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Tellabs (TLAB)

Q4 2006 Earnings Call

January 23, 2007 8:30 am ET

Executives

Tom Scottino - Senior Manager of Investor Relations

Krish Prabhu - President and CEO

Tim Wiggins - EVP and CFO

Analysts

Brant Thompson - Goldman Sachs

Tim Long - Banc of America

Tal Liani - Merrill Lynch

John Anthony - Cowen & Company

Michael Genovese - Citigroup

Marcus Kupferschmidt - Lehman Brothers

George Notter - Jefferies

Ken Muth - Robert Baird

Ehud Gelblum - JP Morgan

Presentation

Operator

Good morning. My name is Laurie, and I will be your conference operator today. At this time, I would like to welcome everyone to the Tellabs' Investor Relations conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions].

Thank you. Mr. Scottino, you may begin.

Tom Scottino

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

Before we begin, I'd like to remind you that certain statements made on the call this morning may be considered forward-looking. Such statements are subject to risks and uncertainties and actual results might differ materially. A discussion of the factors that may affect future results is contained in Tellabs' most recent SEC filings. Tellabs disclaims any obligation to update or revise statements contained in this presentation based on new information or otherwise. This presentation this morning may also include non-GAAP financial measures. A reconciliation between non-GAAP financial measures and GAAP financial measures can be found at our "tellabs.com" website as well.

With that, I'll turn the call over to Krish.

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Krish Prabhu

Thanks, Tom, and good morning everyone. Welcome to our earnings call. This past quarter was a tough quarter for us. Both revenue and earnings were substantially off from what we had guided at the end of 3Q.

We have had a track record of providing certain spec guidance for the past several quarters. However, as we had indicated in our preannouncement earlier in the month, our 4Q results were affected by two significant events, the BellSouth-AT&T merger and the deferred revenue associated with the launch of the ROADM product.

Tim Wiggins will walk you through the details, so I won't delve into that, right now. Instead, let me take a little time to reflect upon some of the highlights of 2006. During 2006, we shipped our 1-millionth ONT to Verizon and delivered a GPON system to their lab for testing.

Our IP data products strategy has been focused on applications pertaining to wireless back call and multi-service edge networking. In 2006, we topped the $100 million annual revenue mark for data products and penetrated tier-1 customers, like Telstra and Telecom Italia. This adds to our list of existing tier-1 customers, such as Cingular, Verizon, NTT, Comcast and Vodafone.

Our strategy for selling SDH products in a price competitive international market is focused on Ethernet-over-SDH. During 2006, we had record sales of our SDH products led by the launch of our new product 6325. We added 15 new customers. We now have over 160 customers in 60 countries for this product line.

During 2006, we introduced IPTV and VDSL2 capability in our FTTC product, which is deployed predominantly at BellSouth. Today, BellSouth has a prominent demo that features 80 megabits to the home based on our FTTC platform.

During 2006, we successfully completed the ROADM FOAs at Verizon and started shipment of the product. These accomplishments clearly position Tellabs as a broad based provider of products for IP Transport and access.

Looking forward to 2007, we have a few initiatives identified. Firstly, we have very active margin improvement programs pertaining to the ONT and ROADM product lines. We will begin to see the impact of these programs towards the latter half of 2007. We are working with Verizon to complete their testing of the GPON product and get approval for field deployment.

We will build upon the momentum in our IP data products, as we penetrate other tier-1 international customers. We plan to work with AT&T to upgrade part or all of the 1.5 million fiber lines in BellSouth territory to provide IPTV service.

We also plan to address AT&T's desire to bring DSL to 100% of their territory by using the 1000 product which is widely deployed there, especially in rural and semi-urban areas. We plan to build upon our ROADM success at BellSouth and Verizon and we hope to announce a few other wins in North America in 2007.

As we look at providing guidance for 1Q, we have assumed that some of the conditions we saw in 4Q will persist in 1Q. While this may be a bit conservative, we feel that this is the best guidance we can provide at this time.

I will stop there for now and hand it over to Tim and come back for Q&A. Tim?

Tim Wiggins

Thanks, Krish, and good morning everyone. Total revenue for the full year 2006 amounted to about $2 billion, up 8% from about $1.9 billion in 2005. The year-over-year increase in annual revenue was driven across all three segments: broadband, transport and services.

On the strength of that revenue growth, improved gross margins and our continuing focus on controlling operating expenses, Tellabs produced $329 million in non-GAAP operating income for the year. That's up 31% from last year when non-GAAP operating income amounted to $251 million.

Consistent with our announcement of January 5th, total revenue for the fourth quarter of 2006 was $455 million. That compares with $521 million in the fourth quarter of 2005. The year-over-year quarterly revenue decline can be attributed primarily to two items.

First, reduced spending by AT&T, BellSouth and Cingular prior to the completion of the AT&T-BellSouth merger -- sales to these customers in the fourth quarter of 2006 were about $80 million below the comparable period in 2005. And second, during the quarter, we deferred about $40 million in revenue associated with product shipments, primarily 7100.

For the fourth quarter of 2006, non-GAAP operating income amounted to $35 million, or 8% of revenue, compared with $96 million, or 18% of revenue, in the fourth quarter of 2005.

For the fourth quarter of 2006, revenue from customers in North America amounted to 70% of the total versus 76% in the fourth quarter of '05. Revenue from customers outside North America amounted to $137 million in the fourth quarter, up 10% from $124 million in the comparable period of '05.

Looking at the individual business segments. The broadband segment includes our access, managed access and data products. For the full year '06, revenue for the entire broadband segment was $1.80 billion, up 4% from revenue over $1.42 billion in '05. Revenue growth for the year was driven by increased sales of data and access products.

Broadband segment revenue for the fourth quarter of 2006 was $249 million compared with $302 million in the fourth quarter of '05. The decline here is primarily related to lower sales of access equipment.

For the full year, revenue for our access products amounted to $653 million which is up 6% compared with $617 million we recorded in all of '05. The increase here was driven primarily by higher sales of single family ONTs.

Access revenue was $138 million in the fourth quarter of '06 compared with $180 million in the fourth quarter of '05. The year-on-year decline can be attributed primarily to lower sales to BellSouth prior to the completion of the AT&T-BellSouth merger.

In addition, higher sales of fiber-to-the-premise equipment, PONs and single-family ONTs were offset by lower sales of copper access platforms to independent operating companies. Fiber platforms accounted for 60% of access product revenue in the fourth quarter of '06.

Revenue from managed access products came in at $320 million for the full year '06 compared with $365 million in '05. For the fourth quarter of '06, managed access revenue was $80 million compared with $91 million in the fourth quarter of '05. The decline here is primarily related to reduced Tellabs 8100 product revenue. On a sequential basis, overall managed access revenue was up slightly from Q3 '06 to Q4.

The Tellabs 8800 multi-service router series and the Tellabs 8600 managed edge system make up our data category. For the full year, revenue for these products was $107 million, nearly double the $60 million we recorded in '05. For the fourth quarter of '06, revenue from data was $31 million consistent with the level we recorded last year.

For the full year '06, broadband segment profit was $120 million versus $156 million in 2005, as improved data performance was more than offset by a shift in our access business mix towards single family ONTs. In Q4 '06, broadband segment profit was $20 million versus $62 million in Q4 '05, driven by lower revenue and access revenue mix shift I described earlier, which resulted in a higher volume of single family ONTs.

Turning to the transport segment. Transport segment revenue for the full year '06 was $778 million. That's up 15% from $674 million for the full year '05. The increase was driven primarily by higher sales of the Tellabs 5500 cross connect systems and 3000 voice quality equipment.

For the fourth quarter of '06, transport segment revenue was $159 million. That compares with $175 million in the fourth quarter of '05. The year-over-year decline reflects lower sales of the Tellabs 5500 systems, partially offset by increased sales of other transport products.

Within the transport segment, the wireless continues to be the prominent driver for the full year '06. North American wireless customers accounted for approximately 62% of all transport revenue up from 54% in '05. For the fourth quarter, North American wireless customers accounted for approximately 50% of all transport revenue compared with 66% in Q3 '06.

Looking at the Tellabs 5500 cross connect business specifically, for the full year '06 we shipped approximately 10.1 million T1 equivalents versus 7.3 million in '05. In the fourth quarter of '06, we shipped approximately 1.8 million T1 equivalents compared with 2.8 million T1 equivalents in Q3 '06 and 2.7 million in 2Q '06.

About 35% of this quarter's 5500 system revenue came from new systems, systems expansions, and software upgrades, with the balance of 65% consisting of port card growth on our installed base. The new system percentage compares with 36% in Q3 '06 and 30% in Q2 '06 and reflects in part successful acceptance of the new FP 11 feature package.

At the end of the quarter, 20% of the card slots in our installed base were open. For the full year 2006, transport segment profit was $415 million versus $318 million in 2005. The increase here is primarily due to higher revenue and improved margins.

In 4Q '06, transport segment profit was $69 million versus $87 million in Q4 '05 as the impact of lower 5500 revenue was largely offset by a positive mix shift towards some other transport products. The decline here was largely due to the inclusion of some up-front costs for future deliverables associated with launching the Tellabs 7100 ROADM.

Looking at the services segment, for the full year '06 services segment revenue was $183 million, up 9% from 167 in 2005. For the fourth quarter of '06, services segment revenue was $47 million, up 7% from $44 million in the comparable period of '05.

For the full year '06, services segment profit amounted to $66 million. That compares with $48 million in '05. For the fourth quarter of '06, services segment profit amounted to $18 million versus $14 million in the comparable period of '05. The improvement reflects increase in revenue from high value support agreements and professional services.

Turning to overall profitability for the full year '06, net income on a GAAP basis amounts to $194 million or $0.43 a share. That compares with GAAP net income of $176 million or $0.39 a share in '05. On a non-GAAP basis, net income for 2006 amounted to $258 million or $0.57 a share and that compares with non-GAAP net income of 252 or $0.55 a share in '05.

The year-on-year net income comparisons are affected by changes in our tax provision. As you may recall, for the full year '05, we benefited from operating loss carry-forwards that resulted in a 9% effective tax rate. For '06 our effective non-GAAP tax rate without the benefit of the operating loss carry-forwards was 31%.

For the fourth quarter of '06, GAAP net income amounted to $29 million or $0.07 a share, and that compares with GAAP net income of $92 million or $0.20 a share in the fourth quarter of '05. Non-GAAP net income for the fourth quarter of '06 amounted to $47 million or $0.10 a share, and that compares with non- GAAP net income of $100 million or $0.22 a share in the fourth quarter.

Our non-GAAP net income calculations exclude deal related stock compensation, amortization of purchase intangibles, equity based compensation expense and other non-GAAP adjustments as described in this mornings press release.

The effect of equity based compensation expense in 4Q '06 was $10 million, for a full year total of $42 million. This reduces our non-GAAP EPS by about $0.01.5 in 4Q and about $0.06 for the full year. That way of looking at things is consistent with our first call in [royers] compile, mean EPS estimates for Tellabs. As usual, you'll find a complete reconciliation of our GAAP and non-GAAP results in this morning's press release.

Our non-GAAP gross margin of 40.7% for the fourth quarter of '06 compares with 48.9 in the third quarter of '06 and 46.6 in the second quarter. As you know, our gross profit margin is dependent on product and customer mix which was responsible for the shift between Q3 and Q4.

We are seeing increased variability in overall gross margin percentage as the mix of new and established products changes. The reason for the increasing variability is a difference in margins between these products. Contributing to the shift in this quarter was about 11 points of margin decline related roughly in equal doses to first, 7100, where we booked some up-front costs for future deliverables.

Second, 5500, which provided an overall percentage of total revenue and saw a mix shift toward lower margin customers and our 1600 single family ONT, which was affected by new pricing that went into effect about 1/3rd of the way through the quarter, and which grew to become a larger overall percentage of our total revenue mix. These impacts were offset by about 3 points of improvement from established transport and managed access products and lower manufacturing overhead costs.

Turning to operating expenses, non-GAAP OpEx for the fourth quarter of '06 came in at $150 million, about 33% of revenue and that compares with $153 million in the third quarter of '06. For the quarter, R&D expenses came in at $79 million and SG&A were $71 million. At $79 million, R&D equals about 17% of revenue. In the fourth quarter of '05, R&D expenses of $85 million amounted to about 16% of revenue.

Other income on a non-GAAP basis amounted to $13 million versus $12 million in the third quarter of '06. Our tax provision on non-GAAP pretax income for the quarter was $1.2 million. That makes our effective rate for the full year approximately 31%.

The tax provision for the quarter reflects the benefit of recording domestic R&D tax credits recently reestablished for 2006. It also reflects a benefit related to some foreign tax reserves that we reversed during the quarter because they are no longer needed. We expect our effective tax rate for the first quarter and the full year '07 to be about 33% plus or minus and that reflects the 2007 R&D tax credits.

Turning to the balance sheet now, in the fourth quarter we changed our way of calculating DSO and inventory turns. To give you a better view of our working capital, we are now calculating these metrics using a three-month average receivable and inventory balance which we believe provides a more realistic view of working capital performance.

Using this new method, DSO was 59 days in 4Q. On an apples-to-apples basis that compares with 54 days in 3Q. The increase here is primarily related to back end loading during the quarter. Again using the new method, inventory turns were 5.8 times versus 6.4 in 3Q '06. Inventory in terms of dollars increased to 167 million from 156 million in the third quarter. The increase here is primarily related to the 7100 deferral offset by a reduction in access product inventory.

CapEx during the quarter was $18 million compared with $15 million in the third quarter of '06 and amounted to $67 million for the full year and that compares with $62 million last year.

During the quarter, we purchased 3.6 million shares of our stock for about $40 million. For the full year, we purchased about 22 million shares of our stock for about $272 million. At quarter's end, the actual number of shares outstanding was 439 million compared with 442 million at the end of the third quarter. Since we began to buy shares back in 2005, we have purchased about 46 million shares at a cost of $465 million.

At the end of the quarter, our cash and investment balance stood at $1.300 billion, up $69 million from the third quarter of '06. This increase was largely driven by cash provided by operations of $118 million offset by the cash used to repurchase shares during the quarter. Headcount at the end of the quarter stood at approximately 3,700 consistent with the level at the end of the third quarter. Book-to-bill was above one.

Turning to our outlook. Given what we see in the market, we expect that the first quarter of '07 will look a lot like the quarter just ended. We expect first quarter revenue to be flat to slightly down from the $455 million we recorded in 4Q '06 in a range between $445 million and $455 million. We expect gross margin to be 40% plus or minus depending on product mix.

As I said earlier, we are seeing increased variability in overall gross margin percentage as the mix of new and established products changes due to the differences in margins between the two. We are looking for non-GAAP OpEx to be in the mid 150's range as we absorb some near term R&D program cost.

Like 2006, our 2007 target is to have quarterly operating expense trend down through the course of the year. In Q1, we expect the effect of expensing equity based compensation will be about $9 million split between operating expense and cost of goods sold.

I know that's been a long discussion, but at this point, we'll open the floor to questions. Laurie? We're ready for the first question.

Question-and-Answer-Session

Operator

[Operator Instructions]

Our first question comes from Brant Thompson of Goldman Sachs.

Brant Thompson - Goldman Sachs

Good morning. I was wondering if you could give us an idea since the spending pause that you've seen has been described as temporary in your press releases and it seems to largely relate to either BellSouth/AT&T or the 7100, the shift in that revenue.

Could you talk a little bit about how we should expect the rest of this year to progress? Do you have some visibility at this point that even though first quarter is weak that second quarter you get more clarity?

Could you talk about that progression and then as a housekeeping question, can you talk about your thoughts on share buyback as we go forward this year? Thanks.

Krish Prabhu

Thanks, Brant. I will address the first question, Tim can certainly chip in and add to it and Tim, if you will address the second question on share buy back. Yes, we think the pause in spending, I think Tim alluded to the fact that year-on-year revenue from three customers that were in the middle of the merger, BellSouth, AT&T and Cingular was $80 million.

Our gap in what we did between last year and this year was less than $80 million, so you see what a big impact spending or lack of spending from those customers had on our revenue. We feel -- we sell a broad range of products into those set of customers. We sell cross connects and 8800 product to Cingular.

We sell ROADM cross connects and access products to BellSouth and we sell access products and cross connects to AT&T. So I feel that as they look at their network and put their CapEx plans in place for 2007, that revenue will come back. Some of it will definitely come back. We just have to wait and see at the end of the day, they have certain ideas about how they will spend their CapEx and we have very little visibility into that right now.

As far as 7100 is concerned, we shipped a lot of the product in 4Q. I think Tim referred to the fact that there was about $40 million of revenue that was deferred. We're entering an era where these are complex products. The 7100, in fact, does everything that sonic products do, more or less, does everything that DWDM products do more or less, plus does more in the form of reconfigurable ODMs.

So these have multiple software releases and we enter into an era of products with multiple elements and the accounting treatment of such elements is very complex, as we are finding out. So I think that this is again something that normalizes and stabilizes as we do a certain amount of revenue in the next few quarters for this product line.

In terms of the whole year, as I mentioned earlier in my piece of the talk, we have lots of exciting things happening. We believe the networks worldwide both in wireless and fixed are transforming in our space, especially transport and access. There's more IP traffic coming in. How this IP traffic gets handled and gets passed on to router networks is where we play, and we have had several wins in '06.

We've added several tier 1 customers in accounts where we never did business before, and we think all of that momentum catches up at some point when the traffic in the network just reaches a certain threshold, and I think that's definitely going to come around. Whether it happens some time in 2007 for us to see the significant increase or whether it happens in 2008 is a matter of time. Tim?

Tim Wiggins

Brant, we have about a little north of $200 million of authorization left under our share buy back program and at this point, I would see us continuing to be active with that program as we look into the balance of the year.

Brant Thompson - Goldman Sachs

Thank you.

Operator

Your next question comes from Tim Long of Banc of America.

Tim Long - Banc of America

Just a few questions on the ONT side. You mentioned the price reductions coming, I guess a third of the way through the quarter.

First, are there any other price cut plans there in the next quarter or two and then could you just update us on your timeline for gross margin and targets for progression there, and how the VPON, I'm sorry, the GPON will impact that timeline? Thank you.

Krish Prabhu

Okay, again, I'll answer part of the question and Tim if you feel free to chip in. The ONT pricing, we believe has stabilized but at least for now, but you never know. That's determined by the players in the market and how badly other players want this business. There was a precipitous decline in price because some of the other bigger players wanted in, and we went down in price to hang on to the business.

Just prior to that, we had actually recovered nicely in terms of margins going back to early 2005. In fact, if I look at 2Q of '06, we did almost, well I don't want to give you a specific number for the product but we had very good ONT sales in 2Q of '06 and we had good steady state margin for those products. I think the pricing has stabilized for awhile.

We have now focused on doing a lot of integration in the ONT. In fact, the ONT plays a key role where the home network meets the public network, so in this context, to the not only the fiber network meeting the copper network in the home but also how deep you push the fiber in the home, how you handle the battery back up and the integrated power supply unit, how you minimize the labor cost in the home.

We have had several advances and a lot of learning over the million ONTs that we have shipped and all of that has translated into designs that have much better cost optimized. So I feel reasonably confident that over the next few quarters we will be able to bring back the cost structure of this ONT to a situation vis-à-vis price like what we had in 2Q of '06.

The transition from BPON to GPON, that's a customer call. We don't know when the customer is ready to transition from BPON to GPON, but virtually everything that we do in our BPON ONT carries over. In fact the mechanics, the assembly, the motherboard, it's almost identical except for a chip that changes between BPON and GPON. So we feel very confident that we are best positioned to handle that transition.

Tim Long - Banc of America

And that there'd be no impact on margins from that transition?

Krish Prabhu

That's our expectation for now. In fact, if you'll recall that RFP that we won fourth quarter and that resulted in price concessions was for GPON. So what we were forced into is to price the BPON ONT at GPON prices.

So we don't expect further price declines. But that's a market condition that competitors also have a say. So you know, I can't speak more about that right now other than right now, our expectation is that from a pricing standpoint, BPON and GPON ONTs are going to be equivalent.

From a cost standpoint, we have another degree of integration that happens in our GPON ONT as we go to a system on a chip and that's going to give us additional improvement in our cost structure.

Tim Long - Banc of America

Thank you.

Operator

Your next question comes from Tal Liani of Merrill Lynch.

Tal Liani - Merrill Lynch

Hi, guys. I may be trying to dice the numbers a little bit too much here. The first question -- I have two questions -- the first question is on the profitability and growth in '07. And the way I look at it is if I look at your transport revenues, they account for about roughly 40% of total revenues. But if I allocate the expenses to the various divisions, two things might have happened this quarter if you don't mind to discuss it.

First, transport revenues accounted for 120%, 118% of total profits. So transfer profits accounted for more than 100% of total profits. Even if you improve GPON profitability, how would this change going forward because this number did fluctuate between 65% of the bottom to sort of 80% of the top and this quarter its way too high?

And the second point is transport, it seems like the margins of the transport business, again, after allocating the expenses in some way we're doing it here, margins of transport went down substantially sequentially from the last three quarters also. So is there any decline in profitability of pricing or is it just because I allocated the expenses -- sorry, any decline in profitability of transport, and second, for '07, what is the outlook for the transport growth because that's going to drive total EPS? Thank you.

Krish Prabhu

So let me just say a few things and Tim can amplify. I don't understand your framework for the allocation you were talking to. We do report transport segment and broadband segment profitability. If your concern is -- and as you see now reporting both segments are profitable.

The one big difference we had in 4Q compared to 3Q was that the product mix was at the low end of our mix spectrum. Tim talked about product mix changing from a combination of cross connects, which have the best possible margin amongst our various products to ONTs at the other end of the spectrum which have the worst possible margin.

And we had a very favorable situation in 3Q which resulted in a near 49% gross margin, whereas in 4Q, we had an unfavorable mix coupled with Tim talked about certain costs associated to deferred revenue which were accounted for future deliverables. That brought the margin down to 40%.

I don't think there's any secular change in the characteristic of the transport business unless the customers clearly signaled to us that they're not buying anymore cross connects. And as we said, we haven't seen that. The first half of the year typically sees stronger wireless sales so we shall see over the next two quarters. The second half of the year, the wireless cross connect sales tail off a little bit.

We fully expect that this year's transport revenue will have significant 7100 component in it and that definitely has lower gross margins than the cross connect. So anyway, Tim, do you understand the question a little bit better than I do and maybe you can add something to it.

Tim Wiggins

Well, Tal, let me --

Tal Liani - Merrill Lynch

By the way, I just allocated other expenses you don't allocate to the divisions. That's why I tried to drive up operating margin per division and tried to reconcile between total operating profit per division. That's the only difference.

Tim Wiggins

Right. And we don't do that because we're not smart enough to know how to really do that and get a good answer. So we think a better way to look at it is that the segment profit level which, of course, is revenue less cost less R&D expenses.

With respect to the broadband segment profit in 4Q, it really was driven by what we described -- it went from 20 -- or $62 million to $20 million. There was a shift, really, I think that came from the unusual spending patterns at BellSouth. So we certainly saw less of the 1100s. We also saw the increase in the ONTs and lower sales to the IOC. So basically you had a mix shift and a price reduction for the single-family ONT that kicked in.

So Krish talked about first in Q1, we'll have the full pricing reduction for the full quarter. But as we go through the year, by the end of the year we expect to get that product back to a similar standing that we had with the old product. So I think the best way to look at the business is the segment data that we've used. And when you start at trying to allocate the G&A and other expenses, you're really looking at the business a different way than we look at it and try and manage it.

Tal Liani - Merrill Lynch

And so what is the best guess for if I look at the two ranges, 41% gross margin versus 49% gross margin the last two quarters, what is the best way for us to model the gross margin going forward?

Tim Wiggins

Well, if the business recovers as we think it will that means it will increase some of the higher margin traditional products, 5500, and we would see the margin, gross margin rise.

So I think what you're seeing is a common aberration when we look at the 4Q results and until the business recovers, we have a higher mix of these new products where we're in early pricing or we're shipping high -- low counts of high margin parts like the 7100 where we're shipping frames and systems that are seating.

So there's two things that are going to go on, Tal, as we go through the year. One, we'd hope the business comes back -- 5500 comes back. We see no reason why that won't happen given the technology into the customers' networks and the growth of the traffic.

But we have, by the way, Tal, seen disruptions as we looked at and we talked about last year how this correlates to minutes of use. When you look at our data there, you do see some fits and starts that can be explained by near term disruptions. But if you say what best describes the growth of that product, its minutes of use.

So I think what we're looking for is a return to more normal mix, which would raise our margins off of where we are today. I think probably our 3Q margin in the kind of intermediate term is probably at the high end of our range. And we hope that what we're seeing in this 4Q, first Q would be at the low end of the range. But I think the key is improved cost performance on 71 ONTs and the return of the 5500, and that will drive margins up.

Tal Liani - Merrill Lynch

Thank you.

Tim Wiggins

You're welcome.

Operator

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

John Anthony - Cowen & Company

Good morning, guys. A couple of questions. First, can you give us a sense of where you expect operating expenses to base on an absolute dollar level?

Tim Wiggins

For Q1?

John Anthony - Cowen & Company

No. For the year. You said it's going to trend down, but if you start in the mid 150s and you trend down, it doesn't look like you're going to have any material year-over-year decline. And given the outlook for the first quarter, I'm just curious if you guys are planning on a year-over-year decline for total operating expenses and that's where the question comes from?

Tim Wiggins

Yes, we are. And depending on how the year unfolds, how much decline is an open question, but our target is to come in below OpEx for this year in '07. I'm sorry, for -- we want to beat 06's OpEx in '07.

John Anthony - Cowen & Company

You want to beat it; okay?

Tim Wiggins

Yes, be lower.

John Anthony - Cowen & Company

On the revenue guidance, does that -- does the Q1 revenue guidance imply any pick up in business or are you just basing it off of what you're seeing kind of the tone of business you're seeing now?

Krish Prabhu

Well, John, traditionally Q1 sees strength in wireless, a little bit of beginning of the growth in Europe for our managed access products. Last year, we saw in Q1 a lot of Katrina related activity. But what we have modeled Q1 for now is we've been a bit conservative in assuming that conditions that we saw in 4Q will persist in Q1.

We've looked at our backlog. Book-to-bill was above 1 in Q4. We've looked at that and then we also looked at traditional book ship that we do in the first quarter for our various products.

So based on that, we feel comfortable guiding you to a flat quarter that looks like 4Q. But we'll see in the first few weeks whether there is business pick up that might give us a little more uplift.

John Anthony - Cowen & Company

And from a mix standpoint, would you give us some sort of quantification about what kind of 5500 shipments you expect in the first quarter?

Krish Prabhu

For now, based on historical 5500 performance and backlog going into 1Q, we think 5500 content in 1Q will be better than 4Q. And for various reasons, we don't like to talk too much about individual products. But I think it's safe to say we think it would be better than 4Q.

John Anthony - Cowen & Company

Okay. And lastly, on your opening comments, Krish, you mentioned about upgrading the 1.5 million BellSouth lines and working with AT&T on the total access 1000's. Can you give us a sense, is that something that you've already begun to do or is that something that you hope to do?

Krish Prabhu

Well, we have worked very closely with BellSouth to identify a road map for IPTV services on those 1.5 million lines. We have a very impressive demo that we have constructed in BellSouth labs where our product has been upgraded.

It has two elements, the IPTV engine as well as the video sell to drop capability which delivers 80-meg to the home and seven HDTV channels. But at the end of the day, will they upgrade those lines? Part of those lines or some of those lines? Is that important to them as a business objective? Is that a key driver in the new company?

I can't speak for it. So when you say is it a hope or is it a plan? I'm going to say that for now, we don't have an identified agreed to plan because we're waiting to hear what AT&T's CapEx plans are for 2007. But we've been working very closely with the technical folks at BellSouth to make sure that all of those lines can be upgraded to the schedule that they want to upgrade to.

And I'm also hopeful that it's an important initiative for them because in some of their FCC disclosures, they have talked about video capability on the 1.5 million lines in BellSouth's territory.

John Anthony - Cowen & Company

Got it. Thanks a lot.

Krish Prabhu

Yes.

Operator

Your next question comes from Michael Genovese of Citigroup.

Michael Genovese - Citigroup

Great. Thanks a lot. Krish, I'm wondering about the outlook for OLT sales to return at Verizon, specifically, you know, here in the first quarter. What's your outlook for better orders on OLTs?

And could you also comment on the pricing of OLTs? Did the price cut affect OLTs or is was that purely an ONT issue? Thanks.

Krish Prabhu

The price cut is largely an ONT issue. At least from an impact standpoint, it's blended configuration, so you know, I don't know the specific details. But what we've seen in the BPON rollout is an OLT seating followed by PON cards that get bought and plugged into the OLT.

And then we see ONTs as and when the take rate goes up, so the last two, three quarters we've seen flat OLT sales. We've seen flat PON card sales. But we've seen significant ONT sales. So as they reach out to more markets, I fully expect that they'll come back and start feeding more OLTs in the field, start plugging those OLTs with more PON cards.

And both of those are good margin products for us compared to the ONT margins. So I think you'll see a few cycles of that happening, especially if they were to take the BPON up to 10 million customers as they've advertised.

Michael Genovese - Citigroup

But at the current time, you don't have any solid visibility to anything that would help your first quarter sales in any meaningful way?

Krish Prabhu

The problem with that is we do have a frame agreement with the customer where we get a frame order. And then, they pull from that order at the schedule that they want to. So we can't just look at our backlog and orders and tell you that we have solid visibility. It all depends on when they will pull what they want based on their network inventory.

Michael Genovese - Citigroup

And quick follow-up for Tim. Just a real quick -- you -- is it because it's the fourth quarter that you didn't provide an unaudited cash flow statement? You guys normally give us full statements when you report the quarter.

Tim Wiggins

Right. We just weren't comfortable that we had all of the pieces nailed down and it's just been a very busy quarter for us. So we weren't able to get that out this time, Mike. But the cash flow was nice at 117 from ops and you can see it in our bank account.

Michael Genovese - Citigroup

All right. Thanks.

Tim Wiggins

You're welcome.

Krish Prabhu

Does he have access to your bank account?

Tim Wiggins

No, but I told him what's in there.

Operator

Your next question comes from Marcus Kupferschmidt of Lehman Brothers.

Marcus Kupferschmidt - Lehman Brothers

Hi, good morning, guys.

Tim Wiggins

Morning, Marcus.

Marcus Kupferschmidt - Lehman Brothers

Just wanted to clarify the gross margin. In the fourth quarter, did you take all the costs on this $40 million deferred product?

Tim Wiggins

Well, we took a series of cost markets that had no offsetting revenue or margins so these were costs that had to do with future deliverables under the contract things like training seats, training systems and support agreements and things of that nature.

Marcus Kupferschmidt - Lehman Brothers

I mean -- so you have all the cost of goods sold associated with those $40 million of revenues were recorded --

Tim Wiggins

No. No. The only costs that are in there are the costs associated with these future deliverables. The costs of goods sold associated with the products we shipped was deferred with the revenue.

Marcus Kupferschmidt - Lehman Brothers

So therefore, the 4Q on those COGS is not, can you quantify that for us?

Tim Wiggins

I did. It's the -- I had those three elements that made up 11 point decline, it was the number one item. So figure it's about a third --

Marcus Kupferschmidt - Lehman Brothers

And if we think about 1Q, what are you assuming in terms of your sales mix, such that when you eliminate these temporary costs, the gross margin is still pretty flattish?

Tim Wiggins

Well, we had some very interesting things to happen in 4Q. One is that we saw, well 5500 was down in terms of contribution. We saw strength from some of the other traditional transport products; VQE, 5300, even 6500.

So Marcus, what we saw is that as we pushed for revenue and worked the customers, those were positive contributors to our margin, as was our service business which had a good, solid fourth quarter. So what you're seeing in 1Q is one, you'll see a full quarter of ONT pricing.

Two, we expect some improvement as Krish mentioned in the 5500, but we're seeing some of these other areas that were in that three points of positive contribution would come back to -- or revert to a more normal level so we'll lose some margins from those areas.

Krish Prabhu

Yes. Marcus, at this point, we are not in a position to give better margin guidance. You know we feel comfortable with the guidance we gave. And again, as I said, if the 5500 revenue component increases, I think we now have a good understanding of ONT pricing and what it does to our margin.

We'll have a full quarter of that. We only had two-thirds of a quarter in 4Q. I think Tim talked about some of the costs associated with future deliverables on the 7100 so some of that's behind us. We'll see how the quarter goes, but this question was asked before and Tim kind of walked you through it.

There was a decline from 49% down to 41% and the three elements that he talked about, except for the ONT, we think the other two elements will not be there, 5400 will come back and we think that some of the 7100 costs are not going to be there in 1Q.

Marcus Kupferschmidt - Lehman Brothers

All right. Thanks very much. That's great.

Tim Wiggins

Thank you.

Operator

Your next question comes from George Notter of Jefferies.

George Notter - Jefferies

Hi there. Just to clarify something. You guys said earlier on the call that 60% of the access division revenue came from fiber based products. Is that right?

Tim Wiggins

Right. Correct.

George Notter - Jefferies

And then I guess I was trying to understand the trajectory of the fiber to curve revenue stream going forward. I mean, you said it was I believe softer here, obviously, as part of the BellSouth/AT&T merger in Q4, but what's the outlook there?

Is it fair to say that you start to see that business coming back as they start to integrate the two networks together and continue that present mode of operation deploying fiber to the curb into new areas of construction or is it more likely that AT&T decides to rollout fiber to the perm in those geographies?

I mean, have you thought about that and how should I think about it in the context of the upgrade of the existing 1.5 million lines? I heard what you said earlier, Krish, about that but any flavor, or any sense you can give us for the trajectory of that business would be great.

Krish Prabhu

Okay. Let me address the 1100 in a little more detail because it is emerging as a flagship product for us, and up to now, it's largely been deployed only at one customer, BellSouth. We have evolved this product to 1150, which is a multi-service configuration.

Which basically means that you can take the fiber all the way to the premise or you can take to stop the fiber at the node and a lot of the road map discussions with our customer here lately have been on how the 1150 supports both those configurations in addition to the core configuration for what -- which it was designed which was a fiber to the curb.

We have started marketing this product in Europe with one tier 1. We have had very good early in-roads. Some of the fiber to the curb or fiber to a building or fiber to a neighborhood, which is dense, actually works out very good from an economic standpoint for this product and especially if there is a video play out on IPTV play. I think we can leverage that and this sets the stage for taking this product beyond BellSouth.

As far as the use of this product, in BellSouth's territory, for new construction, we feel that the economics, the methods of procedure, some of the engineering guidelines that the field folks use, the incumbency, the cabinets designs in which this product goes, all favor and our own validation and checks with customers both in San Antonio as well as in Atlanta favor that new construction in the nine states of BellSouth, at least our best assessment now is we'll continue with the 1100 and the 1150.

The upgrade of the 1.5 million lines at BellSouth is really an initiative that the customer needs to choose. The customer decides to put that on a fast track, we are ready because have tested out the technology and we feel reasonably good that at least what our product needs to do at the physical layer and the switching layer, it works very well and scales up nicely. So to your question, I think over the next two years, the 1150 will clearly emerge as a flagship product for Tellabs as part of the access portfolio.

George Notter - Jefferies

Got it. One very quick follow-up on that. Where does the 1150 rate out in terms of gross margin contribution relative to some of the other products in the Company?

Krish Prabhu

Well, we have products that are above 40% and again, we don't want to talk specific gross margins about our products but the OLTs, the 1150, any of the access node that we sell are comfortably in that range.

The ONT as we said has been price challenged because of the recent price drop. And we're working to get that into the positive territory, or low gross margin territory, that we had in 2Q of '06, and everything else in the Company falls comfortably in the 40% plus gross margin range.

Tim referred to the 7100 early systems being seating systems with very few transponder content as we load those systems, the transponders the margins look much better. Also as we have configurations that are not eight degree ROADMs but two degree ROADMs, the price points -- the cost points are much better for us.

George Notter - Jefferies

Great. Thanks.

Operator

Your next question comes from Ken Muth of Robert Baird.

Ken Muth - Robert Baird

Hi. On the managed access side, the 8100 if you look at kind of your '06 results, that category is down about 11% year-over-year. What do you kind of see in '07? Is there something that you have fixed with the product? Have you updated the product or do you see another decline in '07 or is that going to turn around?

Krish Prabhu

Yes. We had a slight decline. We had an 11% decline that you talked about. We saw a little recovery in the second half of the year, orders picking up and business picking up. I feel we do have visibility into a couple of large orders in Asia that will give us some good revenue.

Now, I just don't know when that revenue will materialize but it also depends on the customers plans to play that out in the network. I think it's safe to say that '07 would be flattish compared to '06 on 8100. We'll see what happens. Increasingly, a lot of the 8100 applications are being covered by our 8600 product and that has far more capability and it's one of the two data products that we market.

So the transition plan for us is to keep 8100 revenue stable and grow the 8600 revenue in some of those incumbent customers.

Ken Muth - Robert Baird

Then on the AT&T, BellSouth, Cingular, you thought that was about $80 million in revenue and that was for the quarter I assume in Q4?

Krish Prabhu

No. That was the $80 million in revenue decline.

Ken Muth - Robert Baird

Right.

Krish Prabhu

Between 4Q of '05 and 4Q of '06.

Ken Muth - Robert Baird

A year-over-year number.

Krish Prabhu

Year-over-year number. Understand that 4Q of '05 had some spurt because of Katrina related stuff on the access side, but like I said, it includes the broad range of products to three different customers.

Ken Muth - Robert Baird

Well, I mean, given those three major carriers, obviously now one now, do you think that there's going to be a possibility for a pick up a little bit in Q1 from that in Q2 or does it really seem still, you know, kind of unclear and that's going to be hopefully in the second half '07 event that they start spending again?

Krish Prabhu

That's a question I really can't comment. Largely because, I would be speculating. At the end of the day, we do believe that network pressures create some reason to spend at the same time that network inventory that needs to be exhausted, so I really don't know.

I think we've had a couple of quarters where, the spending has been held back, and we felt that 1Q, we can go out and tell you that we have evidence that says the spendings come back in 1Q. But 2Q, you know when I say we are hopeful that's what we think. We think in 2Q and 3Q, we start seeing better coverage. We'll see. We'll -- from the order inflow in 1Q we'll get a sense of that.

Ken Muth - Robert Baird

Okay. Then last quick follow-up, on the 5500, do you get a sense that there could be any technology substitution with pseudo wire or just a straight Ethernet switches at these cell sites, at some point in time in '07 or is that still a longer term thought for these carriers?

Krish Prabhu

Well, we've done a lot of wireless bids and we participated in a lot of wireless bids where pseudo wire has been pushed and in fact, we have one wireless customer in the US. That has been pretty active on pseudo wire for wireless backhaul, especially as they look at four gig technologies like WiMAX.

And we have a combination of products, the 5500, the 8800 and the 8600, which give a pretty comprehensive IP Ethernet, pseudo wire solution. We have also demonstrated pseudo wire interoperability between our products and other products in customer networks, outside and especially in Tier 1 networks with international customers where we do interoperate with other suppliers who also have pseudo wire interoperability.

So, I don't think that's the reason why the 5500 sales have had this temporary blip or you know what we feel strongly is a temporary blip. I think as Tim referred to it, we've gone back over several quarters and we report each quarter that T1 equivalents on 5500, you will see a few fits and starts in the 5500 shipments. But we did have last year for two, three quarters there was a strong deployment window from Sprint as they were trying to catch up on some of the deployment they did not do in earlier quarters.

Ken Muth - Robert Baird

Okay. Great. Thank you.

Krish Prabhu

We have time for one more question.

Operator

And sir, that question comes from Ehud Gelblum of JP Morgan.

Ehud Gelblum - JP Morgan

Hi, thank you very much. Tim, if I could dive a little bit into your break down of gross margin, I thought that was great. The gross margin, if we understand the 7100 is a lower gross margin product right now.

Tim Wiggins

Yes.

Ehud Gelblum - JP Morgan

If you had actually recognized that 40 million of gross margin of 7100, I imagine the gross margin would have been lower than 40% so I want to understand that.

Tim Wiggins

Ehud, at the current seating systems it's close to breakeven and we expect that to improve with the configuration changes and more transponders.

Ehud Gelblum - JP Morgan

Okay. So the main -- I'm still trying to understand these up front costs.

Tim Wiggins

We have a contract that we agreed to deliver things like training systems for free. We agreed to deliver certain number of training seats to train their technicians. We agreed to phone support. We agreed to certain other incentives that you know were part of the negotiation process and the accounting for those Ehud, is once we have approval on the systems, which we got on the FOAs, those costs have to be recognized and so that's what we did in 4Q.

Ehud Gelblum - JP Morgan

Great. And those were basically in COGS, not OpEx? I guess it's just a matter of --

Tim Wiggins

Those are all COGS. Those are all COGS with no revenue, so it's pure margin deterioration.

Ehud Gelblum - JP Morgan

Okay. So we get 4 points of margin back from that and move into next quarter and I'm imagining the big offset there is having a full quarter of the ONT price declines.

Tim Wiggins

Well, we had two out of three months of shipments had the new pricing, so you got some additional price declines. So we know, we've got one more quarter, so two-third of it was at that new price.

Ehud Gelblum - JP Morgan

Okay. So I guess the full quarter, which is one-month difference is enough to offset that 4 points of my guidance.

Tim Wiggins

Well, no. I think down in this other -- the other point I made, Ehud, was that there were other things. We saw some improvement in other transport products, we saw improvement in our service business, we saw some improvement in some of the elements of the managed access, so and we had some manufacturing efficiencies.

So those things would back to more normal. So I think when we looked at all the moving pieces, and I have to tell you, it was a very complex quarter because the business usually runs kind of within a channel or, you know, it runs in a very predictable place. You know fourth quarter really upset a lot of those relationships. So there's an awful lot of moving pieces.

But when we took all of those and looked into Q1, and we said that, you know, we see the margins at this 40% plus or minus. So what we're seeing is service business is typically not as strong in Q1 but our costs can't reduce as fast. You know we see some of these things that happen in 4Q on the other transport products would not be there.

We mentioned, we expect some improvement in 5500 business, full quarter of ONT pricing, so it's a number of things but I think your thinking is directionally correct.

Ehud Gelblum - JP Morgan

There was a -- same 40% but there's a very, very different 40% the next quarter than it was in Q4?

Tim Wiggins

Yes. It is.

Ehud Gelblum - JP Morgan

Okay. More along those lines, the BPON cost structure, Krish, you were mentioning that you would go back to at the new pricing level you'd get the cost structure back to where you were in Q2 of earlier this year.

I just want to reconfirm that Q2 earlier this year was a breakeven cost structure for the most part for those ONTs, so is that basically what we're looking at or am I miss remembering?

Krish Prabhu

No. You're right. Breakeven to very small single digit, we will start shipping more multi-tenant units. That helps us in gross margin, especially if the customer has what we call an urban assault, if they take fiber in a big way into urban neighborhoods, we have a family of multi-tenant units, we think some of that will come in the latter part of the year.

The single-family units that we referred to or talked about as we price the BPON ONTs because of pricing pressure in the market at GPON prices, we took a hit on our margins, so it's a slight negative, it's no where near what it was when we had acquired AFC because that was as we had characterized it as grocery negative.

And some of the cost reductions we are doing right now, the integration. Today, in the home, you have a power supply unit, a battery backup unit, and then you have the ONT, and then you have the broadband home router and all of those things add up to 600, 700 bucks, I don't know what it adds up to, but that's real cost for the customer.

So we're doing a lot of things there that allow us to take this ONT straight to the desktop and I think that will give us not only some cost recovery because of our integration efforts but also some, hopefully, some pricing flexibility as we work with our customer.

Ehud Gelblum - JP Morgan

So as we -- as that comes back to sort of a breakeven to low single digit margin, wouldn't that get offset as we -- by the recognition of the 7100 revenues which will happen later this year, so therefore, is it reasonable to assume that we stay in the low 40% range?

Krish Prabhu

Well, yes. I think that's a good point. We need to understand the time schedule for recognizing 7100 revenue and how much of it gets recognized. We're working with our external auditors to understand how that plays out. So that we can kind of guide you better because this is as Tim, said with significant volume.

The early systems are systems that have more or less racks and empty shelves and but as we put in more featured transponders into the system, as we are working on our price reduction and as we look at two degree configurations, there are quite a few two degree ROADM configurations in the network and we're also working on supply chain for getting elements that are much cheaper than what we have in the optical component elements.

I think in the second half of the year, we expect that margins to start improving and I think that would be a good time to understand what its impact is on our overall aggregate margin which I guess is your question.

Ehud Gelblum - JP Morgan

Right.

Krish Prabhu

How does that impact the overall aggregate margin? I think we're in a window between 40% which I called at the bad-end of the spectrum to 48%, 49% which we saw last quarter in 3Q, at good-end of the spectrum, and we're doing everything to manage that our margin kind of ends up in the middle of the spectrum or better. That's certainly the key incentive for the entire management team.

Ehud Gelblum - JP Morgan

Right. If I could squeeze one last quick thing in. Tim, you mentioned that 5500 there was a mix shift to lower margin customers. Could you explain -- basically I thought that BellSouth and SBC and Cingular were the reasons for drop off and I would have imagine that the large customers like BellSouth, SBC and Cingular would have been your worst margin customers because they're so large they have more pricing power than the smaller guys. Can you just kind of walk me through the margin shift and why -- whose the -- I didn't know there were lower margins picked up under customers?

Tim Wiggins

Well, there are, and it's essentially the wireline customer's use less of the features of the 5500 and so the pricing is a little bit different there. So we saw -- you saw the change of our wireless wireline percentage from 60% back to 50% in 4Q.

Krish Prabhu

Yes. Again, Ehud, in wireline customers, we sell a lot into the IOC's as well as we sell into Rbox customers outside of AT&T. So when you look at that, I think that's what Tim was referring to.

Ehud Gelblum - JP Morgan

And those are lower margin, so with pick up and wireless it will bring the margin back up?

Krish Prabhu

That's right. The wireless customers would buy feature rich cross connects which have better margins.

Ehud Gelblum - JP Morgan

Great. Thank you very much.

Krish Prabhu

Well thanks, everyone. I appreciate your interest in Tellabs. We'll catch up with you in the next call.

Tim Wiggins

Thank you.

Tom Scottino

Thank you.

Operator

Thank you for participating in today's conference. You may now disconnect.

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