Lucent Technologies F1Q06 (Qtr Ending Dec 31, 2005) Earnings Conference Call Transcript (LU)

Jan.25.06 | About: Lucent Technologies (LU)

Lucent Technologies (LU)

Q1 2006 Investor Relations Conference Call

January 24th 2006, 8.30 AM.

Executives:

John DeBono, Vice President of Investor Relation

Patricia Russo, Chairman and Chief Executive Officer

Frank D’Amelio, Chief Operating Officer, Chief Financial Officer

Analysts:

Paul Sagawa, Sanford Bernstein

Alex Henderson, Citigroup

Ehud Gelblum, J.P. Morgan

Scott Coleman, Morgan Stanley

Paul Silverstein, Credit Suisse

Brantely Thompson, Goldman Sachs

Timothy Long, Banc of America

Jiong Shao, Lehman Brothers

Nikos Theodosopoulos, UBS

Paras Bhargava, BMO

Kenneth Muth, Robert W. Baird

Simon Leopold, Morgan Keegan

Brian Modoff, Deutsche Bank

Richard Windsor, Nomura

Operator

Ladies and gentlemen thank you for standing by. Welcome to the Lucent Technologies Investor Relations Conference Call. At this time all participants are in a listen only mode. Later we will conduct a question and answer session. Instructions will be given at that time. If you should require assistance during the call, please press “*” followed by “0”. As a reminder this conference is been recorded. I would now like to turn the conference over to your host John Debono, Vice President of Investor Relation. Please go ahead.

John DeBono, Vice President of Investor Relation

Good morning everyone. With me today are Patricia Russo Lucent’s Chairman and CEO and Frank A. D’Amelio, Chief Operating Officer and Chief Financial Officer. We will begin with Pat and Frank providing an overview of Lucent’s results for the quarter and fiscal, and then we’ll open the call up for your questions. Any one has not yet seen a copy of our earnings release it is available on Lucent’s website. Now, before we begin let me remind everyone that this conference call is open to the media and we are providing a simultaneous webcast of the call for the public. The replay of the call will be available on the company’s website this afternoon; it will run through January 31st. The PDF version of the slide that of a video streaming, along with this call was preposted to our website for your reference. I also want to remind you that today’s remarks also includes some forward looking statements about our plans and our expectations for future performance. The actual results could differ materially from those suggested by our statements today. Additional information about our forward-looking statements and factors that could affect future results, is described in our recent SEC filing including our 10-K, 10-Qs and 8-Ks. Now at this point of I will turn the call the call over to Pat.

Patricia F. Russo, Chairman of the Board and CEO

Thanks John. Good morning everyone thanks for joining us. As we announced earlier today, Lucent reported revenues of 2.05 billion for the first quarter of fiscal 2006 and this compares with 2.43 billion in the previous quarter and 2.34B in the year-ago quarter. Despite this disappointing drop in revenue, we were able to maintain a solid gross margin performance of 42%, due primarily to our continued focus on simplifying our operations and diligently managing our cost structure. On the bottom line, we reported a net loss of 104 million or $0.02 per share for the quarter and this loss includes the charge of 278 million or about $0.06 per share due to the previously disclosed judgment in the Winstar case.

Frank will provide more details on our financial results in just a few minutes, but first, I’d like to provide some context to the revised guidance we issued 11 days ago as well as a little color around what we’re seeing in the market and in our business.

As you know, on January 13th, we announced that while we had previously anticipated annual revenues for fiscal 2006 to increase on a percentage basis in the mid single digits, we now expect annual revenues to be essentially flat or increase in the low single digits for the year. While we are clearly disappointed by having to change our guidance, we do consider this to be a temporary setback to the progress we’ve made and we are confident that our performance will be much stronger for the remainder of the year. Why do I say that? Despite our Q1 revenues, we continue to be encouraged by the opportunities we’re working in the opportunities we’re involved in across our portfolio and around the world and these are opportunities that align with our strengths and the investments we’ve been making.

From a product and services perspective, let’s take a look at them. In wireless, we expect some of our large North American CDMA wireless customers to continue adding network capacity throughout 2006 and as high speed wireless data communications emerges as the key differentiation tool for mobile operators, to start migrating toward EV-DO Rev A later in the year. We also expect several of our other wireless customers in North America to be building out new markets and we’ve announced some of those contracts previously. We expect significant revenue growth in UMTS during second half of the fiscal year as we accelerate our rollout and grow our market share.

In Services, the transformation from legacy to IP networks is driving significant demand for Lucent Worldwide Services as a network integrator. Our strategy of investing in and enhancing our multivendor skills is helping us to capitalize on these opportunities even with customers who don’t have Lucent products in their existing networks. We’re seeing a lot of activity in the Lucent Worldwide Services sales pipeline around network transformation services, which plays to our strengths in transcending traditional outsourcing and managed services. This will enable Lucent to capture more services dollars by offering not just OpEx and CapEx reductions but also quicker to market revenue generating services. In fact, we’ve made significant progress with several yet-to-be-announced customers who will soon launch new revenue generating services that Lucent will host via our global network operation center. We’re continuing to build an annuity of services contracts built upon these transformation capabilities. Just last week, we announced a multiyear agreement to operate and manage the U.S. based network facilities of Pacific Crossing, which owns and operates the trans-Pacific fiber optic cable. And we are engaged in additional annuity opportunities in new services growth markets similar to the nine-year $187 million contract we signed with Capgemini and TXU last year.

In wireline, we continued to see increased interest in our Ethernet services, especially in metropolitan applications and that’s really across all of our customer segments. We’re seeing customers deploy our integrated optical and data solutions to provide the optical transport, Ethernet aggregation and Ethernet switching for the next-generation video distribution applications that are linked to our IPTV solution, converged Ethernet solutions, IMS, and wireless backlog solutions, and in the access space, we expect to see increased IPTV sales to some of our North American customers in second half of the year. In addition to these opportunities, which I’ve characterized more along the product and services segment, we see additional, encouraging signs around the world; you’ve heard me reference several opportunities in North America, let’s look at some of the other regions

In the Caribbean and Latin American region, we expect continued growth across our portfolio of products and services, with both existing and new customers, in particular, we’re encouraged with the progress we’re making with IPTV in that region

In Europe, we’ll see revenue growth from recent contract wins, some of which are announced, some of which are not, and new customers building next-generation networks. We’re also making progress in growing our professional services and network integration business in that region as these and other services capabilities serve as an excellent entry into customers where we have little to no installed base.

In Asia, we expect revenue in Korea, Japan, and India to be stronger in the second half 2006 than in first half and this is based on opportunities we have with both existing and new customers and they are primarily driven by our wireless applications and service offerings.

Looking further ahead, we expect to continue to see our customers invest in the next-generation of networks based on IMS, which play to our leadership position in that space. To date, we’ve announced 7 customers for our IMS portfolio, which we believe is more than anyone in the industry, and we have continue to expand our list of IMS trials with fixed, mobile, and converged customers. In all, we currently have 77 trials underway with now 16 customers. This includes Verizon, which is currently conducting an extensive lab trial of a wide range of elements from our IMS portfolio

Under evaluation in Verizon’s lab are several Lucent offerings, including: Our Session Manager, Our Active PhoneBook, Our MiLife solution, SurePay, Feature Server, Network Gateway, And our VitalSuite Network Performance Management software. Obviously, this represents a considerable opportunity for us and we believe the depth and breadth of our IMS offers, our unique Bell Labs technologies, and the multivendor integration skills and expertise offered by our Services business position us well to help them meet this emerging market need. As we said this the past, IMS is more of a longer-term play in terms of revenue but our early leadership in this space has positioned us well for when we expect revenues to ramp in 2007.

Before I turn it over to Frank, let me close by sharing a few thoughts on his new position. As you know, we recently announced that Frank has been appointed Lucent’s Chief Operating Officer. With our industry undergoing a significant transformation as the boundaries between telecom, media and the Internet worlds continue to blur, I concluded the time was right for us to once again have a Chief Operating Officer responsible for driving growth, operational excellence, and flawless execution across the business. As COO, Frank will be responsible for leading the operations of the business, including sales and product groups, the Services business, the supply chain, IT operations, and labor relations. This will allow me to increase my focus and attention on both Lucent’s longer-term strategic issues and strategic growth opportunities and as well to continue to spend more time with customers

As you know Frank’s leadership as CFO has been vital to Lucent’s turnaround. He has played a significant role in helping guide Lucent through one of the most difficult periods in our industry’s history - named, which I am working as aggressively as possible, and as such, he will now provide details on our first quarter results. Frank?

Frank A. D’Amelio, COO and CFO

Thanks, - always, the charts I will be reviewing today are included in our webcast. With that, let me get to our financials.

Today, we reported revenues for first quarter of fiscal 2006, 2.05 billion, a decrease of 16% sequentially and a decrease of 12% compared to the year-ago quarter

Sequentially, revenues in the U.S. decreased 11% to 1.34 billion while international revenues decreased 23% to 704million. This resulted in a geographic mix of 66% in the U.S. and 34% outside the U.S. We reported a net loss of 104million or $0.02 per share. These results compare with net income of 372 million or $0.07 per diluted share in fourth quarter fiscal 2005.

The first quarter’s loss included a charge of 278 million or about $0.06 per share due to a Bankruptcy Court judgment relating to litigation between Lucent and the trustee for Winstar Communications. This judgment is being appealed to the U.S. District Court for the District of Delaware. You’ll note that the basic and diluted share count as of December 31st was the same, and about at about 4.5 billion shares.

Since we reported a net loss, there was no dilutive effect of stock options, warrants, and convertible securities on our share count. The gross margin rate for first quarter was 42% of revenues compared to 46% in fourth quarter. The sequential decrease was due largely for lower volume as fixed costs were spread over a lower revenue base. The fiscal 2006, we continue to expect to generate an annual gross margin rate of 41 to 43%. Operating expenses for first quarter fiscal 2006 were 940 million, an increase of 130 million sequentially. Before getting into details on operating expenses, let me point out the following.

Our net pension and postretirement benefit credit for first quarter was 104 million, down $81 million compared to the prior quarter. The net credit includes a gross pension benefit of 167 million and a cost of 63 million for postretirement benefits, which is primarily retiree healthcare. Consistent with prior periods, about two-thirds of this amount is reflected in operating expenses and the remainder impacts our gross margin. We continue to expect our annual net pension and postretirement benefit credit to decrease by approximately $300 million during fiscal ‘06 from the 718 million in fiscal year 2005.

In addition, other income in first quarter of fiscal 2006 included a $33 million minority interest credit related to a reduction in the profit from one of our joint ventures. And in first quarter, we recognized $16 million of income taxes, primarily attributed to non-U.S. earnings. U.S. deferred income taxes were not recognized during the quarter due to the U.S. pre-tax loss, resulting primarily from the Winstar charge. We continue to expect to recognize tax expense of approximately $170 million in FY 2006 with approximately 100 million for U.S. deferred taxes, most of that expense is now expected to be recognized in second half the fiscal year.

Now back to operating expenses. The first quarter’s operating expenses included litigation charges of $283 million, related almost exclusively to the Winstar charge. The fourth quarter results included 71 million of charges resulting from the settlement of several litigation matters. Sequentially, all other SG&A decreased by 43 million to 380 million, due largely to lower accruals from employee incentive awards and cost control efforts across the business. R&D of 280 million, $283 million reflects a 36 million sequential decline related largely to lower mobility trial expenses, lower accruals from employee incentive awards, and deficiencies gained as a result of actions taken across the business. The SG&A and R&D expense declines more than offset the sequential decline in the net pension credit. In first quarter, we recognized 24 million in stock compensation expense compared to 5 million in the prior quarter. The sequential increase was due to the inclusion of stock option expense in accordance with FAS 123(NYSE:R); 21 million was reflected in operating expense and remaining 3 million was reflected in cost. We continue to expect stock compensation expense to be about $100 million for fiscal 2006. Including the $278-million Winstar charge mentioned earlier, we now expect fiscal 2006 operating expenses as a percentage of revenue for E to R to be about 33%

Now, I’ll make some comments on our segment performance. As I mentioned on last quarter’s earnings call, effective with first quarter of fiscal 2006, we are reporting under a new segment structure. Revised historical segment results are available on our website

The prior period segment results were revised to conform to the new reporting structure and to reflect some other changes including the elimination of certain revenue sharing arrangements, the internal transfer of certain organizations, and revised internal allocations of employee benefit rates. Mobility Access and Applications Solutions, which includes CDMA, UMTS. WiMax, and applications, revenues for first quarter were 945 million, a decrease of 139 million or 13% sequentially

U.S. revenues declined by 6%, driven primarily by lower sales of application products, Non-U.S. revenues decreased by 33%, due primarily to lower CDMA sales in China, and delay of 3G license awards in China could continue to have a negative impact on future network deployments in that country. Segment income for first quarter of 317 million decreased $90 million decrease was $90 primarily to a lower gross margin, which was partially offset by lower expenses. The lower gross margin was due primarily to lower sales volume and the favorable impact in the prior quarter of revised estimates to long-term contracts. The lower expenses were due in large part to the inclusion in the prior quarter of higher R&D expenses related to product trials and continuing efforts to reduce spending. Going forward, we now expect fiscal 2006 annual revenues for the Mobility Access and Applications Solutions segment to be essentially flat for the year

First quarter revenues for Multimedia Network Solutions, which includes optical, data, and access networking, were 395 million, a decrease of 75 million or 16% sequentially. U.S. and non-U.S. revenues decreased 17 and 15% respectively compared to fourth quarter.

The declines were due primarily to $60-million decline in optical sales, which were particularly strong in fourth quarter. Segment income of 45 million decreased by 48 million sequentially, driven primarily by a lower gross margin which was offset somewhat by a slight decrease in expenses. The lower gross margin was due primarily to lower volume and an unfavorable product mix. For Converged Core Solutions, which includes both legacy voice and next-gen next-generation IMS/VoIP core products, revenues for first quarter were 145 million145 million, a sequential decrease of 91 million or 39%. U.S. revenues decreased 37%, due largely to a decline of sales of legacy voice products. Non-U.S. revenues decreased 40%, due primarily to lower sales of PHS products in China. Circuit switching and PHS revenues in first quarter declined 72 million sequentially and accounted for approximately 50 and 20% of total Converged Core revenues respectively.

Segment income decreased by 16 million sequentially, resulting in a breakeven performance. The decline was due primarily to a lower gross margin, which more than offset slight decrease in expenses. The lower gross margin was due primarily to considerably lower volume. For fiscal 2006, we now expect annual revenues for the combined Multimedia Network and Converged Core segments to be down somewhat y-over-year.

For the Services segment, which includes maintenance, deployment, and network transformation services such as professional and managed services as well as network operations software, revenues were 540 million in first quarter, a decrease of 53 million or 9% sequentially. The sequential decrease was driven primarily by a decline in revenue related to professional and maintenance services, which offset an increase in deployment services revenue related to a large U.S. network deployment.

On a sequential basis, U.S. revenues decreased 6% to 322 million and non-U.S. revenues decreased 13% to 218 million. Sequentially, segment income of 89 million decreased by 15 million, due primarily to a lower gross margin, which offset a decrease in expenses. The lower gross margin was due largely to lower volume and an unfavorable services mix. The expense decrease was driven primarily by efficiencies related to the integration of the network operations software business. Going forward, for fiscal year 2006, we now expect revenues for the Services segment to grow at or slightly below 10% year-over-year.

During Q4, we used 523 million in cash for operating activities, due primarily to the payment of fiscal 2005 employee incentive awards into a lesser extent an increase in working capital. Cash generated from operating activities in the prior quarter was approximately $1 billion, including a 902 million federal income tax refund. Capital spending, which includes internally user software, decreased by 46 million to 30 million in first quarter. We continue to expect capital spending to fiscal 2006 to remain relatively consistent with the fiscal 2005 level.

During Q1, we funded approximately 59 million in retiree healthcare and other postretirement benefits out of operating cash. Going forward, for fiscal 2006, we expect operating cash funding requirements for retiree healthcare and other postretirement benefits to be about $250 million. The U.S. pension plans meet the requirements of ERISA’s funding rules, and we do not expect to make any contributions to the qualified U.S. pension plans through fiscal 2007. In addition, in January ‘06 we will use about 300 million in cash to collateralize a financial instrument to be issued in connection with the Winstar judgment.

Now, some details on working capital. Inventory turns decreased from 7.2 to 6.2. DSOs increased from 52 to 63 days. Going forward, we continue to expect a normalized level for DSOs of about 60 days, and our headcount at December 31st, 2005, was approximately 30,200, a decline of about 300 from September 30th, 2005. This reflects a decline of almost 600 in the U.S. and adds of almost 300 in non-U.S. regions. Now to the balance sheet

As of December 31st, 2005, Lucent had cash and marketable securities of about 4.4 billion compared with about 4.9 billion on September the 30th, 2005. The sequential decrease was driven largely by cash used in operating activities. Total debt and convertible securities remained relatively flat in first quarter at 5.4 billion, and our net debt position increased by 533 million to approximately $1 billion. From a maturity perspective, our debt portfolio continues to remain relatively long dated. As of December the 31st, 2005, about 80% of our public debt, convertible securities mature in or after 2010 assuming the 8% convertible security is put back to us. Now I will turn I back to John DeBono

John DeBono Vice President of Investor Relation

We are now ready to begin the Q&A session. In order to allow us to respond to many questions as we can during our call, we ask that you limit yourself to one single part question. As soon as you’ve finished asking the question, you’ll be removed from the queue.

Operator, can we have the first question please?

Question-and-Answer Session

Operator

Ladies and gentlemen, if you wish to ask a question, please press “*” “1” on your touchtone phone, you may remove yourself from queue at anytime by pressing the “*” “2” key. If you are using a speaker phone, please pickup the handset before pressing the numbers.

The first question is from Paul Sagawa with Sanford Bernstein.

Q - Paul Sagawa

Thank you very much.

A - Frank D’Amelio

Good morning Paul.

Q - Paul Sagawa

Good morning. If we look in a bit to the Mobility numbers, noted that the US application sales were is, are EV-DO upgrades, largely application definitions that you laid out or is it more specific, software, thing like push to talk or e-billing or whatever? The second piece of that, is in the numbers, have you now begun recognizing revenue from the Cingular, and would you expect aftermath in that customer revenue stream in future quarters?

A - Frank D’Amelio

Paul, this is Frank, by the way, you were fading in and out, but I think I heard the questions, so let me answer them and hopefully I heard them correctly. So first in terms of, you mentioned applications with mobility. In my comments, I said that in the US mobility revenues were down quarter over quarter, sequentially by 6%, and essentially all of that was a decline in application product sales, not mobility product sales, and internationally mobility was down 33% quarter over quarter and that really was due to the decline in CDMA sales in China. Now to your specific questions, when we talk about applications and then relate that to EV-DO sales, the EV-DO sales are really mobility product sales, they really don’t have a material impact at all on the application numbers. So I think that was your first question. And I believe your second question was ‘Frank, are you guys beginning to book revenue on the Cingular contract?’, we typically don’t call out revenues by individual customer or contract or product. However, we did book revenues to that contract this quarter, and we do expect as a company our UMTS revenues to increase significantly in second half of the year.

A - John DeBono

Next question please

Operator

Your next question is from Alex Henderson, with Citigroup.

Q - Alexander Henderson

Great thank you very much.

A - Frank D’Amelio

Good morning Alex.

Q - Alexander Henderson

Good morning, congratulations, by the way on your promotion.

A - Frank D’Amelio

Thank you, Alex.

Q - Alexander Henderson

So a couple of questions on your guidance there, when you talked about the weakness in China, can you give us some sense of whether you’re further pushing out your assumptions on the timing of the Chinese licenses impacting your business further out into the back half of the year, and what your thoughts are in terms of the timing of that? And then the second one is, given the steepness of the decline here in revenues in first quarter, what is it that’s giving you the confidence in that rebounding quickly enough to get you back to a flat to up slightly revenue guidance. I am not sure I followed, the timeline there very clearly?

A - Frank D’Amelio

Okay. Let me do this. Let me hit the second question first in terms of a Frank, given the absolute revenue number in Q1, why do you guys feel confident about the remainder of the fiscal year and the guidance we provided? And then we will come back to, because that’s the bigger question, then we will come back to the timing issue around China with the licenses. So we see lots of encouraging signs right now in our business, across our product portfolio and across our regions. So let me just kind of rip through some of them, give you, for some of the things we’re seeing, not to be, they’re not meant to be all inclusive but they’ll give you kind of a flavor to the various things we see. So first in an area like wireless, we see our large US CDMA customers continuing to add network capacity throughout fiscal year 2006. So that’s one thing. We see our other US wireless customers continuing to build out new cities. As I mentioned in my comments to Paul, we expect our UMTS revenues to increase significantly in second half of the year. If you look at an area like services, right now we’re seeing substantial activity in our sales pipeline there. Now obviously our job is to convert that into contract wins, we see substantial activity there. We’re seeing lots of opportunities for annuity service business similar to the nine-year $187 million contract we announced last fiscal year with Capgemini Energy-TXU, and In fact recently we announced a managed service deal with Pacific Crossing to operate and manage their network. If you look at optical, we are seeing lots of increased interest in Ethernet over optical services particularly in metropolitan applications and once again our job is to take those opportunities and convert them into contract awards. We’re seeing increased interest in IPTV and we’re seeing lots of opportunities across all of our regions, whether it’s CALA, EMEA, Asia. So it’s based on all those things and all the things we always talk to you all about, right? Looking at our sales model, talking to our customers, understanding their CapEx spend, it’s all of those things in combination that really we take into account before we make the statements we may including the statement around our confidence remainder of the fiscal year. So that’s the answer to your second question. In terms of the question on China, we are not assuming, I’ll call it any positive material impact, on our revenues in fiscal year 2006 resulting from the issuance of those new licenses. So that’s how I would answer the question.

A - John DeBono

Next question please.

Operator

The next question is from Ehud Gelblum with J.P. Morgan.

Q - Ehud Gelblum

Hi good morning. Thank you.

A - Frank D’Amelio

Good morning.

Q - Ehud Gelblum

Hey, and Frank I do have to congratulate you on your promotion as well.

A - Frank D’Amelio

Thank you, Huddy.

Q - Ehud Gelblum

If I can, my question is to dig a little bit deeper into the revenue and the gross margin, because the gross margin actually was quite impressive I thought given the revenue shortfall. If I can clarify from that previous question it sounded like the revenue, your confidence going forward is coming more from the revenue opportunities you’re seeing as opposed to recovering the revenue shortfall from this quarter. So I just want to first of all confirm that what happened this quarter was not necessarily revenue recognition issue with percent of completion but more had to do with simply lost share, lost revenue, lost opportunity that you expect to make up going forward in new opportunities as opposed to recovering this. And my, that was a confirmation, but my real question has more to do with the gross margin. It seems like that it didn’t fall as much as I thought it would have, and it sounds like you, or it looks as though you have a very nice control on the variable cost structure on your revenue now so that it’s not a fixed cost structure, does that have something to do with percent of completion and the fact that more of your contracts are now under percent of completion from the change you made and the accounting change last year and so therefore can we see a more stable gross margin going forward because of that?

A - Frank D’Amelio

I understand the questions. So let me comment on each one. First on the revenue, let me see if I can come at this. In terms of the revenue, I think what happened is we clearly thought we were going to have a bigger Q1 revenue number, we clearly thought the number would be higher. But remember the rhythm of our revenues in the business, right. Most of our revenue is recorded in the last month of a quarter, and then most of that revenue is recorded in the last 2 weeks of a quarter. So clearly the revenue we recorded in the last month and last 2 weeks was lower than we expected, kind of point one. And so you say well why, Frank? Why was it lower than we expected? And there is a couple things. One is we didn’t see some of the calendar yearend spend from our customers that we’ve seen in the past, in fact in certain instances we actually saw it pull back.

A - Patricia Russo

Right. So there was no, we saw no capital flush and in fact actually saw a tightening up very late in December.

A - Frank D’Amelio

So we didn’t see any of that which really from my perspective, once you don’t see that at the end of the calendar well then those CapEx budgets are gone, right the calendar year for our customer ends, those CapEx budgets are now completed and then we go into a new calendar year from a customer perspective with new budgets. So those are dollars that basically weren’t spent or we didn’t get and therefore you don’t get them back because those budgets are gone. And so now what we are doing is we are working into the New Year’s calendar budgets, calendar CapEx budgets for our customers. Then in terms of POC, POC by the way today is give or take about 25% of our revenues, but no, I would not be, use that as kind of an explanation for what happened with the gross margin quarter-to-quarter. Let me talk about what happened with the margin quarter-to-quarter. And I’ll talk about some of the commentary specific to the margin being in the low 40s, despite the decline in revenue. What really happened quarter-over-quarter with the decline was primarily a volume issue, which I alluded to? We are down 4 points quarter over quarter, most of that the majority of that is really driven by the lower volume. There’s some onesies here and there, some other onesies in terms of a plus point or minus a point but the big attribution quarter-over-quarter is really driven by the lower volume level. And then in terms of the margin itself, remember, early, when we had our Analyst Day back in the fall, we have a lot coming at us this year in terms of earnings, right? We’ve got the pension credits down 300 million, we’ve got tax, we’ve got compensation expense per FAS 123(R) of another 100 million, we have got the U.S deferred taxes that we called out of 100 million. So we’ve been all over all of our spending, COGS, expense, all of it. Quite frankly, we’re always all over it but we’ve been acutely all over it since the fall, knowing we’ve had these issues coming at us and I think what we’re seeing in the quarter is really much of the benefit of the work we’ve been doing in those areas, that’s showing through in the results. So that’s how I’d answer the question, it isn’t from my perspective, the POC accounting.

A - John DeBono

Next question please.

Operator

The next question is from Scott Coleman with Morgan Stanley.

A - Frank D’Amelio

Good morning Scott.

Q - Scott Coleman

Good morning, thank you. I have a question on profitability both near-term and long-term. As you look out over the rest of this year, you gave us I think some good points on your revenue growth, gross margin. As Services and Mobility trade positions in terms of leading growth, what do you expect for profitability trends over the next, over the rest of this year? And then second, Pat, to go to your comment on IMS growth taking off in 2007, what’s your expected impact on the business model as IMS and applications grow from a margin and expense standpoint?

A - Frank D’Amelio

So I’ll hit the profitability trends question. So Scott, in terms of profitability trends, I think the way I’ll answer that is based on the guidance that I provided for the year, because we don’t get into quarterly guidance numbers. What I said is we continue to expect our annual gross margin rate to be 41 to 43%. And I said given the $278 million legal charge we recorded this quarter, we now expect annual operating expenses as a percentage of revenue to be about 33%. So you can work the 41 to 43 less, the about 33% for ER and that gives you kind of an operating margin range from a profitability perspective.

A - Patricia Russo

Yeah. And Scott, with respect to IMS, couple of things I would just point out. We believe we’ll start to see a ramp of revenues associated with the IMS contracts with the portfolio, as customers really start to deploy these new services on these new platforms. From a margin and a profitability standpoint, there are many elements underneath this umbrella of IMS, right? You’ve got gateways, you’ve got elements that are strictly software, you’ve got application servers where there’s a software element, so I would say, I would answer your question in the following way. Number one, we’re very comfortable with the, with the aggregate margin of the IMS portfolio when you take the entire mix and believe that we will be able to continue to be in the range of the margin guidance we have provided as that really starts to ramp. So, we feel pretty good about the margin potential in the IMS space.

A - John DeBono

Next question please.

Operator

The next question is from Paul Silverstein with Credit Suisse.

A - Frank D’Amelio

Good morning Paul.

Q - Paul Silverstein

Good morning Frank, good morning Pat. I wasn’t sure on Don’s comment about the multi-part, do they have to be related to each other on the questions? So much for my humor, A couple of questions for you.

A - Frank D’Amelio

Paul, I’m sorry. I didn’t get it initially I’m sorry.

Q - Paul Silverstein

You know what, my wife doesn’t understand my humor either.

A - Patricia Russo

Sorry Paul, we got it now.

Q - Paul Silverstein

It’s all right, my wife doesn’t understand it either. Pat, if I may, your Verizon IMS comment, I’m not sure I understood, is Verizon, have you already signed up for IMS, or is that in trials? Your Services comment on the guidance. Can you refresh my memory what the guidance was for Services previously? And finally, on your Rev A timing comment. I think Len Lauer yesterday or last week at a conference made the statement that they’re projecting Rev A in ‘07, ‘08 timeframe, so I just wanted to reconcile your comment about the Rev A rollouts with what I thought I understood to be his comment, and finally why no budget flush?

A - Patricia Russo

Okay. So let’s go to the, let’s see, the first, let me comment on your first question. I got them all down here. Number one, what we said with respect to Verizon was that we are in trials with Verizon, okay. And so as you all know, the process here is a process of you get into trials, things get tested, customers evaluate, they then decide, etcetera. So the stage we are in and what we said with respect to Verizon is they are trialing many elements of our IMS portfolio, we’re very pleased with that, and we consider that to be a very important opportunity. With respect to, the second question was regarding Services, go ahead Frank.

A - Frank D’Amelio

Yeah, Paul, the previous guidance we gave on Services was that the revenue would grow at or slightly above a 10% growth rate. This time we said the revenue would grow at or slightly below a 10% growth rate. And that’s a year-over-year growth rate, so ’06 to ’05.

A - Patricia Russo

With respect to the capital flush, Paul, I’m not sure I can answer why, because you’d have to almost go customer by customer. But as Frank noted, we often see at the end of the calendar year some capital flush roll through, and in this particular quarter, we didn’t really see that anywhere, and in fact in a number of cases actually saw a pulling back very late in the quarter with respect to business moving through, and therefore, in some cases obviously that spending not occurring, and in other cases some moving into this quarter. With respect to EV-DO Rev A, what we’ve said is we expect the availability of Rev A late in ‘06, and we expect to see some of that fall into our business, but we haven’t commented on a customer by customer basis. So there’s not necessarily an inconsistency in what you heard and our view of the opportunity late in the year for Rev A to have some positive impact on the business.

A - Frank D’Amelio

And Rev A for CDMA and obviously HSDPA for UMTS.

A - John DeBono

Next question please.

Operator

The next question is from Brantely Thompson with Goldman Sachs

A - Frank D’Amelio

Good morning Brant.

Q - Brantley Thompson

Hey Frank. Listen I was wondering if you could give us a little, some more comments on your second half year confidence and how much are you counting on it to come from new wins versus existing business that’s been won. One of the things that this quarter’s miss highlighted is that you’ve got, you already have a high-level of customer concentration, fairly close relationships with these guys and it was a pretty big miss that we didn’t see coming. So, as we look out into SECOND HALF, kind of what gives you confidence and how much is that going to be on new wins? Because you highlighted a lot of new opportunities, I just want to know kind of what we’re betting on that’s still on the come.

A - Frank D’Amelio

So I think the way I’ll answer this is as always it’s a combination, right? I mean it’s clearly a combination of business to be won and existing business. And I’m going to elaborate a little bit. But for example, we make a statement around we expect UMTS revenues to increase significantly in second half of the year. That’s really for the most part existing business and then expanding on that existing business. So, we’ve lots of opportunities to expand existing business with existing customers, point one. Point two, remember in our business, even when you win contracts, you then have to get the orders to fill on those contracts and book revenue. And then, when you do POC accounting just because you do POC accounting doesn’t automatically mean you book revenue, right? You’ve got to get orders, you’ve got to ship, you’ve got to meet operational milestones, you have to get acceptance and then after you do those kinds of things, you’re able to book revenue. So we have lots of opportunities in the business going forward for the remainder of the year where I’ll call it what existing customers, existing business, significant opportunities to grow that revenue for the remainder of the fiscal year and then obviously we want to add to that, supplement that with new business, new awards, so, to help with the financial performance. Remember, this is an industry, though, where sales cycles are fairly long. So, you’re not, once you get into January, almost February, you aren’t going to win a whole lot of what I’ll call new business, new customers and see that impact the fiscal year results, in any real material way when you look at the annual numbers. Most of the business has to come from existing customers, and then existing and new contracts. I think that’s how I would answer it. Pat, do you want to?

A - Patricia Russo

Yeah. No, I think the categories Frank described is right, we have some announced wins where we haven’t really recorded much revenue at all yet and we’ve got orders, and we know it’s going to flow as we move through the year. Frank mentioned an example, there are other examples of contracts we have announced. There are contracts, there is business we have won that we have not yet announced, simply because we haven’t finalized a few things and the customers haven’t been ready and therefore we know from a demand standpoint that there will be a requirement for us to deliver and therefore we’ll book revenue in ‘06. And so there’s those kinds of categories, and then thirdly, things that we are expecting that are on a shorter sales cycle and it’s a matter of factoring your sales funnel and your opportunity funnel and your win rate and your expectations about what you believe you’re going to deliver, which is contributed to by the product unit views and the sales team’s views. So it’s really those categories, when you put it all together that cause us to say what we say about what we think is going to happen for the rest of the year.

A - John DeBono

Next question please.

Operator

The next question is from Timothy Long with Banc of America.

A - Frank D’Amelio

Good morning Tim.

Q - Timothy Long

Good morning, thanks, two quick ones if I could. First, if you could just talk a little bit about India. I think that was one of the areas where Pat had talked about some better growth in second half. Obviously, that’s been a market where it’s been a little tougher pricing environment. Just give us your thoughts on pricing there and whether or not with the, now that we’re much into follow on contracts rather than initial contracts, if we’re seeing any better pricing or margin performance on those contracts? And then secondly, the WCDMA share gain comment, I think this might have been asked some way, share gains in second half, and over the next year, are we talking mostly Cingular there to drive those share gains, or are we talking some potential other contracts and where geographically might we look for some of those other WCDMA wins?

A - Frank D’Amelio

Yeah, so, let me answer the second question first, on the CDMA question, I think the way I’ll answer that is the statement around revenues in second half of the year being increasing significantly, that’s with existing customers. That’s the assumption underneath those revenues. And then obviously, we’re working on other opportunities. But that statement is based on existing customers. And then in terms of India, we still see the pricing environment there as extremely challenging. And what we’re trying to do is win business, but win business in, I call it, the right way. And so we’re being prudent in terms of what we’re doing there, we’re trying to win business we’re trying to win it the right way and what we’re not going to do is sign business with big contract losses. And we haven’t done that. That clearly by the way, can have an adverse impact on revenue. But a positive impact on profitability and cash flow and our bias is profitability and cash flow. So where there’s really difficult pricing challenging pricing we’re walking away from that business.

A - John DeBono

Next question please.

Operator

Your next question is from Jiong Shao with Lehman Brothers.

A - Frank D’Amelio

Good morning Jiong.

Q - Jiong Shao

Good morning, Frank. Thank you very much. I have a quick clarification first and a question. Frank, I think you mentioned a 33% OpEx as percentage of the revenue. I want to make sure, is that for the entire year or that’s a number we should look at when you exit fiscal year 2006. And my question is a follow up question on WCDMA, I know other than Cingular and you have in the past talked about E access in Japan. I was wondering do you have any other trials you can talk about give us a little bit more color in terms of your position in the WCDMA for the next couple of years?

A - Frank D’Amelio

Yeah, so the 33%, by the way, you heard that absolutely correctly. That’s the fiscal year ‘06 guidance statement. So that’s annual operating expenses as a percentage of revenue will be about 33%, and remember that includes $278 million charge we reported this quarter for the Winstar case. In terms of some other UMTS/W-CDMA trials we could talk about, one we always mention is kind of what we’ve got going on with the Chinese Ministry of Information Industries, we are conducting a trial now with China Netcom in Shanghai on our UMTS capability. So that’s clearly a trial we’re working on we’re working with field testing and that’s clearly a major area of opportunity for us going forward.

A - Patricia Russo

And I would just add to that, we also have a couple of trials of our base station router which plays into the UMTS network that we’re working as well. And obviously when it relates to Wideband CDMA we’re also participating in bidding on opportunities for the core network and the IMS network. So, there’s the RAN, there’s the RAN piece of Wideband CDMA and then there’s other aspects of the Wideband CDMA networks which we’re also focused on, as we seek to try to enter into these networks where we were not participating in the first round, in addition to what Frank said.

A - John DeBono

Next question please. Operator next question.

Operator

Your next question is from Nikos Theodosopoulos with UBS

A - Frank D’Amelio

Good morning Nikos.

Q - Nikos Theodosopoulos

Good morning, just a couple of quick questions.

A - Frank D’Amelio

Sure.

Q - Nikos Theodosopoulos

On the, on the accruals for the incentives, I believe last year the company paid $350 million in year-end incentives that were accrued throughout the year and paid this quarter. Given the new guidance that you have which is lower than when you entered the year, these incentive accruals are already showing up in your OpEx being lower, if you hit your guidance, Frank, what do you think these employee incentive payments would be? So that would be the first question. And then the second question very quickly on the CapEx budget flush was your comments there US specific or more global in nature that you didn’t see the year-end budget flush you normally see?

A - Frank D’Amelio

All right, I’ll let Pat, Pat will handle the budget flush question. Let me handle the accrual question. So, first, Nikos, in terms, in terms of the accounting and then the cash you’ve got it spot on right. So what we do is every quarter, we book a compensation accrual during the fiscal year and then we pay it out in the first fiscal quarter of the following year. So for example for fiscal year ’05 we’ve booked accruals in each quarter and based on achievement of an internal plan. And then the cash was paid in December of 2005. So in the first fiscal quarter of the following year which is first Q1 of fiscal year ’06, this past December we paid out all in 450 million, in employee incentive awards it was our short-term awards plus our long-term awards so it was all in 450 million and that’s really for example what drove the cash used in operating activities. It was 523; the bulk of it was that item. And that’s number one. In terms of the accruals, and relating that to operating expense, our comp accruals this quarter were lower than our comp accruals last quarter. So you know if you look at our OpEx quarter-to-quarter, on a GAAP basis it was 940 million this quarter it was 810 million last quarter and then I called out litigation charges that were included in each of those numbers, right? It was give or take about 70 million in Q4, and this quarter 280 million just around the numbers if you were to subtract those numbers from the GAAP numbers you get 740 for last quarter and about 660 for this quarter and give or take about half of that, half of that, is a result of the lower compensation accruals, which is what I think you’re asking me. In terms of our employees and what could they expect for the year, clearly we need to complete the fiscal year determine what our performance is versus our internal plan and that’s what will drive the accounting. But based on first quarter, the payouts will clearly be lower than they were in fiscal year ‘05. That’s how I would answer the accrual question. Pat?

A - Patricia Russo

Yeah. Nikos, regarding the budget flush, obviously capital budget availability late in the year has tended to be more present and visible to us obviously in North America simply because of the mix of the business. But I would answer your question in a way that says we really didn’t see any budget flush anywhere and certainly did not see that in the US, in the customer stats that make up our business. So I didn’t see anything dramatically different, globally from the US, but obviously given the amount of business we do in the US, that’s where we’ve tended to see the impact of what happens when there’s a capital flush at the end of the year, and we just didn’t, we just flat out didn’t see it.

A - John DeBono

Next question please.

Operator

Your next question is from Paras Bhargava with BMO.

A - Frank D’Amelio

Good morning.

Q - Paras Bhargava

Good morning, just a follow-up on the budget flush question, do you think that the lack of a budget flush this quarter typically I mean there is, people set a budget, CFO sets a budget, the engineers spend all they can towards the end, do you think this implies anything for CapEx targets? I know Verizon said some things but a lot of people haven’t actually come out with formal CapEx and CapEx guidance? Do you think this implies anything for 2006, the 2006 market, in terms of CapEx?

A - Patricia Russo

Yeah. Paras, I’ll just give you my opinion and I think each of the large operators always shares what their capital expectations are. No, I wouldn’t take from what we saw or didn’t see last quarter as an indicator of what the capital plans will look like customer by customer. So my answer to your question is no. Not based on anything I’ve heard, not based on any conversations I’ve had, I think it was just simply, what we said, and I wish I had a, a more textured explanation. But there are some years where you see an availability of capital late in the year; this wasn’t, this wasn’t one of them.

A - Frank D’Amelio

At least not for us.

A - Patricia Russo

Yeah at least not for us by the way, I can’t, obviously I can’t speak for others. But for us in the markets where we are, we just didn’t see it

A - John DeBono

Next question please.

Operator

Your next question is from Ken Muth with Robert W. Baird.

A - Frank D’Amelio

Good morning Ken.

Q - Kenneth Muth

Good morning. Is your new Multimedia Access Platform commercially available today? And if so, you mentioned earlier your IPTV, how many trials are you in?

A - Frank D’Amelio

So in terms of the Multimedia Access Platform, our MMAP, let me just spend a minute or two on the product and then I’ll talk about the availability of it and then I think Pat will talk about IPTV. In terms of the MMA, it’s, it supports DSL, fiber to the home or premise and WiMAX, and it supports all of it in a single frame. So kind of a very integrated, very dense network element that we think has the potential to be very successful in the marketplace. We expect to do some I’ll call it trialing and controlled introduction of that later on second half of the fiscal year, with general availability early in fiscal year ’07. So that’s kind of the timeline for that product.

A - Patricia Russo

But we’ll have a controlled introduction available in the second calendar quarter.

A - Frank D’Amelio

Which is second half the year?

A - Patricia Russo

Yeah second half of our year.

A - Frank D’Amelio

Right, second half of our fiscal year right.

Q - Kenneth Muth

Okay and then you know…

A - Frank D’Amelio

I was talking FY

A - Patricia Russo

Yeah. Sorry. I’m sorry, go ahead.

A - Frank D’Amelio

Then maybe you could just talk about IPTV.

A - Patricia Russo

Yeah, our participation in IPTV shows up in a couple of ways and obviously some of these we’ve announced and talked about publicly like with Bell Canada and with Telefonica, and others we haven’t. So we are participating in IPTV rollout utilizing our Access Platform and doing the integration work for customers in some cases. We are participating in some areas, especially in Latin America, as the network integrator for IPTV rollouts but not necessarily utilizing the Lucent Access Platform. So we continue to see good opportunities there, even where we’re not participating in the product, on the product side of the access front. And we have some trials underway; I would say a handful that we have not announced for our IPTV solution as well in North America and in the Caribbean-Latin American region.

A - John DeBono

Next question please.

Operator

Your next question is from, Simon Leopold with Morgan Keegan

A - Frank D’Amelio

Good morning Simon.

Q - Simon Leopold

Good morning Frank. Thank you. I wanted to ask a question to look at the issue of revenue recognition policy. I will ask it very explicitly and hopefully you’ll give us as much detail as you can. But I guess what I’m looking for specifically is, is there a change or difference in your revenue recognition in the Cingular UMTS project versus the Verizon work. My assumption has been that Verizon, you’re recognizing revenue of shipments of base stations and equipment, and Cingular, there’s some other terms and conditions. So if you could speak to that point.

A - Frank D’Amelio

Yeah. So we don’t comment, I don’t comment on individual revenue recognition by contract. But I think the way I’ll answer the question and it should get at your question is in two ways. First, we have not had any, I’ll call it, revenue recognition changes in the quarter that in any way would have changed the rhythm of the numbers. I think that would be the first thing and then the second thing, in terms of specific POC accounting, we did not have any POC accounting changes within the quarter, once again, that weren’t expected or, we didn’t have any changes, so therefore, there wasn’t anything that wasn’t expected and that didn’t have any impact on the revenue numbers one way or the other. I think that’s how I’ll answer the question.

A - John DeBono

Next question please.

Operator

Your next question is from Brian Modoff with Deutsche Bank.

Q - Brian Modoff

Yeah. A couple questions for you. One, Pat, can you quantify what an IMS contract would look like and give us an idea what the size of one of these contracts would be? And then secondly, can you talk about the number of UMTS trials that you have ongoing or how many UMTS opportunities you see this year, like, can you perhaps talk about eAccess company you’ve talked about in the past? How are things going with that company?

A - Frank D’Amelio

So first on the IMS contracts today in the trials, the way I describe this, Brian, is today there are, I’ll call it, smaller opportunities. They’re tens of millions, they’re not big, three-digit contracts. From my perspective, what we’re seeing now is almost an appetizer and then the entrees are to come. So there’s a lot of dabbling still going on. It’s still very much in the learning curve mode. It’s clearly a critical element to next-generation networks service enabling, leveraging tunes and gaming and music and content and all those kinds of things, but today the contracts are relatively small. But I, but that would, what’s good about that is the big contracts are to come. And the rhythm of it is very consistent with what we’ve seen in new introductions of this magnitude in the past where the contracts initially are smaller and then they get bigger as we go along.

A - Patricia Russo

Yeah, the other thing I would add to that is when you think about IMS contracts, there are, there is the hardware and software elements of those as Frank points out in tens of millions. And then there’s the whole integration services opportunity set, which is much larger than our traditional service opportunity associated with any hardware sales. So it’s a very different construct of opportunity for us. That is why we always say you can’t just look at gateways in an applications server, but you have to look at what does being in an IMS network for your customers bring you with respect to other applications and services that connect to it and as well the services element. So as Frank noted, most of these deals are at, are defined as what I call the early stages as customers start to deploy the service and then we are working with them on migrating. I mean, their goal by the way is to get out of their legacy networks on to all-IP networks and they won’t be finished until they’re totally off the legacy and on to the IP. So these contracts we expect form the, as Frank called it, the appetizer but it’s a foundation for growth as the transition from legacy to IP occurs, as the services get proved in, and we see not only the hardware and software opportunity but we see lots of services opportunity with it. Okay.

A - Frank D’Amelio

And then, Brian, your second question was on the UMTS trials or opportunities we currently see. Right now, we are working opportunities in several places; I mentioned China earlier on the call, other places in Asia and Europe, Western and Eastern Europe relative to opportunities we’re currently working. And the other thing we need to do is where we do have business we want to expand. And we want to delight our customers and expand our existing business. So those are the things we are working on.

A - John DeBono

Operator we have time for one last question.

Operator

Your last question is from Richard Windsor with Nomura

A - Frank D’Amelio

Good morning Richard.

Q - Richard Windsor

Good afternoon Frank. Just a quick one really, you effectively seemed to have moved your Services guidance down a little bit. I was wondering if you could talk to why you’ve changed that guidance because we are generally under the impression that Services was the engine of growth this year.

A - Frank D’Amelio

Yeah. So one, you’re absolutely right. The guidance does move down slightly but still a healthy growth rate. If you look at what we said, we expect Services to grow at or slightly below 10% so a healthy growth rate. And in terms of why we changed our overall guidance including Services, quite frankly it was the low Q1 number. If you look at Q1 number, we would, 2.05 billion, Services was 540 million. It was down 9% sequentially and so when we looked at the overall picture, looked the at the elements of the pictures, we thought it was prudent to, based on everything we currently see for the remainder of the fiscal year, to make the revisions that we made to our guidance statements including the Services guidance.

A - Patricia Russo

And I would just add for Richard and everyone, it obviously does not, it’s not intended to imply that we are not aggressively pursuing opportunities to do better than that obviously. But I think Frank’s answer is right on and he will now have the opportunity in his new role to go execute against all of this and I have every expectation he will.

A - Frank D’Amelio

I’m looking forward to it.

A - John DeBono

Thank you both. Frank, I know you have some closing comments to share.

Frank D’Amelio Chief Operating Officer, Chief Financial Officer

Thanks John. Despite the decline in revenue in the first quarter, we are confident that our performance will be much stronger for the remainder of the year. We expect annual revenues for fiscal ’06 on a percentage basis to be essentially flat will increase in the low single digits for the year. Revenues in the second half of the fiscal year are expected to be significantly higher than the first half of the year. We achieve the gross margin rate of 42% for the first quarter and we continue to expect to achieve an annual gross margin rate of 41% to 43%. Our quarterly gross margin rate maybe saw such quarterly fluctuation towards the potential positive or negative impact changes its sales volume levels, products services and geographic mix and competitive pricing pressures and our ability to continue to realize cost reduction. We continue to highly mange expenses including the 278 Winstar charge recorded in the first quarter. We now expect annual operating expenses as a percentage of revenues to be about 33%. And that’s always our focus remains on continually improving performance and creating shareholder value. Thanks for your time and interest today.

A - John DeBono

And thanks to all of you for listening in with us this morning. As always if you have follow up question, please un-hesitate call any member of the Lucent Investor Relations team. Have a good day.

Operator

Ladies and Gentlemen, this conference will be available for replay, starting today at 12.00 PM and running through midnight on January 31. You may access the replay by dialing 1-800-642-1687, international participants may dial 1-706-645-9291, the access code is 3057136. That’s concludes your conference for today thank you for your participation.

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