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Tellabs Inc. (NASDAQ:TLAB)

Q3 2007 Earnings Call

October 23, 2007 8:30 am ET

Executives

Thomas Scottino - Director of IR

Krish Prabhu - President &CEO

Tim Wiggins - CFO

Analysts

Scott Coleman - Morgan Stanley

Ehud Gelblum - JP Morgan

Brant Thompson - Goldman Sachs

George Notter - Jefferies

Simon Leopold - Morgan Keegan

Nikos Theodosopoulos - UBS

Todd Koffman - Raymond James

Tim Savageaux - Merriman

Marcus Kupferschmidt - LehmanBrothers

Operator

Good morning. My name is Luan andI will be your conference operator today. At this time, I would like to welcomeeveryone to the Tellabs Investor Relations Conference Call. All lines have beenplaced on mute to prevent any background noise. After the speakers remarksthere will be a question-and-answer session. (Operator Instructions). I wouldnow like to turn the call over to Mr. Thomas Scottino. Sir, you may begin yourconference.

Thomas Scottino

Thank you Luan and good morningeveryone. With me today are Tellabs President and CEO, Krish Prabhu and ourExecutive Vice President and CFO, Tim Wiggins. If you haven't seen the newsrelease we issued this morning, you can access it at www.tellabs.com. Before webegin, I'd like to remind you that this presentation contains forward-lookingstatements about future results, performance or achievements, financial andotherwise.

These statements reflectmanagements current expectations, estimates and assumptions based on theinformation currently available to Tellabs. These forward-looking statementsare not guarantees on future performance and involve risks and uncertaintiesand other factors that may cause Tellabs actual results, performance orachievements to be materially different from the results, performance orachievements, expressed or implied by the forward-looking statements containedin this presentation.

A discussion of the factors thatmay affect future results is contained in Tellabs most recent SEC filings,including descriptions of the risk factors that may impact Tellabs and our forward-lookingstatements made in this presentation. The forward-looking statements made inthis presentation are being made as of the time and date of its livepresentation. This presentation is reviewed after the time and date of its livepresentation, even if it is subsequently made available by Tellabs on itswebsite or otherwise. This presentation may not contain current or accurateinformation.

Tellabs disclaims any obligationto update or revise any forward-looking statements based on new information,future events or otherwise.

This presentation may alsoinclude non-GAAP financial measures. Reconciliations between non-GAAP financialmeasures and GAAP financial measures can be found on our website tellabs.comand in our SEC filings.

With that, I will turn the callover Krish.

Krish Prabhu

Yeah, thank you Tom. Good morningeveryone. As usual, I'll just give you some high-level view points and TimWiggins our CFO, will dive into the details, both of us will come back andanswer your questions.

As with others, our third quarterresults were adversely affected by a slow down in spending primarily from NorthAmerican wireless carriers. We saw that most directly in the Transport segment,where 5500 digital Cross-Connect revenue was down sequentially year-on-year andthis affected our earnings in a disproportionate manner, since the 5500 hashealthy gross margins.

We don’t have much visibilityinto the North American wireless carrier spending plans, but traditionally,they've always spent more in the first half of the year compared to the secondhalf of the year.

Elsewhere, we saw continuedstrength in the third quarter, Broadband segment revenue was up 13%sequentially and 2% year-on-year, within this segment data products, thefastest growing part of Tellabs portfolio, were up 64% sequentially and 79%year-on-year.

As a reference point, the revenuefor our data products for all of 2005 was $60 million. We nearly approachedthat number in the third quarter with our data products.

As you may recall, our focus hasbeen on IP/MPLS and pseudo wire applications, as they pertain to mobilebackhaul and multi-service edge. We saw sequential revenue increases in allaccess products. Sales of FTTP and FTTC platforms reached an all-time high, up25% sequentially and 20% year-on-year.

The Service segment revenue wasup 19% year-on-year. Sequentially, the Service segment revenue was down 15% asyou recall in 2Q because of some revenue deferral on 7100 program with a majorcustomer, part of the services and part of the revenue from 4Q and 1Q which wasdeferred and recognized in 2Q.

Most promisingly, we saw asequential gross margin improvement in our 7100 ROADM and single-family ONTproducts. We've been working diligently to improve margins in both theseproduct areas and it continues to be an area of primary focus within Tellabs.

As for Tellabs, over the past fewyears, we've been transitioning from a TDM business which was primarily basedon Digital Cross-Connect and Managed Access to an IP business based on ROADMs,fiber access and data.

Three years ago, most of ourrevenue came from Cross-Connect and Managed Access. This quarter, more thanhalf of our revenue comes from the newer products. In addition to a strongcustomer presence with Tier 1 carriers in North America,this includes both wireless as well as fixed line operators.

Over the past few years, we haveestablished a direct sales presence with several Tier 1 carriers outside the US andthis has been done primarily on the strength of our technological offerings,especially in data.

Looking forward, to improveearnings, we must cut operating cost, improve gross margins and diversify ourcustomer base. Our operating costs have declined steadily over the last severalquarters. We will continue to optimize our operating expenses through ongoingrestructure.

We have several product costreduction plans and some of them have are already been improved, as I mentionedon the 7100 and the ONT.

As we look at 2008, we expect ourgross margins in BPON ONTs and ROADMs to continue to improve as we introduceseveral new configurations to the market.

We continue to diversify ourcustomer base, as we have seen with our data products; application specificsolution selling has led to our data products now being deployed in more than50 customer networks.

Just a few years ago, we weretalking about field trials. With the launch of 7100 nano and the 7100international versions, we are hopeful to have similar success.

Let me pause there, I’ll turn thecall over to Tim, after that I’ll come back and take your questions. Tim?

Tim Wiggins

Thanks, Krish, and good morningeveryone. In Systems, the announcement of October 4th, total revenue for thethird quarter of 2007 amounted to $458 million down 12% from the third quarter of2006. The year-on-year decline can be attributed to lower revenue in theTransport product segment, partially offset by increased revenue in theServices and Broadband product segments.

GAAP net income for the thirdquarter of 2007 amounted to about $4 million or $0.01 per share that compareswith $59 million or $0.13 a share in the third quarter of 2006. Theyear-over-year decline in net income is primarily related to the lower level ofTellabs 5500 wireless revenue and the products mix shift toward new access andtransport products.

Non-GAAP net income for the thirdquarter of 2007 amounted to $14 million or $0.03 a share and that compares with$73 million or $0.16 per share in the third quarter of 2006. Our non-GAAPresults for the third quarter of '07 include $18 million in pre-tax charges forspecial items, $6 million of which was associated with previously announcedrestructuring charges.

Equity-based compensation expensefor the quarter amounted to about $7 million or $0.01 a share. Taking equitycomp into consideration, as First Call and Reuters do when compiling mean EPSestimates for Tellabs, gives you $0.02 in non-GAAP EPS for the third quarter of2007. As usual, you'll find a complete reconciliation of our GAAP and non-GAAPresults in more detailed year-over-year comparisons in this morning's newsrelease.

On a sequential basis, thirdquarter revenue of $458 million was down from the $535 million we reported inthe second quarter of this year. The sequential decrease is more than you mightexpect in the seasonally slower third quarter, but you will remember that in2Q, we recognized about $45 million of deferred revenue related to 7100 ROADMdeployments in 4Q '06 and Q1 '07.

For the third quarter of 2007,revenue from customers in North Americaamounted to $325 million or 71% of the total, down from 2Q when North Americancustomer revenue excluding the deferred 7100 revenue, that I just mentioned,was about $368 million. Revenue from customers outside North America amounted to $133 million in the third quarter of 2007, up10% from the second quarter of this year.

Turning to the individualbusiness segments, Broadband segment revenue for the third quarter of 2007 was$279 million, up 13% compared with $246 million in the second quarter of thisyear. As you know, the Broadband segment includes our access, managed accessand data products. The sequential increase in the Broadband segment revenueresults from increased revenue levels across the data and access product areas.

Looking at the elements of ourBroadband segment, access revenue was $157 million in the third quarter, up 17%from $135 million in the second quarter of 2007. All product areas withinaccess segment were up with the largest sequential increase in single familyONTs for Fiber-to-the-Premise applications.

The growth in ONT unit volume,taking into account the price reductions that went into affect last year iseven greater than the growth in revenue would suggest.

Fiber platforms overall, bothFiber-to-the-Curb and Fiber-to-the-Premise, accounted for approximately 72% ofaccess product revenue in the third quarter of '07 compared with 68% in thesecond quarter. This was the highest level of fiber access revenue everrecorded Tellabs. Managed access revenue in 3Q '07 was $65 million comparedwith $77 million in the second quarter of 2007. The decline here comesprimarily from the 8100 managed access system. The Tellabs 8800 Multi-ServiceRouter Series and the Tellabs 8600 Managed Edge System make up our datacategory.

For the third quarter of 2007,revenue from data was $57 million, up 64% from $35 million that we recorded inthe second quarter of this year. Data is the fastest growing part of theTellabs portfolio and we saw solid sequential increases in both the 8800 and 8600product lines this quarter.

Looking at the first nine monthsof 2007, data revenue totaled $121 million, that’s up 58% from $76 million inthe comparable period of '06. That’s 13% more than the total for all of lastyear.

In 3Q '07, Broadband segment profitwas $23 million compared with a segment loss of $800,000 in 2Q '07. Theimprovement here is primary related to improved product mix, including moredata revenue and lower R&D cost.

Turning to the Transport segment,for the third quarter of 2007, Transport segment revenue was $123 millioncompared with $223 million in the second quarter of 2007. The decline reflectssequentially lower sales of 5500 systems to multiple North American wirelesscarriers and a lower level of 7100 ROADM revenue following the catch-up in 2Q.

Looking at the Tellabs 5500Cross-Connect business specifically, we shipped approximately 9,50,000 T1equivalents in the third quarter of 2007 compared with 1.9 million in 2Q '07.About 28% of this quarter's 5500 system revenue came from new systems, systemsexpansions and system upgrades, with the balance of 72% consisting of port-cardgrowth on our installed base. That compares to about 36% from new systems,systems expansions and upgrades and 64% from port-card growth in Q2.

At the end of the quarter, 19% ofthe card slots on our install base were open, compared with 20% in Q2.

North American wireless customersaccounted for 16% of Transport product sales in 3Q '07, compared with 39% in2Q. By the way of comparison in 3Q '06 North American wireless customersaccounted for 66% of Transport revenue.

Transport segment profit for 3Q'07 was $22 million compared with $81 million in 2Q '07. The decrease waslargely driven by the lower level of Tellabs 5500 revenue and partially offsetby improved ROADM gross margins that Krish mentioned.

Looking at the Services segment,Services segment revenue for the third quarter of '07 was $56 million and thatcompares with $66 million in 2Q '07, when we were able to recognize deferredrevenue from 7100 service activities in 4Q '06 and Q1 '07, in addition to ournormal activities.

For the third quarter of '07,services segment profit, driven by lower revenue level, amounted to $17 millionversus $26 million in the second quarter of this year.

Non-GAAP gross profit margin at31.8% for the third quarter of '07 compares with 35.4% in the second quarter of'07. As you know our gross profit margin is dependent on product and customermix, which was responsible for the shift between 2Q '07 and 3Q '07.

Contributing to the shift thisquarter was about 5.5 points of margin decline related to lower 5500 revenueand about 1 point of decline related to Services. This was partially offset byabout 2 points of improvement from the higher level of data revenue and the7100 and ONT which together produced about 1 point of gross margin improvement.

Turning to operating expenses,non-GAAP operating expenses for the third quarter of '07 came in at $147million or about 32% of revenue, compared with the $148 million we recorded in2Q.

For the quarter, non-GAAP,R&D expenses came in at $84 million and SG&A expenses were $63 million.At $84 million, R&D equals about 18% of revenue. Other income on a non-GAAPbasis amounted to $11 billion, versus $14 million in the second quarter of '07.The decline here is related primarily to foreign currency losses resulting fromthe weaker US dollar.

Our tax provision on non-GAAPpretax income for the quarter was a benefit of about $4million. The benefitreflects the impact of a decrease in our annual effective tax rate from 30%,through the first half of the year to 24% as of 3Q, driven by a decrease inincome earned from domestic operations. We expect our effective tax rate forthe rest of the year to be about 24%, plus or minus.

Turning to the balance sheet now,day sales outstanding was 58 days in Q3, up from 52 days in Q2. The increasehere is primary related to higher level of international sales which typicallycarry longer-terms.

Inventory turns were 6.5 timesversus 5.9 in Q2, '07. Inventory in terms of dollars decreased to $167 millionfrom $175 million in the second quarter of '07.

CapEx during the quarter was $12million compared with $15 million in the second quarter. And during the quarterwe purchased about $1.2 million shares of our stock at a cost of $14 million.The actual number of shares outstanding at quarter's end was 439 million,compared with 438 million at the end of the second quarter.

Since February 2005, we havepurchased nearly 51 million shares of our stock at a cost of $514 million. Atthe end of the quarter, our cash and investment balance stood at $1.372billion, up $53 million from the second quarter of this year. This improvementwas primarily driven by cash from operating activities which was positivelyaffected by reduced working capital balances and the strengthening of the Euroversus the US dollar. Headcount at the end of the quarter stood atapproximately 3800, consistent with the level at the end of the second quarter.Book to bill was slightly below one.

Turning to our outlook for thefourth quarter of this year, as we look at 4Q, our assumption is that currentmarket conditions will persist. We don't see any signs of meaningful year-endbudget flush at this time.

We expect that fourth quarterwill look very much like the third quarter. We expect revenue, gross margin andoperating expenses to be about the same and we are assuming a similar productmix.

As I mentioned earlier, we expectour tax-rate for the fourth quarter will be around 24%, plus or minus. Inaddition, we expect the effect of expensing equity-based compensation in 4Qwill be about $8 million, split between operating expense and cost of goodssold.

At this point, we will open thefloor to your questions. Luan, we are ready for the first question.

Question-and-Answer Session

Operator

(Operator Instructions). Yourfirst question comes from Scott Coleman with Morgan Stanley.

Scott Coleman - Morgan Stanley

Thank you, good morning guys.Couple of questions; first, in the access business. Last quarter, Krish, youtalked about putting some plans in place to reinvigorate some of IOC's, yetyour copper business is flat around mid $40 million per quarter. Is this aboutthe level you'd expected to stand on a go-forward basis?

Krish Prabhu

For the copper product you mean,Scott, or are you talking about plans to upgrade copper cabinets to fibercabinets?

Scott Coleman - Morgan Stanley

Clearly that’s ongoing, butshould copper stay around this level going forward? Or do you think it will godown further from here?

Krish Prabhu

Well, there is no market reasonto believe that copper will stay at that level, largely because our operatorsare themselves faced with getting more revenue from their customers. Part ofthat revenue is to do more broadband at higher bit rates of broadband, 5 megand 8 meg, what they call competitive broadband or beyond DSL, as well as videowherever they have a business case for offering video. So, I do expect atleast, this is our game plan, to continue to turn that business into a higherrevenue level but helping our customers transition their cabinets tofiber-based cabinets that can then support VDSL to drop to the customerdepending on how far they push the fiber.

Scott Coleman - Morgan Stanley

Okay. And so then, you expectthis to be still a considerable growth area for Tellabs, particularly withinthe IOC marketplace?

Krish Prabhu

Well, that's our plan. We talkedabout it last time mainly because we've introduced 1150 and 1134. These areproducts that are going nicely into many existing cabinets, have GigEinterfaces toward the network, and can drop VDSL2 and also have an IPTV enginein the core of the product that allows them to support IPTV, or some version ofIPTV. It takes a little while to work because there is a large customer baseout there, and we have to do it. In some cases the business deal, and in somecases the direct sale, depending on where they are in their investment cycle,but that's our plan over the next few quarters. To continue to transition thatIOC base into some sort of a revenue growth engine.

I mentioned earlier, we arelooking actively at customer diversification because we have been somewhatconcentrated in terms of tier 1 in North America.Part of that customer diversification is to get more access out of businessgrowing with the IOCs, as well as, with the help of our 7100 nano introducedROADM, especially two degree ROADMs for smaller carriers in North America.

Scott Coleman - Morgan Stanley

Okay. Maybe on different topic ifI could, buyback is something the Board seems to have been considering frommuch of this year. Krish, I am curious what your perspective is, what's theBoard waiting for here to make a decision? Clearly, you have ample capacity onthe balance sheet. It’s a great way to return value to shareholders. I’m justcurious, what it’s going to take to get the Board over the line on thisparticular issue, it seems some more like a no brainier at this point.

Krish Prabhu

Well, if you look at buyback inisolation, everything you said probably makes sense, but the Board is lookingat a broader strategic view and buyback is just one dimension. Our Board isworking very hard, we give the Board periodic updates on our business on themarket, on everything and it’s a question, I guess, that’s better answered bythe Board. But I must tell you that the Board is very actively looking at allalternatives, and all I can say is what you mentioned about buyback is just oneelement.

Scott Coleman - Morgan Stanley

Does the challenging businessconditions make a buyback less likely in your opinion?

Krish Prabhu

I don’t know. The businessconditions are challenging, but that’s part of it is market; part of it is atransition we are talking about. We have a pretty good game plan, as Imentioned; margin improvement, operating costs through continued restructuring,and customer diversification. And we now have a broader product portfolio tosell, and our products are taking route in the network. It certainly ischallenging, but I wouldn’t characterize the business as something that doesn’thave life, it does have significant life, and the Board has got to factor ineverything as they look at what’s on their plate.

Scott Coleman - Morgan Stanley

Thank you guys, I’ll pass it on.

Operator

Your next question comes fromEhud Gelblum with JP Morgan.

Ehud Gelblum - JP Morgan

Hello, thank you very much. Acouple of questions, if I could. First of all, you mentioned that the grossmargins on 7100 and single family ONTs have improved. Can you sort of quantifythat a little bit and tell us, are the ONTs above zero now? I imagine the 7100is above zero, should we be looking at that currently in the low single-digitsfor both of them? Or if you can, give some kind of quantification and wherethey are going next year?

Krish Prabhu

Yeah. Ehud, I'll mention fewthings and let Tim amplify. We typically don't like to isolate gross margins byproducts but our answer is going to be more to give you the trends that you arelooking for. The 7100 is in positive territory, single-family ONTs have beennegative. The new configurations that we are introducing take us to a breakevenpoint on single-family BPON ONTs. We think at best those gross margins will bebreakeven or in single digit positive. Only 7100 depending on theconfiguration, depending on the mix of transponders and systems, as well as,some of the cost reductions that we are doing on high volume transponders andoptical amplifiers. Our expectation is that those gross margins will approach35% to 40%. We just don't have a timetable at this time.

Ehud Gelblum - JP Morgan

Okay. So, if I can repeat, theONTs are still negative currently. The plans you have in place are to go tobreakeven by when, by the end of next year?

Krish Prabhu

No. Earlier than that, we can'tbe too specific, but our plan is based on the configurations that we arelaunching and the configuration that the customer is deploying to help themoffset some labor costs. We expect that breakeven point to be sometime in 2008.

Ehud Gelblum - JP Morgan

Okay. And then does it get betterthan that or it kind just stays around breakeven and at least it's not adetriment?

Krish Prabhu

On the BPON ONTs, anticipatingthere isn't another round of pricing concessions. We think that it stays atthat level. We might improve a little bit with volume efficiencies and cost ofparts reduction.

Ehud Gelblum - JP Morgan

Okay. And then the 7100 is now positive territory. My guess is, it'sstill low to mid-single digits but it gradually moves up as you said, the30%-35% over the course of a couple of years, that’s a rough way to model it?Am I correct?

Krish Prabhu

I don’t know yet. It depends onmix, it depends on what configurations customer orders. This past year has allbeen started configurations, which really have low priced point and a highercost because of common equipment, but as the transponder mix increases thosemargins improve.

Ehud Gelblum - JP Morgan

Okay, that’s awesome. If you goto the Transport side in the 5500, the fall-off this quarter was just fairlysignificantly. Was the fall-off as you recognize from a single customer, orfrom couple of customers that you can count? And is it across the board at allyour customers?

Krish Prabhu

Well, there are four NorthAmerican wireless customers. Three of them have been spending heavily in thepast, and our sense is, all four of them paused to collect their breath thisquarter. I don’t know Tim, if you have anything more to add, but I think, as welook at the numbers it's across all four.

Tim Wiggins

That’s right.

Ehud Gelblum - JP Morgan

Okay. And you are expecting allfour to again be below next quarter? I don’t remember correctly, you recognizerevenue on shift in? When 5500 business is done, a new product has been out fora long time. So, if they spend in the fourth quarter, you would recognize itimmediately, there is not really revenue recognition issue with 5500 sales, isthat right?

Krish Prabhu

Yeah, that’s true. Also we do alot of book shift, so I can't speak for sure but we should be able to supplyfrom a supply standpoint also. We should be covered if the business comes infourth quarter.

Ehud Gelblum - JP Morgan

Okay. So your anticipation right now implicit in your guidance isthat there will be no real spending above the $1 million T1 equivalence in Q4.Even though some these carriers have spoken about much stronger CapEx overall,either you are not expecting that CapEx to come through, or you are expectingit come in other areas than 5500, so is that a good assessment?

Krish Prabhu

There are customers who have madecomments that they will spend more, the third quarter really was the quarter wethought they would start spending. This is a business that is steady, there isno share gains or share shifts, so we were surprised and cut off guard with theanemic level of spending by wireless carriers in North America and so goinginto Q4, we have given you our best assessment based on what we see right now.

Ehud Gelblum - JP Morgan

Okay. Then the Transport margin ended up, I calculated, about 17.5%down from 36% in Q2 and then the 50s before that. Was that just as the trendsas the mix within transport fell more towards 7100 and last till 5500 there isa significant fall-off, or was there some price declines as well at the sametime in the 5500?

Krish Prabhu

It's largely from mixture,

Ehud Gelblum - JP Morgan

Okay. And then finally, the 7100, is it still essentially rising inBellSouth supplying the sales there?

Krish Prabhu

Well, we have a few small carriersespecially with smaller configurations. We are now diversifying our customerbase. We also have one large trial going on with another major RBAC-likecustomer in North America and we are alsolooking at some early starter systems internationally.

Ehud Gelblum - JP Morgan

Okay. That's very helpful, thanks guys.

Krish Prabhu

Thank you.

Operator

Your next question comes fromBrant Thompson with Goldman Sachs.

Brant Thompson - Goldman Sachs

Hi guys. I had couple of things,you had mentioned in the press release that the data business benefited fromthe completion of kind of second phase of big project in Asia.What's the outlook there in terms of how many phases are left in the pipeline?Some of the other large customers that come in and take up a place, or howshould we think about that outlook? And then, I have got a follow-up.

Krish Prabhu

Well, we've had big projects inNorth America, projects with wireless carriers, a project in Europe, a bigproject in Asia. So, I think we mentioned thatthere was a completion of one phase. There are additional phases with thisparticular customer in Asia. We also have anOEM channel open up in Asia. So, at thisstage, I think we have more than 50 customer networks on the 8800 productalone, we have several smaller customers in addition to that, so, yeah, it’sgot a nice niche in mobile backhaul as well as customers trying to transition.Frame ATM Traffic to IP/MPLS and that traffic is a high margin revenue for manyof our customers. They don’t want to abandon it, and yet they don’t want tokeep deploying obsolescent technology just to support that revenue.

So, we have a nice comfortableniche, our predictions are I think, Tim didn’t go into specifics, but if marketconditions in 4Q are similar to 3Q, we should continue to see improvement indata business.

Brant Thompson - Goldman Sachs

If we turn to the Transportbusiness, if you look at the T1 equivalent level in the quarter, but also justa trend in that over the last six quarters and then take that into context withthe fact that cash use versus new systems, that mix has also had really hitsome low points in terms of the number of new chassis and the lowest point Ithink we have seen since 2001. Are we at a point here, despite the fact thatthere is some wireless demand out there that may resume at some point, are weat a point now where if we look at the last six months worth of revenue data,T1 data, chassis data, that we’ve got the cross mix businesses, and is in astate of secular decline and it’s just a question of what data we wake up toand how the bigger drops are. How do we really think about the demand outlookfor that business when you put those numbers over the last kind of six quarterstogether? The trend looks fairly clear. So, I think we have confidence thatthere is a kind of stability that we had in this business or we actually,finally seeing this segment of the industry, really start to roll over?

Krish Prabhu

Well, I guess. Our assessment isthat it's a little too early to make that call as to whether its seculardecline now, for a couple of reasons: one, I think if you look at the last sixquarters or maybe going back to eight quarters there were at least two mergersthat were being consummated, Sprint, Nextel and AT&T Wireless and Cingular.There is also 2G to 3G transition plans. And there is also a spectrumallocation, there is the new 7100 spectrum coming on. No one really knows whatWiMAX is, the timetable for WiMAX, and the use of alternate spectrum.

So, when you factor all of thatin, I think it's fairly safe to say that there is a possibility that continueduse of T1 for backhauls, especially as the network becomes hot and trafficengineering rules, even though some of them have been relaxed now, people goback to more stringent traffic engineering rules, largely because of decline inquality or just the traffic has gone up so much or even in the launch of newservices mix; 2G, 3G services.

So, we'll have to wait and seewhat the first half of next year looks like because that's when most of thesewireless carriers spend their budget. We'll have to see where they arespending. Now, we do have through our 8800 and 8600 product considerableactivity in mobile backhaul outside the US. In fact, outside the US wesell no Cross-Connect. So, all our mobile backhaul is 8800, 8600 and even inthe US,we now have a couple of networks where these products are deployed as well asbeing trailed.

So, we will have to see bothsides of it, we are well prepared if the transition from T1 to Ethernet happensfaster and at pretty fast ramp. At the same time, if the T1 service continuesto grow just because of reasons I mentioned, we certainly have a very strongposition with our Cross-Connect, Brant. My best assessment at this time is,we’ll have to wait and see how the first two quarters in '08 shape out to makethe call whether the Cross-Connect have seen its best day in the wirelessnetworks.

Brant Thompson - Goldman Sachs

And then for last question, areyou seeing increasing pricing pressure on that Cross-Connect business since theprice per port for a T1 or T3 relative to an Ethernet equivalent is so muchmore expensive? Are you seeing that the consolidation is leading to yourcustomer is being able to yield much greater pricing power against you?

Krish Prabhu

These are also systems that arewell embedded and they are well embedded in their OS. And so, their transfercosts are not that small as you would see at the start of an RFP cycle, forexample. So, yeah we do see some pricing pressure, we manage it on acase-by-case basis. But I really believe that, the biggest issue as far astheir concern is, is what traffic engineering rules do they use? How muchlonger can they go with mobile networks having the capacity that they currentlyhave in their network? And at what point do they start transitioning from T1 toEthernet. That is what will decide what our business level is for 5500cross-connection wireless carriers.

Brant Thompson - Goldman Sachs

All right. Thank you.

Operator

Your next question comes fromGeorge Notter with Jefferies.

George Notter - Jefferies

Hi, thanks very much. I was justcurious about the Fiber-to-the-Curb and Fiber-to-the-Prem business. I think youmentioned earlier was up 25% sequentially. Can you talk a little bit about whatdrove that bump? And also can you talk about the outlook in that business as wesee AT&T Verizon transitioning from BPON to GPON, what can we expect there?Thanks.

Krish Prabhu

George, we can't be too specificin terms of breakdowns, but I think both FTTP and FTTC saw gains in 3Q comparedto 2Q. Tim talked about the ONT volumes which tells you that its not just theFTTP network equipment but its also is a measure of our customer success inmarketing that service and getting new customers, and that business grew quitewell both, especially, in terms of unit numbers because we now have lowerpricing per unit.

Looking forward, I do believethat our FTTP business at Verizon, as they transition from BPON to GPON, we areone of their approved GPON suppliers. We have a very competitive product, infact, in terms of our new mechanics, our product, which is the 17-inchmechanics. We have the highest density of pon terminations in a rack. It's avery advanced product and given all our experience on ONT, we are ready whenthe customer is ready to do that transition, at least, that's our game plan.

As far as FTTC is concerned manyof you have written up outside of AT&T that business is the business thatwe talked about to an earlier call transitioning copper business to fiberbusiness for many of the small carriers. But at AT&T, it's largelydependent on their appetite for FTTC and how much FTTC would they do inconjunction to FTTN and FTTP. So, we will just have to wait and see how thatplays out over the next couple of years.

George Notter - Jefferies

Got it. And then one lastclarification, on the share buyback that you did this quarter, could I assumethat, that was the piece of the share buyback program associated with employeestock option exercises, or was that associated with the ad hoc buyback program?

Tim Wiggins

The former, it’s the automaticprogram that uses option exercise proceeds to buy shares.

George Notter - Jefferies

Got it. Thanks.

Operator

Your next question comes fromSimon Leopold with Morgan Keegan.

Simon Leopold - Morgan Keegan

Thanks. I wanted to see if wecould talk a little bit more about the mix trending going forward, I thinkfollowing up from the last question. It seems to me I was pretty surprisedabout the fall-off but surprised positively about the data networking. So, areyou predicting in the next quarter not just similar revenue levels, but similarmix and then if you could extend those thoughts as to how those things aretrending in our way?

Krish Prabhu

Well, I think Tim talked aboutthe mix issue. Maybe you want to address it and I’ll talk a little bit about'08.

Tim Wiggins

Yeah. I think Simon, our view atthis point based on all the data we have is that 4Q will look very much like3Q, both in terms of volumes, but also mix.

Krish Prabhu

Okay, I talked a little bit about'08, we don’t like to look that far out in the crystal ball but just to kind ofgive you a sense of the trends, we do believe that our mobile backhaulsolutions, both especially outside the US which are predominantly data productswill continue to build steam, we have won several lot of piece for our 8600product. We are now selling it through OEM channels, as well as, selling itdirect-to-large wireless carriers and many of those carriers have been a littlemore aggressive in their 2G to 3G transition, largely because of their betterutilization of 3G spectrum, and so we do believe that we will continue to seegrowth there.

Our success in several largenetworks and transitioning, Frame/ATM services to IP/MPLS, especially as wecomplete another phase in the Asian customer that Tim talked about, or someoneasked the question about earlier, that will continue to see more growth in2008, or should.

We are going to be a lot moreactive in selling the 7100 product overseas. We have participated in severalbidding exercises for RFPs. Identifying the advantages of the product thatespecially on the strength of our success with large American carriers here.So, that should see some improvement.

The program on upgrading smallaccess players with their old copper systems and our first generation fibersystems to ones that can not only provide broadband at 8 meg, but also give youan upgrade faster IPTV. Certainly, we are hopeful we will see more of that in2008.

We will have to wait and see whathappens to the Cross-Connect. There was a question earlier with wirelesscarriers, has it seen its best day or is there another spring in 2008, we willjust have to wait and see.

Managed access continues its slowdecline. What we are trying to do with managed access products is to transitionthat base from its existing 8100 and 6300 SDH products. We are extending thelife of the SDH by offering Ethernet on SDH and as far as 8100 is concerned, weare transitioning it to 8600, because they are both managed by the samemanagement system.

So, those managed access productscontinue to transition to Ethernet service from E1 services. We have an idealpath to transition that base to the 8600.

Simon Leopold - Morgan Keegan

And just a little bit more detailon the Broadband access business. In this quarter, am I correct in thinkingthat the Fiber-to-the-Prem business is now got to the point where it's morethan twice of your Fiber-to-the-Curb?

Krish Prabhu

For reasons you can understandand appreciate, we don’t like to get too much specifics by product. But theFiber-to-the-Premise business has been growing very strongly. You can see thatintense comments about ONTs. You can also probably see it in our customer, somecomments about their take rates. We are also seeing small amount so thatdeployment both BPON on the 1000 platform with other customers. So, they aresmall not yet meaningful. But the Fiber-to-the-Curb business is largely anAT&T southeast business. The Fiber-to-the-Prem business is largely Verizonbusiness and we don’t want to go ahead and give you more specifics than whatwe've mentioned.

Simon Leopold - Morgan Keegan

But it's fair to conclude theyare heading in the opposite direction?

Krish Prabhu

No. It's not fair to concludethat. We said that there are sequential increases from 2Q to 3Q and I thinkit's fair to say that, even in the Fiber-to-the-Curb business we saw someincrease from 2Q to 3Q. Like I said, if FTTC is largely dependent on one customerappetite for deploying that configures.

Simon Leopold - Morgan Keegan

Thank you very much.

Krish Prabhu

Yes.

Operator

Your next question comes fromNikos Theodosopoulos with UBS.

Nikos Theodosopoulos - UBS

Yes, thank you. I had a couple ofquick questions. Can you comment on 10% customers in the quarter?

Krish Prabhu

We have two.

Nikos Theodosopoulos - UBS

Okay. How many 5500 product? Didyou actually see a change in the gross margin of that product over the lastcouple of quarters as the business has declined, or has the gross margin stayedthe same even though the revenues have been coming down?

Krish Prabhu

Well, I don't know the specificsbut I am not aware of any gross margin declines, even if it has changed alittle bit, there is always some volume mix, in fact, but there will be nomarket driven declines in gross margins on that product.

Nikos Theodosopoulos - UBS

Okay. And I wanted to go back tothe share buyback. You mentioned that the share buyback this quarter was onlybased on the automatic plan related to the option exercises. And given that thestocks been down significantly here over the course of year, is there acorrelation to the active buyback activity by the company and any strategicdiscussions you may be having, that could include selling the company becauseit just seems to me that with stock down here and the cash position its notclear why you wouldn't be buying back shares unless there was some restrictionsthat from strategic discussions that would stop you from doing so?

Krish Prabhu

No, you want me to answer thatquestion?

Nikos Theodosopoulos - UBS

I could only ask it, I don't knowwhat you want to do with it.

Krish Prabhu

I think we talked about itearlier, all I can say there is no additional comment, the Board's looking at amultitude of issues, this buyback just happens to be one dimension in thatspectrum. And that's how we can say at this point.

Tim Wiggins

I'd add Nikos, if you go back towhen we started this exercise and we talked about it with our shareholders atthe annual meeting that we felt that it was prudent and I agree thatcontemplating a sizeable share buyback among other options there it would beunfair and imprudent to be buying shares back from sellers who you may turnaround sometimes very soon or after and announce those significant plans.

So, I think we felt that while welooked at these various options, the right thing to do is to spend the openmarket purchases just to be fair to folks so that we weren’t buying shares backinto a transaction that may move the stock price around. So, I think wecontinue to look at it, certainly the world has changed since when the Boardstarted this, I have spoken number of times publicly and said I thought theBoard would have this sorted out by the end of the year. I can’t speak for theBoard at this point, but based on from where I said that timing still makessense. And I think the Board is acting prudently it took us a long time toaccumulate a billion, almost a billion four now. Certainly, taking some time tosort out what the right move is makes sense to me. And I think, suspendingpurchases while you do that, once again is the right thing to do.

Nikos Theodosopoulos - UBS

Okay. Just one last question,Krish, on the industry this year all the big telecom equipment companies,Alcatel, Nortel, well let’s leave Nortel out, Alcatel, Ericsson, Nokia, Siemensthat did big consolidation over the last year or so have seen their marginsdeteriorate. It almost suggests that scale for the sake of scale that all thesecompanies were trying to achieve so far hasn’t proven to be a good strategy. Doyou think size and scale matters in this business or do the carriers just haveso much buying power trying to achieve scale, it's just not going to be good strategy?

Krish Prabhu

It's a great question. I havealways felt it's not size and scale alone its fitness. So, if you are reallybig and you are really fit, it's one thing, but if you are big and you areunfit it's certainly the disadvantage.

The carriers do have considerablepricing leverage. There is a small number of carriers with very limitedspending. They have very ambitious plans to transition their network becausethey have to retool their service portfolio and both on the wireless, as wellas, on the fix side. And they are certainly exercising a lot of their pricingleverage.

So, I can't speak for the bigguys, because their strategy has been, one of trying to bundle a lot of thingsand offer both in space and time. A huge offer that has revenue recognitionissues, that has margin issues.

As far as we are concerned, wehave found a lot of success in offering application specific solutions, mobilebackhaul being a great example. We think that similar success exists in ROADMsand the transition of SONET/SDH networks to ROADM/DWDM networks and we alsobelieves that in niche pockets such success exists in fiber, except there we'vegot to be a little smart as to what kind of fiber access solutions andstrategies we offer, especially to smaller customers.

So, I think for consolidationsake, it will probably take some time to prove out if that's the right thing.There is no doubt the industry. We'll have fewer suppliers tomorrow than todayand there will be consolidation.

I think the bigger issue is, whatis your fitness level? How do you exercise your fitness level in a pricingenvironment where the customer exercises a lot of leverage and a big portion ofour customer diversification strategy is just to be able to be competitive inthat environment?

Nikos Theodosopoulos - UBS

All right. Thanks a lot.

Operator

Your next question comes fromTodd Koffman with Raymond James.

Todd Koffman - Raymond James

Thank you. Can I just get aclarification on the ONT revenue? Is it true that, on a year-over-year andsequential basis, the ONT revenue was up both in revenue and in units for bothsequentially and year-over-year?

Krish Prabhu

Yes that’s true, Todd.

Todd Koffman - Raymond James

So, in the prepared report whenyou are citing the fiber access revenues were lower in both time periods due tolower prices of ONT. You are sort of not explaining, why that segment revenuewas weak since it sounds like the ONT business was actually in revenue stillup?

Krish Prabhu

I don't know which preparedcomments you are talking about. But I think we said that the fiber accessbusiness, both FTTP and FTTC, showed sequential as well as year-over-yearincreases. And I think Tim's comments were that, in spite of a lower unitvolume on ONTs we had pretty large spike increase in revenue.

Tim Wiggins

I think Todd, this thing you needto also take into account in our access numbers is the copper part of thebusiness, which we have seen decline.

Todd Koffman - Raymond James

Okay. Just a separate questionbut along the same line just in expense. On the 7100 OTS were revenues upsequentially and year-over-year, as well as, unit sequentially inyear-over-year?

Krish Prabhu

Well, sequential revenue needs tobe normalized because as you know we did the large revenue recognition hump in2Q because revenue that was shipped in 4Q and 1Q and deferred was recognized in2Q. But if you look at on a normalized basis for example, if you look at whenwas the product shipped, and not when it was recognized or reported, then yeah,the trend is that we are increasing sequentially both in revenue as well as inmargin, gross profit contribution.

Todd Koffman - Raymond James

Very helpful. Thank you verymuch.

Krish Prabhu

Okay.

Operator

Your next question comes from[Mike Eastman] with Merriman.

Tim Savageaux - Merriman

Hi, [Tim Savageaux] here. Quickquestion, you'd mentioned and this is following a bit on the last question. Youhad mentioned and I thought quite interestingly that new products accounted forover half of your revenue, and I would like to kind of drill down on that alittle bit more. I assume that would mean Broadband data, fiber access and the7100 if you could confirm that for me? And then maybe give us a better sensewith a greater degree of precision as to what greater than half means is thatsignificant or just a little bit more, and I imagine that implies about a thirdyear revenue run rate and transport is 7100 at this point now, a follow upafter that?

Krish Prabhu

Well, yeah, it is true. We aretalking about all three product lines the 7100 product line now which hasmultiple configurations of a product based on the size of the ROADM deploymentyou do, either 8 degrees, 4 degrees, or 2 degrees. Then the fiber accessproducts which is primarily 1100 product family, the 1000 product family aswell as the 8865 GPON product family which hasn't seem revenue yet but is inour trial.

And then, the last piece is thedata products which Tim mentioned the 8600 product and the 8800 product whichthe 8800 is a multi-service edge and the 8600 is a managed access like product,except it supports IP/MPLS and pseudo wire instead of TDM. So, that combinedrevenue of those three products and I don’t have the details, if I did I wouldgive you specifically but that combined revenue is compared to third quarter of2004, that revenue is more than half of our total revenue today. Now, what wasyour other question?

Tim Savageaux - Merriman

I think that was it.

Krish Prabhu

That was it, okay, good. Unless,Tim do you have any more specifics? No. Okay. But I think you can work it out,we report but several segments and if you do a little bit of triangulation youwill see especially this quarter because the cross-connect revenue wassubstantially lower. We said 950,000 T1 equivalents compared to 1.9 million T1equivalents last quarter, so that in itself gives you a sense of what thedecline was in cross-connects.

Tim Savageaux - Merriman

I think I got it, while at thispoint then the question is does the growth part grow faster than the non-growthpart decline. And I know you commented on that earlier, but I’d like to ask youagain, whether you believe in the aggregate whether Tellabs is capable ofgrowing in 2008?

Krish Prabhu

Well, we are not going to talkabout 2008 for reasons you can understand. We don’t have visibility into theyear, but for in advance, certainly our operating plans call for continuing tofind ways to sell more of our growth products and also continuing to find waysto get more life out of our mature products and barring customers buyingbehavior in a particular quarter either because of a budget freeze or becauseof a mandate. I think we will be successful in doing both. We will be able toget more life out of our mature products, just primarily the 5500 and the managedaccess and we will be able to sell more of our new products, the three productsplus as you talked about.

Thomas Scottino

Hey Luan, I think we have timefor one more question now.

Operator

Your final question comes fromMarcus Kupferschmidt with Lehman Brothers.

Marcus Kupferschmidt - Lehman Brothers

Hey, guys.

Tim Wiggins

Hi, Marcus.

Marcus Kupferschmidt - Lehman Brothers

Couple of things I want to talkabout. Let's talk about the business and what you guys think the appropriatemargins structures are? We are talking about some improvement here in newproduct margin, so where do you think the gross margins can go and theoperating margins, and how do you think about balancing OpEx with gross margin?And I have a follow-up after that.

Krish Prabhu

Well, let me say a few words andTim can add. I think our gross margins, especially, if we achieve our twoprimary objectives, which is to get our ONTs to a breakeven business. For BPON,and when we launched the GPON to have the GPON ONT at a breakeven business onday one and secondarily, to get the ROADMs to margin level of north of 35% to40% gross margins.

Our data product margins aregood. Some of our newer 7100 configuration margins are good. I think it's fairto say that we could have a business that has aggregated gross margins north of35%. Right now, we have gross margins, this quarter I think we reported 31.5%.I think its very mix dependent. If you have a lot of data products. If you havea lot of 7100 in the smaller configuration more 7100 blades going into largerdeployed configurations less of the high-cost ONT more of the new configurationon the ONT's. Yeah, I think the margins would be north of 35% at an aggregatelevel. In terms of timing, its very difficult to forecast that right now, wewill just have to see, if the 5500 comes in strongly first half of next year,that has had in past, the significant impact on the aggregate gross margin.

Marcus Kupferschmidt - Lehman Brothers

As far as I guess one thing I amwondering is OpEx. Do you think about as a percent of revenue, I don’t see manysystems levels companies with OpEx below low 30% of revenues. So, what kind ofleverage do you have? I know we've talked about cost cutting in the past.

Krish Prabhu

Well, do have several levers onthe OpEx side. We continued to restructure as you looked at the last eightquarter, we have had a pretty good record of keeping the OpEx in check. We dohave initiatives in terms of developing configurations for our products thatare smaller, sleeker configurations that have a lower starting point. They canbe derived as derivative products from our big existing configurations rathereasily without much R&D involvement. So, part of our plans are to continueto diversify our customer base to a combination of direct selling and sellingthrough some select channels. So, when you factor all that in, we've got to seewhat is the right OpEx optimization. It’s a little too early for us to sharethat in great detail. But we are very focused on watching OpEx because that’san important lever in delivering earnings to our shareholders.

Marcus Kupferschmidt - Lehman Brothers

Before I change the topic, sotherefore 32% gross margin in third quarter, you are saying doesn’t make you inthe Board say, incrementally we need to push OpEx forward?

Krish Prabhu

32% operating expense you mean?

Marcus Kupferschmidt- Lehman Brothers

I mean, your gross margin was 32%, doesn't it make you wantto push the OpEx forward?

Krish Prabhu

Well, yeah, that's an important element, I am just notprepared to say that's a conclusion we have arrived at. I think it suffices tosay that we will continue to restructure and optimize our expenses just toachieve our objectives in terms of customer diversification, new derivativeproducts, as well as try to understand the realities of the new gross marginmodel, which is 35%, not 45% or 50%, which is what we had enjoyed in the past.

Marcus Kupferschmidt - Lehman Brothers

Okay. Andjust to clarify, Tim you said 16% of the quarter revenues are North American orthe Transport was North American wireless?

Tim Wiggins

Yes, 16.

Marcus Kupferschmidt- Lehman Brothers

So it's about $20 million?

Tim Wiggins

Are you asking that I can calculate Marcus?

Marcus Kupferschmidt- Lehman Brothers

So let's says that's about $20 million.

Tim Wiggins

It was a very soft quarter, absolutely.

Marcus Kupferschmidt- Lehman Brothers

Alright and the point is data you guys say, you have hit aninflection point and this is not just timing of converting contracts, thebusiness is really moving forward?

Tim Wiggins

Well, I think the number show that there has beensignificant progress. It's still early lifecycle and there is going to be somelumps to it, but I think the data speaks for itself in terms of salesimprovement year-on-year.

Krish Prabhu

Yeah, I think it's probably what the scoreboard tells you.We could tell you whatever we feel, that's kind of irrelevant Marcus and whenthe dust settles, it's I think we have not gone against head-to-head with traditionalapplications like hedge routing or SMS or core routing, we have chosenapplications on data platforms that have some niche as we have developed somespecific software on our products that helps us there, and I think that'sshowing in the results.

Marcus Kupferschmidt- Lehman Brothers

The comments continue to hit an inflection point. I justwanted to make sure that was what you were truly intending to convey, betterthan [few] of our recognition?

Krish Prabhu

Well, I think the data will show whether we’ve hit aninflection point or not. If you look at the next few quarters, I think itsstill too early to say they have hit an inflection point, but I think doingalmost $60 million of data sales in this quarter compared to $60 million thatwe did in all of 2005 is a pretty good trend.

Let me thank all of you for your interest in the company. Wecontinue to deliver maximum results to our shareholders in a tough market. Weunderstand our responsibility, we understand our challenges and we’ve have outlinedsome of those today. We’ll come back and report in another three months. Thankyou very much.

Operator

Thank you for participating in today’s conference call. Youmay now disconnect.

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Source: Tellabs Q3 2007 Earnings Call Transcript

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