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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 - Lehman Brothers

Operator

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

Thomas Scottino

Thank you Luan and good morning everyone. With me today are Tellabs President and CEO, Krish Prabhu and our Executive Vice President and CFO, Tim Wiggins. If you haven't seen the news release we issued this morning, you can access it at www.tellabs.com. Before we begin, I'd like to remind you that this presentation contains forward-looking statements about future results, performance or achievements, financial and otherwise.

These statements reflect managements current expectations, estimates and assumptions based on the information currently available to Tellabs. These forward-looking statements are not guarantees on future performance and involve risks and uncertainties and other factors that may cause Tellabs actual results, performance or achievements to be materially different from the results, performance or achievements, expressed or implied by the forward-looking statements contained in this presentation.

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

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

This presentation may also include non-GAAP financial measures. Reconciliations between non-GAAP financial measures and GAAP financial measures can be found on our website tellabs.com and in our SEC filings.

With that, I will turn the call over Krish.

Krish Prabhu

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

As with others, our third quarter results were adversely affected by a slow down in spending primarily from North American wireless carriers. We saw that most directly in the Transport segment, where 5500 digital Cross-Connect revenue was down sequentially year-on-year and this affected our earnings in a disproportionate manner, since the 5500 has healthy gross margins.

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

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

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

As you may recall, our focus has been on IP/MPLS and pseudo wire applications, as they pertain to mobile backhaul and multi-service edge. We saw sequential revenue increases in all access products. Sales of FTTP and FTTC platforms reached an all-time high, up 25% sequentially and 20% year-on-year.

The Service segment revenue was up 19% year-on-year. Sequentially, the Service segment revenue was down 15% as you recall in 2Q because of some revenue deferral on 7100 program with a major customer, part of the services and part of the revenue from 4Q and 1Q which was deferred and recognized in 2Q.

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

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

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

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

Looking forward, to improve earnings, we must cut operating cost, improve gross margins and diversify our customer base. Our operating costs have declined steadily over the last several quarters. We will continue to optimize our operating expenses through ongoing restructure.

We have several product cost reduction plans and some of them have are already been improved, as I mentioned on the 7100 and the ONT.

As we look at 2008, we expect our gross margins in BPON ONTs and ROADMs to continue to improve as we introduce several new configurations to the market.

We continue to diversify our customer base, as we have seen with our data products; application specific solution selling has led to our data products now being deployed in more than 50 customer networks.

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

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

Tim Wiggins

Thanks, Krish, and good morning everyone. In Systems, the announcement of October 4th, total revenue for the third quarter of 2007 amounted to $458 million down 12% from the third quarter of 2006. The year-on-year decline can be attributed to lower revenue in the Transport product segment, partially offset by increased revenue in the Services and Broadband product segments.

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

Non-GAAP net income for the third quarter 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-GAAP results for the third quarter of '07 include $18 million in pre-tax charges for special items, $6 million of which was associated with previously announced restructuring charges.

Equity-based compensation expense for the quarter amounted to about $7 million or $0.01 a share. Taking equity comp into consideration, as First Call and Reuters do when compiling mean EPS estimates for Tellabs, gives you $0.02 in non-GAAP EPS for the third quarter of 2007. As usual, you'll find a complete reconciliation of our GAAP and non-GAAP results in more detailed year-over-year comparisons in this morning's news release.

On a sequential basis, third quarter revenue of $458 million was down from the $535 million we reported in the second quarter of this year. The sequential decrease is more than you might expect in the seasonally slower third quarter, but you will remember that in 2Q, we recognized about $45 million of deferred revenue related to 7100 ROADM deployments in 4Q '06 and Q1 '07.

For the third quarter of 2007, revenue from customers in North America amounted to $325 million or 71% of the total, down from 2Q when North American customer 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, up 10% from the second quarter of this year.

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

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

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

Fiber platforms overall, both Fiber-to-the-Curb and Fiber-to-the-Premise, accounted for approximately 72% of access product revenue in the third quarter of '07 compared with 68% in the second quarter. This was the highest level of fiber access revenue ever recorded Tellabs. Managed access revenue in 3Q '07 was $65 million compared with $77 million in the second quarter of 2007. The decline here comes primarily from the 8100 managed access system. The Tellabs 8800 Multi-Service Router Series and the Tellabs 8600 Managed Edge System make up our data category.

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

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

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

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

Looking at the Tellabs 5500 Cross-Connect business specifically, we shipped approximately 9,50,000 T1 equivalents 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, systems expansions and system upgrades, with the balance of 72% consisting of port-card growth 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% of the card slots on our install base were open, compared with 20% in Q2.

North American wireless customers accounted for 16% of Transport product sales in 3Q '07, compared with 39% in 2Q. By the way of comparison in 3Q '06 North American wireless customers accounted for 66% of Transport revenue.

Transport segment profit for 3Q '07 was $22 million compared with $81 million in 2Q '07. The decrease was largely driven by the lower level of Tellabs 5500 revenue and partially offset by 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 that compares with $66 million in 2Q '07, when we were able to recognize deferred revenue from 7100 service activities in 4Q '06 and Q1 '07, in addition to our normal activities.

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

Non-GAAP gross profit margin at 31.8% 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 customer mix, which was responsible for the shift between 2Q '07 and 3Q '07.

Contributing to the shift this quarter was about 5.5 points of margin decline related to lower 5500 revenue and about 1 point of decline related to Services. This was partially offset by about 2 points of improvement from the higher level of data revenue and the 7100 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 $147 million or about 32% of revenue, compared with the $148 million we recorded in 2Q.

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-GAAP basis amounted to $11 billion, versus $14 million in the second quarter of '07. The decline here is related primarily to foreign currency losses resulting from the weaker US dollar.

Our tax provision on non-GAAP pretax income for the quarter was a benefit of about $4million. The benefit reflects 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 in income earned from domestic operations. We expect our effective tax rate for the 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 increase here is primary related to higher level of international sales which typically carry longer-terms.

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

CapEx during the quarter was $12 million compared with $15 million in the second quarter. And during the quarter we 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 have purchased nearly 51 million shares of our stock at a cost of $514 million. At the end of the quarter, our cash and investment balance stood at $1.372 billion, up $53 million from the second quarter of this year. This improvement was primarily driven by cash from operating activities which was positively affected by reduced working capital balances and the strengthening of the Euro versus the US dollar. Headcount at the end of the quarter stood at approximately 3800, consistent with the level at the end of the second quarter. Book to bill was slightly below one.

Turning to our outlook for the fourth quarter of this year, as we look at 4Q, our assumption is that current market conditions will persist. We don't see any signs of meaningful year-end budget flush at this time.

We expect that fourth quarter will look very much like the third quarter. We expect revenue, gross margin and operating expenses to be about the same and we are assuming a similar product mix.

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

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

Question-and-Answer Session

Operator

(Operator Instructions). Your first 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, you talked about putting some plans in place to reinvigorate some of IOC's, yet your copper business is flat around mid $40 million per quarter. Is this about the 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 fiber cabinets?

Scott Coleman - Morgan Stanley

Clearly that’s ongoing, but should copper stay around this level going forward? Or do you think it will go down further from here?

Krish Prabhu

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

Scott Coleman - Morgan Stanley

Okay. And so then, you expect this to be still a considerable growth area for Tellabs, particularly within the IOC marketplace?

Krish Prabhu

Well, that's our plan. We talked about it last time mainly because we've introduced 1150 and 1134. These are products that are going nicely into many existing cabinets, have GigE interfaces toward the network, and can drop VDSL2 and also have an IPTV engine in the core of the product that allows them to support IPTV, or some version of IPTV. It takes a little while to work because there is a large customer base out there, and we have to do it. In some cases the business deal, and in some cases 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 that IOC base into some sort of a revenue growth engine.

I mentioned earlier, we are looking actively at customer diversification because we have been somewhat concentrated in terms of tier 1 in North America. Part of that customer diversification is to get more access out of business growing with the IOCs, as well as, with the help of our 7100 nano introduced ROADM, especially two degree ROADMs for smaller carriers in North America.

Scott Coleman - Morgan Stanley

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

Krish Prabhu

Well, if you look at buyback in isolation, everything you said probably makes sense, but the Board is looking at a broader strategic view and buyback is just one dimension. Our Board is working very hard, we give the Board periodic updates on our business on the market, on everything and it’s a question, I guess, that’s better answered by the Board. But I must tell you that the Board is very actively looking at all alternatives, and all I can say is what you mentioned about buyback is just one element.

Scott Coleman - Morgan Stanley

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

Krish Prabhu

I don’t know. The business conditions are challenging, but that’s part of it is market; part of it is a transition we are talking about. We have a pretty good game plan, as I mentioned; margin improvement, operating costs through continued restructuring, and customer diversification. And we now have a broader product portfolio to sell, and our products are taking route in the network. It certainly is challenging, but I wouldn’t characterize the business as something that doesn’t have life, it does have significant life, and the Board has got to factor in everything 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 from Ehud Gelblum with JP Morgan.

Ehud Gelblum - JP Morgan

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

Krish Prabhu

Yeah. Ehud, I'll mention few things and let Tim amplify. We typically don't like to isolate gross margins by products but our answer is going to be more to give you the trends that you are looking for. The 7100 is in positive territory, single-family ONTs have been negative. The new configurations that we are introducing take us to a breakeven point on single-family BPON ONTs. We think at best those gross margins will be breakeven or in single digit positive. Only 7100 depending on the configuration, depending on the mix of transponders and systems, as well as, some of the cost reductions that we are doing on high volume transponders and optical amplifiers. Our expectation is that those gross margins will approach 35% to 40%. We just don't have a timetable at this time.

Ehud Gelblum - JP Morgan

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

Krish Prabhu

No. Earlier than that, we can't be too specific, but our plan is based on the configurations that we are launching and the configuration that the customer is deploying to help them offset some labor costs. We expect that breakeven point to be sometime in 2008.

Ehud Gelblum - JP Morgan

Okay. And then does it get better than that or it kind just stays around breakeven and at least it's not a detriment?

Krish Prabhu

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

Ehud Gelblum - JP Morgan

Okay. And then the 7100 is now positive territory. My guess is, it's still low to mid-single digits but it gradually moves up as you said, the 30%-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 on mix, it depends on what configurations customer orders. This past year has all been started configurations, which really have low priced point and a higher cost because of common equipment, but as the transponder mix increases those margins improve.

Ehud Gelblum - JP Morgan

Okay, that’s awesome. If you go to the Transport side in the 5500, the fall-off this quarter was just fairly significantly. Was the fall-off as you recognize from a single customer, or from couple of customers that you can count? And is it across the board at all your customers?

Krish Prabhu

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

Tim Wiggins

That’s right.

Ehud Gelblum - JP Morgan

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

Krish Prabhu

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

Ehud Gelblum - JP Morgan

Okay. So your anticipation right now implicit in your guidance is that 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 expecting it come in other areas than 5500, so is that a good assessment?

Krish Prabhu

There are customers who have made comments that they will spend more, the third quarter really was the quarter we thought they would start spending. This is a business that is steady, there is no share gains or share shifts, so we were surprised and cut off guard with the anemic level of spending by wireless carriers in North America and so going into 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 trends as the mix within transport fell more towards 7100 and last till 5500 there is a significant fall-off, or was there some price declines as well at the same time 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 in BellSouth supplying the sales there?

Krish Prabhu

Well, we have a few small carriers especially with smaller configurations. We are now diversifying our customer base. We also have one large trial going on with another major RBAC-like customer in North America and we are also looking 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 from Brant 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 from the 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 how should we think about that outlook? And then, I have got a follow-up.

Krish Prabhu

Well, we've had big projects in North America, projects with wireless carriers, a project in Europe, a big project in Asia. So, I think we mentioned that there was a completion of one phase. There are additional phases with this particular customer in Asia. We also have an OEM channel open up in Asia. So, at this stage, I think we have more than 50 customer networks on the 8800 product alone, we have several smaller customers in addition to that, so, yeah, it’s got 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 many of our customers. They don’t want to abandon it, and yet they don’t want to keep deploying obsolescent technology just to support that revenue.

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

Brant Thompson - Goldman Sachs

If we turn to the Transport business, if you look at the T1 equivalent level in the quarter, but also just a trend in that over the last six quarters and then take that into context with the fact that cash use versus new systems, that mix has also had really hit some low points in terms of the number of new chassis and the lowest point I think we have seen since 2001. Are we at a point here, despite the fact that there is some wireless demand out there that may resume at some point, are we at 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 a state of secular decline and it’s just a question of what data we wake up to and how the bigger drops are. How do we really think about the demand outlook for that business when you put those numbers over the last kind of six quarters together? The trend looks fairly clear. So, I think we have confidence that there 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 is that it's a little too early to make that call as to whether its secular decline now, for a couple of reasons: one, I think if you look at the last six quarters or maybe going back to eight quarters there were at least two mergers that were being consummated, Sprint, Nextel and AT&T Wireless and Cingular. There is also 2G to 3G transition plans. And there is also a spectrum allocation, there is the new 7100 spectrum coming on. No one really knows what WiMAX is, the timetable for WiMAX, and the use of alternate spectrum.

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

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

So, we will have to see both sides of it, we are well prepared if the transition from T1 to Ethernet happens faster and at pretty fast ramp. At the same time, if the T1 service continues to grow just because of reasons I mentioned, we certainly have a very strong position 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 make the call whether the Cross-Connect have seen its best day in the wireless networks.

Brant Thompson - Goldman Sachs

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

Krish Prabhu

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

Brant Thompson - Goldman Sachs

All right. Thank you.

Operator

Your next question comes from George Notter with Jefferies.

George Notter - Jefferies

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

Krish Prabhu

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

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

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

George Notter - Jefferies

Got it. And then one last clarification, on the share buyback that you did this quarter, could I assume that, that was the piece of the share buyback program associated with employee stock option exercises, or was that associated with the ad hoc buyback program?

Tim Wiggins

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

George Notter - Jefferies

Got it. Thanks.

Operator

Your next question comes from Simon Leopold with Morgan Keegan.

Simon Leopold - Morgan Keegan

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

Krish Prabhu

Well, I think Tim talked about the 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 at this point based on all the data we have is that 4Q will look very much like 3Q, 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 of give you a sense of the trends, we do believe that our mobile backhaul solutions, both especially outside the US which are predominantly data products will continue to build steam, we have won several lot of piece for our 8600 product. We are now selling it through OEM channels, as well as, selling it direct-to-large wireless carriers and many of those carriers have been a little more aggressive in their 2G to 3G transition, largely because of their better utilization of 3G spectrum, and so we do believe that we will continue to see growth there.

Our success in several large networks and transitioning, Frame/ATM services to IP/MPLS, especially as we complete another phase in the Asian customer that Tim talked about, or someone asked the question about earlier, that will continue to see more growth in 2008, or should.

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

The program on upgrading small access players with their old copper systems and our first generation fiber systems to ones that can not only provide broadband at 8 meg, but also give you an upgrade faster IPTV. Certainly, we are hopeful we will see more of that in 2008.

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

Managed access continues its slow decline. What we are trying to do with managed access products is to transition that base from its existing 8100 and 6300 SDH products. We are extending the life of the SDH by offering Ethernet on SDH and as far as 8100 is concerned, we are transitioning it to 8600, because they are both managed by the same management system.

So, those managed access products continue to transition to Ethernet service from E1 services. We have an ideal path to transition that base to the 8600.

Simon Leopold - Morgan Keegan

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

Krish Prabhu

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

Simon Leopold - Morgan Keegan

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

Krish Prabhu

No. It's not fair to conclude that. We said that there are sequential increases from 2Q to 3Q and I think it's fair to say that, even in the Fiber-to-the-Curb business we saw some increase from 2Q to 3Q. Like I said, if FTTC is largely dependent on one customer appetite for deploying that configures.

Simon Leopold - Morgan Keegan

Thank you very much.

Krish Prabhu

Yes.

Operator

Your next question comes from Nikos Theodosopoulos with UBS.

Nikos Theodosopoulos - UBS

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

Krish Prabhu

We have two.

Nikos Theodosopoulos - UBS

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

Krish Prabhu

Well, I don't know the specifics but I am not aware of any gross margin declines, even if it has changed a little bit, there is always some volume mix, in fact, but there will be no market driven declines in gross margins on that product.

Nikos Theodosopoulos - UBS

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

Krish Prabhu

No, you want me to answer that question?

Nikos Theodosopoulos - UBS

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

Krish Prabhu

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

Tim Wiggins

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

So, I think we felt that while we looked at these various options, the right thing to do is to spend the open market purchases just to be fair to folks so that we weren’t buying shares back into a transaction that may move the stock price around. So, I think we continue to look at it, certainly the world has changed since when the Board started this, I have spoken number of times publicly and said I thought the Board would have this sorted out by the end of the year. I can’t speak for the Board at this point, but based on from where I said that timing still makes sense. And I think the Board is acting prudently it took us a long time to accumulate a billion, almost a billion four now. Certainly, taking some time to sort out what the right move is makes sense to me. And I think, suspending purchases 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, Siemens that did big consolidation over the last year or so have seen their margins deteriorate. It almost suggests that scale for the sake of scale that all these companies were trying to achieve so far hasn’t proven to be a good strategy. Do you think size and scale matters in this business or do the carriers just have so much buying power trying to achieve scale, it's just not going to be good strategy?

Krish Prabhu

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

The carriers do have considerable pricing leverage. There is a small number of carriers with very limited spending. They have very ambitious plans to transition their network because they have to retool their service portfolio and both on the wireless, as well as, on the fix side. And they are certainly exercising a lot of their pricing leverage.

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

As far as we are concerned, we have found a lot of success in offering application specific solutions, mobile backhaul being a great example. We think that similar success exists in ROADMs and the transition of SONET/SDH networks to ROADM/DWDM networks and we also believes that in niche pockets such success exists in fiber, except there we've got to be a little smart as to what kind of fiber access solutions and strategies we offer, especially to smaller customers.

So, I think for consolidation sake, 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 today and there will be consolidation.

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

Nikos Theodosopoulos - UBS

All right. Thanks a lot.

Operator

Your next question comes from Todd Koffman with Raymond James.

Todd Koffman - Raymond James

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

Krish Prabhu

Yes that’s true, Todd.

Todd Koffman - Raymond James

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

Krish Prabhu

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

Tim Wiggins

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

Todd Koffman - Raymond James

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

Krish Prabhu

Well, sequential revenue needs to be normalized because as you know we did the large revenue recognition hump in 2Q because revenue that was shipped in 4Q and 1Q and deferred was recognized in 2Q. But if you look at on a normalized basis for example, if you look at when was 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 in margin, gross profit contribution.

Todd Koffman - Raymond James

Very helpful. Thank you very much.

Krish Prabhu

Okay.

Operator

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

Tim Savageaux - Merriman

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

Krish Prabhu

Well, yeah, it is true. We are talking about all three product lines the 7100 product line now which has multiple configurations of a product based on the size of the ROADM deployment you do, either 8 degrees, 4 degrees, or 2 degrees. Then the fiber access products which is primarily 1100 product family, the 1000 product family as well as the 8865 GPON product family which hasn't seem revenue yet but is in our trial.

And then, the last piece is the data products which Tim mentioned the 8600 product and the 8800 product which the 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 combined revenue of those three products and I don’t have the details, if I did I would give you specifically but that combined revenue is compared to third quarter of 2004, that revenue is more than half of our total revenue today. Now, what was your 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 you will see especially this quarter because the cross-connect revenue was substantially lower. We said 950,000 T1 equivalents compared to 1.9 million T1 equivalents last quarter, so that in itself gives you a sense of what the decline was in cross-connects.

Tim Savageaux - Merriman

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

Krish Prabhu

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

Thomas Scottino

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

Operator

Your final question comes from Marcus Kupferschmidt with Lehman Brothers.

Marcus Kupferschmidt - Lehman Brothers

Hey, guys.

Tim Wiggins

Hi, Marcus.

Marcus Kupferschmidt - Lehman Brothers

Couple of things I want to talk about. Let's talk about the business and what you guys think the appropriate margins structures are? We are talking about some improvement here in new product margin, so where do you think the gross margins can go and the operating 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 and Tim can add. I think our gross margins, especially, if we achieve our two primary 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 on day one and secondarily, to get the ROADMs to margin level of north of 35% to 40% gross margins.

Our data product margins are good. Some of our newer 7100 configuration margins are good. I think it's fair to say that we could have a business that has aggregated gross margins north of 35%. 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 have a lot of 7100 in the smaller configuration more 7100 blades going into larger deployed configurations less of the high-cost ONT more of the new configuration on the ONT's. Yeah, I think the margins would be north of 35% at an aggregate level. In terms of timing, its very difficult to forecast that right now, we will 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 am wondering is OpEx. Do you think about as a percent of revenue, I don’t see many systems levels companies with OpEx below low 30% of revenues. So, what kind of leverage do you have? I know we've talked about cost cutting in the past.

Krish Prabhu

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

Marcus Kupferschmidt - Lehman Brothers

Before I change the topic, so therefore 32% gross margin in third quarter, you are saying doesn’t make you in the 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 want to push the OpEx forward?

Krish Prabhu

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

Marcus Kupferschmidt - Lehman Brothers

Okay. And just to clarify, Tim you said 16% of the quarter revenues are North American or the 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 an inflection point and this is not just timing of converting contracts, the business is really moving forward?

Tim Wiggins

Well, I think the number show that there has been significant progress. It's still early lifecycle and there is going to be some lumps to it, but I think the data speaks for itself in terms of sales improvement 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 when the dust settles, it's I think we have not gone against head-to-head with traditional applications like hedge routing or SMS or core routing, we have chosen applications on data platforms that have some niche as we have developed some specific software on our products that helps us there, and I think that's showing in the results.

Marcus Kupferschmidt - Lehman Brothers

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

Krish Prabhu

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

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

Operator

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

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Source: Tellabs Q3 2007 Earnings Call Transcript
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