearly believe we are making good progress. We have announced 10 customer contracts. This year, we have announced contracts with Cingular, SBC, and now AT&T. We just recently announced an IMS contract win with KPN, and then we have 116 trials for IMS elements with 24 customers.

We feel we are making very good, steady, solid progress from a footprint perspective as well, which is a key element of positioning ourselves for the future.

John DeBono

Next question, please.

Operator

Your next question comes from the line of Tim Long with Banc of America.

Tim Long - Banc of America Securities

Thank you. If I could just follow-up on that, and then ask a question about wireless CDMA. On the IMS, does getting the revenues this quarter, does that change your timeline at all, or your expectation as to when it could be a meaningful contribution?

Secondly, you mentioned good software revenues in Q4 for EV-DO Rev A. Could you just talk a little bit about what type of impact that has to both revenues and I would imagine it had a big positive impact on gross margins in the quarter? Thank you.

Patricia F. Russo

I will take the first question, and then I will let either Frank of John answer the second question. In terms of the IMS revenues this quarter, does that have any -- you asked whether it has any meaningful contribution to a change in view about how this might ramp going forward. The answer is no. We have been saying that we believe in the latter part of ’06 and then on into ’07 is when we would start to see this accelerate.

Of course, what you get at the beginning is very high growth rates on obviously a smaller base, and then as that base builds, the growth rates decline, but it becomes more meaningful just in terms of absolute numbers.

We see no change in that as a result of this quarter. We think we will see that flow as we move through ’07 and then on to ’08 and beyond.

John Kritzmacher

With regard to your question around the impact of Rev A deployment on our revenues for the quarter, what I would say is, as we called out earlier, the primary driver for the increase in revenues sequentially was in fact the rollout of EV-DO Rev A, along with the rollout of HSDPA, but clearly Rev A was the primary driver in the sequential increase.

Then, with regard to the impact on margins, you mentioned software and how that might driver our margin rates. I would just point out that the Rev A deployment is a combination of hardware and software, so you should not think of that uptake as being all software. It is a typical mix of hardware and software, as has been the normal trend for our mobility business.

The reason we refer to the software so much is that in order to be able to recognize revenue on the hardware, we also had to have that software release out there, accepted, and generally available.

John DeBono

Next question, please.

Operator

Your next question comes from the line of Paul Sagawa with Sanford Bernstein.

Paul Sagawa - Sanford C. Bernstein & Co.

Quickly, a clarification and then the question. The clarification is just, you have a timeline of the events as the deal closes here, you get the approvals, you actually close the deal, you get the distribution of the ADR. Would there be some planned road show after that? I assume this is the last quarter, if everything goes on schedule, the last quarter we will see any separate Lucent earnings, so we get a sort of combined year-end earnings statement. Could you just give a view of how this is all going to play out from your information flow to investors over the next little bit? That would be appreciated.

Next, if we look at the market for WCDMA infrastructure, basically there is an enormous shift happening with the Alcatel-Lucent merger, but also the Nokia-Siemens merger combining the number two and three players in that business, Motorola essentially exiting producing their own 3G equipment and sourcing gear. We are down from what had been six or seven real competitors to four. Your business has been, I think, somewhat limited by your exposure in emerging markets and in Europe, whereas you had very strong performance with Cingular.

Could you talk a little bit about, has this changing industry structure changed the way the carriers are going about the transition to 3G? Is there any chance that there are opportunities for a combined Lucent-Alcatel to get back into European accounts that may have already chosen the initial vendors? Could you talk a little bit about how the change in industry structure in 3G changes your opportunity to move your --

Patricia F. Russo

Do you want to answer the question, and then I will --

John Kritzmacher

Let me start first around the timeline and try to help you. If we look at the series of events that still will unfold before us over the coming months, as we have said, we continue to expect that our merger with Alcatel will close by the end of the calendar year. That of course is dependent upon us working our way through the remainder of the CFIAS process, which we are diligently working on.

Then, in addition to impacts on the flow of information for investors, Alcatel of course has a couple of other transactions underway. One is the contribution of some assets to TELUS around their space business, which is likely to happen sometime within the calendar year, and also their acquisition of Nortel’s UMTS assets, another change that will impact the reported information around the financials for the business.

What you should expect from us is that in the early February timeframe, we will report financial results for the December ending quarter, with the combination of the business that of course will include some stub periods for the businesses that are being merged into the Alcatel operation.

What you should also expect from us is that we are going to provide you with some pro forma information at that time that will give you a fuller picture of the performance of the collective businesses, including Lucent pre-combination for the December ending quarter. Expect that to be available to you in early February.

Patricia F. Russo

I think at that time, to your question, Paul, we would be laying out our view of the going forward business, in terms of the opportunity set, and lay into that obviously the expectations around synergies, et cetera. All of those things will happen I think in that timeframe.

Let me try to respond to your question on the industry structure. It is a big question, and first of all, I think it is good that the industry is consolidating. We believed that would take place and frankly, our customers want for that to happen. I think the fact that if you fast-forward and assume the Lucent-Alcatel combination closes and the Alcatel-Nortel combination closes, we are assuming that happens, then what you have are three large players, if you will, and the Nortel-Alcatel-Lucent combination provides a footprint that includes Western Europe, some sizable customers there. It includes the future prospects of the GSM base that Alcatel has been successful in penetrating. I would assume that it might include any Nortel GSM customers who want to move to UMTS, and therefore -- or wideband CDMA, and therefore there may be some obvious opportunity to partner and work together there. Then, of course, Lucent’s position in obviously the U.S.

I think geographically, we feel good about what this portfolio and base of customers looks like. Obviously we have some integration work to do with respect to the product portfolio, but I think this is shaping up to be fewer larger players, which is what our customers want.

What we will all be working on, quite frankly, is what are the services that are going to help drive the demand for the 3G bandwidth and capability, so that we can continue to grow it, and then in time, obviously use that base and the assets we have to evolve to what will ultimately, longer down the road, become 4G.

That is kind of how I see things shaping up, and I think our customers are looking forward to that, and I think the opportunity that Alcatel, Lucent and Nortel’s businesses have is to be a very strong viable contender in any of the major bids that go on around the world. That is what I would expect.

John DeBono

Next question, please.

Operator

Your next question comes from the line of Paras Bhargava with BMO Capital Markets.

Paras Bhargava - BMO Capital Markets

Good morning. Pat, you mentioned something in your commentary about the impact of the merger in the near-term, because it is taking a little longer, perhaps, to close than you might have liked. Maybe you could provide some color on what that impact is. Is that a delay in revenues that you are expecting? Is that a delay in decisions? Just some color around what exactly you meant by those comments.

Patricia F. Russo

It is a fair question. Let me just give you an example of how uncertainty manifests itself.

You have a customer who is making a decision with respect to an access purchase, and absent specific information on what exactly will the combined company portfolio be, if in fact they can delay that decision, they might delay that decision if their network requirements enable them to do that. That is an example.

You could point to that kind of example in any of the areas where there is product overlap. Obviously it does not apply with respect to GSM or CDMA, but certainly in the areas where we are bringing two portfolios together, where there is any uncertainty with respect to the portfolio, then you can have a customer who says “Gee, I would rather wait.”

I think it manifests itself, from my perspective, at least from the examples I am aware of, in delay as opposed to losses, and what customers want to know is what exactly is your roadmap and what are your timeframes.

I was very clear to point out I think this is temporary. I think it is short-lived, and I think as soon as we are able, as a combined company to spell out the details for our customer, this issue, to the extent that it exists, does not exist, or goes away.

John DeBono

Next question, please.

Operator

Your next question comes from the line of Simon Leopold with Morgan Keegan.

Simon Leopold - Morgan, Keegan & Company

Thank you. I wanted to see if we could get a little bit more color around the trends in the wireless business from a modeling perspective. Specifically interested in understanding how the Rev A business affects gross margin, and also if you could give us a sense how to think about the margin and product mix between the CDMA 2000 and WCDMA products.

John Kritzmacher

With regard to the overall flow of our business, what we are expecting is continued deployment of Rev A well out into 2007. If that is across the year, we are going to be introducing additional feature sets for Rev A in the spring, and then again in the fall, and out in the fall, we will introduce some push-to-talk capability. That is important here in the U.S.

With regard to gross margins, we generally do not break out gross margins within the distinct product lines, but what I would say is there is nothing distinctly different about Rev A from our core CDMA business. It continues to be a highly profitable business for us.

As you would expect, the margin rates on the UMTS business are lower than they are on our CDMA business, given where we are with respect to volumes there.

John DeBono

Operator, we have time for one last question.

Operator

Your last question comes from the line of Ken Muth with Robert Baird.

Ken Muth - Robert W. Baird & Co.

On the IMS portfolio, do you see anything significantly changing as you bring together the Alcatel and Lucent solution sets?

Patricia F. Russo

Let me tell you what I think the change is. I think the change is a broader customer base, given Alcatel’s activity in that area and our activity, and an even more robust portfolio than either company has on its own. Where in fact we have any portfolio rationalization to do, our expectation is, given the size and significance of the customer contracts we have, anything we do there would be done on an evolutionary, more drawn-out basis than something in a first year.

We are going to work very hard to take maximum advantage of our strong position and Alcatel’s strong position and leverage the expansion of that base and make sure we do nothing that will disrupt the existing contracts and the deployments that we have underway.

From my perspective, I think the change is positive and expanding as opposed to anything else.

John DeBono

Thank you, Pat. Pat, I know you want to make some closing comments.

Patricia F. Russo

Yes, let me just say to all of you that assuming obviously we close the merger with Alcatel by the end of the year, this would be our last quarter speaking to you as a standalone company. Incidentally, it happens to be just about 10 years from the actual launch and spin of Lucent out of AT&T, so it has been 10 years in the running. I just wanted to take advantage of the opportunity on behalf of all of the employees of Lucent to thank you for the many quarters of interest and good questions and engagement that we had with you, and to tell you that we look forward to speaking with you as a combined company as we go forward and along the timeline that John Kritzmacher outlined for you.

Thanks very much for your interest over the years, and we look forward to speaking to you as we bring these companies together.

John DeBono

Thanks, Pat, thanks, Frank, thanks, John, and thanks to all of you again for listening in with us this morning.

As always, if you have any follow-up questions, please do not hesitate to call any member of the Lucent investor relations team. Have a good day.

Operator

Ladies and gentlemen, this conference will be available for replay starting at 12:00 p.m. today and running until midnight on October 31st. You may access the replay by dialing 1-800-642-1687. International participants may dial 1-706-645-9291. The access code is 6820600.

That does conclude the conference for today. Thank you for your participation.

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