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Tellabs, Inc. (NASDAQ:TLAB)

Q2 2010 Earnings Conference Call

July 27, 2010 8:30 AM ET

Executives

Tom Scottino – Investor Relations

Rob Pullen – CEO

Tim Wiggins – EVP and CFO

Analysts

Jim Suva – Citi

George Notter – Jefferies

Simona Jankowski – Goldman Sachs

Ehud Gelblum – Morgan Stanley

Mark Foo – RBC Capital Markets

Rod Hall – JP Morgan

Jeff Kvaal – Barclays Capital

Nikos Theodosopoulos – UBS

Simon Leopold – Morgan, Keegan & Company

Larry Harris – C.L. King & Associates

Todd Koffman – Raymond James

Operator

Good morning. I would like to welcome everyone to the Tellabs Investor Relations Conference Call. (Operator Instruction) Mr. Tom Scottino, Sir, you may begin.

Tom Scottino

Thank you, Valerie, and good morning everyone. With me today are Tellabs CEO, Rob Pullen; and our Executive Vice President and CEO, Tim Wiggins.

If you haven't seen the news release we issued this morning, you can access it at our tellabs.com website.

Before we begin this morning, I would like to remind you that this presentation contains forward-looking statements about future results, performance or achievements, financial and otherwise. These statements reflect management's current expectations, estimates and assumptions. These forward-looking statements are not guarantees of future performance and involve risks, uncertainties and other factors that may cause Tellabs' actual results, performance or achievements to be materially different. A discussion of the factors that may affect future results is contained in Tellabs' most recent SEC filings. The forward-looking statements made in this presentation are being made as of the time and date of its live presentation. If the presentation is reviewed after the time and date of the slide presentation, it may not contain current or accurate information. Tellabs' disclaims any obligation to update or revise any forward-looking statement based on new information, future events or otherwise.

This presentation may also include some non-GAAP financial measures. Reconciliation between non-GAAP financial measures and our GAAP financial measures can be found at our www.tellabs.com website and in our SEC filings.

Having said that, I'll turn the call over to Rob.

Rob Pullen

Thanks, Tom, and thank you everyone for joining us on our Investor call. Today, I'll review Tellabs strategy, its customers and progress during the second quarter and the first half of 2010. If you look at our first half, we successfully executed Tellabs strategy and the results show. Our strategy is to focus on the mobile Internet and it's producing profitable revenue growth. Tellabs business continue to perform better and better. If you think about it, we're working now with over 140 customers around the world.

Now let's turn to our progress. Our second quarter revenue grew 10% from a year-ago quarter. Our GAAP gross profit margins increased to 53.5% which is the highest since 2004. We are in $0.16 per diluted share on a GAAP basis and that's up from $0.04 a share in the year-ago quarter. In a few minutes, Tim's going to give you more detailed overview of the second quarter.

Tellabs performance is driven by our focus on the growth of the mobile Internet. We're advancing our strategy by focusing on investments in growth products and services. Tellabs growth results from an understanding of our customer's businesses from bringing them new innovative ideas and for making Internet and IP technologies and our professional services.

What sets us apart is our focus on best-agreed products for specific applications, and our goal is to drive high performance in networks. That particularly important is smart phones proliferate and create unprecendented demands on mobile networks. Today, 85% of our research and development investment goes into our growth products. These include bojecan (ph) and IP data products that power the mobile Internet such as the Tellabs 8600, 8800 Systems and the Tellabs SmartCore 9100 platform.

We're also investing in advancing our optical and business service solutions with the Tellabs 7100 Optical Transport System, and we continue to invest in growing Tellabs professional services. Our strategy is working. We're winning new customers for all of our growth products. Its result, in the second quarter, 58% of our revenue came from growth products, that's up from around 52% in the year-ago quarter where we actually had a revenue recognition, a big revenue recognition for a customer in Asia-Pac.

We're now intensifying our focus on innovation and growth products. During 2010, we expect to invest about 17% of sales in Research and Development, and we're hiring and recruiting Engineers, sales executives and services professionals, all who have Internet and IP expertise, and we're doing this around the world. We're doing it in Finland, China, India, Silicon Valley and here in Naperville, just to name some of the locations.

We're also advancing our strategy by innovating in growth markets. Our focus is squarely on the mobile Internet. Customers are rapidly building network capacity to keep up with surging mobile data traffics from BlackBerries, iPhones, Androids, dangles and iPads to name a few. And we're only seeing the infancy of mobile video in a JumpTap-Campbell ( ph ) networks. Tellabs is primely positioned in the mobile Internet market with our mobile backhaul and, increasingly, our mobile packet core solutions.

During the quarter, as some of you saw, Tellabs' stock dropped and was based on information about one of our customers, AT&T. And I want to address this issue head on. While I can't speak for our customer, we do know that AT&T is trialing a third vendor in its mobile backhaul networks. At the same time Tellabs fee is good demand from AT&T. We're in the network now, we're seeing growth on the embedded base and we believe we offer the lowest risk and the least cost evolution to the long-term evolution in the mobile backhaul.

If you look at Tellabs today, worldwide, Tellabs remains the market leader in packets of backhaul networks. But as markets grow larger, we expect more competitors come in and we compete globally on a day-by-day basis. We are determined that Tellabs will compete for and win customers as they transition our mobile backhaul networks to Internet and long-term evolution. To be clear, we're going to offer two fast forward to LGE for our customers. First we offer, as we do today, Internet functionality on our existing platforms which we believe is the lowest risk in least cost migration to the LTE backhaul. Next, we're already working on the next generation solution for long-term evolution including the mobile internet. We expect both of these solutions to be both compelling and highly competitive.

Remember, as I mentioned as I kicked-off this call, Tellabs is working with more than 140 mobile customers around the world. And our mobile business continues to grow. Just to give you some flavor for this, in the second quarter, we recognized revenue from seven new Tellabs 8600 and 8800 customers in EMEA and Latin America. Recently, Tellabs won a mobile backhaul contract in partnership with Nokia-Siemens networks from Megaphone. As some of you may know, Megaphone is one of the top three mobile carriers in Russia. We're particularly optimistic about that future.

Also in the second quarter, the Tellabs 7100 optical transport system gained nine new customers both in Latin America and North America. One of these new Tellabs 7100 customers is AboveNet, which operates high bandwidth private optical networks in 15 U.S. cities and London. And they're expected to grow as well and we hope to grow with them. We also recognize revenue from three new customers for the Tellabs SmartCore 9100 platform. That brings us to a total of 10 customers for our newest platform, and we continue to work with customers in more than 20 ongoing trials, all with the SmartCore 9100 platform.

When I look back in the first half of 2010, it's clear that Tellabs strategy is working. We're investing in growth products, we're focusing in growth markets and we're winning new customers. We're also teaming up with world-class customers and partners. As we advance our strategy, we're achieving profitable revenue growth. We're excited about the opportunity to grow Tellabs business as we see the future of the mobile Internet unfold. With that, I'll turn it over to you Tim and we can go through more of the detail.

Tim Wiggins

Thanks, Rob, and good morning everyone. To begin with, I'd like to make a few observations about the quarter. As Rob mentioned, total revenue for the quarter was $423 million and that was up 11% on a sequential basis and 10% on the year-over-year basis. Revenue from our growth portfolio increased to account for 58% of our total revenue. We saw a sequential and year-over-year growth in both data and transport revenue driven by strong demand in North America. Gross margin is 54%, is up sequentially and on a year-over-year basis. Operating expenses at $134 million were flat with the prior quarter and that excludes restructuring and other charges, intangible assets, amortization and equity-based comp. Non-GAAP net earnings were at $67 million, were up significantly both sequentially and year-over-year.

Let me get into the specifics. As I've just mentioned, total revenue for the second quarter of 2010 amounted to $423 million up 11% from $380 million in the prior quarter and at the mid-point of the guidance range we gave you in April. On a year-over-year basis, total revenue was up 10% compared with the second quarter of 2009. On a sequential basis, we saw our growth in Broadband and Transport segments.

Looking a little deeper into the Broadband segment, sequential growth in data and access revenue offset a slight decline in Managed Access revenue. Within Transport, we saw increased revenue from both the Digital Cross-Connect Systems and Optical Transport Systems. Revenue in the Service segment was essentially consistent with the prior quarters. GAAP net earnings grew into $64 million in the second quarter, up 40% from $46 million in the first quarter of this year.

On an EPS basis that translates to $0.16 per diluted share up from $0.12 for basic and diluted share in the prior quarter. On a year-over-year basis, that compares with $16 million or $0.04 basic and diluted per share in the second quarter of 2009. On a non-GAAP basis net earnings, excluding charges for special items, or $67 million or $0.17 per basic and diluted share. To take the $67 million in non-GAAP net income and subtract $7.5 million or $1.03 per share for equity base count and that's to be consistent with the way the First Call writers compile and report estimates for Tellabs, the result is $0.16 in non-GAAP EPS for the second quarter of 2010.

Looking at our revenue, on a portfolio basis, revenue from growth products which includes the Tellabs 6300 Managed Transport System, the Tellabs 7100 Optical Transport System, the Tellabs 7300 Ethernet Natural Series, Tellabs 8600 and 8800 Data Series, the Tellabs SmartCore Platform 9100 and professional services grew sequentially in the second quarter to account for 58% of the total revenue, up from 52% in the year-ago quarter and slightly higher than the first quarter of this year.

On a geographic basis, revenue from customers in North America grew to account for 78% of total revenue in the second quarter, up from 72% in the prior quarter. We anticipate that in the third quarter, the split between North America and international revenue will return to the more normal 2/3, 1/3 range we saw through the full year of 2009.

Let's take a look at the segment data for the second quarter. Broadband segment revenue for the second quarter of 2010 was $229 million up 19% from the prior quarter. On a sequential basis, growth in data and Access product revenue offset a slight decline in Managed Access revenue. Data product revenue driven by strong demand in North America, was $159 million in the second quarter of 2010, up 21% from $131 million in the first quarter of 2010.

For the second quarter in a row, the Tellabs 8800 Multiservice Router contributed more revenue than any other product. Both revenue and shipments from our Tellabs SmartCore 9100 platform were up sequentially. Shipments nearly doubled in 2Q over Q1 levels. We anticipate that revenue growth from this product will accelerate in the back half of the year.

Data is our largest product category accounting for 38% of total revenue. Looking at the first six months of 2010, compared with the first six months of last year, data revenue increased about 71% from $170 million to $290 million. Access revenue was $40 million in the second quarter, up 34% from $30 million in the prior quarter driven primarily by an anticipated sequential increase in single-family ONTs.

Turning to the managed access category, revenue in the second quarter of 2010 came in at $30 million consistent with the prior quarter. A slight increase in revenue from the Tellabs 8100 offset a slight decrease in revenue from our Tellabs 6300. Taking all that into account, broadband segment profit for the second quarter of 2010 was $86 million, up from $61 million in the first quarter of this year. Segment profit increased primarily from the higher level of revenue from data products.

In the transport segment, revenue was $133 million in the second quarter, up 4% from $128 million in the prior quarter. We saw increased revenue from both cross-connect systems and optical transport systems on both a sequential and year-over-year basis. Transport segment profit driven primarily by the higher level of cross-connect revenue was $52 million in the second quarter, up 14% from $45 million in the prior quarter.

Services segment revenue was $61 million in Q2, essentially consistent with the prior quarter. Services segment profit amounted to $21 million, up from $20 million in the first quarter of 2010.

On a gross margin basis, non-GAAP gross margin for the second quarter of 2010 was better than anticipated at 53.8%. That is up 2.9 percentage points from 50.9% in the prior quarter. Gross profit is dependent upon product and customer mix. The shift to this quarter is primarily attributed to two factors. About half of the improvement was related to the higher level of revenue from data products and the balance was related to profitability improvements on optical networking systems and single-family ONTs.

Turning to operating expenses, total operating expenses on a non-GAAP basis came in at $134 million, consistent with the prior quarter. That is below our prior guidance due largely to lower than planned R&D spend in the quarter. Non-GAAP R&D expenses for the quarter were up slightly at $69 million or slightly more than 16% of revenue. SG&A expenses for the quarter declined to $65 million.

Other income amounted to $5 million in the second quarter compared with $7 million in the prior quarter primarily due to lower interest rates earned during this quarter. Our tax provision on non-GAAP pretax income for the quarter was $32 million for an effective tax rate of 32%. Looking ahead, we expect our effective non-GAAP tax rate for 2010 to be 32%.

I would like to turn to the balance sheet now. During the quarter we generated $110 million in positive cash flow from operations. CapEx was $10 million for the quarter. DSO was 63 days, down from 64 days in the prior quarter. Inventory turns was 5.7 times versus 5.6 at the end of the prior quarter. At the end of the second quarter inventory in terms of dollars was $136 million compared with $129 million at the end of the prior quarter. The increase in inventory is related to increased revenue and our efforts to mitigate the component and supply constraints.

During the quarter we purchased 1.8 million shares of our stock at a cost of $16 million. We also returned almost $8 million to shareholders via our quarterly cash dividend. The actual number of shares outstanding at quarter's end was $385 million. Headcount at the end of the quarter stood at 3300. Book-to-bill was just below one for the quarter and above one for the first six months.

Turning to our outlook for the third quarter this year based on orders in 2Q, backlog and given the overall market conditions, we are guiding for third quarter revenue to be in the range between $425 million and $435 million. That is up sequential in what's typically a soft quarter for us. On a year-over-year basis it equates between 9% and 12% growth. We expect gross margin in the third quarter to be 51% plus or minus a point or two, depending again on product mix which we anticipate will shift toward less data revenue and more revenue from optical transport systems and single-family ONTs.

We expect non-GAAP OpEx for the third quarter to be up in dollars to approximately $140 million as we continue to ramp spend on R&D particularly for the SmartCore platform in combination with the anticipated spend on parts and prototypes. In addition, we expect the effective expensing equity based compensation in the third quarter will be about $8 million, split between operating expenses and cost of goods sold.

To recap then, we made solid progress in the second quarter and the first half of 2010. We saw a solid year-over-year revenue growth and we are guiding for the same in the third quarter. Gross margin was up both sequentially and year-over-year. While operating expenses are up on a year-over-year basis in real dollars, we have kept them to a lower percentage of total revenue and we generated $110 million in free cash flow from operations.

Having said that, we will open the floor to your questions. We are ready for the first question.

Question-and-Answer Session

Operator

Thank you, sir. (Operator instructions) Our first question will come from the line of Jim Suva of Citi.

Jim Suva – Citi

Thank you, gentlemen and congratulations on the results and I think the EPS especially was very strong. To that effect, when we look at the gross margins I know a lot of it has to do with mixed outlook but I think one can't help but notice for the past three quarters you pretty much beat gross margins by about 200 basis points.

So can you talk a little bit more about your gross margin guidance about the product mix versus are you building in some conservatism because given your cost restructuring and stuff, it just seems like you guys are really on track to maintaining these high levels of profitability so can you speak to that a little bit more detail?

Tim Wiggins

Thank you, Jim, for your comments. It's Tim and good morning. One thing that we are trying to stress in our gross margin guidance is it is highly dependent on mix. You recall that we have been talking about a potential dip in the third quarter and that's why we went outside our normal guidance and offered guidance on our margins for the full year. The reason we are doing that was just to warn the Street that we saw a shift coming in the third quarter which would have more of our products that while they are improving and their margins are still below corporate average, one of the things that contributed in 2Q was improved profitability of our 7100 system and our single-family ONTs.

So what we saw was a very solid quarter in data. We will have another good quarter in 3Q but not at those levels likely and we see an increase in our business on those two lower margin products. So this is the dip we have been anticipating. If we end up having a stronger quarter in data or cross-connects, we could exceed the margins but we are trying to call them as we see them but as the business is very dependent on mix, the good news is that the mix has come in more favorable than we thought. But we do believe that the growth is going to return to these other products and we expect that away on our margins. So that's why we are providing the guidance we are today.

Jim Suva – Citi

Great. Thank you and congratulations to you and your team.

Rob Pullen

Thanks, Jim.

Operator

The next question comes from the line of George Notter of Jefferies.

George Notter – Jefferies

Thanks very much. Just expanding on the last question, you guys have got into the high 40s for the year in terms of gross margin and I heard what you said certainly about the dip in mix and in margin in Q3. But if I just step back and look at the business from a longer-term perspective, does it make sense that we continue to track above 50% going forward again beyond Q3? It certainly seems like that would make sense given where you are in terms of the growth profile of the company and where it's coming in terms of products. What's your thought there?

Rob Pullen

Yes, George. Thanks. I will answer that question. You are right. While Tim said that in the third quarter we expected a mix and a slightly downward impact on gross margin, it's clear that our previous guidance of the high 40s is not likely to occur. We have done over 50s in the first two quarters we are guiding 51 plus or minus a point or two here in the third quarter. So we do expect that previous forecast is now rendered obsolete and we should be somewhere in the 50.

George Notter – Jefferies

Right. Where do you think this business can go to in terms of gross margins? Do you think this is the low 50s gross margin business in your mind longer term? Do you think it could be a mid-50s gross margin business? How do you think about where this can go?

Rob Pullen

Well, George, as you know, we are giving guidance beyond the following quarter but you can see that our trend has been moving up for the past two years and somewhere around these levels is hopefully sustainable for us.

Operator

The next question will come from the line of Simona Jankowski of Goldman Sachs.

Simona Jankowski – Goldman Sachs

Hi, thank you so much. I just wanted to ask a question on the AT&T situation and then a second quick one on the business outside North America. But just looking at AT&T, can you just give us a sense for, even if set aside the LTE opportunity, how long do you think the 3G business you've got there right now could actually keep growing even when they start ramping their LTE backhaul network? And do you think they'll be necessarily going to three vendors there? Or would they still be looking to go with the two vendors there for LTE?

Tim Wiggins

Well, first of all, you're going to have to talk to AT&T about specifics in their network. But what I can tell you is is that we're in the network today, in the 3G network. Like all customers around the world, I would expect as customers are telling me, they want to get a return on investment on their 2G and 3G assets, and that will be in the network a very long time. Then as for going forward, LTE, you'll have to ask AT&T but we do know that we are approved today with one other vendor, and AT&T has certainly introduced a new vendor, and we would expect that just to be competitive going forward.

Simona Jankowski – Goldman Sachs

And then just quickly on the business outside North America, it seems like that declined about 40% year-over-year, which is a bit of an accelerated decline, if I did my math correctly. Can you just comment again on what drove that and what you think drives it back up next quarter?

Rob Pullen

Sure. Well, first of all, is Tim alluded to, we saw a fairly strong demand from North America and we had a slight pickup in Asia-Pac, but we had a decline in Europe, the Middle East and Africa and Latin America and that was specific for the quarter. But looking forward for the next quarter, we expect that our revenue outside of North America, or international revenue, to pickup to be more consistent with 2009 type levels.

Operator

Your next question will come from the line of Ehud Gelblum of Morgan Stanley.

Ehud Gelblum – Morgan Stanley

Hi, guys, thank you very much. Couple of questions. First of all on the – can you give us a sense, Tim, as to how large the 9100 was? Are we still talking a couple of million or did the recognition get you into the $5 million to $7 million range for this quarter? And kind of how should we be looking at that in terms of what you can actually recognize in terms of revenue in the back half of the year? Rob, in terms of talking about AT&T and how that fits in, what share do you have right now in that network? Can you give us a sense what that is? And when you said they're testing a third vendor, is that for 3G? I was a little confused, or is that for LTE? So does that get put into the 3G network whenever that vendor gets approved? Or is that not until the 4G network comes in and then I said if I could follow-up on just gross margin profile does that 100 LTEs, I'm just understanding how that's improving, too.

Rob Pullen

Well, first of all, let me take the AT&T question. You will be going to have to talk to AT&T specifically, but we expect that this trial to take some period of time. It took off closer to two years to get operationalize within the network. And I would expect that there could be competitive threats both on the existing network, 3G, as well as the LTE transition.

Tim Wiggins

Let me pickup on the 9100. So I mentioned in my remarks that we saw a doubling of the shipments in 2Q but, let's say, we're starting from a low base, that's the way anticipated and we see a fairly significant ramp. So the shipments are certainly in the millions, but for this thing to execute to the kind of numbers we have, we expected a fairly significant ramp in the back half of the year as the Tellabs sales force and balance sheet help support the growth and the light-course products. So far, so good. We got a big held decline to the balance of the year, but we got pipeline and the opportunities and we're driving hard to get there.

Ehud Gelblum – Morgan Stanley

And then on the – can you give us a sense of, I'm sorry I meant to ask, about the 10% customers obviously the usual too. But can you give us a sense – is there a third and how large were those too?

Rob Pullen

No, we had two 10% customers this quarter, the usual suspects, Ehud.

Operator

Your next question comes from the line of Mark Foo of RBC Capital Markets.

Mark Foo – RBC Capital Markets

Thank you. Rob, I was just wondering, how should we think about the second quarter half of the year considering your guidance for the third quarter? If you kind of look at broad trends and CapEx linearity by Verizon and AT&T so far, what should we expect it to go in the typical seasonality of the fourth quarter? And then how does that seasonality get adjusted because of the growth outperformed by Internet.

Rob Pullen

Well, first of all, Mark, we're in the smaller sub-segments versus the over CapEx, and those sub-segments are growing at greater than the normal CapEx, so that's kind of one data point for you, particularly in this mobile backhaul, mobile internet. Next, as you can tell, we guided up in the third quarter, which seasonally is down, Mark. If you go back and do an analysis over, probably, the past decade, we've only had one or two third quarters that were – and while we're not given guides for the fourth quarter, I don't see anything in customer behavior that were changed from the normal seasonality.

Mark Foo – RBC Capital Markets

And what would be normal seasonality considering your products now?

Rob Pullen

Well, the fourth quarter is usually up versus the third quarter.

Mark Foo – RBC Capital Markets

And should we rather look at things from like year-over-year basis? Or should we still back trend the sequential or should we go quarter to quarter?

Rob Pullen

Well, we supply both because we think they're both important. You're comparing the world that's pulling out of a recession year-over-year and trend sequentially. So I continue to look at both.

Operator

The next question comes from the line of Rod Hall of JP Morgan.

Rod Hall – JP Morgan

Thanks for taking my question. I just have two quick ones. First of all, I wonder if you can comment on AT&T again whether the third competitor would be end-to end. Are we talking about 8600 and the 8800 impacts? Or is one or the other potentially more impacted from a share point of view, if that then they'll just get approved eventually. And then my second question is on the international revenue growth. You guys are optimistic about the returning Q3, can you just comment, I know you've been in trials with the different carriers over there? Can you comment about how that's going? Are you anticipating in Q3 some additional revenue from new customers? Or is it just a return of CapEx from existing customers? And if it is a return of CapEx, can you talk about how you expected – how the trials are going and how that might play out through the backend of this year?

Rob Pullen

Sure, I'll take that, Rod. First of all, the approved products at AT&T are the 8800 and 8600. And I didn't give a quantitative answer before but I'll sure go back. We have a majority of market share at AT&T at the small backup. As for, and Rod, you'll going to have to talk to AT&T about that. I do expect to continue participating in AT&T's network, and as I said earlier, I do expect this new competitor to come in and challenge us for some share. But I can assure you, that we're going to compete and justify our business. As I mentioned earlier, we believe that we're offering the lowest risk evolution and migration to LTE, and we believe it's the least cost as well. We're also working on our next generation products.

Now for international trials, we did, as I said earlier, some softness in EMEA and Latin America in the second quarter, even in Asia-Pac and North America were slightly up. I do expect, and we do expect, the second half in international be up over the first half. Now the trials were actually doing well. We've been in many trials, both with our mobile backhaul, as well as our packet core, and those are starting to show results including in the quarter. I mentioned Megaphone, we've been pursuing, winning new share in Russia now for a couple of years. We invested in the space when this new management team took over. And with the help of our partners, Nokia Siemens, we turn that trial into a victory. And Megaphone is one of the great three cellular carriers in Russia, so we are making progress. We're initiating new trials. And as I've shared with you over the past couple of years, we're talking about new customer victories and we have a lot overseas, which is now registered to be about 140 customers worldwide, for this small backhaul.

Rod Hall – JP Morgan

Okay. Rob, can I just follow up on a few other points? One, can you give us any indication of how many trials you're in at the moment internationally just so we can kind of gauge how big that opportunity might be? And then the second one circling back to this AT&T point, is the third vendor, that's being tested, are they being trialed at both the base station level, the kind of 8600 level and the aggregation level? Or do you know?

Rob Pullen

Yes. First of all, as for AT&T they're being trialed at both the base station as well as the mobile telephone switching office or the hopping point, which is what we're doing today. Next, I don't have a break out by geography and the number of trials, what I do know is that we're in over 30 plus trials today when you take a look at the 9100 and 8800 and 8600 worldwide.

Operator

The next question comes from the line of Jeff Kvaal of Barclays.

Jeff Kvaal – Barclays Capital

Yes, thank you very much. I was wondering, two quick questions, one is could you talk a little bit about the status of 9100 AT&T, is that in trials there or how should we think about that and then, Tim on your sign, can you – I mean the OpEx has been great with good control this quarter. So have you shifted your plans or should we expect the OpEx to continue to begin to raise or do you think there is an opportunity for becoming a little bit below plan for the next several quarters?

Rob Pullen

Let me take the first one, Jeff, first of all for competitive reasons we don't break out individual customers and trials on any of our product 9100, but I will tell you is that AT&T already has incumbents for the packet core, while we will continue to promote our value proposition, we'll have to evaluate that over the future. Tim, want to answer the second question.

Tim Wiggins

It is strange Jeff as this will sound, it was a little disappointed our OpEx wasn't higher in the quarter. I know that probably sounds unusual, but you know what, we're really looking here as to accelerate our investment in these new product platforms and what we had expected in Q2 was some of the parts and products which can be a little lumpy to come in earlier but as we mentioned to you earlier on that we're accelerating our R&D spend. We're adding headcount in this packet core area and IP area. We've got some exciting prospects for the future. We think we're uniquely qualifying in terms of our install base.

So we'd like to see the – we expect to see the spend go up, that's been our plan as we accelerate and we think that will probably come more than 3Q based on what I see today.

Jeff Kvaal – Barclays Capital

Thank you both.

Operator

The next question comes from the line of Nikos Theodosopoulos from UBS.

Nikos Theodosopoulos – UBS

Hi. I had a couple of questions, so on the, I guess starting with the optical margins and the ONT margins, it seems like your profitability in broadband and in transport were driven by those two factors sequentially. So where those – was there anything one time that led to that or do you see that as sustainable and potentially able to expand from here on either of those two products going forward?

Rob Pullen

Nikos, so what we saw in the quarter was improvement in our rate which is measure of our both our margin improvement and the mix, you know price. So we think that this would probably be the 13th, well it should probably be the 10th or 11th quarter out of 13 where we've seen improvement. So we've seen steady rise in margins in both these products as we continue to cost reduce in the 7100 area, we've seen shifts away from some of the optical and more into transponder cards. So I believe we're on a steady and secular increase in these margins and we expect to continue to do that albeit slowly, it's kind of a slow battle not anything revolutionary but we just keep chipping away at it and over time you wake up and realize, these things have moved from not very good to at least respectable margins.

Nikos Theodosopoulos – UBS

Okay, so we should look at this as, there was a step function this quarter but going forward your plan is to continue to improve – we should expect to see a back, a big decline in the 7100 here in the margin?

Rob Pullen

Well if you call it a step function, I'll call it a baby step, I mean it was progress but not I mean not err shattering and it will always be subject particularly in the 7100 to mix. If we have a particular core where we won a significant new account, expect margins to be under pressure as we ship early systems, and but it's a kind of game between layer lifecycle of transponder cards versus early systems.

So it will tend to waver up and down depending on where we are in the cycle of new customers and what they're doing, what their build out, but again back to the secular trend overtime if you look at it, without being overly granular, you'd see a continuing to edge up.

Nikos Theodosopoulos – UBS

Okay, all right. And then on the international, if I just look at the total guidance you gave in the mix you expect next quarter. It would seem that the international revenues are going to up almost $50 million sequentially. Is that going to be broad based, the broad – managed access 7100 product lines data or is that issued in the press release more driven by the 7100. How broad based or how product specific will that be?

Rob Pullen

Well first of all you're right. We – the international revenue should pick up quarter-over-quarter. We do believe that it will be broad based Nikos, we see increasing demand from the optical networking products also the data products internationally.

Tim Wiggins

Even in managed access.

Rob Pullen

Yes, managed access is up slightly as well. So it's a broader pickup Nikos.

Nikos Theodosopoulos – UBS

Okay, great. All right, that's it. Thanks.

Rob Pullen

Thank you.

Tim Wiggins

Thank you.

Operator

The next question comes from the line of Simon Leopold of Morgan, Keegan.

Rob Pullen

You there, Simon?

Simon Leopold – Morgan, Keegan & Company

Hello.

Rob Pullen

Hello, how are you?

Simon Leopold – Morgan, Keegan & Company

Okay, sorry about that, technical difficulty. (Inaudible) a couple of quick clarifications first, one on the guidance for the operating expenses of the roughly $140 million. Is that including your stock based compensations assumption or backing out stock based compensation?

Tim Wiggins

It's a non-GAAP, so back it out.

Simon Leopold – Morgan, Keegan & Company

Back it out, okay. great, and then moving on your forecast, it sounds like its implying your data products could be flat to slightly down in the third quarter, just considering your commentary in the gross margin and the mix shift. I want to know if I am hearing that correctly.

Rob Pullen

Look for the data products to be closer to Q1 and Q2 so actually they would be down based on the mix we see today.

Simon Leopold – Morgan, Keegan & Company

Okay, thank you.

Tim Wiggins

But they were up year-over-year.

Rob Pullen

Yes.

Simon Leopold – Morgan, Keegan & Company

Okay. That's all, so that's help me figure out how to understand that. And then two more, one was and Rob thanks for taking this AT&T issue head-on, I'd like to kind of look backwards on this a little bit and see if you can tell us was there any substance or the concern in terms of what's going on near-term ignoring kind of the opportunity or possibility of if it is later, what's kind of in the tone temperament of what happened either during the quarter or more recently?

Rob Pullen

Well if I understood your question correctly Simon, I believe the market overreacted to the rumors and that's why we wanted to address this head-on, we continued to perform well in the account, as I said we're offering both an evolution to the embedded base of equipment as well as the next generation system and the stock is, from what I could tell over the past few days moving in the proper direction for fair valuation of Tellabs.

Simon Leopold – Morgan, Keegan & Company

But was there any substance to just the idea that there was some modest share shifting for backhaul during the quarter?

Rob Pullen

If there was any Simon, it was very modest, very modest.

Simon Leopold – Morgan, Keegan & Company

Okay and one last and this is sort of a big picture question I think. You mentioned the partnership with Nokia-Siemens, and I just wanted to understand broadly, I think you've had partnerships with Ericsson in the past. How much of your sales have been coming through partnerships and how do you see that has an avenue towards your strategy over let's say the next year, partnerships in general?

Rob Pullen

I don't have the specific percent off the top of my head in revenue through partnerships. Tim, do you happen to have that? We'll follow-up with you on that, okay Simon, but having said that we actually use partners to get global distribution. It's part of our strategy, both Nokia-Siemens and Ericsson to name a couple as well as local partners and distributors all over the world. We used that to gain more access to our global customers, I mean take a look at even in a company like Ericsson, we've been working together for 22 years.

We're working primarily on 2G and 3G networks today and we're constantly exploring new ways to work together in the future. And I mentioned already that this partnership with Nokia-Siemens networks helped enable our victory at Megaphone.

Simon Leopold – Morgan, Keegan & Company

So is it reasonable to think that concerned about AT&T's purchasing policies and its domain strategies could be addressed through a partnerships as well?

Rob Pullen

Absolutely, I mean as I said to all you and Tim and I mentioned here, the AT&T issue is real, that's we wanted to address that head-on, but we believe that through our direct channels and our partnership, we can continue to overcome that.

Simon Leopold – Morgan, Keegan & Company

Okay, thank you.

Operator

The next question will come from the line of Larry Harris of C.L. King.

Larry Harris – C.L. King & Associates

Yes, thank you. I wanted to talk a bit about the 5500 tier II have done fairly well this past quarter I think up year-over-year. If you look at the 5500 sales for this year, is there a possibility that it could be up for the full-year as opposed to perhaps being flat or slightly down?

Rob Pullen

Well, you're right. We did fairly well on the second quarter with the 5500 and as we mentioned to all of you over maybe the past decade, we thought that it would be, you know while the product was later in its lifecycle it would have a long tail to it. We've not given guidance for the full-year but it's very possible, it could be flat to up year-over-year.

Larry Harris – C.L. King & Associates

Okay, good. Okay, thank you.

Operator

The next question will come from the line of Todd Koffman of Raymond James.

Todd Koffman – Raymond James

Thank you very much and Rob again thanks for the clarity regarding AT&T, one last question on that. As it relates to the timing, the situation in business opportunity for LTE, backhaul AT&T, when do you think they'll have – you'd have clarity to how to sort of spend their share and position agreements would shake out, or we'd see like we're getting fairly laid into the choice cycle and so, and I think, can you tell me when is the timing when you'd have a lot of clarity on and there are few business opportunities there.

Rob Pullen

I don't think there will be a perfect time for clarity Todd. We're going to continue to battle this out day-by-day in the field and right now customers including AT&T are spending fair amount of money in their 3G and transitioning the LTE.

Todd Koffman – Raymond James

Thank you.

Tim Wiggins

Valerie, do you have any more questions at this time?

Operator

And at this time sir, there are no further questions. Would you like to proceed with your closing remarks?

Tim Wiggins

Yes, we will.

Rob Pullen

Sure, thanks. Good questions. We're pleased with our progress. We're focusing on the mobile internet, it's paying off and we're trying to grow our business profitably while we're helping customer succeed with this mobile internet. Thanks a lot for following Tellabs and your good questions. Take care and we'll talk to you soon.

Operator

This concludes today's conference call. You may now disconnect.

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