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Alcatel-Lucent SA (ALU)

Q2 2007 Earnings Call

July 31, 2007 7:00 am ET

Executives

Pascal Bantegnie - VP IR

Patricia Russo - CEO

Jean-Pascal Beaufret - CFO

Analysts

Alexander Peterc - Exane BNP Paribas

Paul Sagawa - Sanford Bernstein

Tim Boddy - Goldman Sachs

Tim Long - Banc of America Securities

Richard Windsor - Nomura Securities

Phil Cusick - Bear Stearns

Kulbinder Garcha - Credit Suisse

Stuart Jeffrey - Lehman Brothers

Ken Muth - Robert Baird

Remi Thomas - Cheuvreux

Simon Leopold - Morgan Keegen

Presentation

Operator

Welcome to the Alcatel Lucent 2007 Second Quarter Earnings Release Conference Call. At this time all participants are on a listen-only mode. Later we will conduct a question and answer session instructions will be given at that time (Operator Instructions).

And as a reminder this conference is being recorded. I would now like to turn the conference over to Pascal Bantegnie. Please go ahead.

Pascal Bantegnie

Thank you, Mary. Hello to everyone and welcome to our second quarter 2007 earnings call. With me today on the call are Pat Russo, Alcatel Lucent Chief Executive Officer, Jean-Pascal Beaufret, Chief Financial Officer. Pat and Jean-Pascal will provide an overview for second quarter results and discuss the market and company’s outlook.

Later in the call we’ll conduct a question and answer session. Please restrict yourself to one question please and no follow-up question. If anyone has not yet seen a copy of our earnings release or the slide presentation from the webcast of this call, which is available on our website at alcatellucent.com.

Before we begin I’d like to remind you that certain statements we’ll be making today maybe considered forward-looking. Please refer to the Safe Harbour statements contain in today’s releases.

At this point I’d like turn the call over to Pat.

Patricia Russo

Hello, everyone. Thank you for joining us today. We have some -- we seem to have technical issue here, we’re looking into. Okay, as you all now earlier today we announced our audited results for the second of quarter 2007. I’m just going to wait here for a minute until we find out what is happening technically.

Okay, I’ll try to move ahead here. Before Jean-Pascal reviews the numbers in more detail, I’ll make some comments about the quarters result. As you all know, we are now halfway through the year and we have had two full quarters as a combined company. I would tell you we remain encouraged by the progress we are making in some key areas during the quarter, we’ll talk about those. Overall, while a few of our businesses were down year-to-year, most of our businesses grew in this quarter on a year-over-year basis.

First, our Q2 revenues sequentially grew by a solid 13% at a constant exchange rate with the strongest performance seen in our wireline and our services businesses. From a regional perspective we saw a strong growth in Asia-Pacific. This revenue growth is a bit above what we said when our Q1 results were announced. I think the strength and the depth of our combined product portfolio, our ongoing communications with customers around our merged portfolio, and our plans for that has enabled us to continue to build some solid momentum in our order intake, which has contributed to revenue growth in the quarter.

Secondly, we remained focused on executing on our integration plans and taking cost out of the business. During this quarter we saw some evidence of cost reductions out of our cost structure primarily coming from our IS/IT and R&D. It is clear to us that in area such as savings from procurement were existing inventories need to be factored in. The savings ramp in this area will be seen more clearly in the second half of the year.

During the quarter, we had further headcount reductions of approximately 1,900 positions. This was before the impact of new managed service contracts and acquisitions, which were around 400 positions. Year-to-date we’ve reduced approximately 3,800 before the impact of managed service deals. This represents 30% of our three year target of 12,500.

Our Q2, 2007 gross margin suggest difficult pricing environment, one that has been impacted in the short-term and not only our need to withstand some level of collective efforts by our competitors to unseed us our customers but, as well they -- need occasionally to support some product migrations. Additionally for this transition year of 2007, we are strategically reinvesting the gross margin savings in selective markets to position the company for the long-term, while achieving most of our operating expense savings on a comparable basis.

In the second quarter gross margin was negatively effected by or negatively impacted by an unfavourable product in geographic mix, continued investments as I described and the impact of some product transitions cost as customers migrate their networks.

Our integration and synergy plans are progressing. We’re clearly gaining more visibility on the combined businesses as the people, process and systems come together. Clearly gross margin this quarter is lower than we would have liked. It’s lower than what we believe is our opportunity, and we don’t believe that it’s indicative of the business going forward. We face the tensions as you all know on regaining sales momentum. We know in our industry that decisions customers make to buy or not can have long-term consequences.

During the quarter, we signed and announced more than 46 contracts some of which represent revenue synergies. These winds stand our entire product application and service portfolio and I think demonstrates the strengths of the company. A few examples, we announced, $400 million contract with India’s, Reliance Communications. This is a case where we were selected not only to expand the CDMA network to more than 20,000 towns and 600 villages, but the solution also includes GSM and so we are entering the GSM portion of their network for the first time.

Second, example was the case of Telecom, New Zealand, where we are their technology partner for new 3G W-CDMA upgrade, which is an addition to the recent contract for CDMA EVDO Rev A. In the -- with the IUSACELL, we signed a contract to expand and enhance their existing mobile network for CDMA2000 EVDO at the same time it has given us entry into the wireless transmission part of their network for the first time with our digital microwave radio links.

We had many other significant winds in the quarter across all regions and product groups that I think speak to strength of our portfolio. We continued to see good opportunities for growth and services. We recorded an 11% year-over-year increased in service revenues at a constant rate. And on a quarterly basis revenues were up 26% sequentially.

We’re focusing on for a tier in some strategic growth areas. The IP transformation of networks, applications integration, multi-vendor maintenance, network operations as well as enterprise related services. We announced the number of contracts you’ve seen in these areas as well, which I think shows evidence of some good traction.

Let, me make a few comments before turning over to Jean-Pascal about the market trends that we’re seeing. We continue development in deployment of all-IP networks across all other regions continues to be fuelled by the accelerated launch of video services by operators. During the quarter we announced the number of contracts where operators have embraced our Triple Play Service Delivery Architecture, some examples Portugal Telecom and Vodafone Portugal.

Secondly, we see optics continuing to play a vital role in the global backbone to handle increased video traffic. For Q2 our optical revenues were very strong in both terrestrial and submarine as the portfolio supports high bandwidth requirement for IP video services. Our IP services router business saw a robust growth as well during the quarter confirming our number two position. These two macro trends are having a very positive impact on our wireline business.

Third, the world’s consumers continue their thrust for broadband services. Our customers continue to rely on our IP based DSLAMs and Fiber-to-the Home solutions. The second quarter was our highest ever quarter for DSL shipment, we shipped 9.6 million lines and for the first time more than 50% of those were based on the IP platform, while the GPON and Fiber-to-the Home momentum continued in those North America and Europe. GPON remains the technology of choice for very speed service, as well for mobile broadband we saw year-over-year increased in CDMA in North America. And we announced two new WiMAX trials in the quarter. And Alcatel-Lucent now has more than 70 trails deployed.

And lastly, Chinese technology choices and timing for 3G networks are yet to be determined. However, we are benefiting by being able to offer CDMA, Wideband CDMA and TD-SCDMA based solutions and we saw some good results on TD-SCDMA in this quarter as well.

I’ll just net this out by telling you that these macro trends, we continue to see going forward and we believe that our portfolio and the global and yet local nature of our business are well aligned to take advantage of these opportunities. With that early commentary I’ll turn it over to Jean-Pascal. Jean-Pascal?

Jean-Pascal Beaufret

Thank you Pat. And first good afternoon and good morning everyone. I’m on chart nine adjusted P&L now. As in previous package this presentation will as you know refer Alcatel-Lucent results on an adjusted basis. Net of all purchaser price accounting increase is we believe that it provide, it provide to more meaningful and comparable basis for the evolution of our business performances. Preliminary the markets due to their demand when looking at the result this quarter and comparing them with last years performance Q2 adjusted result is a translation impact from the whole leverage from $126 for 1 euro average rate in Q2 ‘06 to 135 average rate in Q2 07, which obviously impacts those of all top line and of cost and expenses.

For our revenues for the second quarter of 2007 were 426 million euro showing a very steady sequential growth of 13% of constant rate, 11% of an actual rate increases and 0.5% growth year-over-year at constant rate. As we’ll see in a moment when I discuss our business segment, we saw wireline and services were reported the strongest growth, while core networks and to lesser extent wireless revenues decreased at the time when we continue to make considerably investments in the next generation of this technology.

As said by part of business in Asia Pac grew by over 20% year-over-year. Where adjusted gross profit of 33.4% of sales, represented margin decreased of 1 percentage point compared to the 34.3% margin, reported last quarter and a decrease of 4.7 points compared to the gross margin reported in a year ago period.

Let me now focus on the analysis of the gross margin evolution on a quarterly sequential basis first. Our gross margin during the quarter includes a positive impact of 34 million or 0.5 points, from the favorable resolution of a commercially litigation settlement. You may remember that last quarter we also reported a significant item of about 130 million euros or about 3.3 points of sales which was related to the investment the group has been required to make in product conversions and both for the rationalization mostly and which had negatively affected our gross margin. Therefore for comprising purposes, if we now normalize these two effects resulting a sequential decreased in that just gross margins of about 5 points. That can grossly be explained as follows

First, strategic investments that we have made to maintain and acquire footprint. Second, develop in fast growing economies, representing about 3 point of sales, 1 point of which is net on the cost. We are also seeing here the impact of some product transition cost, as customers might have their network and are asking from us to ought them. Secondly unfavourable impact on product mix representing about 2 point of sales, mainly to that of which as you know might vary quarter-to-quarter. The company adjusted operating income for the quarter was 819 billion loss as thought was 225 million euros improvement opportunity.

As we said in May we cannot discount the fact that we may continue to make similar investments to enhance our commercial positions going forward and we said that on 19 May. Now, for the sake of for the priority of comparison, let me explain briefly also the year-on-year evolution in our gross margin which is basically similar, which reduce by about 5 point. From last year we did make strategic commercial investments. Primarily in emerging economies representing about 2.5 points out of which of 1 point represented upfront costs. Additionally about 2.5 points of the decline is due to diverse high product mix impact. We are also seeing the impact of some product transition growth discussed in our migrated network to next generation’s development, deployments.

Going to chart 10, we the operating expense evolution now. Let’s have a look at how we represented. The year-over-year, as well as a sequential comparison of the actual adjusted operating expenses should be down as you remember taking into consideration the effect of the scope of the business changes, namely the impact of the UMTS radio access acquisition effective as on January ’07, which do not exist in 2006 in our disclosed earnings, our pro forma earnings. The significant Euro/US exchange rate evaluations, the change in R&D capitalization from 14 million for example in the current quarter compared to 32 million euros in the year ago quarter, and negative 11 million euros last quarter. And some one of such as capital gains or losses which former Alcatel had regularly identified in the past.

The key take away today of that is that over last two quarters, it seems end of 2006 or comparability expenses have declined. In Q2 ’07 our estimated comparable operating expenses declined sequentially by 3.4% and by SEK 3% compared to the same period last year. This is subject to further refinement of our comparable matrix, but this is best estimate that the company is tacking now for their expenses. We have continued to take cost out in R&D and we are starting to see the positive impact of our rationalization effort in the sales and marketing expenses and G&A expenses. The reduction in OpEx is accelerating, however having said that OpEx savings will be more visible into second part of the year and as we indicated we are planning to achieve most of our operating expenses savings on a compounded basis.

Last if we continue reviewing our balance core card analysis and look at the evolution of the net operational have, these also went down by 1900 in the quarter before impact of the managed service in the use and acquisitions, that have resulted in the in sourcing of SEK 400 operating hedge and which were not planned in our initial plan.

Year-to-date, the decline in operating headcounts stands at 3800 before manage services used and acquisitions representing about 1160 heads, 1160 heads.

Now let’s go to slide 10 and let us provide some comments on the operating statements. Carrier segments revenues for the quarter were 3,102 million euros a 5% decline year-on-year and then 11% increase sequentially those have constantly generate. The adjusted operating loss was 73 million and 2.4% operating margin. A significant investments in markets which I mentioned earlier clearly impacted this business segment and particularly in the areas of wireless and conversions.

Looking more in detail at the individual business good performance. We see a 7% increase in the top-line of the wirline business groups, which were euro 1505 versus a year ago quarter and then that 18% increase sequentially those at constant rate. Revenues were very solid in access, with strong growth in our IP-based DSLAM and fiber-to-the-premises businesses. We reported the highest ever quarterly delivery of DSL lines at 9.6 million and for the first time over half of this volume from the IP-based DSLAM platform. The IP/MPLS service routing business recorded the tenth consecutive quarter of growth, confirming our number two market position.

Revenues were very strong in optics, with all the business divisions going in order to support high bandwidth requirements for IP video services.

Wireless Business group for wireless business group having use were 1,237 million, 8% decline compared to the year-ago quarter, but 4% increase sequentially goes at constant exchange rate.

Decline year over year was largely driven by low volumes, particularly in 2G GSM radio in Africa and Eastern Europe, shipments however, were strong in South East Asia and in China where we improved our market share. The new 2G product offerings gained traction as mobile operators migrate to all-IP architectures and is at the basis of a sequential growth.

3G business recorded good growth, primarily driven by TD-SCDMA in China through a partnership with Datang and grew sequentially driven by Western Europe and South Korea. CDMA revenues increased in North America, with continued EVDO Rev A upgrades and growth in the subscriber base while investment in China -- in CDMA in China and Latin America declined.

For convergence business group the revenues were Euros 362, 27% decline year-on-year, but recovering sequentially by 6% those expressed at constant exchange rate. While we continue to make progress in growing the NGN business the revenues do not yet offset the declines in classic core. We continue to make very significant R&D investments in advance of the market and this is resulting from the IP network transformation that are under way.

Turning to the enterprise business segment, the revenues of 376 million grew by 5% year-on-year and by 3% sequentially at a constant rate. Adjusted operating income was Euro 23 million, a 6.1% operating margin.

We’re seeing continued good momentum in IP telephony migration pulling infrastructure upgrades for small, for medium and large businesses. The group continued further investments and efforts in channel developments. In addition Alcatel-Lucent’s has acquired privately, held company NetDevices, which delivers enterprise networking platforms known as Unified Service Gateway and designed to reduce the cost and complexity of managing branch office networks.

And finally service businesses segment, the revenue were 750 million an increase of 11% year over year, 26% sequential. Adjusted operating income was Euro 29 million, a 3.9% operating margin. The services continued to focus on the strategic growth areas of IP transformation, application integration, multi vendor maintenance, and network operations. In particular, IPTV remains a major driver of IP network transformation. Key win for us was the award BT in assisting them into migration of 20 million customers over the new all-IP 21 century network.

The network operation and hosted services registered a strong performance as well, with significant wins including a three year contract with Vivo in Brazil. And in turn is going build out of a carrier network operations centers with China’s Shanghai’s Telecom.

Looking at the revenues per geography, the Asia Pacific segment reported a very strong 21 percentage growth year-on-year constant exchange rate which was mainly driven by Chinese market. GSM and CDMA were we are clearly gaining market share, which was driven as well by Australia. This revenue up was slightly down 3% year-on-year, with growth driven by the increased demand for fixed and mobile high bandwidth services that offset by 2G wireless in Eastern Europe.

North American revenues declined by about 4% year-on-year at the concentrate rate, as other wireless revenues were declining from last year.

On chart number 13, we are presenting today an adjusted P&L and below the operating line restructuring cost which amounted to 176 million for the quarter. I’ll provide more detail on the restructuring cost shortly, next slide.

In the quarter, we recorded some significant entries namely an impairment increment charge. Let me explain in detail what it is? As in the case -- it just a case every year customarily group conducted an impairment test during the second quarter. Review is conducted business division by business division and incorporates an analysis of net assets and enterprise values. This is in compliance with IAS 36 and SFAS 104 suite. By the way, you will find a detail of that in the note of to our earnings.

Impairment charge we have booked is in relation towards CD -- W-CDMA assets and is largely due to the timing in the revenue generation of this product for more solutions faces core initial expectation and to reduction in margin estimate as well. This doesn’t reflect a change in overview of the markets acceptance for our new W-CDMA platform nor does it effect or better use in the necessity of mobile high bit rate technology deployments for a more flexible radio and core capabilities looking forward to 4G.

The internal assessments lead to a 298 million impairments charge in adjusted P&L and a further 128 million impact in the purchase price allocation which combined represented about 2.5% only of the related assets. This impairment refers exclusively to our W-CDMA assets. The second major item, you can see that on the P&L, we also booked a credit resulting from the amendment of our post retirement benefit plans. Effective generally first to some eight company perfection growth coverage offer to all former Lucent management recoveries is changing to reflect a drug plan similar to the Medicare program of retirement. As a result, the present value of the associated healthcare liabilities reduces by in after taxed amount of 80 million. Finance costs and other financial income posted to positive 81 million during the quarter resulted from pension credit and current cost of debt. Share in net income of equity affiliates was 60 euros. Tax expenses amounted to 236 million including two main elements. 185 million charge related to the OPEB amendment and we’ve got 60 million from up-divisional tax charges including the tax on the pension credit.

In cash terms, tax payments were only 19 million during the quarter. Income from discontinued activities was 29-22 million loss in the quarter which included the remaining tax impact of the capital gains related to the Thales transactions which we booked into Q1 quarter.

Next, I’ll provide some detail on restructuring and progress to date on the integration program.

I’m now on chart 13. The total restructuring cost booked to date provides you with an idea of the speed at which our integration plans progressed. Total restructuring provisions booked in the quarter were 176 million all related to monetary costs, which in addition to the 320 million euro charge in the previous quarter represented cumulatively about 30% before estimated three year cash restructuring cost.

About half of the provision in the second quarter covers stipulation cost and primarily these are the people located in developed countries. Most of our European affiliates have already posted restructuring plan. This quarter charge also include provisions for the restructuring of our manufacturing facilities in the Belgium. Over the quarter we’ve seen an expedition into the number of departure in the high cost countries. In terms of restructuring related cash outflows, we’ve utilized 99 million over the period, which you’d see is reflected in our cash flow statement and 182 million euros cash outflows over first half of the year.

Let’s look now next chart of the progress of full integration program. I’ll give you a few examples. As you know inline with organization the implementation of full integration plans are preferred and many toward in three principal areas. Business groups, regions and corporate functions. At the regional level for example, during the two quarter 11 legal entities consolidation have been completed. At Corporate level, in the area of procurements we have completed negotiations with over 250 of our top of suppliers. In the area of manufacturing, we completed sales of Belgium factory and closed our Canadian facility.

We’ve consolidated our reengineered warehouse in 14 countries and have reduced the rate of logistic service contracts in Europe through vendor consolidation and in the US due to increased volumes. The area of IT, we are on target to close 3 Data centers in ’07 with ongoing plans for 2008 reduction and we have 67 applications which have been decommissioned including four on the most costly top application. Real estate we have increased facility acquisition from the 25 we had in March to 60 locations in Q2.

Next point is about operating working capital. If we see commenting on this for June quarter operating working capital we presented 7.9% for to any 12 months revenues fairly stable over the last three quarters. As a reminder it was 8% in Q1 ’07 and 8.2% in Q4 ’06. As announced the inventory step up impact has been basically absorbed during the first quarter. The value of the different components of this operating working capital, net receivables, inventories and payables, progress payments, increased sequentially and this is inline with the increased level of business in revenues. For 2007, we maintain overview of an operating working capital being in a range of 8 to 12% with possible fluctuation from one quarter to the other.

Cash flow statements, two principal development to highlight. First, our free cash flow generation is showing an improving trend. Second, we ended the second quarter with a net cash position of 221 million versus net debt position of 48 million in Q1. As you can see there is clear improvement in the free cash flow generated by the company. On an adjusted basis Alcatel Lucent Engineering did cash flow formation of 280 million before restructuring operating working capital increased in tax rates and CapEx.

Investments in working cap and other working cap resulted in a negative 116 million restructuring cash outflows, cash outlay were 99 million and tangible CapEx and R&D Cap were 201 million. All that resulted in negative figures from 167 or 309 million euros, improvement sequentially indicative of the positive type.

Next slide is about balance sheet and I would very simply said to quite straight forward observation I’d like to mention that we have reduced the goodwill’s, stabilize working cap, increasing cash, reduced in long-term liabilities and increasing reserves primarily related to restructuring.

One last message is related to the funded status of full pension and all the busty time and benefits. As you may observed from this slide the funded status of full pension and OPEB acquisitions, improved by 1.2 billion during the June quarter. Since, beginning of the year the funded status was over 2 billion, an improvement of over 2 billion going from a slight under-funding at year end 2006 to an over-funding of 2.2 billion at the end of the first quarter. So, this improvement is primarily related to the interest movements the OPEB plan amendment as well as the performance of plan assets.

With that I turn it back to Pat for some concluding comments.

Patricia Russo

Yeah, thank you Jean-Pascal. Let me make a few comments about the outlook and then we will open up it for Q&A. As we stated in the press release today, we continue to anticipate sequential growth as the year progresses, we’re expecting a strong rate in the second half of the year, that based on the continued good order flow and the improving backlog obviously that implies a great deal of execution on our part in terms of delivering against customer orders but we are expecting a strong ramp in the second half of the year and as a result continue to expect that revenue will increase on a percentage basis in the range of the carrier market growth rate which we continue to believe is in the mid-single digits and obviously that is constant exchange rate.

So, in summary, stepping back from all of this, we continue to believe that the positive long-term potential and benefits of the merger are strong with good growth potential. Our order pipeline is gaining momentum. Our integration plans are progressing. Not withstanding some newer initiatives we are managing that obviously effect gross margin, especially this quarter. We’re confident that our product rationalization or cost reduction efforts will lend themselves to improve financial performance in this area overtime. We are managing a large complex integration. In an industry that is not waiting for a merger to be completed and that obviously put some short-term pressure on the company as we work hard to build and enhance our customer relationships. Sure that we establish the kind of footprint that we want in areas for future growth and keep our eyes on our competitors and as well proceed with our integration.

In the second half, we know we’ve got to continue to focus on building sales momentum with a sharpened focus on margin and work to continue to drive cost and expense out of the business all while keeping our customers happy. Our people are committed to do that and with that I’ll open it up for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from the line of Alexandre Peterc from Exane BNP Paribas. Please go ahead.

Alexandre Peterc - Exane BNP Paribas

This is Alexandre Peterc, Exane BNP Paribas. I would just like to clarify a few hints that you dropped into your press release. Your press release is pretending to the gross of margins. You seemed to be implying that there would be an improvement in yours margin as going forward. Now, I wondered if you could be a little bit more precise with what that going forward means. From what Jean-Pascal had said, it appears that maybe about 200 to 300 basis points of gross margin improvement could be expected in the coming quarters based on the -- or some other quarters indications has given. And then the second clarification would be related to the investment that you’re making on the growth margin level. The wording seems to imply that those investments would be primarily done in 2007, and then from 2008 on we could look at cleaner gains is in terms of cost cutting on your operating profit line. Is that a correct into prediction of what you are saying here? Thanks.

Jean-Pascal Beaufret

Yeah, Alexandre, I think to answer your two questions, which are basically, partly the same. First of all, do we provide any guidance on the improvement of the gross margin for the rest of the year by 200 or 300 points? The answer is no. We do not provide that. We are saying the gross margin in the June quarter was lower than we would have liked and was negatively impacted by a continued significant in key markets. By the way additional, if you remember what we said on May 11th, we said exactly the same. We said that we would to invest in special margin key markets what impacted as well as you know by an unfavorable product and geography mix and by the impact of some product transition cost as customers might had their network. We are facing, you remember, a quite fast transitioning and migration to IP based, IP structures, IP architectures where the pricing of that and the pressure of this market, provided for us to help and to support our customers in the cost of the solutions and installation. So we’re not providing any guidance for the gross margin. We are saying that we believe that the leverage this quarter is not indicative of what we do see in our business going forward. Then, could we hope with these investments -- could we hope that these investments will be one of or it would be our strong cost and will reduce a gross margin will improve? We’ve the cost cutting which we are making into regulation cut? Yes, yes. If we are tackling now big markets and develop countries as well as the emerging countries, it’s because the pricing pressure in these times is quite high and we are of course we will recover, we will catch up with this strong reduction in cost we do see in opponent. So the answer is of course, we should see these as non-anticipation of the hill margin we will ask further we focus productions.

Patricia Russo

Alexandre, let me just add to that without being specific with respect to numbers. But if you think about the early years of our integration that being this year, there are a couple of things that are happening; that with time we believe will change, right. So what are they; number one, we are going to customers and talking to them about the migration of our product portfolio and in some cases and by the way that happening now that’s likely not to happen as we go forward. Given where communicating all our plans, I would say more up front with respect to the merger and that result, as Jean-Pascal said, in us been willing to make some concessions. Secondly during the period of in the early days of the merger obviously, we have had some attacks on our customer base with offers per swapped out etcetera and we have concussively chosen to make sure that we maintained our customers. At the same time we have the wideband CDMA swaps that we have already talked about going on. So to your point about kind of ’07, ’08 etcetera, I think it is fair to say, there are a set of transitional activities that are occurring earlier on in the merger that we would -- than we would except to be occurring future points in time. So the reason we’ve said things the way we have is, we don’t believe this quarter’s margin is indicative of our opportunity going forward and as you also know we have not yet seen the benefit of all of the product rationalization and cost reduction work that affects the gross margin line as well.

Jean-Pascal Beaufret

Next question please.

Operator

Our next question is from line of Paul Sagawa from Bernstein, please go ahead.

Paul Sagawa - Bernstein

I want to just -- the margin question that would be, I think on everyone’s mind since I think the negative case will be may not in favor, believe it but the only reason, the revenue line is accelerating is because we are making significant price concessions on the market price and that there is some permanent to the relatively weak margins you see. So, if you look back to where your margins were pre merger, sort of a basis. You’ve mentioned that some portion of your cost savings will be reinvested in terms of R&D etcetera. I think it’s reasonable to interpret your cost cut though as being, sometime once again pass this initial -- this initial flow of the specific integration cost, you would be able to deliver some reasonable amount of your cost cuts against those operating margins, yielding margins better than what you did prior merger otherwise you wouldn’t have had any real impetus for doing the merger in the first place. So I am hoping that you consider to firm a bit the ability you are expected ability to be able to deliver significant improvement to where margins were prior to the merger since margins obviously taking a dip to the worse in the last few quarters relative to where you were prior to the merger. And as you get a little touch, how quickly we might expect you to be able to deliver overall positive operating margins better than what you were prior to the merger. So high volume transition period that we really have to make our way through, I know you can’t be lack of perspective up to 2008 too much there.

Patricia Russo

Let me check or crack it that in Jean-Pascal jump into here. First of all, the theory of the case, of course is that the strength of the portfolio, we are mass in each of the key areas of the business will give us market position. That gives us some increasing leverage that the rationalization of the product portfolio will allow for a lower cost to support that portfolio and that affects, that affects many elements of the income statement including gross margin that the manufacturing rationalization between the two companies will allow for us to better utilize the capacity that both companies have and that the procurement savings that we are able to achieve in combination will in fact lend themselves to better pricing, better bargaining power with suppliers. We continue to believe all of those things are as we, as we work on the opportunities that we have. The unknown, the unknown element around gross margin, of course is what happens to price in the industry, so even before the merger we, both companies were constantly working to do product cost reduction, efficiency improvement to deal with price levels in certain aspects of the market that decline. But understanding that, the theory of the case and we absolutely believe that we are to be able together to produce better margins than we could separately and I would tell you without giving detail in one of our large business groups we believe we are going to see that this year. Okay, so we got a lot of things going on in this mix, but I have no reason to believe based on what I see that your thesis is not something that is available to us and we are working toward as we work on the 1.7 billion of synergies that we’ve talked about over the coming three years. Thank you. Jean-Pascal any -- you want to add to that.

Jean-Pascal Beaufret

Next please.

Operator

Our next question is from the line Tim Boddy from Goldman Sachs. Please go ahead.

Tim Boddy - Goldman Sachs

Hi, yes, thanks. I'm afraid I'm going to keep going on the margin point because it seems very critical. When do you think you'll be comfortable to say the long term operating margin ambition, and if not now, if you could just articulate why not and under what conditions you could see more comfort in doing so?

And, I guess a line to that. It feels as though the greater focus now on reinvesting in the business, and your market share, particularly in parts of the Wireless business in such that you could keep reinvesting for quite some time with the same rationale of reaching a sustainable market position and gaining better leverage of pricing, so what are the reasons why rationale is going to be now to invest as opposed to try and maximize profitability would change next year or the year ahead? Thanks very much.

Jean-Pascal Beaufret

Hi, Tim, to answer theme. First of all when do we give an enterprise model of more specifics on the any operating model? We said in June that we would we are in the condition here and we would first look at the way we are delivering which we has progressing well after than the last year by the way. But we would say before giving you more specific in the operating margin. We would like to really see this executed and flowing through or quarterly P&S into some, so I believe that we certainly will be ready to give more specifics very early into 2008 year.

Patricia Russo

Yeah, go ahead.

Jean-Pascal Beaufret

Then about reinvesting what would your question is basically why shouldn’t you – shouldn’t we continue and why as to reinvest always and what is the rationale of investing now. I would say two things. First of all a merger and the consolidation in the industry is an opportunity to reshuffle the market share and as the certainly for all customers to reconsider the way they are looking at their suppliers and their major solutions. Then they are aggressively going to an IP confirmation of the network. They want to mix it. They don’t want to mix it, so we are expressing today a bit of time more all that is resold and reconsidered by everybody. We cannot miss any major market share. So I would say that there are technology related opportunities and the rationale of technology related situation or circumstances and they are certainly a merger related circumstances in list I view of the pricing and of the solutions.

Tim Boddy - Goldman Sachs

Yeah, and Tim I would just add to that because I think Jean-Pascal said it will and that said of circumstances in our case is highlighted by the triple integration of our YB -- wide band CDMA portfolio at a time when they are continue to be a number of frequent decisions being made around the world for movement to 3G. So we have a timing factor this year that is related to the customer decision cycle around the 3G technology and as you know at least we believe that being there and being in has a lot to say about your ability to migrate to what will become 4G and at the same time as Jean-Pascal said the merger-related aspects of this do create an opportunity not only for us to establish position with customers, but for customers in the near-term to be more proactive and aggressive. So I would not expect that as we move through this transition year, we would see the same level of quote unquote strategic investments.

Jean-Pascal Beaufret

Next question please.

Operator

Your next question is from the line of Tim Long from Banc of America. Please go ahead.

Tim Long - Banc of America

Thanks. Maybe I’ll put gears here little bit. You talk about some of the wins that you have able to pull cross by the merger of Alcatel and Lucent and all seem to be on the wireless side. Could you talk to us a little bit about any wins or opportunities that you see both on the IP Routing piece, any optical piece have you seen any of those yet? Are there any of those in the pipeline? Thank You.

Patricia Russo

Tim, the -- I am thinking a lot here because I can’t recall any large contracts we announced that were strictly Wireline, but there is many cases where the optical position that we have say for example the former Lucent CAD where we are pulling through now the IT product that was in the former Alcatel case. So we have obviously a more robust set up capabilities that we’re able to bring into customers. I’m just looking, yeah, China telecom is an example where we brought forward our IP service capability and along with some optical capability. So and there is a number of -- there is a number that we announced, but I can’t -- there is -- I can’t take out a specific big swing item but there is lots of contracts we’re announcing where we’re announcing optical along with IP or access along with IP under the triple -- under this triple play architecture. So we clearly see benefit on the Wireline side. And I think it’s evidenced by the way of the Wireline growth. We are seeing good growth in our Wireline business, good growth in our optical, good growth in IP, so we feel that that business is doing quite well.

Jean-Pascal Beaufret

Next question please.

Operator

We move to the line of Richard Windsor from Nomura. Please go ahead.

Richard Windsor - Nomura Securities

Hi, Thanks for taking my question. And what I would like to concentrate on is the profitability across your different divisions. I’m concerning from looking at when CDMA business was in Lucent and its profitability actually there the operating levels are actually very good. So what I’m kind of wondering is again when I look at the rest of your business which is progressed reasonably well during Q2 versus Q1. We are actually looking at the bulk of the problems and the bulk of the losses being mainly focused in GSM UMTS and is that really being underlined by again this large impairment that you took against that business?

Jean-Pascal Beaufret

Well, we won’t get to more specifics you know that we don’t disclose the ability in profit at the Business Group level but at the Carrier segment level. But I wouldn’t follow you the results in the Carrier Business are related to all the businesses. Take out well and which is progressing well and quite profitable, take out a lot of wireless businesses which are very profitable and the developing well and we see them increasing quite well in the year. We still have of course a significant amount on investments in those areas such as W-CDMA which are clearly impacting or profitability of top lines this is clear. And we do see in the conversations area what we are mentioning here with the margin and with R&D which is the pace of migration of all customers which are asking from us to help them and to support them migrating the core network architectures to IP clusters a lot. Clusters in margin and clusters in R&D, so it impacts clearly as well in the Carrier segment and the profitability.

Patricia Russo

In the case of GSM there which what I would add to that, you recall from our last call, we talked about the platform transition to the new 20RX which we will start to see the impact of in Q3 and Q4. So we are making a major change there in terms of that technology, its functionality, its feature richness as well as its cost profile.

Jean-Pascal Beaufret

Next please?

Operator

We move to the line of Phil Cusick from Bear Stearns. Please go head.

Phil Cusick - Bear Stearns

Hi. Thanks for taking my question. Now would you go the revenue guidance and the first half to second half guidance is fairly aggressive still. I know there hasn’t been a change. But I wondered if you could talk about what’s built into that guidance? Are we expecting a big ramp up from AT&T mobility on the second half? Or are there other things that are in particular going to be strong on the second half that may have been weak in the first? Thank you.

Jean-Pascal Beaufret

First of all, our guidance is based on the current outlook in the backlog. We’re seeing that the backlog overall is increasing. We are seeing continued growth in Wireline not particularly from one major customers. We’re seeing a major development in the fibre to the home in the second half which will certainly impact the Wireline revenue topline in the second half. We do see as well good course prospect in the GSM area and the W-CDMA area in wireless. We are based on a clear rump in those areas and the hunt is quite challenging by the way we’re maintaining, we’re guiding on a quite good course in the second half but its challenging in terms of volumes. And we see as well a ramp in the core architectures in converters so all across the board in the Carrier business group; we do see a significant course not to speak about services where we have shown in the June quarter a quite, quite good recovery. So it’s not based on a particular deployment in one customers I would say it’s quite well dispersed us quite over all lines of businesses and all customers.

Patricia Russo

And the only thing I would add to that as if you look at what’s going on in the market it’s pretty reflective of where the growth opportunities are in the market including around some of the emerging high growth countries.

Pascal Bantegnie

Next question please?

Operator

We move to the line of Kulbinder Garcha from Credit Suisse. Please go ahead.

Kulbinder Garcha - Credit Suisse

Yes, thank you. Just a question on a cost saving targets. I guess given that you are reinvesting probably in margins so and margins aren’t quite working our lease for this year, probably the fist half a little bit lower we expected. And if actually executional 30% of your headcount restriction today, why aren’t you raising your long term cost saving target and nothing looks very likely now given the, you done 30% of your headcount reduction in the first six month already and you are progressing quite well in the real estate and ISIT. So why aren’t those long term cost saving targets being revised outputs?

Jean-Pascal Beaufret

Well, because we are quite confused. We are achieving most of are fixed expenses savings for 2007 and then since we grow in 2008. In 2008, we have a better view of the cost model for company, the model of the company. We will be able to look at it from a three year period point of view.

Patricia Russo

Yes. I would just add. I think, we are two quarters into this. We feel good about the things we can point to that are indicative of the integration plans being on track in the reductions that we had planned for, gosh now almost a year ago, but it’s still relatively early. So, all I would add to that is, we are committed to driving as much cost and productivity out of and into the business, if you will, as this possible, but for now I think it’s probably most prudent to leave our long-term expectation as they are. While you now that we are going to work hard to overachieve.

Pascal Bantegnie

Next question please.

Operator

We move to line of Stuart Jeffrey from Lehman Brothers. Please go ahead.

Stuart Jeffrey - Lehman Brothers

Hi there. Thank you. Quick question first one first go on the OpEx in terms of property expense evolution. Could you discuss whether or not you built currency into that and maybe for the comparable growth rates? What happened if you would did on a constant currency basis and perhaps also give us indication of what the full year 2006 number is so that we can perhaps make some other adjustments outsourced to see where the 2007 of fixed numbers might come out of?

Jean-Pascal Beaufret

OpEx, this is clearly a comparable matrix, which have detailed in the capital market. This is clearly based on a constant currency, because if you want to compare last year to this year you did take your account of the sharp decline of the euro dollar rate. So we are building in our comparable figures a constant currency of course. If the data is going down the portion of a cost fixed expenses expressing dollar would go down as well. So we can not take the benefit of that. We are at least state from the real currency decline was currency changes from one year to the other. Then your second part of your question is whether we could give a full year or six. So with time we are giving every quarter by the way it’s important to understand we do not preclude to refine these analysis. I said it in May 2007, we have given the first time a full year pro-forma earnings of the company for 2006 and we have modified that in May and we still in May said that we this is subject to further refinements and this is further definition. But this time we would add more clarity when the people are digging into the cost in to our organization today, looking backwards and what’s we were as a separate company in 2006 makes of course the view of that change or it will be. We give quarter after quarter and give it to small price leases more publicly as soon as we are further refinements, but we are speaking it not a big changes where we are speaking of refinements.

Pascal Bantegnie

Next please?

Operator

Our next question comes from Ken Muth from Robert Baird. Please go ahead.

Ken Muth - Robert Baird

Hi. Could you tell me, do you expect the CDMA market to rebound in the second half ’07 or its stay around that current levels?

Patricia Russo

Ken, I wouldn’t use the term rebound associated with CDMA. CDMA from our standpoint as we’ve said is a large and relatively stable market. There are puts and takes around the world obviously the announcement we’ve made with Reliance in India indicates a strong commitment and continued growth in that part of the market. We’re seeing good take up on where they as more broadband services are get deployed on the other hand, as we noted today, we see some declines in Latin America and China. When the 3G licenses are issued in China there is obviously a potential for CDMA 3G to play a very positive role there and therefore we could see some growth. So large market, stable market, we continued to enjoy the global leading share position by a lot very profitable business for us and we think it positions us well for the growth that will occur as well as future transition that might occur as the technology moves a few years down the road.

Pascal Bantegnie

Okay. Two more question please.

Operator

Thank you. We'll move to the line of Remi Thomas of Cheuvreux. Please go ahead.

Remi Thomas - Cheuvreux

Hi. Thank you couple of questions if I may? One on Wireless one on Wireline. On Wireless am I right in assuming that the bulk of the potential negative impact of the investments that you made in pricing over the first half in terms of new contract will actually come in the second half or maybe in early ’08 as those contracts actually start shipping. And therefore we should not be expecting the significant improvement in gross margin. And on Wireline, I am hearing that you guys are running into some tactical issues with your IP DSLAM at telecom in Telia’s French subsidiaries at each stake related to the fact that they don’t have your network management software and that they’re using Cisco routers. I was wondering if this issue was isolated or have you had the similar issue elsewhere at other clients where you are not providing an end-to-end solution?

Jean-Pascal Beaufret

Price margin Remi, you can effectively assume I am saying today that we are investing in developed and emerging markets is significant to amounts of a margin. I am saying so and I am saying that part of this is uphold cost, so you can assume that this uphold cost will not come back again over the last, by period of the 2007 year and ’08, because if this is for -- unless we are at investing in more market in other key areas we won’t absorbs uphold cost, but the fact is that, the margin will be of course in a first time, the margin will be lower, but we will catch up with a recovery in terms cost reduction into margins. So the profile, you can demit looking at the list of our customers which we have published, announced in the June quarter you can see what has been done just to invest in those markets and you can see of the margin quick evolve withstand. Although I am not -- I am clearly about your IP DSLAM questions. I am pretty sure that the network management software is very good and every customer should have to take their network by management software. But I am not completely aware of what you’re saying about these customers and the IP DSLAM platforms.

Patricia Russo

Yes. And let me -- we’ll be happy to follow up if there’s something specific we can have our folks talk with you about that just to recall what Jean-Pascal and I both said ant that is that now over 50% of the shipments are related to the IP, the IP DSLAM. So, that product is going quite well in the market, very well accepted by customers and we can follow up on this specific issue, but I am not aware of the problem that you noted.

Pascal Bantegnie

Thank you. We’ll take one last question please?

Operator

Thank you. That comes from the line of Simon Leopold from Morgan Keegan. Please go ahead.

Simon Leopold - Morgan Keegan

Thank you. I wanted to get a clarification and then a question I didn’t hear. In terms of clarifications there’s one word to look pass the restructuring impairment of asset charges in this quarter. I am coming up with earnings of five euro cents. I just want to confirm that that’s correct? And then in terms of the question, I understand the concept of re-investing savings, but I feel like it’s a blank check when we come to do our modelling. So if we could get a bit more explicit in terms of a sense of where you see your operating expenses, gross margin during this year that would be very helpful. Thank you.

Jean-Pascal Beaufret

Though, therefore we are prepared to give that to reduce that -- this kind of specifics after a period of time, after a year of transitions where we would like first to check and to see the path that we do savings or may and the market is evolving. It’s what we said that after a transition year we would give more specific on a model early to some eight. We won’t give it as a breakdown for expenses, type of expenses we are looking for going forward before certain time, you can understand that because we would like to execute on that. On the impairment charge and the net of the EPS per charge you have to take account of 13 cents net source 13, 14 cents less due to the impairment charge we are showing in our adjusted pro forma P&L. So let’s do the math, and let’s take out 13, 14 cents per share.

Patricia Russo

Well, let me just say, first of all I want to thank you for taking the time and I appreciate your obvious interesting good questions. I would just close by saying we spent a lot of time talking about gross margin, we’ve tried to give you a sense of what’s going on in the gross margin and try to suggest that we don’t believe this quarters level is indicative of the business going forward. And while we operate obviously in a competitive pricing environment. We have a lot of activities under way to focus on cost reductions and efficiency improvements. So, I know that there is a desire for more detail always, we try to give you directional statement about how we see the business and as Jean-Pascal said we’d expect to be able to provide a more specific financial profile for the coming couple of years as we come into 2008. So, thanks for your attention. Thanks for your interest and we’ll talk to you next quarter.

Operator

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Source: Alcatel-Lucent Q2 2007 Earnings Call Transcript
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