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Tellabs Inc. (NASDAQ:TLAB)

Q1 FY08 Earnings Call

April 22, 2008, 8:30 AM ET

Executives

Robert W. Pullen - President and CEO

Timothy J. Wiggins - EVP and CFO

Thomas Scottino - Senior Manager, IR

Analysts

Brian Coyne - FBR Capital Markets

Tal Liani - Merrill Lynch

Nikos Theodosopoulos - UBS

Tim Savageaux - Merriman Curhan Ford & Co

Ehud Gelblum - JPMorgan

Todd Koffman - Raymond James

Simon Leopold - Morgan Keegan

Scott Coleman - Morgan Stanley

Andrew Shopick - Nutmeg Securities

Tim Long - Banc of America

Operator

Good morning. My name is Carol, and I will be your conference operator today. At this time, I would like to welcome everyone to the Tellabs Investor 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.

Thomas Scottino - Senior Manager, Investor Relations

Thank you, Carol, and good morning everyone. With me today are Tellabs' President and CEO, Rob Pullen; 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 tellabs.com.

Before we begin, I'd like you to remind you that this presentation contains forward-looking statements about future results, performance or achievements, financial and otherwise. The statements reflect management's current expectations, estimates and assumptions. These forward-looking statements are not guarantees of future performance and involve risks, uncertainties and other factors that may cause Tellabs actual results, performance or achievements to be materially different.

A discussion of the factors that may affect future results is contained in Tellabs most recent SEC filings. The forward-looking statements made in this presentation are being made as of the time and date of the slide presentation. If this presentation is reviewed after the time and date of the slide presentation it may not contain current or accurate information. Tellabs disclaims any obligation to update and revise any forward-looking statements based on new information, future events or otherwise.

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

With that said, I will turn the call over to Rob.

Robert W. Pullen - President and Chief Executive Officer

Thank you, Tom and good morning everyone. It's great to have a chance to talk with you today. While I know many of you, some for quite a while, this is my first chance to really talk to you as the President and CEO of Tellabs. Before we get into the discussion of our first quarter results I wanted to share with you; one some observation from my first weeks on the job and two, our vision for Tellabs as we move forward.

In my first days as President and CEO, I've taken some time to listen to customers, employees and a couple of themes clearly emerge from those discussions, even though I am a little tired from my travels around the world. But a couple of themes have emerged from those discussions.

The first one is we've great people. I recently visited our teammates in Finland where we have a lot of good work being done on our 8600 product line. We've some very smart people all around the world, working to help our customers be successful. These individuals are helping position us for the mobile backhaul space and as some of you know, reading our annual report, we've now won 55 of 57 RF Access in this space with some of the biggest wireless carriers in the world. We now need to focus on turning that into a profitable revenue for Tellabs.

Second, our customer relationships are healthy. I've spoken with our customers, many of whom we've known for several years, for many years in most cases. And some we would call friends. They tell us they like doing business with Tellabs. They tell us we are ahead of the competition in many instances and they tell us they like to buy more of our products and services.

Additionally, we're positioned in the right markets. We truly believe Tellabs is focused in the areas that are important to our customers; mobile backhaul, that I just mentioned, business services, converged transport, consumer broadband and professional services. We're positioned to help customers with their biggest challenges, delivering new revenue generating services and at the same time, reducing their costs.

Additionally, we've a strong financial position. Our balance sheet is healthy and strong. At this time of considerable turmoil in the equity and debt markets, we've the financial assets we need to operate and grow the business. These are all assets that we can leverage and we will.

On the other side of the ledger as you know, you can always find areas for improvement, and we have those as well, and we'd see the following. We need to improve how we communicate our value proposition. We need to do a better job communicating our value proposition to all of our customers. This is especially important as we look to increase our business with the independent operating companies, international customers and our channel partners to accelerate our growth initiatives.

As you saw, I had concern about profitability in some of our products. In my first days, you saw us address some of those difficult situations which in this case our largest customer. We discontinued working with Verizon on the 8865, because it did not make economic sense for us to continue. We couldn't define a path towards profitability.

As a result of that decision, we will continue… discontinue development on the Tellabs 8865 platform and concentrate our GPON efforts on the Tellabs 1100 platform, which we feel has a broader applicability to many customers around the world. The 1100 platform is designed to offer our customers the options to do fiber-to-the-node, to-the-curb, and to-the-premises, all in the same platform.

We're evaluating the impact of these decisions now. Our intent is to redirect our cost savings associated with this change to accelerate growth initiatives. As for our vision, we see Tellabs as a company that innovates to help customers succeed. To me, that means the following, anticipating and understanding customer needs. We need to maintain customer intimacy and customer satisfaction. We need to be the thought leaders for the development of new products and services, and I underline services as well. We need to deliver innovative products and services to help our customers succeed. This is what we're about. Helping or innovating products and services to help our customers succeed.

Additionally we need to have a relentless pursuit of performance excellence. Here is where our shareholders interests are aligned with those of our customers. In addition to innovating for customers we need to innovate around our internal processes to improve profitability. We've taken the first steps toward improving performance excellence with our $100 million plan to reduce our operating cost. That's the way I say … that's clearly the way I see things today.

Turning to the first quarter, we performed well, despite challenging industry and economic conditions. Tim in a moment will go through all the financial data. At a high level we saw strong sequential growth with all of our transport products. We had a burst of strength across the board in Tellabs 5500 from North American wireless carriers. We're continuing strength in the Tellabs 7100 and was augmented as we began a new major build for a service provider in North America.

Additionally our data products are off to a great start in 2008. On a year-over-year basis our revenue from data products increased 51%. These products deliver next generation business services and wireless backhaul. That's terrific performance from our fastest growing product line.

Our Managed Access Business declined and that's not entirely surprising as our data products are emerging as next generation solutions for business services and mobile backhaul. Access was also down. Our fiber business declined as one of our major customers is preparing to transition to a new architecture and another is being affected by economy and the slowdown in new housing starts.

Services were strong out of the gate as well. Our revenue was up 34% year-over-year and we had growth in both our attached services such as support agreements and deployment, as well as in our professional services.

On the gross margin side we saw strength in the Tellabs 5500 and data and together with cost reductions, we were driving corporate gross margins up to 38%. Our expenses are getting under control as we begin to realize the benefits from our cost reduction efforts including a $100 million plan. All of this translates to positive results in the bottom line well ahead of last quarter.

But before I turn the call over to Tim, I wanted to discuss the guidance we put in this morning's news release. As most of you know the industry is facing headwinds and our second quarter is challenging. Despite the strength we saw from North American wireless customers in Q1, all indications we've today points a sequential decline for Q2. As you might suspect this impacts our Tellabs 5500 most directly, on both the revenue side and what their product means for our overall gross margins.

At the same time we expect sequential growth in most other areas of our business. We'll be happy to discuss this guidance and other issues with you during the question and answer. But for now, I'm going to turn this over to Tim.

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

Thanks Rob and good morning everyone. Let’s dive into the first quarter results. For the first quarter of '08, total revenue amounted to 464 million and that compares with 469 million in the fourth quarter of '07. A strong sequential revenue increase in the Transport segment was offset by a decline in the Broadband segment and a slight decline sequentially in the Services segment.

GAAP net income for the first quarter amounted to 17 million or $0.04 a share. On a sequential basis that's up substantially from the 6 million or $0.01 a share we reported in the fourth quarter of '07. Non-GAAP net income for the first quarter amounted to 32 million or $0.08 a share. Again, that's up significantly from the 17 million or $0.04 a share we reported last quarter. Our non-GAAP net income for the first quarter of '08 excludes about $23 million and pretax charges for special items, about $9 million of which is related to 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 First Call does when compiling mean EPS estimates for Tellabs, gives you $0.06, a non-GAAP EPS for the first quarter of '08. 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 new release.

Revenue from customers in North America amounted to $350 million or 75% of the total in the first quarter, compared with $334 million or 71% in the fourth quarter. Revenue from customers outside North America amounted to $115 million in the quarter and that compares with $135 million in the fourth quarter.

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 was $202 million versus $274 million in the fourth quarter of '07. Lower revenue from Access and Managed Access products partially offset by increased data product revenue produced a sequential decline in Broadband revenue.

Looking at the elements of the Broadband segment; Access revenue was a $100 million in the first quarter compared with a $154 million in the fourth quarter of '07. Our Fiber Access Business declined as one of our major customers is preparing to transition to new architecture and another is being affected by the slowdown in housing. Fiber platforms overall, both fiber-to-the-curb and fiber-to-the-premise, accounted for about 69% of Access product revenue in the first quarter, and that compares with 71% in the fourth quarter of last year.

Managed Access revenue in Q1 was $59 million, compared with $89 million in the fourth quarter of '07. The decrease here comes primarily from lower sales of our Tellabs 8100 Managed Access System.

The Tellabs 8800 Multi-Service Router Series and the Tellabs 8600 Managed Edge System make up our data category. For the first quarter, revenue from data was $43 million, up $40 million from the fourth quarter of '07. But on the year-over-year basis, data is our fastest growing product category. First quarter '08 data revenue grew 51% from the comparable period in '07, driven by increased revenue from global wireless and wireline customers.

Broadband segment profits for the first quarter was $9 million compared with $32 million in 4Q '07. The decline here is primarily related to the lower level of Tellabs 8100, 1000 and 1100 product revenues.

Turning to the transport segment; for the first quarter, transport segment revenue was $206 million, up 52% compared with a $136 million in the fourth quarter of '07. The improvement reflects sequentially higher sales of the Tellabs 5500 cross-connect systems and Tellabs 7100 ROADM. The ROADM businesses improved as we began a major new network build in North America. The Tellabs 5500 business benefited from a burst of spending by major North American wireless carriers.

Looking at the 5500 cross-connect business specifically, we shipped approximately 2.3 million T-1 equivalents in the first quarter, and that's up from 1.1 million in the fourth quarter of '07. About 44% of this quarter's Tellabs 5500 revenue came from new systems, systems expansions and system upgrades, with a balance of 56%, consisting of port card growth on our installed base. That compares with the fourth quarter of '07 when new systems, expansions and upgrades accounted for 28% of revenue. At the end of the quarter 19% of the card slots in our installed base were open and that's consistent with the level at the end of 4Q.

North American wireless customers accounted for 44% of transport product sales in Q1, up from 26% in the fourth quarter. Transport segment profit was $79 million, up from $24 million in 4Q '07 driven by the higher level of Tellabs 5500 revenue, and increased contribution from our Tellabs 7100 ROADM.

Turning to the services segment; for the first quarter services segment revenue was $56 million compared with $59 million in the fourth quarter. Despite that, services revenue was up 34% year-over-year. The services segment profit amounted to $14 million compared with $19 million in 4Q '07. The decline here is primarily related to the lower overall revenue and service revenue mix.

Non-GAAP gross margin was 38.7% for the first quarter, up from 33.7% in the fourth quarter of '07. As you know, gross profit margin depends on product and customer mix, which was responsible for the improvement between 4Q and Q1 '08.

Contributing to the shifts this quarter was about 5.5 points of improvement from the higher level of Tellabs 5500 revenue. In addition, our cost reduction programs for the ONT and Tellabs 7100 ROADM combined to provide about 1.5 points of margin improvement. These two improvements are partially offset by 2 points of overall decline related to a number of factors including product mix shifts, lower services margin, partially offset by improved manufacturing efficiencies.

Turning to operating expenses, non-GAAP operating expenses for the first quarter came in at 144 million or about 31% of revenue down from 149 million we recorded in 4Q '07. We are beginning to see improvements from the cost reduction activities announced in the third quarter of last year.

For the quarter non-GAAP R&D expenses came in at 78 million and SG&A expenses were 66 million. At 78 million R&D equals about 17% of revenue. Other income on a non-GAAP basis amounted to 11 million in the first quarter and that compares with 7 million in the prior quarters. The increase here is primarily related to the absence of an impairment charge that was taken in 4Q '07.

Our tax provision on non-GAAP pretax income for the quarter was about 15 million. Our rate is higher than previously forecast because we expect to earn more in higher tax geographies this year. We now expect our effective tax rate for 2Q in the balance of the year to be about 32% plus or minus.

Turning to the balance sheet now, day sales outstanding was 57 days in Q1 and that compares with 58 in 4Q '07. Inventory turns were 6.1 times versus 6.4 in 4Q '07. In the first quarter, inventory in terms of dollars was 166 million and that’s down from 171 million last quarter.

CapEx during the quarter was about 7 million, down from 10 million in the first quarter of last year. During the quarter, we purchased about 21.5 million shares of our stock at a cost of 102… 142 million. The actual number of shares outstanding at quarters end was about 397 million and that compares with 419 million at the end of the fourth quarter. Since February of 2005, we have purchased about 93 million shares or about 20% of the shares outstanding at costs slightly over $800 million.

At the end of the quarter, our cash and investment balance has stood at 1.154 billion, that's down 65 million from fourth quarter of this year. While we generated 82 million of cash from operations in Q1, our overall cash balance declined due to the share buyback. Headcount at the end of the quarter stood at approximately 3,550 down from 3,700 at the end of the fourth quarter. And our book-to-bill was about one.

Turning to our outlook for the second quarter of this year, based on all the information indicators we have today, we expect lower spending across our major North American wireless customers in 2Q. Reflecting this lower spending, we expect the total revenue for the quarter to be in a range between 425 million and 445 million. We expect gross margin in the second quarter to be about 31% plus or minus. On a products mix with significantly less Tellabs 5500 and more Tellabs 7100 in ONTs.

We expect non-GAAP OpEx for the second quarter to be flat to slightly down including the impact of near term third party R&D development costs I mentioned last quarter. We expect these incremental costs to abide in 2Q.

As we discussed previously our overall goals to reduce our expenses and costs through the course of '08, so that when we enter '09 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.

We are making steady progress, reducing our expenses, and we continue to expect that we'll meet our goals as we enter '09. We expect the effect of expensing equity base compensation in 2Q will be about $8 million, split between operating expense and costs of goods sold.

Okay, well at this point, we'll open the floor to your questions. Carol we're ready for the first question.

Question and Answer

Operator

Thank you, sir. [Operator Instructions]. Sir, our first question will come from the line of Brian Coyne with FBR Capital Markets.

Brian Coyne - FBR Capital Markets

Thanks for taking my call. I was wondering if you could spend a little bit of time with your guidance in the 5500 specifically. If you could perhaps just give us a little bit better sense as to what's going on with the wireless customers that you're seeing. How much of that do you think might be some seasonality or is it… what's really the spending slowdown that you're seeing related on the wireless side?

Robert W. Pullen - President and Chief Executive Officer

Well, let me take a stab at that first. First of all, there is the seasonality as part of the business. Wireless expanded typically in 1Q and 4Q, certainly in North America. Additionally, at least one major North American service provider is going through some strife right now, so that's affecting us as well. But the major issue is it's a combination of both of those, and we should see improvements in the wireless spending towards the end of the year based on that seasonality.

Brian Coyne - FBR Capital Markets

And then, just in terms, I guess with your OpEx, it's sort of expense reductions coming up, I mean, do you see that impacting the, I mean, I guess there is clearly not a lot of R&D in the 5500, but how do you see that impacting the next few quarters and if you're down a little bit sequential here you are probably like round about $10 million to $15 million year-over-year but you'd like to be at $100 million. What's, sort of, your level of confidence being able to get to pretty significant cost reductions over the next… I guess the second half of the year.

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

Well Brian, good question. I think, the goal of the processes, it would take us most of the year to operationalize the $100 million reduction and the idea was by the end of the year we'd have those fully in place so that we would start '09 with a $100 million lower cost structure and I think as we've mentioned about $75 million is in the OpEx line and about $25 million is affecting our overhead cost, and with improved margins. So, I think, two things are going on there, one is that Rob really picked us up. Rob's taken a hard look at the $100 million and I think the other thing that we mentioned in the press release is that, as we make some adjustments to our 8865 plans, that we're reallocating some of those resources to some other growth areas. Rob why don't you pick up on that theme?

Robert W. Pullen - President and Chief Executive Officer

Yeah, well thanks Tim. Let me reaffirm our commitment to executing at the $100 million. That will happen. Further more, Brian that will have minimal to no impact on the 5500, if that was one of your questions.

Lastly, our goal here is to free up resources and innovate for customers and help them succeed. We're going to focus on the mobile backhaul, the business services, the consumer broadband and services in general, over the coming quarters and you're going to see us grow in each one of those spaces.

Brian Coyne - FBR Capital Markets

Okay, great that's helpful. And then finally if you could just comment perhaps a bit on the weaknesses on the copper platforms on the broadband side, was that more, sort of, customer specific or perhaps did any secular shift away from spending on legacy networks that we've been hearing about from some others? Thanks.

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

Well, I think, the comps are probably challenging, but the last couple of quarters or maybe late last year, middle of last year there was the lot of spend in DSL apps and we've seen that abate. We have seen some secular decline in the space over time. That trend continues in it.

I think the business for us has largely been around the fiber and you could see that as the percent of our overall Access business have shifted to high 60s, low 70% based on either fiber-to-the-curb or fiber-to-the-premises.

Brian Coyne - FBR Capital Markets

Thanks Tim.

Robert W. Pullen - President and Chief Executive Officer

Okay.

Brian Coyne - FBR Capital Markets

Great. Thanks guys.

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

Thanks, Brian.

Robert W. Pullen - President and Chief Executive Officer

Thank you, Brian.

Operator

Our next question will come from the line of Tal Liani with Merrill Lynch.

Tal Liani - Merrill Lynch

Yeah, yes. Thank you very much. Can you hear me?

Robert W. Pullen - President and Chief Executive Officer

Yes, yeah, absolutely.

Tal Liani - Merrill Lynch

Hi. I have a few questions and first maybe I can start with a bigger question, kind of sticks to back end. When you look at the P&L from a high level, the main issue is that your profits continued to fluctuate with the cross-connect business. Your initiatives that you put in place over the last few years to replace the cross-connect largely failed in a sense that they did not manage to replicate the same level of profitability.

The question is when you look over the next three years, five years and you kind of put today the strategy because you have good cash-flow and good cash position. You put in place the strategy for what's going to happen over the next five years and we know that eventually transport will decline to minimal levels.

So what are the areas that you think you could leverage all the positives you discussed at the beginning of this call, i.e. the client relationships, position in the network etcetera? And how soon should we expect to see you growing into these areas?

Robert W. Pullen - President and Chief Executive Officer

Let me take a stab at that, you have a lot of questions in that one question. First, it is debatable on the issue of failure. If you think about it, well, I'm not happy with the newer products filling up some of our existing products with their high growth margin, Tellabs now generate almost half of this revenue from newer products such as Access, Data and ROADM.

During the first quarter of 2008, 46% of our revenue came from these new products and if you include services in there they would be even higher. As I mentioned you're going to see us focus on these growing markets of wireless backlog, business services, converged transport and our services business in general.

We are going to use our relationship, if you think about it, we do business with 30 or top 35 worldwide service providers, and we are going to try and position and leverage our position with them and these new products for growth.

It's hard to tell, the timing of that growth. We are seeing some strong headwinds in the industry right now. We gave you guidance as to our best insight in the 2Q and we are going to keep focused on our top customers and these growing markets.

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

First of all Tal, it’s a very thoughtful set of questions and I thank you. We're not talking about what happened in OpEx last quarter, I think, as we look forward, I would add the financial side of that. Certainly we have different industry dynamics than we had even a couple of years ago. I think Rob is exactly right. We’ve replaced a lot of the revenue, the problem is that, it’s had margin significantly lower that what we're used to. So not only doest it affect our P&L from the standpoint of profitability but our revenues are significantly lower than they would otherwise be, if these had more historic margins.

Having said that, you know, we have a very strong balance sheet. We have a big cash balance, and we have an ability to continue to work the P&L from a growth of profitability or at least to enhance our profitability by being more efficient. Rob talked about the importance of performance excellence.

So, I think as we look forward, we were in the process of evaluating, you know where is the best place to deploy the strong people of Tellabs in those strong customer relationships. I think this is an open question for a lot of companies in our space. But I can tell you one that we'll continue to use the strength of our balance sheet, the strength of our people, the strength of our customer relationships to do a couple of things.

One, find new ways to assist our customers in driving lower cost in running their networks or driving higher revenue; and secondly, working hard internally on how we run the business to improve our efficiency and performance. I think the combination of those will find or allow us to find a way to get back to a model where we're growing, not just revenues but growing earnings and providing a sustainable increase for our shareholders.

Tal Liani - Merrill Lynch

And maybe just, when you look at other companies that were in your position, and again, I want to mention here Nortel and Lucent and Alcatel standalone, all these names. Some of them have taken more risks when it comes to acquisitions and growing into new areas and some of them have taken less risks.

Where are you positioned, when you look at your portfolio today, you think you have all the required components for the future growth, and is it a question more of execution, or do you think that you would need to further grow into new areas?

Robert W. Pullen - President and Chief Executive Officer

I'd like our product portfolio. I mentioned discontinuing the 8865, we're going to free up some of those resources to innovate for customers and invest more in some of our growth product areas. And with respect to acquisitions where there is a good opportunity for Tellabs to create value for customers and stockholders, we will be an acquirer.

Thomas Scottino - Senior Manager, Investor Relations

Thank you, Tal.

Tal Liani - Merrill Lynch

Good Luck

Robert W. Pullen - President and Chief Executive Officer

Thank you

Operator

Our next question will come from the line of Nikos Theodosopoulos with UBS.

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

Hey Nikos

Nikos Theodosopoulos - UBS

How are you?

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

Fine

Robert W. Pullen - President and Chief Executive Officer

Good, hi Nikos.

Nikos Theodosopoulos - UBS

I had a couple of questions. I guess, the most elaborate one is on the gross margin. On the guidance, you're guiding to a gross margin in the next quarter, that's lower than your trough margin in '07 in the third quarter. And it looks like your transport or 5500 revenues will probably be higher next quarter than they were in that quarter and you've got the cost reductions on the ONTs on the 7100 expense.

So I'm trying to understand why would the margins go so low next quarter when 5500 sales will be better and you've got these cost reductions?

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

A couple of things Nikos, first of all I think that the 5500 business, all I've described is…hello.

Operator

[Technical Difficulty] Ladies and gentlemen please standby. We are experiencing technical issues at this time.

Ladies and gentlemen, today's conference will resume momentarily. Please standby. We are currently experiencing technical difficulties. Again please stand by.

Ladies and gentlemen your lines will now be placed on music hold. Please stay online. The call will resume momentarily.

Mr. Scottino.

Thomas Scottino - Senior Manager, Investor Relations

Yes. Carol.

Operator

This is the operator. Sir, your line did disconnect from the call. You may resume.

Thomas Scottino - Senior Manager, Investor Relations

Thank you very much. Thank you everyone, looks like we had some technical difficulty here. We apologize for that Nikos weren't dodging the question. Nikos, are you back in the line.

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

I guess not.

Operator

Sir his line has been closed down.

Thomas Scottino - Senior Manager, Investor Relations

Okay. Carol we'll take the next question.

Operator

Thank you, sir. Our next question will come from the line of George Notter with Jefferies. George, your line is open. George Notter, your line is open, sir.

Thomas Scottino - Senior Manager, Investor Relations

Carol we will go to…

Operator

We will proceed to the next question, sir. Our next question will be from the line of Tim Savageaux with Merriman.

Tim Savageaux - Merriman Curhan Ford & Co

Hi. Good morning. Can you hear me?

Thomas Scottino - Senior Manager, Investor Relations

Yes we can.

Robert W. Pullen - President and Chief Executive Officer

How is it going Tim?

Tim Savageaux - Merriman Curhan Ford & Co

Going okay. Maybe to follow-up on a couple of the questions thus far to get a little bit deeper beyond the gross margin mix factor. It sounds like, given your commentary about a major new build at the 7100 that you are expecting some pretty significant increases in revenue in that platform perhaps in the quarter and for the year. You mentioned some margin improvements. I imagine that still acts as a drag from an overall margin standpoint in figures. So greatly in your guidance, I wondered if you could comment on that issue?

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

Tim its Tim Wiggins. How much of the answer did we get out on Nikos before we got disconnected?

Tim Savageaux - Merriman Curhan Ford & Co

I honestly can't remember.

Robert W. Pullen - President and Chief Executive Officer

Okay. Let me just take this. Let's answer Nikos' question for the greater good of audience here. You know, someone asked us why our margins were changing from Q1 to Q2. And my response was there is a product mix issue, i.e. there is more 7100 and ONTs at a lower rated margin than the 5500.

Next is, the economy is obviously a tough environment right now. There is a slower new housing starts and at least one major North American wireless carrier has slowed down in spending. With that Tim I will pass it over to you comment on Tim's second part of this question.

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

Yeah, on the ROADM what we see is a steady increase in the product line over the year, that's what we're thinking, sequential increases. I think part of what's happening in 2Q is that with the 5500 returning to levels that were similar to 4Q of last year and overall revenue being lower, the 7100 becomes a large component of the overall mix, and that's slightly above breakeven margin. It has a couple points of margin impact as we go from Q1 to Q2.

Tim Savageaux - Merriman Curhan Ford & Co

Great. And I guess the follow-up is on the GPON side, at least with Verizon, obviously you've felt that was going to be an NPV positive decision for you or I would assume or you would have done it. But there is obviously a lot of component parts to that. You mentioned and I would have assumed coming in, some decline in R&D as a result of that.

But it seems like you're going to reinvest that in the business as opposed to drop it to the bottom line and that’s fair enough. But I think that may call for a little more granular discussion of where it's going. Beyond that, as we look at '09 and out of… and sort of what we would have expected. I imagine you would expect a lower revenue contribution, but perhaps a higher margin contribution given that was sort of a money losing business.

So if you could talk about the overall decision in that economic context, what you're losing, and what you gain and then also maybe more near-term exactly, give us as much detail as you can, from a dollar perspective. Talk about what's being pulled out of R&D and what's being repurposed.

Robert W. Pullen - President and Chief Executive Officer

Well, what I can tell you, Tim, is we're the… GPON decision at Verizon which is really in particular, the 8865 platform only, which was custom designed for Verizon was a positive NPV decision for us. That's why we did it. It didn't make any economic sense and we couldn't find a path toward profitability.

Next, we will continue to be in that GPON business with the 1150, and as I mentioned, a platform that can do fiber-to-the-node, curb, and premise or home.

Additionally, I mentioned that we would be reinvesting some of the R&D dollars into some of our growth areas, in particular, the 8600 and 8800, and the 1150. We're not going to give specific guidance on our R&D about investments for competitive purposes but you're going to see us evaluate, could we have any additional cost savings there as well.

Tim Savageaux - Merriman Curhan Ford & Co

And just a quick follow up, you know, obviously from an overall perspective in broadband, you continue to lose money there on a fully allocated basis. Managed Access is continuing at a fairly steady decline. Were you convinced, are you convinced that that exiting the Access business, sort of in total, this isn't a terrible idea, or what was your decision factor to stay in with GPON and not Verizon, was that, I guess that were on the table or does it remain?

Robert W. Pullen - President and Chief Executive Officer

Let me be clear. We're not exiting the Access business. We are investing in the Access business, and we'll… we're going to try and expand our customer base, both internationally and with the national local exchange carriers and the independent operating companies. The decision we made was to exit the 8865 platform that was solely designed for Verizon.

And as I mentioned it was a negative NPV outcome and we thought that this would be in the best interest of our shareholders and Tellabs. By the way we continue to be a multi-product end service provider to Verizon. We have a great relationship with them. They continue to need our products and services.

Tim Savageaux - Merriman Curhan Ford & Co

Thank you. That's all.

Operator

Our next question will come from the line of Ehud Gelblum with J.P Morgan

Ehud Gelblum - JPMorgan

A couple of things guys. First of all on the gross margin. Rob as you look at the company today, mid to high 30's, gross margin now going to low 30's. The company used to obviously operate in the 50's gross margin.

Do you have, have you done assessment as to where you think the company can get to and it doesn't sound that you're ready to put a stake in the ground right now, but is there some mid to longer term gross margin we should be thinking about, as to where the company should get to?

Can it get to mid 40's, the 45% gross margin a few years out, is that reasonable, can you get back to 50? What are you thinking about where the gross margins can go or do you think that it's perfectly fine and safe to run the company in the 30's?

Robert W. Pullen - President and Chief Executive Officer

Well with the industry turbulence and headwinds Ehud, we're not giving guidance beyond the second quarter on gross margins but what I will tell you is, we're focused on improving our gross margin, reducing our operating expenses and adding new customers to diversify our base going forward and obviously improvement in gross margin is going to be our goal, not decline.

Ehud Gelblum - JPMorgan

Do you think it's feasible to run the company in the 30's for gross margin or if for several years out the company is still in 30's gross margin, will you consider that a sort of a non-tenable way for the company to continue?

Robert W. Pullen - President and Chief Executive Officer

The company can continue at this rate and we'll obviously have to reduce expenses but our goal is to improve them over time Ehud.

Ehud Gelblum - JPMorgan

Interesting, I would have thought that it would be very tough to run a company continually in the 30s with need to get to the 40s. But interesting you think you can actually operate in the 30s.

When you look at Access, the rational you gave for Access declining naturally as its your large customer in fiber transitioning. Once they have completed that transition a large chunk of your Access revenue will therefore not be around anymore.

Does that mean we should permanently look at your Access business as being a smaller chunk than it is today?

Robert W. Pullen - President and Chief Executive Officer

First of all, we are going to continue to be a BPON supplier to Verizon Ehud. We are going to continue to provide them world class performance to maximize the return on investment and so we have a huge embedded base and we are going to have to upgrade the embedded base. And that will be the lowest cost way to continue that growth.

At the same time we are going to try and grow the 1150 GPON business in the national, local exchange carriers and independent operating companies and we'll give you guidance overtime as we get more visibility in that.

Ehud Gelblum - JPMorgan

Okay. Is your strategy, as you are trying to get the 1150 into new customers. Is your strategy to get it in at a low gross margin just to get a foot print sort of the way that several other… cost of your products to 7100 and the ONT's and to Verizon which only was or would you approach those, those new customer sales at a higher gross margin point and say if its lower, I'm not going to take the business.

Robert W. Pullen - President and Chief Executive Officer

We'll pursue the later. We are going to try and pursue these new customers with a cost competitive platform at higher margins to go win some of these new spaces.

Ehud Gelblum - JPMorgan

Okay. And then finally as the 7100 ramps, I'm guessing you are expecting it to ramp throughout the year. Tim, in the past you've given guidance that it was a breakeven. The gross margin I think was even early last year and was supposed to ramp throughout the year. I think it's still a breakeven, if you can give us a sense as to where the 7100 is right now in terms of gross margin and were expected to be by the end of year?

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

We've talked about it being a breakeven product, its passed that level and we are making slow but steady progress, I think we've reported now for the third consecutive quarter that both the ONT's and ROADM's have been positive contributors to our margin improvement. So we expect to see that continue as we work on cost reductions, we work on derivative products, we work on mix shifts, and adding new diverse customers to the base, I think we are making progress on all of those fronts, Ehud.

Robert W. Pullen - President and Chief Executive Officer

Thank you, Ehud.

Ehud Gelblum - JPMorgan

Thanks.

Operator

Our next question will come from the line of Todd Koffman with Raymond James.

Todd Koffman - Raymond James

Thank you, just a follow up on Ehud's comments relating to the margin. Could you just breakout or give some qualitative comment within the transport segment, how big today is the 7100 versus 5500. And I'm assuming since you're talking about the 7100 ramping through the year, how big that mix might shift to by the end of the year? Thank you.

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

Well, certainly, we don't give a lot of granularity on the products there. We try and give you some other kinds of quantitative data that help you assess that, T-1 shipped and alike, but you know the business has grown nicely, where our goals have been as we mentioned to diversify the base.

We were pleased to announce that we are in the new network build. There is some uncertainty I guess maybe I should back at a little on ramping that's our hoped for position. We'll see how that plays out.

Right now what we are seeing is improved profitability, we are shifting some of the mix to some of the transponders which helps, we are adding some of these derivative products and we are finding new customers so I think that's the game plan and we're… so far we're marching towards it.

Todd Koffman - Raymond James

Thank you.

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

Okay.

Operator

Our next question will come from the line of Simon Leopold with Morgan Keegan.

Simon Leopold - Morgan Keegan

Just wanted to follow up, first more of a high level question and then little bit more detail. In terms of the discussions we've been having on gross margin, I'm still coming up with an implied gross margin above the 31% you're suggesting, and maybe… everybody keeps asking the same question, I don't think we're getting it. I don't feel like I'm getting it.

But it feels like there is something else going on in terms of this gross margin. And then, the other thing I'd like to follow up on is, within the FTTX business, how much of a shift is there among the two key customers there? It sounds to us like Verizon is relatively stable and AT&T is down. I just want to confirm that.

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

Well, let me work the margin thing first, Simon. So, I think the things we've said as we expect a significant decline of 5500 back to levels that we saw in 4Q. So I'm not sure what your margin or your model has in 4Q. The second thing is that the ROADM's grow and just by virtue of them growing and lower revenue, moved the margin a couple of points. There are... you're right, there are other things going on.

For example, while we see some increase in our Access business is going to come largely from the ONTs. So that's not a positive contributor. We do see some recovery in the Managed Access space, which would be positive and we hope to see some growth in the data.

Then there's, you know, changes in our service margin and manufacturing efficiency which was particularly good in Q1, which will give a little back as we go into 2Q. Hopefully that's helpful.

Simon Leopold - Morgan Keegan

Maybe just to follow that real quick, probably the key data point is, a rough guess whether the 5500 in Q4, is in the neighborhood of $80 million the right way to think about it?

Robert W. Pullen - President and Chief Executive Officer

I do want to reach there.

Simon Leopold - Morgan Keegan

Okay.

Robert W. Pullen - President and Chief Executive Officer

That's all I'm going to say

Thomas Scottino - Senior Manager, Investor Relations

That's all he's going to say.

Simon Leopold - Morgan Keegan

And the second question about the FTTX customer shifts?

Robert W. Pullen - President and Chief Executive Officer

I'll take that Simon. You're right in your assessment. We expect the business with the one major carrier to be stable and for the other carriers the new housing starts have slowed us down a little bit with the economy.

Simon Leopold - Morgan Keegan

Great thank you.

Thomas Scottino - Senior Manager, Investor Relations

Thank you.

Robert W. Pullen - President and Chief Executive Officer

Thank you, Simon.

Operator

You're next question will come from the line of Scott Coleman with Morgan Stanley

Scott Coleman - Morgan Stanley

Thanks for taking my questions guys. First, your comment about slower spending by North American carriers, I just want to understand that a little bit better. Your guiding for sequential growth across all of your products to 5500. So is this a macro view of spending trends or this more a product specific view to Tellabs and I'm just curious how you're thinking about it right now?

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

I think what Rob said was that in our product categories we see growth, sequential growth with the exception of the 5500 so let me put that back to Rob on the macro question.

Robert W. Pullen - President and Chief Executive Officer

Yeah and maybe I can add some clarity Scott to you. And the macro question with respect to the overall market, we see the CapEx spending flat to slightly up and obviously would vary by geography and demographics around the world.

But the reference I made was there is one particular North American wireless carrier where they have a new CEO and their strategy is up in the air, so their thinking through their strategy and minimizing their spending while pursuing that.

Scott Coleman - Morgan Stanley

Okay, thanks for the clarification. And in terms of operating expenses, Tim can you give an idea of what the third development costs are running at this point? You had them in Q4. You are going to have them in this quarter as well as in Q2. How much is that bumping up OpEx at this point?

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

It's meaningful. I would say that's incremental. I don’t have my calculator, but its 5% to 7% of our overall cost and so while those won't abate completely. We do expect to get through the bulk of that thing and also be for parts and protos and third party assistance, both in terms of headcount, consulting, casting, software development and the like. So there are things that relate to and are unique to where you are in the road map and your particular development cycle.

And we saw that those cost would be fairly higher early in the year and that would take really to Q2 to get through some of those things and then we begin to see the fruits of some of the tough work we are doing on cost reductions and you can see some of that in our headcount numbers announced today.

I would caution folks that we've said that it's going to take really through the end of the year to get to the point where we have the $75 million out of our expenses. So, if you think about, our '07 spend was in the high 590s, 595 give or take and if we are going to get $75 million out of there, it means that we are in the 520 give or take, in terms of the run-rate in '09.

So, that puts our quarterly OpEx spend, when we begin in the first quarter of next year and the 130 give or take. I mean, those are all kind of round numbers but its going to take most of the year to get there and so I want to caution those that are running their models not to get carried away. We will work to try and beat it. But you know we think we've got road map commitments and other things, I think.

I welcome Mr. Rob's view of focusing on some of our growth products and make sure that we can really take advantage of the windows we have and accelerate those as best we can.

Scott Coleman - Morgan Stanley

Just to make sure I understand, 5% to 7% of total OpEx? Is that right?

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

Correct.

Scott Coleman - Morgan Stanley

Okay. You think if this comes down to does it go away or does it comedown to 1% to 2% of OpEx, can you give us….

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

It might cut itself in half maybe a little less.

Scott Coleman - Morgan Stanley

Okay. If this is a leading indicator of new product announcement, I'm just curious what these dollars are being spent on today and should we expect to see new products announcement in the second half of the year?

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

No, it's really as a function of where we are with our R&D spend if you think about it we've got a major advancements coming in our 7100 the ROADM and the nano, we got heavy spend in our data area both in the 88 and 86 as we ramp those products.

The 1150 has being in an area that we've been spending significantly and so it's really the nature of the spend that we've had in these growth areas and some of this costs relate to operationalizing these systems and customers networks. Other times they relate to just what's some artificial way to get through those road map commitments that we have.

Robert W. Pullen - President and Chief Executive Officer

And Tim, the only other thing that I want to add-on to your quick comment is the fact that we are investing in services as well beyond those product areas.

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

Thank you, Rob.

Scott Coleman - Morgan Stanley

One last one, did I hear correctly that you've added a second North American ROADM customer?

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

We've added, we have more than one, but yes we are now in a another network build here in North America.

Scott Coleman - Morgan Stanley

Okay. Is that’s for the nano product or…

Robert W. Pullen - President and Chief Executive Officer

It is for the 7100 ROADM and we anticipate that the nano will be positioned there as well.

Scott Coleman - Morgan Stanley

Okay. Did you recognize revenue on that in Q1?

Robert W. Pullen - President and Chief Executive Officer

We did.

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

Yes, we did.

Scott Coleman - Morgan Stanley

Okay. Thanks guys.

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

Thanks Scott

Robert W. Pullen - President and Chief Executive Officer

Thank you. You're welcome.

Operator

Our next question will come from the line of Andrew Shopick with Nutmeg Securities.

Andrew Shopick - Nutmeg Securities

Good morning. I've got some, some of these pressures I think tie back directly to the acquisition of AFC, and I've got a couple of specific financial questions I'd like to ask, tying back to the balance sheet. How much of the current goodwill of $1.1 billion relates directly to AFC, and also the intangible assets of over $61 million. Most of its AFC related, but do you have those numbers?

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

I would venture a guess, it's about 50%. Andy.

Andrew Shopick - Nutmeg Securities

Okay. Are there any conditions at this time that would cause you to have any concern about the possibility of an impairment to those goodwill and intangibles?

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

Well, there are a number of factors that you take into account when you do impairments. So, the primary one is, if you look at your discounted cash flows for the next ten years by segments, so that would be our transport, our broadband and our services segment, and those… that goodwill is split between those. So that has a lot to do with management's view of the business and how it's tracking to those plans.

The second factor is when you're… the share price of the company is below the book value, which exists today, so the equity value of the company, that cause you to go back and reexamine it. So, it's something that we pay a lot of attention to, and it's something that if the share price continues to be where it is, we need to take another look at that, even as soon as the second quarter.

Andrew Shopick - Nutmeg Securities

Okay. Thank you.

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

Thank you

Thomas Scottino - Senior Manager, Investor Relations

Thank you, Andy.

Operator

And sir, will you take any other questions?

Thomas Scottino - Senior Manager, Investor Relations

Yeah, I think we have time for one more question, Carol.

Operator

Hang on. Your next question will come from the line of Tim Long with Banc of America.

Tim Long - Banc of America

Okay. Thanks for squeezing me in. I have just two quick ones if I could. First, just getting back to the North American wireless customers, you mentioned seasonality in Q1. But if we ignore seasonality, if you could just talk a little bit more about what you're seeing from spending on transport or backhaul related products, a lot of them buzz from carriers both in the U.S., internationally, is just that this huge backhaul requirements right now.

Are you seeing a shift at any of the operators away from your solution to whether it's wireless or more fiber based? So if you could talk a little bit about what your seeing there and if there is any reason for Tellabs to get more involved in some of the other alternative technologies.

And secondly Tim if you could just touch on the book to bill. I think it was over one in the quarter as you mentioned it. It might be over one often in Q1 but if you could just give us a little color, what that means relative to your down revenue guidance is, just give us a little color on whether it's geographically, technology split, and is it just a little more ageing in some of the activity in Q1. Thank you.

Robert W. Pullen - President and Chief Executive Officer

Yeah let me see if I can take a stab at the first question. So, first of all, the CapEx spend for the wireless carriers, in fact is going to be flat to slightly up we believe. Additionally, there is seasonality in their spending, which typically happens in 4Q and 1Q. It happens all year long but the burst [ph] are in 4Q and 1Q.

And your right, the data application is growing and causing huge pressure on the backhaul from the cell site to the mobile switching center and that's good for us. That's why we're focused on reducing operations expense and capital expense in the mobile backhaul. And our 8800 and 8600 are starting to play a much larger role in that space. We're trying to offload. We are both growing T-1s and E-1s globally for that backhaul.

While coming up with new ideas to offload the data on to Ethernet and pseudowire to minimize the operational expense of backhauling we are now with 8600. We've done business cases for carriers, wireless carriers to reduce their operating expense by 30% to 60% annually and that's what one of the reasons we are winning 55 out of this 57 RF Access, which as I said earlier, we now turn into a profitable revenue for Tellabs and we are starting that.

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

On the backlog there are a couple of factors. One is that… Rob mentioned the significant amount of wins that we've had in our 8600 and then he further went on to say that the challenge now is to convert those wins into revenues.

So we've seen some changes in the intake of our orders and given some of the revenue recognition roles, we'll get orders and into backlog before it turns into revenue. That time has elongated a bit in the last couple of years.

The other thing I would add is that, our customers sometimes provide us longer lead time orders. It has do with either their requirements or the supply chain requirements and so we had a order like that in Q1 that will be spread over the next couple of quarters. That shouldn't materially change the composition of business going forward.

Robert W. Pullen - President and Chief Executive Officer

And Tim the only thing I would add is you were right. Our book-to-bill ratio is about one.

Tim Long - Banc of America

Right. Thank you.

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

Thank you.

Robert W. Pullen - President and Chief Executive Officer

Let me thank all of you for participating. I've enjoyed the conversation in my first week here as President and CEO of Tellabs. I look forward to working more closely with each of you. And again, I thank you for your time and your interest in Tellabs.

Operator

This concludes today's teleconference. You may now disconnect.

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Source: Tellabs, Inc. Q1 2008 Earnings Call Transcript
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