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Tellabs, Inc. (NASDAQ:TLAB)

Q4 FY07 Earnings Call

January 22, 2007, 8:30 AM ET

Executives

Tom Scottino - Senior IR Manager

Krish A. Prabhu - CEO and President

Timothy J. Wiggins - EVP and CFO

Analysts

Nikos Theodosopoulos - UBS Equities

Vivek Arya - Merrill Lynch

Raimundo Archibold, Jr. - Kaufman Brothers

Tim Savageaux - Merriman Curhan Ford

Ehud Gelblum - JPMorgan

Scott Coleman - Morgan Stanley

Marcus Kupferschmidt - Lehman Brothers

John Anthony - Cowen & Co.

Brian Coyne - Friedman, Billings, Ramsey & Co.

Simon Leopold - Morgan Keegan

Operator

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

Mr. Scottino, you may begin your conference.

Tom Scottino - Senior Investor Relations Manager

Thank you, Michelle, 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 our tellabs.com website.

Before we begin, I'd like you to remind you that certain statements made on the call this morning may be considered forward-looking. Such statements are subject to risks and uncertainties, and actual results might differ materially. A discussion of the factors that may affect future results is contained in Tellabs’ most recent SEC filings. Tellabs disclaims any obligation to update and revise statements contained in this presentation based on new information or otherwise.

This presentation may also include non-GAAP financial measures. Reconciliations between non-GAAP financial measures and GAAP financial measures can be found at ourtellabs.com site as well.

With that, I will turn the call over to Krish.

Krish A. Prabhu - Chief Executive Officer and President

Okay. Thank you, Tom. Good morning, everyone, and welcome to our fourth quarter earnings call. We put out a release this morning that reflects that both revenue and gross margin for 4Q is slightly above guidance. If you look at the revenue, broadband came in strong. Year-on-year comparisons in broadband reflect the 10% growth in our broadband category, which includes data, access and managed access. The weakness has been in Transport, primarily in our 5500 Cross-Connect. We have been affected by the consolidation in the industry with only three major North American wireless players now. We are to some extent affected by their ability and desire to spend CapEx in any given quarter.

Encouragingly, on the year-on-year comparisons, when we look at 2007, nearly half of our revenue came from products and technologies that Tellabs added since 2003, primarily in access, data, and ROADM. As many of you pointed out, the new products do come with a price, that is the margins are below company average. The last few quarters, we have been working very hard to improve their margins. It is encouraging to see gross margins trending up. They did go up from 3Q to 4Q. Tim Wiggins will give you a breakdown as to what are the moving parts and what affects our gross margins. And in our guidance for 1Q, we also reflect a slight increase in gross margins.

In addition to the gross margin improvement that we continue to work upon, we also announced today $100 million plan to bring our operating expenses as well as our cost to produce products and deliver services to be more in line with the new business reality. As part of this expense, we would be affecting jobs at Tellabs. 225 employees or so also would be... their jobs would be affected. This is in addition to the 125 employees that were affected in the September 2007 restructuring. Again, Tim Wiggins has more details on the plan and he will walk you through it.

Lastly, back in November we announced that I would be leaving the company as of March 1 as CEO. The company has launched its search and the search committee has been working actively along with the search consultants, and their plan is to be in a position to announce the transition and announce a new CEO before my departure.

With that, I will hand it off to Tim Wiggins. I will come back and answer questions along with Tim when he is done. Tim?

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Thanks, Krish, and good morning. In the fourth quarter of 2007, total revenue amounted to $469 million. On a sequential basis, that is up 2% compared with $458 million we recorded in the third quarter of '07. The sequential increases in the transport and services segments offset the decline in broadband segment revenue.

GAAP net income for the fourth quarter of '07 amounted to about $6 million or $0.01 per share. Sequentially, that's up modestly from $4 million or $0.01 a share in the third quarter of '07. Non-GAAP net income for the fourth quarter of '07 amounted to $17 million or $0.04 a share. That's up from $14 million or $0.03 per share in the third quarter. Our non-GAAP net income for 4Q07 excludes $15 million in pretax charges for special items, about $200,000 of which is related previously announced restructuring charges.

Equity-based compensation expense for the quarter amounted to about $8 million or $1.03 per share. Taking equity comp into consideration, as FirstCall and Reuters do when compiling mean EPS estimates for Tellabs, gives you $0.03 of non-GAAP EPS for the fourth quarter of '07. As usual, you'll find a complete reconciliation of our GAAP and non-GAAP results and more detailed year-over-year comparison in this morning's press release.

For the full-year '07, revenue amounted to $1.913 billion, down 6% from $2.041 billion in 2006. The year-over-year decline can be attributed to lower revenue in Transport and Broadband segments, partially offset by increased revenue in the Services segment. GAAP net income for the year '07 was $65 million or $0.15 per share compared with $194 million or $0.43 a share last year. On a non-GAAP basis net income of $104 million or $0.24 a share compares with $258 million or $0.57 a share in '06.

Revenue from customers in North America amounted to $334 million or 71% of the total fourth quarter revenue. While flat on a percentage basis, that's up from third quarter of '07 when North American customer revenue was $325 million. Revenue from customers outside North America amounted to $135 million in fourth quarter of '07 compared with $133 million in the third quarter '07. On a full-year basis, North American customers accounted for 74% of revenue in '07 compared with 76% last year.

Turning to our individual business segments, as you know, the Broadband segment includes our access, managed access, and data products. Broadband segment revenue for the fourth quarter of '07 was $274 million. That's down 2% from $279 million in the third quarter. The sequential decrease in Broadband segment revenue results from lower revenue levels from data and access products.

Looking at the elements of our Broadband segment, access revenues was a $154 million in the fourth quarter compared with a $157 million in the third quarter of '07. The modest decline here is primarily... related primarily to lower sales of access platforms to RBOC customers. Fiber platforms overall, both fiber-to-the-curb and fiber-to-the-premise, accounted for approximately 71% of access product revenue in the fourth quarter, and that compares with 72% in the third quarter.

Managed access revenue in 4Q was $80 million compared with $65 million in the third quarter of '07. The increase here comes from higher sales of our 8100 Managed Access System, driven by large network expansions and higher sales of our 6300 SDH Transport System.

The Tellabs 8800 Multi-Service Router Series and the Tellabs 8600 Managed Edge System make up our data category. For the fourth quarter of '07, revenue from data was $40 million, down from $57 million in 3Q07. The sequential decline here is primarily attributed to lower sales of the 8800 System following a robust third quarter.

In 4Q07, Broadband segment profit was $32 million compared with $23 million in the third quarter. The improvement here was primarily related to higher levels of managed access revenue, partially offset by lower data revenue.

Looking at the full-year '07, access revenue was $567 million compared with $653 million in 2006. The year-over-year decline here is primarily related to lower unit prices for single-family ONTs, lower sales of FTPC platforms, and lower sales of copper-based access platforms to independent operating companies. Managed access revenue was $291 million compared with $320 million in 2006. The year-over-year decline here is related to lower sales of the 6300 SDH System and our 2300 cable telephony system. On a year-over-year basis, data is our fastest growing product category, and we saw a solid sequential increase in both the 8800 and 8600 product lines in '07. Data revenue for the full year totaled $160 million, up 50% from $107 million in 2006.

Broadband segment profit in '07 was $39 million compared with $120 million in '06. The decline here is primarily related to higher revenues from single-family ONTs and lower revenue from copper access platforms, partially offset by the higher level of data revenue I just mentioned.

Turning to the Transport segment, for the fourth quarter of 2007, Transport segment revenue was $136 million compared with $123 million in the third quarter of '07. The improvement reflects sequentially higher sales of 5500 Cross-Connect Systems and the 7100 ROADM.

Looking at the Tellabs 5500 Cross-Connect business specifically, we shipped about $1.1 million T1 equivalents in the fourth quarter of '07, up from $950,000 in the third quarter. That's about 28% of this quarter... this quarter's 5500 system revenue came from new systems, system expansions, and system upgrades, with the balance of 72% consisting of port card growth on our installed base. That's consistent with the third quarter of '07. At the end of the quarter, 19% of the card slots in our installed base were open, consistent with the level at the end of Q3. North American wireless customers accounted for 26% of Transport product sales in 4Q '07, up from 16% in the third quarter. Transport segment profit in 4Q was $24 million, up from $22 million in 3Q, and that was driven by the higher levels of the 5500.

Looking at the full year, Transport segment revenue was $673 million in '07 compared with $778 million in '06. The decline here primarily reflects lower levels of 5500 System, partially offset by the outstanding growth we have seen in 2007 with our 7100 ROADM rollout. Transport segment profit was $238 million in '07 compared with $415 million in '06. The decrease was largely driven by lower sales of 5500 and other cross-connect systems.

Turning to the Services segment, for the fourth quarter of '07, Services segment revenue was $59 million, up 7% from $56 million in the third quarter. Services segment profit amounted to $19 million, up 10% from $17 million in the prior quarter. For the full year, Services segment revenue was $222 million in '07 and that's up 22% from $183 million in 2006, as we saw higher revenue levels from all service offerings across all geographies.

On a full-year basis, Services segment profit was $72 million in '07, up 10% from $66 million in '06. The increase here reflects the higher overall revenue level, partially offset by higher levels of lower margin deployment services.

Non-GAAP gross margin at 33.7% for the fourth quarter of 2007 is up from 31.8% in the third quarter. As you know, our gross profit margin is dependent on product and customer mix, which was responsible for the improvement between 3Q and 4Q. Contributing to the shift this quarter was about 3 points of improvement from higher levels of 5500 and 8100 at a more favorable mix of 1100 products, and about 0.5 point of improvement from sequentially better margins on single-family ONTs. This was offset by 1.5 points, as data products provided a lower percent of our overall fourth quarter revenue. On an annual basis, non-GAAP gross profit margin was 35.5% in '07 compared with 46.1% in 2006. The decline here was primarily driven by a mix shift with fewer 5500 systems and more single-family ONTs and 7100 ROADM systems.

Turning to operating expenses, non-GAAP operating expenses for the fourth quarter of 2007 came in at a $149 million or about 32% of revenue compared with the $147 million we recorded last quarter. OpEx is being affected by third-party development costs in R&D related to new product and future developments, which we expect will continue into the second quarter of '08. For the quarter non-GAAP R&D expenses came in at $34 million and SG&A expenses were $65 million. At $84 million, R&D equals about 18% of revenue. On a full-year basis, non-GAAP OpEx was $594 million in 2007, and that's down $17 million from $611 million reported in 2006.

Other income on a non-GAAP basis amounted to $7 million in the fourth quarter compared with $11 million in the prior quarter. The decline in other income primarily reflects a $5 million charge for the impairment of investments and marketable securities.

Our tax provision on a non-GAAP pretax income for the quarter was a benefit of about $1 million. This reflects a net benefit of about $7 million related to foreign tax reserves that we reversed during the quarter because they're no longer needed, offset somewhat by an increase in state income taxes. We expect our effective rate for 2008 to be about 30% plus or minus.

Turning to the balance sheet, days sales outstanding was 58 days in 4Q, consistent with the third quarter level. Inventory turns were 6.4 times versus 6.5 in 3Q. In the fourth quarter, inventory in terms of dollars was $171 million, compared with a $167 million at the end of 3Q.

CapEx during the quarter was about $20 million compared with $12 million in the third quarter. And on a full-year basis, CapEx was $58 million and that's down from $67 million a year ago.

During the quarter, we purchased about 21 million of our stock at a cost of $147 million. The actual numbers of shares outstanding at quarter’s end was $419 million compared with $439 million at the end of third quarter.

In 2007, we purchased about 25 million shares at a cost of $196 million. Since February of 2005, we have purchased just more than 71 million shares at a cost of about $661 million. Currently, we have authorizations in place to purchase about $630 million of our stock.

At the end of the quarter, our cash and investment balance stood at $1.219 billion, and that's down a $152 million from the third quarter of this year. This decline was primarily driven by our share buyback activities during the quarter. Headcount at the end of the quarter stood at approximately $3700, down from 3800 at the end of the third quarter. Book-to-bill was 1.

Before getting into our guidance for Q1, I wanted to address our cost reduction activities. In this morning's news release, we announced a plan to improve profitability by reducing operating expenses and improving gross margin. Under this plan, together with the restructuring we announced in September of 2007, we expect to reduce our expenses and costs through the course of 2008, so that when we enter 2009 our cost structure will be $100 million less than it was in 2007. About three-quarters of the cuts will come in operating expenses, with the balance in supply chain and services overhead costs. This will be accomplished by further headcount reductions through both layoffs and expected normal attrition, lower spending for prototypes and equipment, and reduction in third-party services. These restructuring activities, while always regrettable, are necessary given the current market realities. As a part of this plan, we expect to incur total charges of about $12 million to $14 million during 2008, with about $8 million of the charges falling in the first quarter.

Turning to our outlook, as we look at the first quarter our assumption is that current market conditions will continue. Based on what we see today and normal seasonality between 4Q and 1Q, we expect revenue for the first quarter to be in the mid-150s range plus or minus.

Krish A. Prabhu - Chief Executive Officer and President

450.

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Thank you, Krish. That would be a bad quarter, wouldn't it? We achieved sequential gross margin improvement this quarter and we expect gross margin in the first quarter to increase to about 37%, plus or minus. We are achieving gross margin improvements from our cost reduction activities and expect to benefit from a more favorable product mix in the quarter. We expect our non-GAAP OpEx in the first quarter to be flat to slightly down including the impact of the near-term third-party R&D development costs I mentioned earlier. We expect these incremental costs to abate by the end of Q2. We expect the expense decline to accelerate in the second half of the year, as we begin to generate improvements from our $100 million plan to improve profitability.

As I mentioned earlier, we expect our tax rate for the first quarter and the full year to be around 30% plus or minus. In addition, we expect the effect of expensing equity-based compensation in Q1 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. Michelle, we're ready for the first question.

Question and Answer

Operator

[Operator Instructions]. Your first question comes from the line of Nikos Theodosopoulos.

Tom Scottino - Senior Investor Relations Manager

Nikos, are you there?

Nikos Theodosopoulos - UBS Equities

Yes. CAN you hear me?

Tom Scottino - Senior Investor Relations Manager

We can hear you now.

Nikos Theodosopoulos - UBS Equities

Yes, I had two questions. The first one on gross margin in the first quarter guidance, can you elaborate a little bit on the mix that you are expecting that would help gathering if more of 5500 sales, but… perhaps you can elaborate on that. And then secondly, do you have the exact percentages of your 10% customers for 2007? Thank you.

Krish A. Prabhu - Chief Executive Officer and President

Let me say quick work on 1Q guidance and Tim Wiggins can add more color. We traditionally have better 5500 sales in the first half of the year with wireless customers, and the visibility we have into bookings for 1Q… it is true that the 5500 content in 1Q is trending up. In addition, we continue to see growth in our data sales as Tim pointed out. Some of that growth is lumpy because under the new revenue recognition rules there are certain parts of the contract that have to be completed before we can take revenue. Now, some of those things may fall in the first quarter and that will help our margin because the data products have better margin. On the access and the ROADM side, any margin improvements will come from better configuration mix as we ship more multi-tenant unit ONTs or we ship more transponder cards. So based on all that we have forecasted for 1Q our gross margins will come in around 37%. Tim, do you want to--?

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

No. I think that's right. And Nikos, we did have two 10% customers in 4Q, but I don't have the exact percentages.

Nikos Theodosopoulos - UBS Equities

What about for the year? Do you them for the year and the percentages?

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

I don't have that with me.

Krish A. Prabhu - Chief Executive Officer and President

It's... we don't have the exact percentages, but we are now looking at the two big North American customers as single entities, not separating their wireless component, which we used to the past but now we look at them as combined entities.

Nikos Theodosopoulos - UBS Equities

Great, thanks.

Krish A. Prabhu - Chief Executive Officer and President

Thanks you.

Operator

Your next question comes from Tal Liani of Merrill Lynch.

Vivek Arya - Merrill Lynch

It's Vivek Arya on Tal's behalf. Krish, my question is on the overall strategy for Tellabs in 2008. Last year in 2007, sales declined 6%. There was carrier consolidation and I think there was price pressure in your access business. In 2008, you still have those same kind of pressures plus you have increasing competitive pressure from Alcatel and Fujitsu, and now there seems to be more macro headwinds also. So what is your level of visibility, and can Tellabs actually grow sales in 2008?

Krish A. Prabhu - Chief Executive Officer and President

Yes. It's good question, Vivek. And as you know we don't give full year guidance for good reasons because of visibility, it is not 20-20 looking that far out. The headwinds that you talk about, there is nothing I can comment on because I am not qualified to give you any intelligent opinion on that. But let me talk a little bit about the difference between '07 and '08.

We launched several new products in '07, the ROADMs for example really took off. We are behind several of the early launch phase revenue recognition issues that typically come up with some of these large contracts. On the ONT side, we saw a tremendous precipitous price decline between '06 and '07. That’s behind us as we crossed the million mark in ONTs shipped last year. So as I look at... and our data products, as I think Tim pointed out, year-on-year they went up from roughly 100 million to 160 million, and we will continue to see good traction in '08, that's our expectation.

So I think '08 will, in my opinion, not see the factors that we saw in '07, especially as we were launching products. These products are now well established, many of the contracts are well underway. And I think it will be more typical for second inning, third inning type of phenomenon in getting revenue off of the new platforms in '08. Now, if the customers continue not to spend because they can afford to do that in a consolidated market or if there is a delay in their spending, that's something that we just have to wait and see. There is nothing we can comment about that right now.

Tim, do you have anything else you want to add?

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Well, yes. I think just to amplify some of the things that Krish said, we had an outstanding year with our ROADM rollout and that product more than quadrupled in terms of revenue. We've had significant growth in our data platforms, and we are excited about continued growth there. We've got our 1150 platform that we are making some headway on. So I think there are a number of elements that should give us some lift in terms of where we are in our product rollouts. At the same time, we are starting the year with some improvement in our 5500 as we go into Q1, at least that's our expectation. So I think we are starting on good footing, and as Krish said, I think we will have to see what kind of conditions the market presents and on top of that as we work hard on improving our gross margins and reducing our costs, improve profitability, we are optimistic that we can significantly improve our performance in '08.

Vivek Arya - Merrill Lynch

A quick follow-up, if I may, Krish. Have you seen any signs so far of carriers pushing out projects or any kind of delays because of what's going on in the economy?

Krish A. Prabhu - Chief Executive Officer and President

Well, we are not in a position to get a market view. We can only comment about what we see in our playground. But I think some of the optimism around IPTV in late '06 and early ‘07, clearly many carriers have [inaudible] 3G services, wireless services I think and then… it is better to ask them to see how they feel. But I think there's more moderation in terms of customer take as far as those services are concerned and the launch of those services.

I think traffic continues to grow in the network whether it's coming from the wireless side or from the coming from the wireless side or from the fixed side, and that's why these wins that we've had in data products at the edge of the network, the wins that we have had in mobile backhaul internationally, as well as the wins that we've had in ROADMS are very important because all of those go to alleviate the pressure on the network due to increased traffic.

So I don't think there is any strong signal that suggests carriers are consciously pushing our projects, but like everyone else they're also concerned about global economy, and we'll just have to wait and see what they do with their CapEx in '08.

Tom Scottino - Senior Investor Relations Manager

Shall we will take the next question now?

Operator

Your next question comes from Rai Archibold of Kaufman Brothers.

Raimundo Archibold, Jr. - Kaufman Brothers

Thank you. One, I guess I have a follow-up question on the gross margin guidance for 1Q as well as a housekeeping item. One, it’s just… I appreciate that you don't necessarily have visibility in terms what the mix will shape up to in the first quarter, but can you give us a sense as to how much of the margin improvement is from some of the cost actions and how much of that we should expect in the first quarter?

And then the second question is I missed your comment in terms of how much of the Transport revenues were related to North American wireless, can you repeat that please?

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Sure. I think the... in terms of a margin improvement in Q1, the major moving element is going to be mix, but it will be assisted by cost improvements. We have seen I think sequential improvements in our ONT margin. We mentioned that as a 0.5-point contributor in our improvement from 3Q to 4Q. We have actually seen improvements in the ROADM as well. We do have a price down in the ROADM that goes into place in one of the big customers early in the year. But we're seeing the fruits of a lot of efforts and cost reduction and have a fairly aggressive schedule for cost reductions throughout '08. I should mention that those are not embedded in the $100 million program that we're talking about. The $100 million program really deals with costs, non-product related costs largely, and we have aggressive actions that we’ll continue to work on throughout the year to help manage whatever price erosion there might be and to actually improve margins.

In terms of the North American wireless customers, it was 26% of our Transport product sales in '07, right.

Raimundo Archibold, Jr. - Kaufman Brothers

Thank you.

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Thank you.

Operator

Your next question comes from the line of Tim Savageaux of Merriman.

Tim Savageaux - Merriman Curhan Ford

Hi, good morning. I have questions about a couple of your segments of your business that appear to be performing a little bit better than most. First, on the Services side, you mentioned you're able to put up some pretty significant growth there in excess of 20%. I wonder if you can talk about the sustainability of that and what's driving that? And that also appears to be a fairly profitable segment of what you're doing. So if you can discuss the Services drivers in little more detail.

And then internationally, you're able to I guess keep still flat to slightly up, but a better performance in the domestic market. I wonder if you can talk about your… what sort of international growth plans you might see in 2008 and how global markets are looking from your perspective?

Krish A. Prabhu - Chief Executive Officer and President

Let me take a crack at the international, and I will have Tim address the source of issue. Internationally, we have business, which is an older business, we lump it under managed access and that business has been somewhat steady in '07. But the big success for us internationally in '07 was our data products, both in terms of mobile backhaul as well as new data products going at the edge of the network to transition, older frame ATM networks to IP/MPLS networks, and this is the area where we have added several new customers, won some RFPs, and this is were I think next will next year we’ll see good momentum… or this year-end in '08 will see good momentum.

So the plan internationally is to pick our battles carefully, keep an eye on margin, but also sell products that have established themselves for certain applications as value leaders. And this plan worked out good for us in '07 and we will continue to build upon it in '08.

We are also looking at configurations of our ROADM products and our access products. Again, in both ROADMs and access we have to see what the pricing situation is and pick and choose our battles carefully. We are also looking at attacking the international market with these two products going into '08.

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

On the Services side, Tim, I think… yes, you’ll recall that I mentioned that we saw improvements in all of our categories and services and in all geographies and attribute that really towards a reinvigorated team that is running our Services business. I think some key things that we saw in 2007 that helped us is the Services team were very instrumental in the large 7100 rollout at a large customer. So that certainly helped to lift the revenues. But also, we've been very successful in growing our professional service segment of the business.

So I think the... we are optimistic about the about the business. There are some headwinds, customers around the world would like to get some of these services for free. So it is really… the challenge for the company is to demonstrate value-add to our customers in a way that they are willing to pay for the services. Our plan for '08 is to grow that business, and we’d like to see the margins remain the same or improve somewhat. So we'll see how that the year rolls out, but we've got some momentum and we hope to continue to improve that business performance.

Tim Savageaux - Merriman Curhan Ford

Just a real quick follow-up on that, and thank you for that. When you talk about, say, for example the 7100 being breakeven from a gross margin standpoint as it ramps up, does that include the impact of services or us services sort of considered separately from a revenue and profitability standpoint?

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

There are different margins, but the revenue that the Services won from that business was below their average.

Tim Savageaux - Merriman Curhan Ford

All right. Okay. Thank you.

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

You're welcome.

Operator

Your next question comes from Ehud Gelblum of JPMorgan.

Ehud Geldlum - JPMorgan

Thank you very much. A couple of questions if I could. First of all, Tim, with the gross margin going back up again this quarter with mix, are we therefore to assume that the gross margin kind of bobs up and down with mix, specifically I guess on the 5500 mix, as we go through the year? And did the 7100 breakeven get better than breakeven like in the mid to high-single digit this quarter or is it still sort of breakeven-ish?

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Well, a couple of thoughts. One is, Ehud, we saw improvement in the 7100 and specific customer accounts during the quarter. We are very close to the breakeven. We expect in next year with cost reductions and change in mix from heavy system item to more transponders that we would see improvements above breakeven next year or this current year in '08. What else did you ask me, Ehud?

Ehud Geldlum - JPMorgan

Does the... I guess 7100 sounds like it is still not quite at breakeven or so and that the mix really impacts you said mostly the gross margin in Q1 as 5500 comes back. Does that mean as 5500 bobs up and down over the course of the year seasonally will gross margin bob up and down?

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

You really confused me with that bobing up and down thing.

Ehud Geldlum - JPMorgan

It’s kind of an Apple terminology.

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Well, I think our view is that we tend to see strength from our wireless customers in the first half of the year. We hope that happens again this year, and that should help us with the margins. We are also working hard in cost reductions. And so I think if we get a heavy 5500 first half, there will be pressure on the margins in the second half. Hopefully, we are not bobbing up and down. Our goal is to continue to improve the results quarter-to-quarter, if we can at all manage that.

Ehud Geldlum - JPMorgan

Okay. Then if we kind of just dig deeper into that T1… the 6500 and how that would act certainly in the second half of the year, 1 million T1 line equivalents, it sounds like it's just going to go up in the beginning of the year, but maybe down in the end. Should we be looking at 1 million T1 equivalents as kind of the steady state? Is this kind of up and down around 1 million from now on, or do you think it's going to fall further?

And if you can make a comment on access as well, it seems to hanging in there like a champ right now. And as Verizon moves to GPON, should we see declines in there over the next year or two as well? Thank you.

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Well, I think we're taking this a quarter at a time, and obviously we’re surprised by the activity in the 5500 last year. So I think we're encouraged to see what we hope to be improvement in Q1. We have done some things again with the 5500 to continue to position us as a great value for our customers, and while it may not be the latest technology in some people's minds it is very effective at delivering. So I think on that basis, we expect that… we will take it a quarter a time and hopefully… Ehud, I don't know at this point where it's going to hold or what the fixed rate is going to be.

I think one of the things that I would add to that as we get to the second of the year is that we have seen acceleration in our data products, both the 88 and 86, and we are very optimistic that given some of the indications we have that data will continue to grow and hopefully will be a strong driver in the back of the year. And as you know, those margins are doing well. In terms of the access products, I think on the copper side we have seen that--.

Krish A. Prabhu - Chief Executive Officer and President

I think he was talking more about Verizon.

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Okay. Go ahead. Why don't you pick that up?

Krish A. Prabhu - Chief Executive Officer and President

Specifically, about your question, access margins in general or Verizon BPON and GPON?

Ehud Geldlum - JPMorgan

Well. I mean, Verizon GPON is certainly the largest driver, of course there is also some share loss from copper driving the whole category, but certainly Verizon GPON is the main driver of what could happen to access, given how strong it really sort of relatively has been over the last couple of quarters.

Krish A. Prabhu - Chief Executive Officer and President

Yes. Verizon GPON, as you know, is going to be shared with one additional supplier and it's not very clear at what rate they will transition from BPON to EPON. But our visibility into 1Q is still the good as far as BPON business is concerned. We should continue to see better margin improvement on the ONTs. We've done some additional cost reduction as well as we are introducing configurations now that are… other than single-family unit configurations and those configurations carry good margin. On the GPON side, we have a very competitive OLT as well as ONT. We are in various phases of testing with the customer, and as and when they're ready to do their transition in a big way we fully expect to have a good role in that transition.

Ehud Geldlum - JPMorgan

Okay. Krish, sorry to see you go. Thank you very much.

Krish A. Prabhu - Chief Executive Officer and President

Thank you.

Operator

Your next question comes from Scott Coleman of Morgan Stanley.

Scott Coleman - Morgan Stanley

Guys, I'm wondering if I could ask a couple of questions about the cost reduction activities. So Tim, a $100 million run rate entering '09, just to make sure I understand that, should we be modeling OpEx in Q4 of this year maybe around $20 million below were it came in 2007? Is that the right way to think about it?

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Well, Scott, a couple of thoughts. One is that we've tried to get some direction without giving quarterly guidance. I think will how the plan unfolds, but we have given you some elements of the plan as we're targeting, and one certainly is from an OpEx standpoint we're looking to reduce it by $75 million from the levels that we have, and about $25 million of the $100 million would be above the line. We expect in the first part of the year to have some of these third-party costs based on some R&D commitments and heavy roadmap commitments that we have. But we're making... we are having... are making and continue to make changes in cost reductions, but they are somewhat mapped by some of these third-party cost that affect us in 4Q. So we think you'll see an acceleration in the back half, and the goal I think as you mentioned correctly is that when we finish '08 we will have eliminated a $100 million from the '07 cost base so that in '09 we will run at least at that level if not better.

Scott Coleman - Morgan Stanley

But I... you think you'll be there sort of exiting '08 rather than... these are '09 targets, but sort of the exit rates from '08, is that right?

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

I don't know that we’ll have completely finished to run the full fourth quarter at the new rate. We might... but I think what… the target is that when we finished the year we’ve completely eliminated, so that when you start '09 you're running at that $75 million lower range in the OpEx.

Scott Coleman - Morgan Stanley

Okay, thanks. And this quarter I think you mentioned the book-to-bill was one, an improvement from last quarter where it was below one. The 5500, it sounds like its the bulk of that improvement as you look out to Q1 and the first half of next year, but is there any other product clarity you can give us within the bookings number?

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

I think we saw kind of a good distribution across all our products and no particular strength in any one.

Scott Coleman - Morgan Stanley

Okay. And on the customer side, last quarter the shortfall came from weakness I think largely at AT&T. You didn't give the percentages out earlier, but did you see more stable or improving spending from AT&T or some of the other large U.S. carriers in the quarter?

Krish A. Prabhu - Chief Executive Officer and President

I think I think it's fair to say that we did see some stabilization between 3Q and 4Q, and I think that comes true in our results. If you look at individually, customer-by-customer, I think it's fair to say at least in 4Q the business stabilized for those customers compared to 3Q. We just have to watch what happens in the first half to understand if that stabilization is more medium-term rather than just one quarter’s effect.

Scott Coleman - Morgan Stanley

Thanks, Krish, and one last housekeeping one on my end. You talked about a price take down coming on the 7100 from a large customer early in '08, but you also talked about improving the gross margins there and a target of getting to break even in 2008. So I just want to make sure that even with the price take downs, that's not going to impede the ability to make this a profitable product on the gross margin line in ‘08?

Krish A. Prabhu - Chief Executive Officer and President

Yes, that's the plan. The plan is on the gross margin line, for the ROADM in particular, with our new nano configuration, more customer diversity, better configuration mix, cost reductions, cost of parts reductions, we are designing new cards that have better cost, especially transponders and optical amplifiers, we will compensate for any committed price reduction at that large customer and we will be break even or better at the gross margin line. That's the plan.

Scott Coleman - Morgan Stanley

Great. Thanks for the detail, guys.

Krish A. Prabhu - Chief Executive Officer and President

You’re welcome.

Operator

Your next question comes from Marcus Kupferschmidt of Lehman Brothers.

Marcus Kupferschmidt - Lehman Brothers

Good morning, guys.

Tom Scottino - Senior Investor Relations Manager

Good morning, Marcus.

Marcus Kupferschmidt - Lehman Brothers

Some things I want to understand, in terms of the restructuring, can you maybe help us understand kind of where are the sources of where you are getting a lot of these benefits for and help us understand… I believe you talked about previously 125 people as a part of restructuring; that got you I think around $17 million of benefit. So it seems like this 225 people is a lot more powerful, there is a lot more cost associated with taking those folks out of the operations they are in. So kind of help us understand how this restructuring is evolving, and then I have a follow-up. Thanks.

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Sure, well, I think as I mentioned in my comments that… it does involve the 375 people that are affected that we have mentioned there, which is give or take 10% of the workforce, but that's not the extent of what we are trying to accomplish. We are also going to manage our attrition, which runs at give or take 5% a year. So that's part of what we are going to do to get the numbers we need. But it also involves managing a lot of our other cost. I’d mentioned these third-party costs that had to do with the parts and protos and third-party code writing and things of that nature that are relatively heavy right now given some of the commitments. So we expect to moderate those. We're also looking at other kinds of expenses, travel, all those expenses that you would expect, Marcus. So this is really an attack across all those fronts to reduce our expenses. So the elements that are coming from this are certainly and unfortunately related to headcount, but by no way are limited to that.

Marcus Kupferschmidt - Lehman Brothers

And what are the main products that are being affected through this, if you could help us understand that?

Krish A. Prabhu - Chief Executive Officer and President

I don't think any product is significantly affected with the restructuring. One of the reasons why we had a delay... and some of you pointed out why we didn't do this restructuring earlier more aggressively because many of our competitors have launched on it, is that we did have some commitments. We were launching new products. All these products have gotten market acceptance, and we didn't want to pull the legs out from this launch by doing some restructuring... big portion of the restructuring is in the way we do R&D, where and how. So I think Tim elaborated on the fact that while the people number may seem, especially if you look at what was laid out back… what was done in September and now and you do a people versus cost comparison, the numbers don't compute. This is a very detailed plan. It's has been thought through, various elements have been included, and the plan is to complete this restructuring in '08, so that when you go into '09, your cost or expense bases for '09 would be $100 million less than in '07. So an essential element of that plan, Marcus, was to make sure that the new products that we have launched ROADMs, access, and data products, were not short-changed because of the restructuring.

Marcus Kupferschmidt - Lehman Brothers

Okay. And if you could just clarify, the 5500, the cross-connects for Tellabs for the wireline operators showed some pretty nice growth in '07 year-over-year. Can you help us understand what drove that? And do you think these kind of revenue levels seems sustainable? Thank you.

Krish A. Prabhu - Chief Executive Officer and President

Well, the T1 network continues to grow and it’s still the bread-and-butter transport network in North America, and I think that's what you're seeing. My earlier point was traffic continues to rise in the network because of increased Internet access or because of increased wireless and mobility, voice. And I think that's what you're seeing. A lot of the wireline carriers, the fixed network carriers are wholesalers for their wireless subsidiaries, and I think what you do see the growth is really a reflection of the increasing traffic.

Marcus Kupferschmidt - Lehman Brothers

Thank you.

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Thank you, Marcus.

Operator

[Operator Instructions]. Your next question comes from John Anthony of Cowen and Co.

John Anthony - Cowen & Co.

Good morning, guys. I apologize if you've already covered this. Krish, you sound fairly optimistic towards the prospects for the TiTAN this year. Would you be willing... I know you're not providing annual guidance, but would you be willing to tell us whether you expect it to... you expect TiTAN to grow… TiTAN revenues to grow this year versus last?

Krish A. Prabhu - Chief Executive Officer and President

Well, John. We are looking at it one quarter at a time and we’ve being chasing in the past for looking at traffic trends and predicting where things would go. Part of the delay what you have here is traffic is not everything here. Three wireless carriers, and between them they can decide to run their network hot, not to spend more money on a particular technology, and wait it out for a while. So there are several factors.

We did see a significant drop between '06 and '07 in the T1s deployed. I think you got those numbers. We're encouraged by the slight growth... by the growth we see in 1Q compared to 4Q. We'll just have to watch it one quarter at a time. I think Tim talked about it earlier. Our visibility is so murky it would be very risky to predict anything else at this time.

John Anthony - Cowen & Co.

Okay. I understand you made some comments on the 8865. Do you still have any belief that you might be able to take the 8865 concept internationally? And at this point, given some of the commentary made by Alcatel and Motorola, is there any way you can handicap your prospects with getting some GPON business domestically?

Krish A. Prabhu - Chief Executive Officer and President

Well, the big thing is that… I am really not aware of any comments made by Alcatel or Motorola on this topic. But the big thing we have internationally is there aren’t too many markets or customers who are looking at fiber rich architectures that are GPON-centric like Verizon is. There are customers who are looking at fiber-rich architecture that are EPON-centric like you have in Japan and Korea and that's a very different architecture as opposed to what Verizon is doing. So we'll just have to wait and see how the market develops for the 8865 over time. The 8865 is a very versatile box. It shares a lot of commonality with the 8800. The new mechanical configuration that the 8865 launches essentially allows us to look at the 8865, the next generation 8800 in some applications, and we're very encouraged by the traction the 8800 is getting at the edge of the network, not just here but internationally. So over time if it looks like lot of packets whether these are Ethernet packets or pseudowire packets or whatever are going through the edge of the network and they happen to go through the 8800 or 8865, that product starts looking a lot like the TiTAN.

So we will just have to see how the world evolves over the next five years. It’s too early to handicap it right now, but part of our strategy in developing the 8865 was not just address Verizon's GPON needs, but also be prepared for any GPON opportunity [inaudible] Verizon or anywhere else in the world and look at it as the next generation development on the 8800 platform for the edge of the network.

John Anthony - Cowen & Co.

All right, and last question. I apologize again if you’ve covered this. The buyback is underway now, and you still have a lot of cash. Can you just update us once more on the M&A strategy and what your thinking is here, especially given that some of the companies there, needless to say, the valuations have come down so dramatically, given your cash balance is there something that might be more appealing to you or is there a way you could use your cash that you may not have been considering in 2007, given the changed valuations?

Krish A. Prabhu - Chief Executive Officer and President

In all fairness, I don't think it’s proper for a departing CEO or a CFO to a comment on it, but I will let Tim take a crack if he wants to.

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Hopefully, I'm not departing a CFO.

Krish A. Prabhu - Chief Executive Officer and President

No, I didn't mean it, sorry. Let me correct that, it’s mot a departing CFO, but an existing CFO.

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

John, you bring up a good point. I think we only had… by the way on the share buyback from the time of the announcement till the... our window closed 14 days. So we were very active to get the 140 million worth of stock. But you are right, the world has changed from even six months ago in terms of the capital markets and debt and valuations and Tellabs’ prospect. So I think Krish is right. It is something that we are thinking about and looking at, but given these prices of the stock we will talk to our Board later this week, but for buyers at on average seven I think you expect us to support the stock price. I think we have room to do both. In terms of capital, we have room to look at acquisitions and we have room to support the share price. So will see what the Board feels on this issue, but that is my view at this point.

John Anthony - Cowen & Co.

Thanks, guys. Good luck.

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Thank you.

Operator

Your next question comes from Brian Coyne of FBR Capital Markets.

Brian Coyne - Friedman, Billings, Ramsey & Co.

Hi, good morning. Couple of things, I apologize if you touched on these earlier. First, I was just wondering if you could give us a little bit more inside into data products? You obviously saw strong growth this past year. And just maybe can you give us some sense as to the elements that could drive that growth and in 2008?

Krish A. Prabhu - Chief Executive Officer and President

Yes, okay. The big… the successive ride in data products in '07 has been on some targeted applications. Internationally, we have positioned one of our products as the key element of wireless backhaul for networks that are migrated from 2G to 3G and use pseudowire technology as a key ingredient to take circuits over packet networks. So we've had a lot of success with one product. We've done some good launch in '07 and we’ve won some RFPs and we have high expectations in '08 for this product. And I think it's positioned in a good space because it's a global phenomenon where wireless traffic is transitioning from 2G to 3G.

The other application for our data products is taking old frame ATM networks and migrating them to IP/MPLS networks. That way the customers can continue to serve existing businesses on existing SLAs, but also launch new Ethernet services or IP services. And I think here 8800 product has found its way into some large networks. In '07, we had to meet certain specific deliverables in terms of software and R&D road maps. We've... we are behind... that's behind us now. We were able to recognize some revenue in 3Q. As we continue to smoothen that deliverables schedule, our revenue recognition will also smooth out on this product.

This product incidentally has also seen application in wireless networks where you have some ATM traffic, as well as applications in enterprise Wide Area Networks, the old IXE networks that MCI and AT&T used to have. Those networks are now also looking at transitioning old services to new, and this product has a nice niche application there.

So we have... our focus on data has been not to [inaudible], be the fourth router supplier in an already crowded market, but it has been on finding niche applications, developing the appropriate software that enables these applications, and selling the product on the basis of value and thereby holding the margin. And I think '07 was a good test year for us. We saw the revenue growth nicely. We grew the number of customers. And I am very hopeful that that trend continues in '08.

Brian Coyne - Friedman, Billings, Ramsey & Co.

That is great. And generally speaking, on the 8800, are you seeing any marginal differential from North America to International?

Krish A. Prabhu - Chief Executive Officer and President

On the data products?

Brian Coyne - Friedman, Billings, Ramsey & Co.

Yes.

Krish A. Prabhu - Chief Executive Officer and President

No, we generally… as they role across the board, we generally don't see market, but when we go into certain markets trying to sell small... to smaller customers, the markets are competitive. Yes, we do see margin pressure. And I think I've mentioned earlier in response to another question, the challenge for us in '08 is to be careful and selective as to which battles we fight, especially on the data front as well as on the ROADM front in international markets.

Tom Scottino - Senior Investor Relations Manager

Michelle, I think we have time for one more question.

Operator

Okay. Your next question comes from Simon Leopold of Morgan Keegan.

Simon Leopold - Morgan Keegan

Thank you. I wanted to clarify an issue regarding your interest income or other income. You've got a lot of cash on the balance sheet, but we are seeing interest rates come down and lot of companies basically putting their cash in safer places. Maybe you could talk a little bit about how you are managing your cash and what kind of interest rate you expect to earn on that cash? And then I've got a follow-up.

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Yes. Simon, it's interesting. It’s… those have become very choppy waters and what we used to think is safe is maybe not so much. So we've probably been more fortunate than most in terms of not having big issues, so we did report a smaller issue, a disappointment this quarter in terms of an impairment, but even in that case so those are agency securities, which we think will recover nicely and in fact have already recovered 1.5 million.

So we're looking around, and what I find is that even money markets aren't necessarily the place to be. We're... we have also a series… a part of our portfolio in municipals that have insurance arm. So we're watching that carefully. I think suffice it to say, this is something that didn't require a lot of attention of mine for the last four years. In the last six months, that required a lot of attention and we're asking for help from outside advisers, because what people think as safe turns out to be not so safe. So far, our yields are holding up okay. We'll see how that goes. I suspect that as the company “safer things,“ right now the treasuries are expensive because a lot of people moved in that direction. So I suspect over time the net result is going to be that interest rates will come down somewhat because people are going to move into a safer territory and will be meeting a crowd of folks there. So I think you are on the right issue and it's an area that we need to continue to focus on.

Simon Leopold - Morgan Keegan

Can you possibly quantify what you think your net other income might be in the first quarter?

Timothy J. Wiggins - Executive Vice President and Chief Financial Officer

Well, we have spent $150 million in share buyback. We'll see what the Board wants us to do as we go forward. So certainly, what we do with the cash will impact that. So far, our yields are holding up reasonably well, but I suspect… I can't really quantify at this point. It depends on how safe the remaining havens are and how much we want to move into kind of a really safe environment. So not sure at this point, but I think directionally you are on the right issue.

Simon Leopold - Morgan Keegan

Okay. And then just… the follow-up was more of a trending question around the ROADM product. Trying to balance a sense of strong demand for the transport capacity, which should drive growth, and then the... our view that there is basically a second vendor that should be rolling out your biggest customer very late in 2008. I'm wondering, how you're thinking about the share shifts versus the overall demand, if you could give us a little bit of color around how that might trend through the year?

Krish A. Prabhu - Chief Executive Officer and President

We can't specifically about customers’ intentions or plans or what they intend to do with the second supplier, but when we won the ROADM business we knew and fully expected that there would be a second supply as we have been BPON and in GPON. So we do have a strategy to work in an environment where there is a second supplier.

We are first side out of the gate. We have a lot of nodes deployed. These nodes have tremendous capabilities. There is a road map commitment with a lot of packet features and so many of the things that were in the second RFP has already delivered on the first deployment... first platform that's deployed.

So our strategy for '08 and '09 is to look at taking this product, especially the nano configuration, and going into other markets, international markets, other customers, because what's happening with the ROADM is not just the SONET, not just the DWDM, but also Ethernet switching. All these three technologies are converging on one platform. So the opportunities indeed are plentiful. The real challenge is how quickly we get the product into the right markets and how the software has been tailored and customized to meet a particular niche application, and that's exactly what we're focusing on. So it isn’t so much about the one customer who may bring in a second supply. For us, the real opportunities are how quickly we diversify the deployment of this technology.

Simon Leopold - Morgan Keegan

Great, and thank you. And Krish, good luck in whatever your next endeavourers might be.

Krish A. Prabhu - Chief Executive Officer and President

Thank you very much. Thanks, everyone. Thanks for your interest in Tellabs. Tim Wiggins and the new CEO will come back in three months and give you an update. Okay. Thank you.

Operator

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

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Source: Tellabs, Inc. Q4 2007 Earnings Call Transcript
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