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Tellabs, Inc. (NASDAQ:TLAB)

Q2 2007 Earnings Call

July 24, 2007 8:30 am ET

Executives

Tom Scottino - Director of IR

Krish Prabhu - President & CEO

Tim Wiggins - CFO

Analysts

John Anthony - Cowen & Company

Brant Thompson - Goldman Sachs

Tim Long - Banc of America Securities

Tim Daubenspeck - Pacific Crest Securities

Tal Liani - Merrill Lynch

Ken Muth - Robert Baird

Marcus Kupferschmidt - Lehman Brothers

Ron Coll - Jennings Capital

Simon Leopold - Morgan Keegan

Ehud Gelblum - J.P. Morgan

George Notter - Jefferies & Company

Presentation

Operator

Good morning. My name is Kenia (ph) and I will be your conference operator today. At this time, I would like to welcome everyone to the Tellabs Investor Relations Conference Call. (Operator Instructions) Thank you.

Mr. Scottino, you may begin your conference.

Tom Scottino

Thank you Kenia and good morning everyone. With me today are Tellab’s 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 maybe considered forward-looking. Such statements are 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 and revise statements contained in this presentation based on new information or otherwise.

This presentation also includes non-GAAP financial measures. Reconciliation’s between a non-GAAP financial measures and GAAP financial measures can be found at tellabs.com.

Having said all that, I'll turn the call to Krish.

Krish Prabhu

Thank you, Tom. Good morning everyone. As you saw from our press release this morning, our revenue came in higher than we had guided during the last call. We met all criteria for recognizing deferred revenue on 7100. That was a rollout that we commenced with one major customer in North America a few quarters ago.

In addition to recognizing that deferred revenue we also saw greater strength in 7100 with other consumers, as well as our data products 8600 and 8800. We are especially encouraged by our efforts in seeding the network with these next generation platforms for Ethernet transport and especially with data platforms for pseudowire mobile backhaul.

Tim Wiggins, our CFO, will provide you greater details as all segments of sequential revenue growth from 1Q to 2Q.

Last year two of our top five customers were involved in a merger which had considerably slowed down their spent with us for some quarters now. We saw some recovery in 2Q, but not quite to pre-merger levels.

On fiber access, FTTP continues to build steam. We see increased shipments of ONTs, OLTs and GPond. FTTP has had some recovery after a poor first quarter. Our focus is on margin improvement, especially for the newer platforms in fiber access and ROADM.

In this regard, we introduced the nano version of ROADM at Nexcom, which will allow us to go after new market segments that are more price competitive and also give us better system level margins. OpEx remains under control, as we continue to be flat or trend slightly down.

Let me pause her and I'll pass it on to Tim Wiggins and I'll come back for Q&A.

Tim Wiggins

Thanks, Krish. Good morning everyone. Let's take a little deeper look at the numbers. Total revenue for the second quarter of 2007 amounted to $535 million, down 3% from the second quarter of 2006. The year-over-year decline can be attributed primarily to lower revenue in the broadband product segment.

GAAP net income for the second quarter of '07 amounted to $30 million or $0.07 earnings per share. That compares with $54 million or $0.12 per share in the second quarter of '06. Non-GAAP net income for the second quarter of '07 amounted to $38 million or $0.09 cents per share. That compares with $73 million or $0.16 cents per share in the second quarter of '06.

Our non-GAAP results for 2Q, '07 exclude $14 million in pretax items for special items, which includes $8 million or $1.2 cents per share in equity-based compensation expense. Taking equity-base compensation expense into consideration as First Call and Reuters do, when compiled mean EPS estimates for Tellabs, gives you $0.07 cents in non-GAAP EPS for the second quarter of '07.

As usual, you'll find a complete reconciliation of our GAAP and non-GAAP results in this morning's news release. These and more detailed year-over-year comparisons are discussed in this morning's news release.

I want to spend a couple of minutes looking at the business from a sequential standpoint. This will give you some additional insight and a better feel for how Tellabs products are gaining momentum in customers' networks as the year unfolds.

Compared with the first quarter of this year, second quarter 2007 revenue of $535 million was up 18% driven by increased revenue across all product and service segments. During the second quarter we met the criteria for recognizing deferred revenue related to our 7100 ROADM deployment. That enabled us to recognize transport product revenue and services revenue related to ROADM deployments that took place in the fourth quarter of '06 and in the first and second quarters of '07.

For the second quarter of '07, revenues from customers in North America amounted to $413 million or 77% of the total. That's up 21% from the first quarter of '07 and consistent on a percentage basis with first quarter '07 level.

Revenue from customers outside North America amounted to $121 million in the second quarter of '07, up 10% from the first quarter of this year.

Turning to the individual business segments, Broadband segment revenue for the second quarter of '07 was $246 million, up 13% compared with $219 million in the first quarter of this year. As you know, the broadband segment includes our access, managed access and data products. The sequential increase in the Broadband segment revenue results from increased revenue levels across all three product areas.

Looking at the elements of our Broadband segment, access revenue was $135 million in the second quarter of 2007, up 11% from $121 million in the first quarter of '07. All product areas within the access segment were up with the largest sequential increases in the Fiber-to-the-Curb systems and single-family ONTs for the Fiber-to-the-Premise applications.

The growth in ONT unit volume, impacted by the price reductions that went into affect last year, is greater than the growth in revenue would suggest. Fiber platforms overall, both Fiber-to-the-Curb and Fiber-to-the-Premise, accounted for approximately 68% of access product revenue in the second quarter of '07 compared with 65% in the first quarter '07.

Revenue from fiber platforms in the second quarter of '07 was the second highest level recorded by Tellabs, exceeded only by the record level achieved in the second quarter of '06. Managed access revenue in 2Q '07 was $77 million, up 12% from $69 million in the first quarter of '07.

Again, we saw sequential improvement across all managed access products, most notably the 8100 managed access system. The Tellabs 8800 Multi-Service Router Series and the Tellabs 8600 Managed Edge System make up our data category.

For the second quarter of '07, revenue from data was $35 million, up 20% from the $29 million we recorded in the first quarter of this year. Data is one of the fastest growing parts of the Tellabs portfolio and we saw solid sequential increases in both the 8600 and 8800 product lines this quarter.

Looking at the first six months of 2007, data revenue totaled $64 million, up 44% from $44 million in the comparable period of '06. In 2Q, '07, Broadband segment loss was $800,000, compared with a segment loss of $15 million in 1Q '07. The improvement here is primarily related to increases in Tellabs 8100 revenue and improved access product margins.

Turning to the Transport segment, for the second quarter of '07, Transport segment revenue was $223 million up 16% from $191 million in the first quarter of '07. As I mentioned at the top of the call, the improvement here is related primarily to the 7100 ROADM product. This was partially offset by sequentially lower sales of 5500 systems to wireless carriers.

Looking at the Tellabs 5500 Cross-Connect business specifically, we shipped approximately 1.9 million T1 equivalents in the second quarter of '07 compared with 2.4 million in first quarter of '07. About 36% of this quarter's 5500 system revenue came from new systems, system expansions and system upgrades, with the balance of 64% consisting of port-card growth on our installed base. At the end of the quarter, 20% of the card slots on our install base were open.

Due to the higher level of ROADM revenue, North American Transport sales shifted from wireless to wireline customers in the second quarter. North American wireless customers accounted for 39% of Transport product sales in 2Q '07, compared with 65% in the first quarter.

Driven by the higher level of Tellabs 7100 revenue and the lower level of Tellabs 5500 revenue, transport segment profit for 2Q '07was $81 million, compared with $111 million in 1Q '07. As we've discussed previously, initial shipments of the 7100 ROADM went out at essentially breakeven margin levels.

Looking at the Services segment, including revenue related to the ROADM deployments for 4Q '06 in the first half of '07 services segment revenue for the second quarter of '07 was $66 million, that's up 56% from $42 million in the first quarter.

In addition to the 7100 revenue, we saw increased revenue from product support services. For the second quarter of '07, services segment profit driven by the higher revenue level amounted to $26 million versus $10 million in the first quarter of this year.

GAAP net income for the second quarter of '07 amounted to $30 million or $0.07 a share and that compares with $25 million or $0.06 cents per share in the first quarter. Non-GAAP net income for the quarter amounted to $38 million or $0.09 per share and that compares with $34 million or $0.08 earnings per share in the first quarter of '07.

As I mentioned at the top of the call, the effect of equity-based compensation expense in 2Q '07 was $8 million or about $1.2 cents. Non-GAAP gross margin at 35.4% for the second quarter of '07 compares with 41.5% in the first quarter of '07. As you know, our gross margin profit is dependent on product and customer mix, which was responsible for the shift between 1Q '07 and 2Q.

Contributing to the shift this quarter was about 10 points of margin decline related to transport products, caused in about equal parts by the recognition of the 7100 revenue and lower levels of 55 and other transport product revenue. This was partially offset by about 2 points of improvement from manufacturing efficiencies and nearly 2 points of improvement from higher services margin.

Turning to operating expenses, non-GAAP operating expenses for the second quarter of 2007 came in at $148 million or about 28% of revenue, just below the $150 million we recorded in 1Q.

For the quarter, non-GAAP, R&D expenses came in at $82 million and SG&A expenses were $66 million. At $82 million, R&D equals about 15% of revenue. Other income on a non-GAAP basis amounted to $14 million, versus $12 million in the first quarter of '07.

Our tax position on a non-GAAP pretax income for the quarter was $16 million. That makes our effective non-GAAP rate 30%, consistent with the first quarter level. And we expect our effective tax rate for the year to be about 30% plus or minus.

Turning to the balance sheet: DSO was 52 days in 2Q, down from 59 days in 1Q. Inventory turns were 5.9 times versus 4.9 in 1Q '07. Inventory in terms of dollars decreased to $175 million from $210 million in the first quarter. The decrease in the inventory and the improvement in DSO and inventory turns are primarily related to the recognition of deferred 7100 revenue.

CapEx during the quarter was $15 million compared with $10 million in the first quarter of '07. The increase here is primarily related to capitalized prototypes and other R&D investments.

During the quarter we purchased about 921,000 shares of our stock at a cost of about $10 million. The actual number of shares outstanding at quarter end increased slightly to $438 million compared to $437 million at the end of first quarter, due to option exercises.

Since February of '05, we've purchased nearly $50 million shares of our stock at a cost of $500 million. At the end of the quarter, our cash and investment balance stood at $1.319 billion, up $17 million from the first quarter of this year. Headcount at the end of the quarter was approximately 3800, consistent with the level at the end of the first quarter. And our book to bill was below one.

Turning to our outlook for the third quarter of this year. As I said earlier on the call, in 2Q we recognized 7100 ROADM revenue from 4Q '06, 1Q '07 and 2Q '07. Looking at 2Q on more of a run-rate basis, revenue would have been approximately $490 million with 38% gross margin.

This excludes deferred 7100 ROADM revenue from 4Q '06 and 1Q '07 and includes only ROADM revenue associated with 2Q. As we look at 3Q based on what we see in the marketplace and seasonality between 2Q and 3Q, we expect revenue for the third quarter to be up slightly from the 2Q run rate I just described with a somewhat lower gross margin.

We expect to see 3Q revenue in a range around $500 million plus or minus and we expect gross margin to be around 36% plus or minus a point or two based on product mix with more single family ONT revenue and less Tellabs 5500 and 8100 revenue reflecting 3Q seasonality.

We expect non-GAAP OPEX to be flat to slightly below 2Q level. And we expect the effect of expensing equity-based compensation in 3Q will be about $8 million split between operating expense and cost of goods sold.

At this point, we'll open the floor to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of John Anthony.

John Anthony - Cowen & Company

Good morning guys. A couple questions. I guess given the gross margin trends which seem to continue to deteriorate a little bit here, do you think you'll be able to put them closer to 40% in the fourth quarter.

I know it's a little ways out, but any guidance you could give there would be extremely helpful, given revenue the mix seems to be hurting you?

Second, on copper access, do you feel like it's bottomed at this point. It's down sharply year-over-year but it looks like it's stabilized quarter-over-quarter? And then lastly on the share buy back, can you just give us an update on variables that would push it one way or the other. Thanks.

Krish Prabhu

Thanks, John, I'll address the first two and let Tim talk about the third. Our gross margin is so dependent on mix. And we mentioned that our wireless trough connect business has been affected by the merger that happened last year. And I think it's well-known in the industry that at least for one major wireless player, the spending has not returned to normal or last year's levels.

It's all dependent on how much they spend in the third quarter and fourth quarter. For the time being, as Tim, pointed out, we resumed a higher mix of ONTs and rodents and a lower mix of 5500 and 8100. But dependant on the mix of 5500 and 8100, I think the gross margin will be somewhere between 36% and 40%. Tim, do you want to add anything to that?

Tim Wiggins

No. I think that's right Krish.

Krish Prabhu

Great. Copper access, we do have a very active plan to upgrade, especially in the independents carriers to upgrade our 60,000 deployed cabinets with newer product, the 1134 and 1150. These products going to exist in cabinets and provide video cell 2 and GigE upgrades and you could even do a Fiber-to-the-Premise or a Fiber-to-the-Curb extension or just plain support Fiber-to-the-Node.

So, we think this will help us get back to higher revenue levels, especially these customers have an active upgrade plan to get them into the video business. I don't know if it has bottomed out, but I think it's fair to say that the last two quarters, we've seen a stabilization and going forward some of our newer efforts to get the 1134 and 1150 in the same cabinets is going to help us drive more revenue into that segment. So in a sense, the copper access transforming into a fiber access is really a play for those cabinets out there. Tim?

Tim Wiggins

John, on the share repurchase, I think as we've discussed at some of the investors conferences, the Board is certainly very carefully considering its options. We continue to provide analysis and input to the board. And they'll continue to look at it. I'm obviously not in position to speak to the Board. But the Board has, over the last two years, shown a significant commitment for share repurchases, spending over a $0.5 billion to purchase shares back.

So we'll continue to work with the board and they will on their own timing make a reasoned decision. We'll just have to see how that plays out.

John Anthony - Cowen & Company

Thanks, guys.

Operator

Your next question comes from the line of Brant Thompson.

Brant Thompson - Goldman Sachs

Hi. I just wondered if you could give us a little color on your position specifically in the BellSouth territory with your access business. And then also, you just mentioned about this upgrade of a big copper installed base in a lot of the competitive carriers, can you give us an idea of the timing of when you expect to see kind of the push for doing that 1134 and a 1150 ramping? Thanks.

Krish Prabhu

I can't really talk specifically about BellSouth and their plans, that's the AT&T southeast, I think that's a question best asked of the customer, but as we recorded, we did see a sequential rise in FTTC shipments between 1Q and 2Q. And we have an upgraded path to providing full video capability, IPTV video capability on the 1.5 million lines that are deployed there.

That's all I can talk. At the end of the day, what happens to that network is really up to the customers. As far as 1134 and 1150 in the independent operating companies is concerned, the upgrade path is -- it provides a very easy way to upgrade DLC cabinets. And in a way, it does a leapfrog over broadband loop carriers, which some of the smaller start-up companies had started deploying in the same customer base.

The speed at which this upgrade happens at this point is not decided by technology, because our technology has been proven, and we've done some very successful lab trials with some of these customers. In my mind, it's more driven by their business conditions, how aggressive they want to be in video, so this deployment and what path they choose to offer video to their customers in their territories.

Brant Thompson - Goldman Sachs

Thank you.

Operator

Your next question comes from the line of Tim Long.

Tim Long - Banc of America Securities

Thank you. Just two quick margin related questions if I could. Could you talk a little about the 7100, and what you're expecting the timeline to be, profitability on that product, as well as what you think it will look like a year or two down the line, when it's stabilized and when not in the early shipment, both?

And then if you could just give us an update on the fiber side. Obviously, good improvements in the quarter, but you're talking about a poor mix in 3Q to single family ONT. Could you just update us on the progress of the margin progression on the fiber side?

Krish Prabhu

Okay. Let me give a few comments, and Tim, feel free to add or amplify what I say. On the 7100, the early shipments had some free systems in them and had configurations that were optical, amplifier, heavy and necessarily carried lower margins. Net, I think we mentioned on an earlier call that this was at breakeven revenue level, so from a profitability standpoint, we are starting at the breakeven point, unlike the ONTs where we've had negative gross margins.

In terms of one or two-year plans, we've done a couple of things. Most of the earlier systems went in with 8-degree or 4-degree ROADMs. These are necessarily big systems that go into big nodes in the network and therefore, carry a much bigger cost. As the network fills up and as they move the system to outer offices, we need 2-degree ROADMs or 4-degree ROADMs and our 7100 Nano, which we introduced at Nexcom, is an ideal system for those deployments. That product has a much better margin on day one.

In addition, we continue to cost reduce the product on certain specialty cards like transponder cards, and as the customer fills out the deployed base with traffic-carrying transponder cards, as the customer's traffic continues to go into the network, we will see the margins return to respectable levels.

Our one-year or two-year picture on this product is clearly to be at 40% gross margin, and we have identified a path to get us there. What will decide how quickly we get there will be dependent more on the kind of configuration the customer continues to deploy -- the customers continue to deploy. We now have several customers in North America, who are using this product.

On the fiber side, we have talked about this in the past, the single family ONT, because of my words and purely my words, irrational market pricing have suffered from gross margin problems, even though we have done aggressive cost reductions. We now, have a situation where we're down to a bill of materials, where a lot of the cost is over 4 or 5 specialty parts, and we're talking with select sourcing partners to see if we can further do the cost reduction on this unit.

Last time, we talked about having some discussions with partners. We haven't concluded our discussions with partners yet. Those discussions continue to make good progress. Hopefully this quarter, we will be in a position to announce, at least a good close relationship with the partner and that will help us, over and above all the efforts that we are doing in terms of margin improvement on the ONTs.

Outside of the ONTs, we really don't have a serious margin problem in the fiber access business. And these are really single family ONTs. Yeah, go ahead, Tim.

Tim Wiggins

Yeah, Tim, I'd like just to amplify some of Krish's comments on the ROADM, just to fill in some things that we've been again, talking to investors about. There are really four elements to the margin improvement in the ROADM picture. Certainly, one is cost reduction; two is obtaining new customers; three is a mix improvement away from these optically heavy systems, the transponders; and the fourth is coming up with new derivative products that have good acceptance in the market including the Nano.

So, I think we do have some scheduled price reductions that are built into our major deployment that will hold margins down in the near term. I think, Krish's view is probably more toward the back end of that, and it really is dependent on us executing on these four elements.

Tim Long - Banc of America Securities

Thank you.

Operator

Your next question comes from the line of Tim Daubenspeck.

Tim Daubenspeck - Pacific Crest Securities

Thank you. First question is managed access. Can you talk about, kind of what your long-term trends are in terms of revenue for managed access and that impact on margins? And then the second question, going back to the Shareholder Meeting, listening to Mr. Burke talk, I got the impression that some type of cash return to investors was imminent. Has something changed since that April Shareholder Meeting to push out the Board action on that cash return?

Krish Prabhu

Okay. Let me address the first one and I'll have Tim to talk about the second one. The managed access business showed sequential increase between 1Q and 2Q. This business is seasonal. It's primarily used with channel partners and direct sales to Tier 2 customers outside the U.S., and a primary application of this particular product line is mobile backhaul.

We have now managed to transition our data products, the 8600 and 8800 under the same network management umbrella. So, I think the future of the managed access business is a continuous evolution from TDM based mobile backhaul for 2G systems to an IP Ethernet pseudo wire based mobile backhaul with the use of our products. And I think, this strategy is paying out quite well, as we see the increase in our data products quarter-to-quarter and year-to-year.

The margins are quite steady, and we feel quite good about the strength of this business for some time to come. It's not a high growth business, but it is a steady business, just to manage the access itself, and it's an incumbent position that we are leveraging to try and transform it into an IP Ethernet pseudo wire business.

Tim, do you want to address the question on share buyback?

Tim Wiggins

Sure, yeah. Tim, I think my takeaway from the board meeting was that that the Board heard the comments of the shareholders loud and clear about capital deployment. I think the Board is aware that it took many quarters to build a cash position, and I think they’re carefully studying their options in terms of what's the right thing to do for shareholder value on that.

And again, as I said earlier, I don't want to speak for the Board. We'll certainly convey your question to them, but I think they'll consider all their options and make a decision when they feel it's the right time to do that.

Tim Daubenspeck - Pacific Crest Securities

Does this -- if you are in strategic discussions, does that prohibit you from making a decision or does that limit the current buyback?

Krish Prabhu

We can’t. I mean, I'm not qualified to answer this question and I'm sure…

Tim Wiggins

I think it's purely hypothetical, but yeah, you could make a construct that that would be a problem if you were.

Tim Daubenspeck - Pacific Crest Securities

All right, thank you.

Operator

Your next question comes from the line of Tal Liani.

Tal Liani - Merrill Lynch

Hello, I think it was my name.

Tim Wiggins

Is that you Tal?

Tal Liani - Merrill Lynch

Yes.

Tim Wiggins

Okay.

Tal Liani - Merrill Lynch

Question about Transport. First question, two questions about Transport. First question is about run rate of 5500. Tim you said that the run rate this quarter was 490 if you take out the extra deferrals. So, if I take out this $45 million difference from Transport, that's where it should be, revenues go back almost to the 4Q levels. And that means, very great pressure on Transport. And the question is, after we've seen the recovery in the month among most severe customers for 5500, why do we see another dip this quarter back to 4Q?

And also, can you give us some information on your visibility on this big customer in the U.S. that is not buying at this point in time. Is it a question of excess inventory, is it a question of plans, is it a question of alternative technology? And what kind of visibility you have, thanks.

Krish Prabhu

Let me take the track and Tim again feel free to amplify. If you look at our wireless cross connect business, and I think your question was more related to wireless cross connect. Over the last several quarters, we did have a -- and we've given you T1 equivalents, so that really is a very good metric to understand the robustness and the strength of this business.

Going back to the 1st quarter 2004 and including the second quarter 2004, when we had the big Verizon Wireless 2Q to 3Q build up. We have been averaging 1.9 million T1 equivalents or better. We had a spike last year in the first half where we did 2.7 million T1 equivalents.

So this quarter's 1.9 million T1 equivalents is still a measure of robustness given that one large customer still not resumed spending to the levels that they had in the past. The wireless business in the U.S. consists of four customers, and they really spend each one of them. Its almost like a sinusoidal wave, they go up and down. Some spend in a lumpy way because they have major 2G to 3G programs, and even as they acquire spectrum. Others spend -- as and when their traffic grows, but when you aggregate it all, you can see the lowest we've done in the last 8 to 10, 12 quarters, is 1.9 million T1 equivalents.

So, and that's about the level we had when Verizon Wireless did their big buildup. So, I'm very encouraged with the validation of our premise, that it's still T1 signals that do the bulk of the work in mobile backhaul. As far as visibility of this large customer, frankly, we think it's best asked of the customer, we're in no position to understand how and when they will spend. All I can say is whether it's edge or UMTS, and this customer has both edge and UMTS for their data applications.

Both -- in the edge application our 5500 is used, and used quite a bit, as it uses up several ports for every circuit that goes through it. And for the UMTS application, both our 5500 and 5800 products are used. So, we just can't comment on the spending plans of this particular customer.

Tim Wiggins

I'd also add that, attributing all the change to the 5500 is erroneous. We've also mentioned there were some other movements within the Transport segment from 1Q to 2Q.

Tal Liani - Merrill Lynch

But just going back to it, the decline in profitability was substantial. So, I'm looking for incremental dollars in Transport. You lost roughly $1 on operating profit, that's from your revenue breakdown that you gave. And the question is here, when this customer comes back, hypothetically speaking, second half of this year, first half of next year, doesn't matter when.

Do you expect profitability to go back to the 45% kind of gross, sorry, not gross, I don't want to speak about gross, I want to speak about operating margin for the division as you report, go back to the 55% operating margin for this division kind of level. Or do you think that -- or is there any pricing pressure in Transport? What I'm trying to get here is, you sell the same 1.9 millions lines, but is there any pricing pressure that has permanent impact on your profitability level?

Krish Prabhu

Well, not substantial. The $1.9 million T1 equivalents between 2Q '04 and 2Q '07, the price for T1 has come down slightly, but I wouldn't say that affects the overall profitability of the segment so much. I think Tim pointed it out, when you have a higher mix of 7100 and the lower mix of wireless 5500. You would see, with the decline in revenue, a proportionate decline in profitability. And it is clearly the single biggest impact in the mix equation. The revenue level of the 5500 to wireless carriers.

So I think, I think you're hypothesis is valid, I'm not sure if it's exactly one to one, but as the 5500 wireless revenue declines, it affects our profitability. Now, the crux of your question was, does it return if the customer starts spending in the second half or first half of next year, and I think it does. I really believe that the revenue recognition on the 7100 the big lump of start up revenue that we did, had break even profitability, anything going forward will have slight improving profitability as we increase the number of customers and improve the configurations that go out, with more transponders and smaller ROADM notes.

So, yeah I think it's a fair assumption that as the cross connect sales to one wireless customers come back, our profitability will rise in proportion.

Tal Liani - Merrill Lynch

Thank you.

Operator

Your next question comes from the line of Ken Muth.

Ken Muth - Robert Baird

Hi, good morning, just on the 3Q guidance of gross margins. 2Q, I would have thought that was impacted more by the 7100 mix, and then some GPON or BPON mix. In 3Q, is it more the gross margin impacted negatively by the fiber to the X products, and just a little of the 7100? I thought we were going to be through kind of this deferred revenue recognition of the 7100 in 2Q.

Tim Wiggins

Yeah Ken, it's Tim, yeah couple of thoughts. One is that, I tried to construct this run rate for 2Q, which was 490. What that includes is one quarter of ROADM shipments. And that margin was 38%. So, kind of all things being equal, you'd expect to see something like that in 4Q short of a recovery…

Krish Prabhu

In 3Q.

Tim Wiggins

I'm Sorry 3Q. Short of a recovery of 5500. What we see coming in 3Q is more ONTs and the seasonal impact that we typically get in 55 and 81. So, those are the three elements, the ROADM from that run rate analysis is about neutral to their from 2Q to 3Q in that construct.

Ken Muth - Robert Baird

On the ONT side, are those predominantly going to be GPON ONTs or what are they -- how do you look at the mix?

Krish Prabhu

It's all BPON in this time. We're shipping a small amount of GPONs. But most of the shipment is BPON ONTs, single-family units. And I think to add to Tim's to point, if the mix is a higher ONT content, and a lower 5500 wireless content. Then you would see degradation in the gross margins.

Ken Muth - Robert Baird

Okay. And then may be one just quick follow-up on the 5500. Its down on the revenue there because of some difficult comparisons, it was down a lot, both quarter-over-quarter and year-over-year. Do you think there's any substitution of technology going on at this time with more either pseudowires or Ethernet or anything like that, in the North American marketplace?

Krish Prabhu

No, I -- can't profess that I know what's exactly happening in the network. But as I said, we know one customer's not spending much, and we know our another customer spent a lot in the first quarter. So, when you look at sequential comparisons, you have a little bit of the disproportion there. But -- and the number of T1 equivalents, 1.9 million is about the best, is about as strong as anything we've shipped for two years, you know '04 and '05.

Just last year we had a big bubble of T1 equivalents. I really believe that pseudowire and Ethernet transports are taking root. They are taking root more where 3G networks, especially internationally are transitioning. We do have a play in that, that's why our 8600 and 8800 revenue continues to grow. Much of that spike is coming from international mobile backhaul deployments. It's also going to happen in North America and we're playing in North America. We have very active trials with the 8600 and we have a pretty sizeable deployment with the 8800. So I think that transition is going to happen, but right now I think we've still got several quarters of T1 mobile backhaul strength.

Tom Scottino

Kenia, we'll take the next question.

Operator

Your next question comes from the line of Marcus Kupferschmidt.

Marcus Kupferschmidt - Lehman Brothers

Good morning guys.

Krish Prabhu

Hi, Marcus.

Marcus Kupferschmidt - Lehman Brothers

Okay. First thing to clarify, the 7100 comments. I was a little confused, so when can we see more substantial improvements in the 7100 to see kind of the revenues generating let's say over a 10% kind of gross margin. It's something we're saying in mid '08, back half of '08?

Tim Wiggins

It's really, Marcus, based on this mix component, the cost reductions and the derivative products. So it's a little hard for us, and we tend not to want to give that kind of specific guidance, but I think the -- certainly what we're seeing is a lot of interest in the product and significant revenue growth. We think this product is going to be in the networks for maybe a decade. So, I think you know, we're struggling through kind of the initial pricing, we've got a number of very aggressive initiatives including the Nano to help us improve that mix, but also recognize we're facing price downs in the existing contracts. So I think it's a little hard for us to pin a number down. We can see a path to kind of corporate average margins, but it's based on a lot of moving pieces. And I think it's dangerous for us at this point to try and pin that down to a specific margin and a time.

Marcus Kupferschmidt - Lehman Brothers

Okay, but you're one big customer is expected to start taking the Nano to at some point in the next bunch of quarters here, as far as your discussions, your contract or the configuration, is right?

Tim Wiggins

Right.

Marcus Kupferschmidt - Lehman Brothers

Okay. And just to be clear, in terms of the overall 7100 revenues, would you expect that revenue base to go up in 3Q versus what you saw in 2Q excluding all those prior deferred revenues?

Tim Wiggins

Give or take. Marcus, I think its -- I kind of looking at it as being similar, could be a little more, could be a little less, we'll see how the quarter plays out. But it should impact 3Q much like it did in that the run rate analysis in 2Q.

Marcus Kupferschmidt - Lehman Brothers

And to clarify, to prior comment by Krish, you think gross margins could be 36 to 40% depending on a favorable outcome of your Cingular coming back would be the key driver to the high end and that’s kind of the key pressure point to get to that level for the coming quarters?

Tim Wiggins

Well, I think, as it's always been, it's very mix dependent. So depending on what ONTs are doing, how we're progressing with some of these cost downs, but probably more importantly what are the 5500, 8100, 63 and some of our VQE products doing that. Certainly the big ones are 55, 81, 63, but a number of our other products do contribute to that. And so if we have some significant improvement in the mix of those things, it can move margins 2, 3, 4 points as we've seen. So I think it's really a function of how the 4Q rolls up. And our visibility for that at that level of granularity, I just can't tell at this point.

Marcus Kupferschmidt - Lehman Brothers

Sure. And I guess, my last question just to clarify that thinking, 1Q '08 would typically then, assuming it's a strong wireless quarter, there's no reason it couldn't be above 40%. I guess, are you saying that's not possible at this time?

Krish Prabhu

No. We're not by any means saying it's not possible. I think we tried to give you a very good guidance for the next quarter. Anything beyond that is something we just don't have visibility as you can appreciate. And I think there are two elements to it, one is the 5500 content coming in from wireless and then the second is the ONT content and depending on those two there are two ends of the spectrum that have an overall impact on the average gross margin.

Tim talked about a mix of other product like data products, our managed access products, as well as VQE products. And all those products tend to make up when we do have quarter of 5500 in the past. So I think you really got to factor in those elements. The general mix of products, the 5500 and the single family ONT.

Marcus Kupferschmidt - Lehman Brothers

All right, thanks.

Operator

Your next question comes from the line of Ron Coll.

Ron Coll - Jennings Capital

Hi, good morning. Two quick questions. First of all, you gave a number of I think $490 million, just as sort of a 2Q run rate view, if you exclude the prior quarter shipments of 7100. It looks like the services business was also up probably as I guess you're recognizing this from prior quarters, so was there any services impact that would impact that. Or what was that level of services impact?

And the second question, just to clarify on the FTTC shipments, sounded like they were up, how much would you attribute this to a seasonal rebound? Thanks.

Krish Prabhu

For the first one, yes, there is an increase in services revenue associated with the deployment of 7100 network. So when we recognize the product we also recognize the services and that's what you see.

As far as FTTC is concerned, there is some seasonality from 1Q to 2Q, and again there's a seasonal increase historically from 2Q to 3Q. It's also dependent on new home construction in the southeast and the kind of spending Freeze or Curbs they may or may not have post merger or during the merger.

So, we are encouraged that the business improved from 1Q to 2Q and we'll wait and see what happens in 3Q. In the past when we had a very active hurricane season, 3Q has looked quite strong based on reconstruction tied to hurricanes. So 3Q is a quarter that's especially for FTTC, that's fairly significant.

Ron Coll - Jennings Capital

Great, and then, sorry, just going back to that. Would it be a proportionate increase that you saw in the services part of the business or was it mostly just on the product side? I want to see if there's a way we can figure out the dynamic there?

Tim Wiggins

The 490, the run rate I gave you took into account the services pick-up as well.

Ron Coll - Jennings Capital

Okay great.

Krish Prabhu

We did a big chunk of product revenues, so associated with that big chunk of product revenue, there's a services component that's one time in 2Q. But I think what Tim was trying to highlight, if you ignore the recognized revenue which is 4Q of last year and 1Q of this year, the run rate for 2Q is 490 and with it there is a services component included in that 490.

Ron Coll - Jennings Capital

Great, okay. Thanks.

Operator

Your next question comes from the line of Simon Leopold.

Simon Leopold - Morgan Keegan

Thank you. I wanted to see if you could clarify something. On the previous earnings call, you talked about the 7100 revenue recognition plus the current quarter level of being $60 million to $70 million.

You gave us enough disclosure to understand that you recognize $45 million of deferred, but I want to be able to make an apples-and-apples comparison to that 60, 70 number you gave last quarter? And then I have a follow-up.

Tim Wiggins

Simon, you're killing me man. The revenue was at the high end of the range we gave you.

Simon Leopold - Morgan Keegan

Okay. And then as a follow-up, wanted to see if you could talk a little about what's going on in the competitive landscape. A couple examples, we've got your 7100 in Verizon. It sounds like they have a new RFP coming out, Packet OTP and you've talked about some advances you're putting on the 7100 to meet that.

If you could talk about your position with that category or product as well as in the independent carriers in the access business, we're seeing a couple of companies targeting that market KOX and ADTRAN and you're really the incumbent. If you could speak to how the competitive environment there is shaping up? Thanks.

Krish Prabhu

The Packet, OTP, the packet capability is actually on our roadmap and committed to the customer as part of a roadmap commitment. So, we will respond to the new RFP that's out there and we will respond it, and we think we are very well positioned to respond because a lot of what's called for in the new RFP is designed in our existing platform as part of the roadmap.

Is it going to create more competitive pressure? Perhaps. But again, also, we have at the end of this year, we would have nearly 1,000 nodes in this particular customer's networks. So that's a significant position of incumbency.

As far as Access is concerned, that's the earlier comment I made. AFC's deployment in the independents and up to 60,000 cabinets out there was the next generation digital loop carrier.

The newer companies you mentioned came out with a broadband loop carrier, which was optimized around providing more DSL capability from that platform. We had upgraded the old next generation digital loop carrier to provide DSL capability. And that's part of the copper business that continued for us over the last several quarters. As we look forward, we now have the 1134 and the 1150.

These are small shelves that go in existing cabinets and provide GigE and video cell 2 capability, which provides a very simple upgrade to much more bandwidth to the subscribers, far beyond what a broadband loop carrier can provide. We also have an IPTV core engine in the 1134 and 1150. So as these customers get aggressive on the video plans, we think we're very well positioned to go beyond just voice and data from that platform.

Simon Leopold - Morgan Keegan

Thanks and just one more quick clarification. You may have addressed this earlier. Your services business popped up this quarter, both in gross margin and revenue. In the coming quarters I assume that goes back to trend in kind of the $40 million to $50 million range and a gross margin below 30%, is that reasonable?

Krish Prabhu

Yeah, I think so.

Simon Leopold - Morgan Keegan

Thank you.

Operator

Your next question comes from Ehud Gelblum.

Ehud Gelblum - J.P. Morgan

Hi, thank you very much. Couple questions if I could. First of all, I just wanted to clarify the last question. Tim, when you said $60 million to $70 million of 7100 revenue on the last quarter conference call, I thought you were referring to just the deferred portion.

It sounds like now you're referring $60 million to $70 million of total 7100, of which is turned out $45 million was deferred and the remainder was in quarter? Or again, was it $60 million to $70 million deferred? I was confused on that issue.

Tim Wiggins

We made it clear or I tried to make it clear I should say in 2Q that we weren't sure whether we were going to meet revenue criteria. So the $60 million to $70 million range was for both the deferred revenue and the in quarter revenue. Because if we didn't meet the criteria, then none of that would have showed up. That's why we constructed it that way.

Ehud Gelblum - J.P. Morgan

Got it and that also includes the services month.

Tim Wiggins

Yes, it did. That was all the revenue that would be associated with meeting the criteria for the revenue recognition.

Krish Prabhu

One customer for one contract.

Ehud Gelblum - J.P. Morgan

Great, and that was $45 million we saw now in the deferred part. Excluding that $45 million, bringing it back down to the $490 million, was book to bill still less than 1 or in that case was book to bill greater than 1?

Tim Wiggins

Very interesting question. Actually it was about 1. It absolutely did impact the book to bill in the quarter.

Ehud Gelblum - J.P. Morgan

Okay, that's helpful. On the route, obviously that one customer by definition was a 45% customer, almost was -- I'm sorry, a 10% customer. Did you have any other 10% customers in the quarter?

Tim Wiggins

We had three in all, including that customer.

Ehud Gelblum - J.P. Morgan

Okay. Again if we look then at your GPON business or your BPON business now at Verizon and evolve that into GPON as you go into next year, it looks as though BPON in your guidance next quarter, your Fiber-to-the-Premise gets stronger. And that's one of the pressures you're seeing on gross margin in 3Q. As you go into next year and that customer moves into GPON, how do you think your positioned and how do you think this BPON business does because it's becoming an increasing part of your revenue run rate?

Krish Prabhu

We think the customer will do both BPON and GPON for a while. We can't again speak for the customer. But based on which offices are offering what service and what additional services does GPON offer over and above BPON, we'll have to wait and see what their mix is between BPON deployment and GPON deployment.

As far as we are concerned, we think the BPON business, we said this last year, that 2007 will be predominantly BPON. I think it's playing out that way. We think there'll be strong BPON business in 2008. We are actively working on the single family ONT, the cost of that has come down quite a bit between 4Q last year and 2Q this year, and continues to trend down, but we think to get the next big quantum improvement in cost, we do need an ODM partner. And those are the discussions we're having right now.

Ehud Gelblum - J.P. Morgan

Last year before prices came down, you were on track I think to hit about 20% gross margin in the ONTs before the pricing got reset at the end of last year. It sounds like with an ODM partner you could get back to that 20%. And what's the timing on that do you think? Is it the middle of next year or the end of next year?

Krish Prabhu

Well, I think the design is the spec has stabilized and the design has stabilized. Whether and then like I mentioned earlier, the pricing did take a precipitous drop, and it was somewhat irrational, but we weren't the ones who caused the pricing drop. Is pricing going to stay the same or is there more irrationality on the horizon? Who knows.

From our standpoint, I think the ODM player's going to help us improve our margins. And that's our goal right now. Any dollar improving the margin or in the cost of this particular unit because we have the volumes is going to go right to the bottom line. And that's what we are focused on.

Ehud Gelblum - J.P. Morgan

Do you think that happens by the middle of next year? If you give us a ballpark timing?

Krish Prabhu

Hopefully, here we're in the middle of some discussions. A lot of information has been exchanged. If they have a fruitful outcome, yeah, I think you'll see improvements for sure in the middle of next year. If those discussions take longer, then that may get delayed.

Tim Wiggins

Yeah. And he's certainly not answering your question it will be a 20% margins the middle of next year. He said improvements.

Krish Prabhu

My point was the margins also depend on pricing. So you never know if the pricing comes down.

Ehud Gelblum - J.P. Morgan

One last question, that major customer of yours for Fiber-to-the-Curb, last year and the year before was sort of ordering BPON ONTs in bulk. They would order them and you would have huge surge in sales and then they stockpiled inventory and you had a quarter or two where your sales came down as they are kind of ate through their inventory. You had stronger BPON ONT sales this quarter, which is why you essentially beat your own guidance, if you strip off the deferred.

And next quarter it looks like they go up again, which is why your gross margin falls. Do you have any comfort level that this customer is not stockpiling again and you don't just see a huge falloff in 4Q? Do you have a sense of what their inventories look like versus the usage and deployment for customers?

Krish Prabhu

No, I really don't. And it's a question best asked of them. We said in the press like you do, that they are signing up many more customers. And that's the difference between last year and this year.

Ehud Gelblum - J.P. Morgan

Okay. Thanks so much.

Tom Scottino

I believe we have time for one more question.

Operator

Your next question comes from the line of George Notter.

George Notter - Jefferies & Company

Hi, thanks very much guys. I wanted to ask a question about going back to the access business, the 1134 and 1150. I'm trying to figure out what you guys really expect from your business there. I mean I think the question was touched upon earlier, but there are companies in the space, CLECs, Occam, ADTRANs entering. There's a myriad of others in there that have had a lot of success for two or three years now selling Next Gen systems.

Many of those guys were coming in and taking those accounts a way from your historical business, AFC. And frankly, I think there's some ill will among many of those customers for Tellabs. There's a lot of perception that the company kind of repositioned its focus into bigger carriers. And, so I guess I'm trying to figure out how much success you can really have in that marketplace, given that many of those accounts have turned over already and many of these customers are predisposed negatively against Tellabs. And how do you reconcile all that? Thanks a lot.

Krish Prabhu

We have serious discussions with these customers, and I'm involved in these discussions and I wouldn't characterize it as ill will, I think they have a business problem and we have a solution. So rather that talk too much about it right now, let's let the scoreboard do the talking.

We'll just watch the scoreboard over the next four quarters. We did not have 1134 and 1150 not also know for two, three quarters. We announced them earlier this year, we showcased them at NEXCOM. We've been having lots of active trials and discussions. And our sales guys are pounding the streets. All I can say is we'll see what the scoreboard says next year at this time.

George Notter - Jefferies & Company

Got it. So any kind of milestones do you think we should watch out for to measure your progress against? Thanks.

Krish Prabhu

Just the increase in access sales and the increase in access profitability. One avenue we have to increase access profitability to counter the drag on profits created by single-family unit ONTs is to improve the mix of customers and is to sell more fiber access systems into IOC. And that's one of the reasons it's right at the top of our list right now.

George Notter - Jefferies & Company

Thanks very much.

Krish Prabhu

All right, thank you everyone. We'll come back in another three months and give you an update. Thanks a lot.

Operator

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

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Source: Tellabs Q2 2007 Earnings Call Transcript
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