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Executives

Tom Scottino - IR

Robert W. Pullen - CEO and President

Timothy J. Wiggins - EVP and CFO

Analysts

Kenneth Muth - Robert W. Baird & Co., Inc.

Todd Koffman - Raymond James

Ehud Gelblum - JPMorgan

Nikos Theodosopoulos - UBS

Vivek Arya - Merrill Lynch

Simon Leopold - Morgan, Keegan & Company, Inc.

George Notter - Jefferies & Co.

Raimundo Archibold - Kaufman Bros.

Scott Coleman - Morgan Stanley

Brian Coyne - Friedman, Billings, Ramsey & Co.

Tellabs, Inc. (TLAB) Q2 FY08 Earnings Call July 22, 2008 8:30 AM ET

Operator

Good morning. My name is Bettina [ph], and I'll be your conference operator today.

At this time, I would like to welcome everyone to the Tellabs Investor Relations Conference Call. All lines have been placed on mute to prevent any background noise.

After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions]. Thank you. Mr. Scottino, you may begin your conference.

Tom Scottino - Investor Relations

Thank you very much, Bettina [ph], and good morning, everyone. With me today are Tellabs' 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 to remind you that this presentation contains forward-looking statements about future results, performance or achievements, financial and otherwise. These statements reflect management's current expectations, estimates and assumptions.

These forward-looking statements are not guarantees of future performance and involve risks and 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. Forward-looking statements made in this presentation are being made as of the time and date of its live presentation. If this presentation is reviewed after the time and date of its live presentation it may not contain current or accurate information.

Tellabs disclaims any obligation to update or revise any forward-looking statements based on new information, future events or otherwise. This presentation may also include non-GAAP financial measures. Reconciliations between non-GAAP financial measures and GAAP financial measures can be found at our tellabs.com website and in our SEC filings.

Having said all that, I'll turn the call over to Rob.

Robert W. Pullen - Chief Executive Officer and President

Thanks, Tom. And good morning, ladies and gentlemen.

I thought I'd share with you where I've been spending my time recently. As you could imagine, I've been spending my time with our key customers, our employees around the world. I've been focusing on strategy, and as I'll give you a little bit more insight, I've been spending some time interviewing some candidates for our executive leadership staff. We've also been spending time with key shareholders.

As you saw in our announcement, we generated $0.13 on a non-GAAP basis and $0.10 per share, one of which was... of which was one-time tax benefit of $35 million or $0.09 a share.

I have some... as most of you know in the industry, there's been some ups and downs on a macroeconomic and a sector perspective, but I'm enlightened after these conversations by our customers and employees in a few key areas.

Tellabs' innovations are gaining traction with our customers globally. In fact, three of our new platforms or three of our platforms achieved record quarterly revenue in 2Q of '08.

The 6300 Multi-Service Provisioning Platform, which is everything from Ethernet aggregation to optics, reached an all-time high. In fact, our managed access revenue was up 42% sequentially from the first quarter of '08.

A lot of these drivers have been in the wireless mobile backhaul space, multiservice router aggregation, some consumer broadband access, and business services.

Our next platform was the 8600 system. This system is showing a lot of promise and that it's focused on mobile backhaul to reduce our customers' capital and operations expense as the data and video traffic grows over the wireless networks, our customers need to find an efficient way to backhaul that service. The 8600 is a great solution for that. In fact, we've won 75 customers including 50 paying customers.

Our 7100 ROADM or reconfigurable optical add/drop multiplexer reached a new high as well, excluding some of the deferred revenue we recognized in the year-ago quarter.

We also recognized in 2Q of '08 revenue from two new customers outside the United States. And you will see that that's going to be the growing theme here from Tellabs. Our year-to-date 7100 revenue is up 62%. Again, it's the bandwidth required for video management and some of this ongoing data and video growth over the wireless networks.

A positive note about the 7100 as well is that our gross margins have risen in five for the past six quarters, contributing to our gross profit here in the second quarter of this year. And I'll comment a little bit later on. We exceeded our guidance on the gross margin. I'll give you some insight into that.

Another positive note, the 8800 multiservice router is up 16% year-to-date, '08 versus '07. And as most of you know, our... the promise is that our 6300, 8800 and 8600 have better than corporate average margins.

Our services revenue was also up sequentially, 7%, and we're seeing continued promise in our professional services. We had significant growth year-over-year from 2Q '08 to 2Q '07.

Now switching to the gross margins, we continue to focus and have discipline on gross margins and profitability and it paid off in '08 and you'll continue to see it pay off in the coming years. Our profit margins were 35%, better than our guidance, and we outperformed in several areas. The 7100 ROADM improved through cost reductions. The addition of these new customers at higher than corporate average margins... excuse me, the higher margins than our normal U.S. business, and we had a beneficial mix in the transponder cards.

We also improved our gross margins through our management's aggressive focus on costs, and in trying to improve our customer mix.

When we look for our outlook for 3Q, we continue to see turbulent industry we are guiding flat to slightly down, and you're going to continue to see us focused and have discipline on our costs. We continue to drive for the $100 million plan to improve our profitability to gross margin increases and net expense reductions in our run rate for '09. You also saw us exit on profitable businesses, specifically, the 8865 business, and we redeployed from resources for growth areas including our services, 7100, 8600 and 8800.

As I mentioned in the last call, we'll be strengthening our executive team by adding EVP of sales and a chief technology officer. You are also going to see us work on expansion through improved channel effectiveness, better coverage on a international basis. We're going to add emphasis outside of North America. As you noted in some of our announcements, our revenue was 34% outside of North America for the quarter versus 23% in the second quarter.

We've been working, as I said on strategy, as a corporation and we're going to share more specifics on that strategy later this year. But one thing you're going to see for us... or from us for sure is we're going to go innovate for customers and maximize for shareholders.

With that, as I said, we continue to see like the rest of the world some top macroeconomic situations and industry sector problems, but we also see some pockets of optimism as I shared with you. With that I'm going to pass the call over to Tim, and he's going to go through some of the financials.

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

Thanks, Rob, and good morning, everyone.

Let's take a look at the numbers. For the second quarter of '08, total revenue amounted to $432 million that compares with $464 million in the first quarter of '08. Sequential revenue increases in the Broadband and Services segments were offset by an anticipated decline in Transport segment revenue as we guided you on our last quarter's call.

GAAP net income for the second quarter amounted to $39 million or $0.10 per share and that compares with $17 million or $0.04 per share in the first quarter of '08. Net income for the quarter was positively affected by the resolution of an audit of our tax filings for the years 2001 through 2005. The successful resolution of this audit enabled us to book a net GAAP income tax benefit of $35 million or $0.09 a share in the quarter. On a non-GAAP basis, net income for the second quarter amounted to $52 million or $0.13 a share, including $0.09 from the tax benefit and that compares with $32 million or $0.08 a share in the first quarter of '08.

On a non-GAAP basis, our net tax benefit amounted to $28 million. Our non-GAAP net income for 2Q '08 excludes about $19 million in pre-tax charges for special items, of which a little more than $5 million is related to previously announced restructuring charges. As usual you will find a complete reconciliation of our GAAP and non-GAAP results and a more detail of year-over-year comparisons in this morning's news release.

Revenue from customers in North America amounted to $287 million or 66% of the total in the second quarter compared with $350 million or 75% of the total in Q1. Revenue from customers outside North America, which was positively affected by the strong euro amounted to $145 million in the second quarter compared with $115 million in the first quarter of this year.

Turning to our individual business segments. As you know the Broadband segment includes our access, managed access, and data products. Broadband segment revenue for the second quarter was $231 million, up, excuse me, 15% from $202 million in the first quarter of '08. All three elements of the Broadband segment were sequentially higher in 2Q. Looking at the individual elements of the Broadband segment, access revenue was $103 million in the second quarter compared with $100 million in the first quarter of '08. Sequentially, higher sales of BPON ONTs and our Tellabs 1000 Access platform offset declines in other access products. Improving ONT gross margins has been a priority for Tellabs, and we have successfully improved ONT margins in the last six quarters.

Fiber platforms overall, both Fiber-to-the-Curb and Fiber-to-the-Premise, accounted for approximately 66% of access product revenue in the second quarter compared with 69% in Q1 of '08. Managed access revenue in 2Q was $83 million, up 42%, as Rob mentioned, with $59 million we recorded in the first quarter '08. The increase here comes from record sales of our Tellabs 6300 SPH transport system and sequentially higher sales of our 8100 managed access systems.

The Tellabs 8800 Multiservice Router Series and the Tellabs 8600 Managed Edge System make up our data category. For the second quarter, revenue from these multiservice routers was $45 million, up from $43 million in Q1 '08. On a year-over-year basis, the data category is our fastest growing product category. Second quarter 2008 revenue grew 28% from the comparable period in '07, driven by increased revenue from global wireless and wireline customers. Looking at the first six months of '08, data product revenue increased 38% compared with the comparable period in '07.

Sales of our Tellabs 8600 system hit a record level this quarter. To date, we have won 75 customers for the product. This reflects a strong value proposition for our customers' needs for next-generation wireless backhaul. Given this building momentum, the challenge before us now is to convert these wins into revenue.

Broadband segment profit for the second quarter was $23 million compared with $9 million in Q1 '08. The improvement here is primarily related to the higher levels of managed access revenue, as well as improved ONT margins.

Let's turn to the Transport segment. For the second quarter, Transport segment revenue was $141 million compared with $206 million in the first quarter of '08. The change largely reflects sequentially lower sales of our Tellabs 5500 system to North American wireless customers, and that's consistent with the guidance we gave you after Q1. And that was partially offset by an increased revenue from our 7100 ROADM.

Looking at the Tellabs 5500 cross-connect business specifically, about 17% of this quarter's Tellabs 5500 system revenue came from new systems, system expansions, and system upgrades. Looking at first six months of 2008, this percentage increases to 35%. The remaining balance consists of port-card growth on the installed base. At the end of the quarter, about 19% of the card slots in our installed base were open, consistent with the level at the end of Q1.

ROADM sales were higher than any quarter in history except for the second quarter of last year when revenue recognition rules enabled us to recognize three quarters worth of ROADM revenue in the quarter. The ROADM business benefited from continued strength at the major North American network build we began in Q1.

In addition, we recognized revenue from two ROADM customers outside the U.S. during the quarter. The ROADM ramp is strong on a year-to-date basis, ROADM revenue is up more than 60% compared with the same period in 2007.

Improving ROADM gross margins has also been a priority at Tellabs. We have improved ROADM gross margins in five of the last six quarters. This improvement has come from cost reductions, the addition of new customers and a beneficial product mix shift toward more transponder cards.

North American wireless customers accounted for 16% of Transport product sales in Q2 compared with 44% in Q1 '08. This shift reflects a lower level of 5500 system sales in North America... in North American wireless networks during the quarter and the growth of our 7100 ROADM platform and wireline networks. Transport segment profit driven by lower 5500 system revenue was $31 million compared with $79 million in Q1 '08.

Turning to the Services segment, for the second quarter Services segment revenue was $60 million, up 7% from $56 million in Q1 '08. Services segment profit amounted to $22 million compared with $14 million in Q1 '08. The increase here is primarily related to the higher level of service revenue and more favorable services mix.

Non-GAAP gross margin was 35.1% for the second quarter compared with 38.7% in the first quarter of '08. As you know, our gross profit margin depends on product and customer mix, which was responsible for the shift between Q1 '08 and Q2 '08. Contributing to this shift this quarter was about 6.5 points of margin decline related to lower level of Tellabs 5500 revenue which was partially offset by about 2.5 points of improvement related to cost reductions, pricing, and component mix for the 7100 ROADM and single family ONT.

The remaining half point of margin decline can be attributed to a variety of puts and takes, including product mix, services margin and manufacturing efficiencies.

At 35.1%, our Q2... our second quarter non-GAAP gross margin is significantly better than the 31% plus or minus level we guided you to at the end of Q1. As you know gross margin improvement is a priority for Tellabs given the significant differences we see in margins across the entire product and services offering.

In this quarter, hard work enabled us to exceed our own expectations. In 2Q, 7100 ROADM margins were better than anticipated. This account for about two points of the difference between our expectations and the actual results. The improvement here comes from cost reductions, the addition of new customers and a beneficial mix for more transponder cards.

Another point of improvement was realized as we shipped fewer single family ONTs than expected and we continue to realize the benefits of our cost reduction efforts. The balance of the improvement came from aggressively managing costs and overall variability related to product and customer mix.

Turning to operating expenses. Non-GAAP operating expenses for the second quarter came in at $141 million or about 33% of revenue, down from $144 million we recorded in the first quarter of '08. The strong euro which positively affected our revenues working against this year. We continue to see improvements from the activities associated with the $100 million cost reduction program we announced earlier this year.

For the quarter non-GAAP R&D expenses came in at $76 million and SG&A expenses were $65 million. At $76 million, R&D equals almost 18% of revenue. Other income on a non-GAAP basis amounted to $12 million in the second quarter and that compares with $11 million in the prior quarter.

As I mentioned at the top of the call, our tax provision, our non-GAAP pretax income for the quarter includes a benefit of $35 million as a result of the successful resolution of a tax audit. We expect our effective tax rate for Q3 and the balance of '08 to be in the range of about 31% plus or minus.

Quickly turning to the balance sheet. Day sales outstanding was 57 days in Q2, consistent with the Q1 level. Inventory turns were 5.9 times versus 6.1 times in Q1 '08. In the second quarter, inventory in terms of dollars was $182 million compared with $166 million at the end of Q1. The increase in inventory relates to the revenue ramp for our 7100 ROADM and multiservice data router products. CapEx during the quarter was about $11 million, down from $15 million in the year-ago quarter. We generated $59 million of cash from operations in 2Q, and looking at the first six months of 2008, cash generated from operations equaled about $141 million.

Since 2005, we've spent $804 million to repurchase about 93 million or about 20% of our shares outstanding. In 2Q, we spent a little more than $1 million to purchase about 200,000 shares. The actual number of shares outstanding in the quarter down... was down slightly from the first quarter at a little more than 397 million. During the quarter, we significantly curtailed our open market stock repurchase program. We believe it's prudent for us to hold on the cash for now, as we work to position the company for future growth and given what we see in the markets and the overall macroeconomic environment.

Moving forward, we will look at our opportunities for growth and given the overall market conditions reassess our options as it relate to our use of cash. At the end of the quarter, our cash investment balances stood at $1.196 billion, that's up $43 million from the first quarter of this year.

Headcount at the end of the quarter stood at approximately 3,550, consistent with the level at the end of the first quarter. Book-to-bill in the second quarter was less than one, and that's down from Q1 when a large multi-quarter order put our book-to-bill over 1. Looking at the first six months of the year, book-to-bill is over one.

Turning to our outlook for the third quarter this year. As you know, Tellabs has traditionally exhibited flat to slightly down revenue in the seasonally slower third quarter. Based on all the information and indicators we have today, we expect that pattern to continue, as well as traditional seasonality there are additional headwinds, we see macroeconomic risks in the economy, in enterprise spending and in our customers' capital spending.

We expect our gross margin in the third quarter to be roughly consistent with the second quarter level plus or minus. The variability here would be a function of customer and product mix, improving gross margins is a priority, and we will work hard to continue to improve gross margins going forward. And we expect our non-GAAP OpEx for the third quarter continue the downward trajectory we've seen so far this year.

As I mentioned earlier, the strong euro which helps our revenues outside the United States works against us when it comes to reducing our euro-based expenses. As we discuss previously, our overall goal is 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 '07. About three quarters of these cuts will come in operating expenses with the balance in supply chain and services overhead costs.

We are making steady progress in reducing expenses, and we'll continue to drive toward our cost reduction goals. As I mentioned earlier, we expect our tax rate for the third quarter and the full year to be around 31% plus or minus. In addition, we expect the effect of expensing equity-based compensation, and 3Q to be about $5 million split between operating expense and cost of goods sold.

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

Question and Answer

Operator

[Operator Instructions]. Your first question comes from the line of Kenn Muth with Robert Baird.

Kenneth Muth - Robert W. Baird & Co., Inc.

Good morning. On the... kind of North American marketplace as you talked about kind of the headwinds, could you also give us just a little bit more insight on them? On the 5500, do we see any kind of upgrade path of the 8600 in that potential changeover in technology or kind of where do you see the 5500 for the next kind of 12 or more months?

Robert W. Pullen - Chief Executive Officer and President

Sure, Ken, I'll take that.

The 5500 is obviously been successful both in the wireline and wireless. It will show a steady decline over its life cycle, but we do expect to see some increased spending on the 5500 toward the end of this year for the upgrade cycle. We also see that, we just released a new high-density line curve, which both saves power from a carbon footprint perspective, as well as reduces cost for our customers. And as you can imagine improves our margin because there was a cost reduction in design. But having said that, that's one of the reasons, Ken, that we introduced the whole mobile backhaul strategy with the 8800 or 8600, and it all integrated under one management system.

You are going to hear a lot more about that in the coming months. But we are looking to transition that network from the time division world of T1s to the packet world of Ethernet aggregation and Pseudo-Wires.

Kenneth Muth - Robert W. Baird & Co., Inc.

Okay. And I guess just try to... how do you kind of hold on the incumbency because you guys do dominate that in the North America specifically? I mean how do you try to migrate your customers here to the 8800 or 8600?

Robert W. Pullen - Chief Executive Officer and President

Well, as you can imagine customers... in fact customers are already migrating, Ken. We haven't made it public as to who those customers are, but customers are already migrating. We've done it based on quite a few things. First of all, the innovation of our technology. One of the few companies that offers the capability to handle the current environment of T1 and TDM or E1, as well as the transition to packets and Ethernet. We use higher quality of service so that you can handle the voice, the time sensitive voice calls. We also are unique in that, we can provide synchronization over the packet world, which is proven to be difficult for many of our competitors. And we are also doing a little bit of bundling, as well as our integrated management strategy. And so we are leveraging that innovation as well.

Kenneth Muth - Robert W. Baird & Co., Inc.

Okay. Thank you.

Operator

Your next question comes from the line of Todd Koffman with Raymond James.

Todd Koffman - Raymond James

Thank you. I could just get a clarification on the 7100 OTS revenues, I think you said they were up sequentially. Is that product segment now in about $80 million a quarter level. And then you also gave some color that you assigned a couple of new... two new customers you recognize revenue on, could you give any qualitative comments on the sustainability and the outlook for that successful product as you look forward? Thank you.

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

Todd, good morning. This is Tim. Yes, you're right, it was up sequentially. We also mentioned that the product is up 62% year-to-date, that by the way takes into account the revenue pickup we had a year ago. So it's got a significant ramp. In terms of ball parking what the revenue is, that's up to you to figure out. I'll turn the second part of the question over to Rob.

Robert W. Pullen - Chief Executive Officer and President

Yeah, we are not given product-specific revenue guidance. But what I will share with you is we're seeing an uptick and an acceptance of the 7100 optical transport system on a global basis. We haven't done a very good job of leveraging this great R&D investment to have global scale, and you are going to see us go pursue that. You are also going to see us, as I alluded to earlier be more aggressive on cost reductions in that product to improve our gross margin. We are also integrating it under our 8000 manager, which is an embedded management system worldwide controlling all of our managed access and our 8600 mobile backhaul business. We're integrating the 7100 technology into that management system to leverage it on a global scale as well.

Todd Koffman - Raymond James

Thank you.

Operator

Your next question comes from the line of Ehud Gelblum with JPMorgan.

Ehud Gelblum - JPMorgan

Couple of questions that I had. First of all, the lower $55,000 revenues you guided to this quarter and it actually turned out, [inaudible] primarily because of one customer that lowered its spending pretty significantly in this quarter versus the first quarter, what is your outlook in terms of... I think, your total revenue outlook, but do you expect that customer to remain stable at the level it's at right now or grow a little bit as it get to the back half of the year or fall?

Next question certainly looked as your international revenues went up, these weak dollar help to translate international sales into higher dollars. In constant currency, can you give us a sense as to where your revenue may have been or would have been, if you look at it more from without the benefit of that International FX thing? And then finally, Rob, it sounds from what you did with your buyback is kind of how you are thinking that you are prepared to start to going shopping for acquisitions to build growth. Can you give us a sense of the kinds of things you're looking for, maybe geographically or are you looking for more international versus the U.S., you're looking for more deepening your access portfolio, deepening other types of things, you're looking at... gives us a sense of the kinds of things that we might be looking at going forward?

Robert W. Pullen - Chief Executive Officer and President

[inaudible] good questions, yeah. Well, first of all, we're not going to comment on individual customers, Ehud. The $55,000 though is down mainly because of the, the North American macroeconomic is tough, and spending in wireless has been slightly down, as well as of course we are transitioning to new technologies as I mentioned with the 8800 and 8600 doing backhauling over Pseudo-Wires. And so we do expect some uptick towards the end of this year on spending in that space, but it's more of a macroeconomic event. Tim, I'm going to let you comment on the weakening dollar and the implications of that, and then I will come back about the question about shopping for different companies.

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

Okay. So, Ehud, when we look at the sequential increase in our euro-based revenues, maybe 25% of that came from the escalating... by the weakening dollar, the escalating euro. We also mentioned the impact on our euro-based expenses. We are... we take a natural hedge approach and we're actually a little bit long on euro revenue, so actually the strengthening euro helps us from an operating income standpoint, it helps our revenue, but it hurts our operating expenses.

Ehud Gelblum - JPMorgan

Do you have a sense of what the sequential may have been? Do you have a sense of what's that?

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

Yes. I think it was up. The euro contributed about 25% of the sequential increase.

Ehud Gelblum - JPMorgan

In the international revenues?

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

Yes.

Ehud Gelblum - JPMorgan

Okay. But what was it in Q1, if we can compare?

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

Well, I think the problem is that the euro rate keeps moving. So... I mean that is.

Robert W. Pullen - Chief Executive Officer and President

Can be found out to know what you want it to compare it to.

Ehud Gelblum - JPMorgan

I understand. All right.

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

All right.

Robert W. Pullen - Chief Executive Officer and President

And answer for your last question you had the... you're going to see Tellabs focus on optimizing our current business right now. We believe we have a fair amount of work to do to optimize our current space. We also will... based on the current capital markets and so on, we believe that reserving our cash to do, if we see an opportunity that's great for customers and great for our shareholders, we'll pursue that. But when I talk about optimization, we're going to be doing a few things here. As I mentioned, we're going to be relentless on our focus on discipline and cost. And so we're going to invest our money in cost reductions. We also need to invest some money in covering the market placement segments better. You are going to see us spend more geographic expansion dominantly in the international markets to get greater coverage and leverage our R&D investments. And by the way, that's currently in some of our numbers. And so, if it makes sense for both our customers and shareholders, we'll pursue acquisitions, but we're not making any of that visible at this stage.

Ehud Gelblum - JPMorgan

Okay. Can I follow-up quickly on the initial thing or you are going to move on?

Robert W. Pullen - Chief Executive Officer and President

No, that's okay. You can ask me a follow-on question.

Ehud Gelblum - JPMorgan

Okay. The follow-on is again, I was under the impression that your guidance for this quarter was really based on, one, maybe two, but one particular customer that did fall-off pretty hard in this quarter. And was just wondering again is that a baseline from this quarter going forward that we have that customer or for the range of customers that caused? I mean this is significant fall-off in Q2 or is that customer potentially going lower? Any sense of that basket of customers that caused us significant decline in Q2? What's happening going forward, you assume that they stay flat from this level?

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

Ehud, what we see is that the conditions that we saw in 2Q will continue into Q3 with the normal seasonality. For our 5500, the third quarter is typically our slowest, and as Rob mentioned, we expect to see some uptick in spend in the fourth quarter in that product line. So, essentially without getting too specific about customers because they get frustrated with us. What we saw that contributed to the decline in 2Q, we expect those conditions across all our four major wireless carriers that would be about the same with the normal third quarter seasonal slowdown that we get.

Ehud Gelblum - JPMorgan

Thanks, Tim.

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

You're welcome.

Ehud Gelblum - JPMorgan

That's great. Thanks, Rob.

Robert W. Pullen - Chief Executive Officer and President

You're welcome.

Operator

Your next question comes from the line of Nikos Theodosopoulos with UBS.

Nikos Theodosopoulos - UBS

Yes, thank you. I had a couple of questions. Let me start first with the 7100. Given the comments you made last quarter that the margins were single digits on that, and in this quarter that they contributed about 2.5 points to gross margin. It sounds like some margins on that product line now are mid-teens, is that reasonable and do you expect the margins to improve on that product going forward, if revenues remain at this level or continue to increase? Just trying to get a sense of how the cost reduction and increased volumes can continue to increase margins there or was there something one time this quarter... maybe the mix that you're thinking about transponders that we shouldn't think it as ongoing?

Robert W. Pullen - Chief Executive Officer and President

Nikos, good question. Nikos, we're not giving out individual guidance on profitability by product for competitive reasons, but I will share with you that the 7100 benefited this quarter from a few different things. The first one is, we added new customers at a higher than product line margin, and that obviously was a positive note. The second one was because of mix. We shipped more transponders to fill out existing slots, which is something that is important in the life cycle of this product. Lastly, we've been focusing on cost reductions, but to date both from a supply chain perspective and from an engineering perspective and going forward you are going to see us be more aggressive in reducing expense through engineering innovation and cost reductions. And so we would expect over the next year or so for this product to improve beyond its current state and margin contribution.

Nikos Theodosopoulos - UBS

Okay, can you just explain on that, on the 7100, you mentioned you have 75 customers, 50 of which are revenue-generating. What... how would you characterize the other 25, are they in trials... I'm trying to understand when they can get converted to revenue?

Robert W. Pullen - Chief Executive Officer and President

Nikos, let me give you a clarification. It's a good question. But when we reference the 75 customers, that was with respect to the 8600 program.

Nikos Theodosopoulos - UBS

Okay.

Robert W. Pullen - Chief Executive Officer and President

It was focused on the mobile backhaul and which is us putting the equipment out both at the sell side and the hubbing point of the mobile switching center to reduce backhaul cost for the growing data and video application. There is 3G iPhones and other phenomena occur in the wireless network. Now we've won 75 customers through RFX process, we have 50 paying customers. The others... the remaining 25 are either in trial or in the early stages of first off with application. And as Tim mentioned earlier, the mandate to our sales force is to turn those opportunities into money. This is our... one of the areas we see for growth here at Tellabs isn't [ph] this mobile backhaul space and we need to have more global scale in pursuing them.

Nikos Theodosopoulos - UBS

Okay, just one last question. On managed access, this was the first quarter you've shown year-over-year revenue growth, since I think the third quarter of '05, and obviously currency helped a little bit there and some of the products you mentioned on the call. I am just trying to get a sense, do you expect this year-over-year growth to continue going forward, because the business has been in a decline the last two fiscal years. What's your sense of how that is going to proceed to the rest of this year, and into '09?

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

Good question, Nikos. I think in both the... the products that make up this category today are 6300 SDH [ph] and our 8100 system have a great install basis, and so I think what we see is depending on what our customer's build strategies are, we'll see this potentially go up and down. I think this second quarter result particularly in our 6300 was the result of some focus that Rob instituted and we've been working some of our channel partners here, and I think there is more opportunity for us to do this. But I would say the 8100 certainly has... later in its life cycle. So I think it's just going to be... depends on how good we are at convincing customers as value propositions and what's going on in their individual builds.

Nikos Theodosopoulos - UBS

Okay, thanks a lot.

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

Okay.

Operator

Your next question comes from the line of Tal Liani with Merrill Lynch.

Vivek Arya - Merrill Lynch

Vivek Arya on Tal's behalf. Couple of questions, and I just wanted to actually revisit some prior questions because I think that are quite important. First is, Rob, what is the company's long-term strategy to drive top-line growth? What has specifically prevented you from making acquisitions so far? Do you think you can organically grow your way out of the current weakness? Because a lot of your new growth products seem to have significantly lower margins, and then I have a follow-up.

Robert W. Pullen - Chief Executive Officer and President

Okay, first of all, the... we're working on strategy, as an executive and management team, and you'll hear more about that later this year. I've been fairly specific on not sharing some of our strategy right now as we focus on that and do some critical thinking internally, and again you will hear more about that. As for acquisitions, as I share with you, we will pursue if they make sense for our customers and our shareholders. I also believe that there is... we need to optimize our current business. And there is... are more organic growth products here at Tellabs. As I shared with you, we have three platforms and have had record revenue in the second quarter of '08, both 6300, 8600, 7100, and the 8800 multiservice routers up 16% year-to-date year-over-year comparison. I also want to articulate to you that in all of these cases, whether it's 6300, 8800 or 8600 including the services business, there all have... they all have better than corporate average margins.

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

Also that, let me add something to this, because I think there is may be a sense or anxiousness about our cash purchases of stock in our acquisition strategy. Our energies are focused largely on optimizing our current portfolio of which we think we got some really significant jumps in our ROADM product, in our wireless backhaul strategy. So we are focusing largely on optimizing channel strategy in our existing portfolio. There is nothing eminent in terms of acquisitions at this point, we are not really net out. But I want people understand that there is not something right around the corner and we stopped buying, so that we can do that. We think, so, when we look at the conditions of the capital markets, and what's going on around this, and as we evaluate what we are going to do for longer-term growth beyond the opportunities that we have in the existing portfolio, we thought it was prudent to pause here. I'm not going to say that at some point in the future, we won't find something that makes good sense. But our core strategy right now is, work with what we have and we'll continue to look at what's available, but I want people to know that it's not like we got something right up our sleeve, and you'll see announcement any day, it's not the case.

Robert W. Pullen - Chief Executive Officer and President

Thanks, Tim.

Vivek Arya - Merrill Lynch

And one quick follow-up. Your third quarter outlook of flat to slightly down, what is the floor on that slightly down? For example, I think last year sales were down 14% sequentially. Is that the kind of decline you're looking at or is it more along the lines of 2% to 3% that's down sequentially?

Robert W. Pullen - Chief Executive Officer and President

We didn't give quantitative guidance, but I will give you some direction. We said, it's normal seasonality and based on the current macroeconomics, we see flattish, we can probably see down a four-tenish [ph]. So that's given you some range.

Vivek Arya - Merrill Lynch

Got it. And just one last question, Rob, if I may. You said third quarter you're seeing macro risk. Can you help us dissect that statement? Is it the weakness in wireless carrier CapEx, is it wireline carrier CapEx, it is enterprise CapEx, is it U.S., is it international? Any color on that would be great. Thank you.

Robert W. Pullen - Chief Executive Officer and President

Vivek, let me try this is a little bit. We do some very detailed bottoms-up look at our businesses, we look into these forward quarters and we get a lot of good feedback from our sales team. But I think, I... that caution Robins [ph] and look we see all kinds of anecdotal evidence all around us. It's up that you guys right, things that we are reading from our competitors, I was reading about challenges in the overall economy. So we go into this period with a view toward flat to slightly down, but we are seeing look we're not immune to these factors, and while we don't have specific granularity to those, I think it would be foolish to go into this thing, and say look, to the extent that some of our customers make a right fate [ph] change on their CapEx spending, because they are seeing weakness in consumer spending. We are reading about enterprise issues. So, I think it would be less about the granularity of what we're seeing and more about what we're seeing around us and saying look, we are not immune to those things and as soon as we think we are, we'll get cut short. So, I think we are trying to put an appropriate level of caution in that because it wouldn't surprise me to have something changed in the middle of the quarter or buying behavior from some of our key customers put on hold, because the CFO of the company said we are going to cut CapEx this period. So, I think it's a broader sense that it's hard to ignore all the stuff that's going on around us.

Vivek Arya - Merrill Lynch

But then just to clarify. You are being cautious because of you are seeing cautious headlines, or you are being cautious because you are really seeing a slowdown in orders, I just want to differentiate between these two things.

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

Well, about the [inaudible] component in our business booking bill in the quarter. Based on the information we have today, we could see normal seasonality flat to slightly down with the caveat that we see a lot of negative news in the headlines that give us a reason for concern as we go into 3Q.

Robert W. Pullen - Chief Executive Officer and President

But I will also add, we are talking to customers. This isn't about the headlines. Tim is just reflecting the sentiment of the industry and the sector. As we talk to customers though, their CapEx... they are uncertain themselves, but they look like it's flat to single digits and it's by the way over the wireless and the wireline. They are suffering from the macroeconomic, the real estate market and so on, so housing starts will affect consumer broadband access business is one example. We're seeing a tightening in the belt on the business customers or the enterprise business, and obviously our customers generate and deliver new services using our equipment to them is one example. So we see some softness in the enterprise space. Western Europe, we see a little bit of softness, but on the other hand, we see some upticks in the world. Eastern Europe, India, Malaysia to name a few, there is some positive sign, and so we are trying to take a educated forecast of those up factors and down factors in the industry and around the world.

Vivek Arya - Merrill Lynch

Thank you.

Operator

Your next question comes from the line of Simon Leopold with Morgan Keegan.

Simon Leopold - Morgan, Keegan & Company, Inc.

Thank you. I wanted to ask a couple of housekeeping questions. First, one was... I don't recall, may be missed discussion of 10%customers in the quarter. And the second one is just trying to make sure I understand the earnings on a pro forma basis consistent with the way First Call has presented it where we're including the stock-based compensation, but excluding the amortization. I'm thinking I'm coming up with $0.02 on that, basically the $0.11 minus the $0.09 from tax, just want to get a clarification on those two first, and then I'll follow-up.

Robert W. Pullen - Chief Executive Officer and President

Maybe I'll answer the first question. We have two greater than 10% customers, Simon, and then, and we are combining the wireless and wireline part of their business. Tim, I will pass it over you to answer the second part of the question.

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

Yeah, there is a couple of different answers to that. If you exclude the equity-based compensation, the First Call estimate was $0.01 and we delivered $0.04, if you included it was 0 and $0.03.

Simon Leopold - Morgan, Keegan & Company, Inc.

Okay, and then just as a follow-up. I know you guys hate giving more detail when you've already given and I... you do provide a bunch, but I'm really trying to get my hands around some of the moving parts here when... particularly when you talk about record quarters for products like the 8600 and 7100, without a baseline, it's a little bit tough to really understand the materiality. So, little bit more help if you could give us a sense of just how material these products are as a percent of your overall revenue, and some sense of where these are going and then specifically on the 7100 announcement of some new international customers, trying to get a sense of how big these are and what's driving those?

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

Well, certainly the 7100 has become a very important part of our Transport segment revenue, and we've given you a number of data points. One was that revenue has quadrupled last year, we've also said that the revenues are up for the first part of this year, 60%. It's more than half of that segment's revenue. I think from the managed access, we obviously, we give you the overall revenue for that segment. I would tell you that the 6300 was larger than the 8100 in this period. The... we'll give you segment information or sub segment information in the data space. The 8800 is still larger than the 8600, but I think we see growing momentum for our 8600 products with the 75 customer wins, and that's attempting to deliver. So I suspect and I'm happy to talk to you later this morning that the models are reasonably closed on these things. Hopefully that additional information is helpful.

Robert W. Pullen - Chief Executive Officer and President

And I'll give you some qualitative information, Simon. The 6300, we believe will have ongoing traction in developing countries. In fact you'll probably hear more about that in the next six months. The 8600, Simon, it’s kind of in the whole mobile backhaul. The operators have a dilemma. They are getting a lot of bandwidth because of data and video on their network and they need to backhaul it, invest the most expensive part of their network. And so, some claim that you need a few E1s or few T1s out of the cell site today. Customers are telling me, and I believe that we... they're going to need 100 megabits or 200 megabits out of the cell site. That's a train that already left the station that is going to show growth in the world over time. And examples of the handheld PCs, iPhones, and so on, are going to drive the continued wireless backhaul and the mobile backhaul space.

Simon Leopold - Morgan, Keegan & Company, Inc.

So, who are you typically beating on these deals?

Robert W. Pullen - Chief Executive Officer and President

Everybody. No, I mean a more thoughtful answer to you is, we see everyone, Simon, we see Huawei, we see Juniper to name a couple. But we are beating them, and we are beating them because we have this end-to-end managed solution is leveraging our existing network management system. We have the product to handle the time division world and the evolving packet world, so we're the bridge. We implement quality of service. We handle those synchronization better than anyone in the world right now. And we're giving great service. And we are going to continue to differentiate on service with our people.

Simon Leopold - Morgan, Keegan & Company, Inc.

Great, thank you for the answers.

Robert W. Pullen - Chief Executive Officer and President

Welcome.

Operator

Your next question comes from the line of George Notter with Jefferies.

George Notter - Jefferies & Co.

Hi, thanks a lot. Rob, I wanted to ask you about your international efforts from a sales and marketing perspective. You talked about it... referenced it quite a bit here on the call. Where exactly is Tellabs right now in terms of its ability to sell and market product internationally? Where are you guys positioned there? Is it something you could respond by geography, is it something that's more organizational and you can talk about sort of the milestones that you're looking towards in terms of building out the sales and marketing distribution capability?

Robert W. Pullen - Chief Executive Officer and President

Well, sure, George, good question, thanks. First recognize we're doing business with 30 of the 35 top providers in the world. And so we are in roughly 130 countries today and part of... when you look at Tellabs, George, in my opinion you'll hear more about this later, we are too leveraged in North America. By the way, we're going to continue to focus on North America, don't get me wrong. But we are going to spend a lot of our time addressing products and services for the global segment, North America included. Next, there are different countries that you're going to hear more about as we roll out the strategy. But I wouldn't be surprised... don't be surprised if you see us being more aggressive both on direct and indirect channels in the BRIC countries, as well as leveraging some of our partners and alliances with the big systems integrators, like an Ericsson, like a Nokia-Siemens, like a Harris Stratex to name a few.

George Notter - Jefferies & Co.

Got it. And is there something, are there any items you can reference just in terms of the products set that would help you in that effort internationally or is this more simply about taking the existing products and levering them in the international markets?

Robert W. Pullen - Chief Executive Officer and President

Well, first of all, we see that we could take many of our existing products on a global basis. As you know that 5500 is dominantly North America. But the 6300, the 8600, the 7100, the 8800, the 1100 broadband access are all global products. I believe when you look at us over the past couple of years, we've made a mistake being too customer focused and not enough market focus, and so you are going to see us spend a lot more time and energy and money on the market-focused approach.

George Notter - Jefferies & Co.

Thanks very much.

Operator

[Operator Instructions] Your next question comes from the line of Rai Archibold with Kaufman Brothers.

Raimundo Archibold - Kaufman Bros.

Thank you. I wanted to go back... I don't... I may be I missed when you answered Simon's question about the non-U.S. customers you signed, can you give us a sense as to again perhaps for geography or the tier 1 carriers in those geographies? And then second, after pulling out of Verizon GPON, you had referenced re-engaging or more effectively engaging tier 2, tier 3 carriers, can you bring us up to date as to where you are, in terms of gaining traction there?

Robert W. Pullen - Chief Executive Officer and President

First of all, your first question is with respect to our 7100 and our ROADM business, we actually sold that to wireline carriers outside the United States, one on in South Africa, and the other on in Puerto Rico. The next point is we as for the tier 2 and tier 3, we are actually spending more time with our... the national local exchange carriers and the independent operating companies as they are building out IPTV solutions with our broadband access and trying to leverage our entire portfolio in this segment, including focusing on business enterprises, mobile backhaul in those spaces.

Raimundo Archibold - Kaufman Bros.

All right. Thank you.

Scott Coleman - Morgan Stanley

Your next question comes from the line of Scott Coleman with Morgan Stanley.

Scott Coleman - Morgan Stanley

Sure. thanks, guys. Few quick ones from me. One, obviously good trends internationally offset by softer U.S. business this quarter. In terms of your flat to down guidance for Q3, how are you thinking about U.S. versus international? Do you think international can hang in around these levels?

Robert W. Pullen - Chief Executive Officer and President

Yeah, we believe that this is a consistent mix plus or minus... but as I said over... the years, you are going to see us focus more and more on elevating this percentage to a higher percent outside of the U.S.

Scott Coleman - Morgan Stanley

So then should we think in Q3 that international is still driven by 6300, more 7100, is that the way to think about it?

Robert W. Pullen - Chief Executive Officer and President

Yes.

Scott Coleman - Morgan Stanley

Okay.

Robert W. Pullen - Chief Executive Officer and President

And 8600 and 8800 by the way.

Scott Coleman - Morgan Stanley

Okay. And then, Tim, on the balance sheet and forgive me if you covered this earlier, but inventory is up about 10% sequentially going into a quarter that you are guiding flat to down. I am just curious what's happening there and why we saw the build this quarter?

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

It's peculiar to some of our customer builds and the mix requirements, particularly in the 7100 ROADM, expect to see inventory bounces back, down to where they were prior to this quarter in Q3.

Scott Coleman - Morgan Stanley

Okay. Great, guys. Thanks.

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

Thank you.

Operator

Your next question comes from the line of Brian Coyne with FBR Capital Market.

Brian Coyne - Friedman, Billings, Ramsey & Co.

Hey, guys. Thanks for taking my call. Also just one or two quick ones. First of all, I'm not sure I caught your earlier answer to the question about your one wireless customer that reduced spending in the quarter and whether you're seeing or expecting a rebound in that account. So, I apologize if you've covered that in detail. But I just missed it. And then the second one really is on gross margins and… can you sort of excel any product rollouts. I mean, did I hear you correctly around the 7100, is that at or higher than the corporate average? I just remember, I think last quarter, I believe these saw margins perhaps just about break-even and wanted to understand if there was a change, what might be driving that? Thanks.

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

Two things, Brian. One on the wireless, what we said is we've got four key wireless customers and we expect the spending behavior that we saw in 2Q to persist in the Q3, but the caveat that's typically Q3 is our slowest quarter for our wireless spend. So, Rob also mentioned we hope to see the 5500 business and 4Q uptick. In terms of the gross margins, what was the question again?

Robert W. Pullen - Chief Executive Officer and President

Yes, I will take it. It was 7100, it was... let me be clear. The 7100 is below our corporate average, but giving us a better contribution in the previous quarter.

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

Five out of six quarters, we've seen improvement in this margin, which is encouraging given that we have at least one large customer that has continuous improvement price reduction. So, we made a lot of progress, the key in the ROADM business is to leverage the technology and other applications when new customers aggressively reduce the cost and over time we'll see a mix shift toward transponder cards, which should have better margin. So I have to tell you, we are ahead of where we expected to be. We have talked about this product as being break-even, and so you can imagine after six... five out of six quarters that we're above break-even. And we're still below our overall growth... corporate gross margin, but we are excited about the product... the product, we're excited about the business model. We think this product is going to be in the customer networks for many, many, many years to come. We're excited about seeing already a swing upward in transponder cards, which means our customers are putting increased amounts of traffic on the product and we are excited about adding new significant customers, one major one last quarter. We're talking now about getting some traction with the product outside North America. So, unlike our 5500, which was pretty much North American centric, we see this platform is having global applicability.

Brian Coyne - Friedman, Billings, Ramsey & Co.

Great, and then....

Robert W. Pullen - Chief Executive Officer and President

I would also add to that that the 7100 is one of the most efficient video distribution systems in the world with some of the features that we have. We also are adding new Ethernet aggregation features to the product we just released. And so that'll be an upgrade cycle for our customers that not only will they get the efficiencies of low-cost transport of voice data and video, including mobile backhaul. But now they can get the Ethernet aggregation on the existing platform, and that's already in a platform that's taken an MSPP that used to be a bare shelf [ph] and put it on the card.

Brian Coyne - Friedman, Billings, Ramsey & Co.

That's great. Thanks so much guys.

Tom Scottino - Investor Relations

Bettina, this is Tom. We will take one more question.

Operator

And your final question comes from the line of Ehud Gelblum with JPMorgan.

Ehud Gelblum - JPMorgan

Hi, thank you very much for the opportunity for the follow-up. Rob, when Krish was still around, he used to speak a lot about how the 6300 was not doing well in emerging markets because Huawei was too competitive and he couldn't make the margins in the emerging markets with 6300. Those are the constant refrain with him and that therefore he was pulling out, but you're going ahead with the 6300 in emerging markets. Now, it sounds like you're saying that the emerging markets are a big growth area for the 6300, has Huawei disappeared? Has margins gotten better there or what has changed now over the last couple of years?

Robert W. Pullen - Chief Executive Officer and President

Well, first of all, Huawei hasn't disappeared nor do we expect it will disappear any time soon. They are a formidable competitor. There is a different approach to the 6300. If we are doing, we are going to be more aggressive in cost reductions with this platform and developing that in lower cost geographies. And there is a different way to go pursue this segment than we secured and pursuing and you're going to see us be more aggressive in that space.

Ehud Gelblum - JPMorgan

Okay. Thank you.

Robert W. Pullen - Chief Executive Officer and President

Unfortunately, this... our time doesn't permit any longer for the... any additional questions. Thank you folks very much. We appreciate your questions and your time and your support. As you can tell, you're going to see us innovate to gain traction with our customers globally, we are going be relentless in our cost reductions on the equipment, as well as getting costs... unnecessary costs out of our business and both innovate for our customers and maximize for our shareholders. So thanks a lot folks and we will talk to you soon.

Operator

And this does concludes today's Tellabs investor relations conference call. You may now all disconnect.

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Source: Tellabs, Inc. Q2 2008 Earnings Call Transcript
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