Here’s the entire text of the prepared remarks from Tellabs’ (ticker: TLAB) Q3 2005 conference call. The Q&A is here. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.

Executives:

Tom Scottino, Sr Manager, IR
Krish Prabhu, President, Director and Chief Executive Officer
Timothy Wiggins, EVP and Chief Financial Officer

Analysts:

Alex Henderson, Smith Barney
Nikos Theodosopoulos, UBS Warburg
Steve Kamman, CIBC World Markets
Gina Sockolow, Buckingham Research
Brantley Thompson, Goldman, Sachs & Co
Simon Leopold, Morgan Keegan
Ehud Geldblum, J.P. Morgan
Steve Levy, Lehman Brothers
Tal Liani, Merrill Lynch
Ken Muth, Robert W. Baird
George Notter, Jefferies
Tim Daubenspeck, Pacific Crest Securities
Michael Davis, Investec
Andy Schopick, Nutmeg Securities

Presentation

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Tellabs Investor Relations Conference Call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question and answer session.

Operator Instructions As a reminder, this conference is being recorded Tuesday, October 26, 2004.

I would now like to turn the conference over to Mr. Tom Scottino, Senior Manager of Investor Relations at Tellabs.

Tom Scottino, Sr Manager, IR

Thank you, Judith, and good morning, everyone. With me today are Tellabs President and CEO, Krish Prabhu and our Executive Vice President and CFO, Tim Wiggins. If you haven't seen the news release we issued this morning, you can access it at tellabs.com.

Before we begin, I will remind you that certain statements made on the call today may be considered forward-looking. I direct you to the risk factors contained in today's news release and in the reports filed by Tellabs with the Securities and Exchange Commission.

In addition, as we're in the process of acquiring AFC, I am obliged to say that this communication is not a solicitation of a proxy from any security holder of Advanced Fiber Communications, Inc. Tellabs, Inc. has filed with the Securities and Exchange Commission a registration statement on From S4 which contains a preliminary proxy statement prospectus. Advanced Fiber Communications, Inc. expects to mail the definitive version of the proxy statement prospectus to its stockholders concerning the proposed merger of Advanced Fiber Communications Inc. with a subsidiary of Tellabs Inc. We urge investors and security holders to read the definitive proxy statement prospectus and any other relevant documents to be filed with the SEC because they will contain important information.

Investors and security holders will be able to obtain the documents free of charge at the SEC's website, that's www.sec.gov. In addition, documents filed with the SEC by Tellabs, Inc., will be available free of charge from Tellabs Investor Relations at 1415 West Steele Road, Naperville, Illinois, 60563, the telephone is 630-798-8800. Documents filed with the SEC by Advanced Fiber Communications, Inc. will be available free of charge from the Advanced Fiber Communications Inc. investors relations department at 1465 North McDowell Boulevard, Petaluma, California, 94954. The telephone is 707-792-3500.

Interest of certain persons in the merger. Tellabs Inc. and its directors and executive offices and other members of its management and employees may be deemed to be participants in the solicitation of proxies from the stockholders of Advanced Fiber Communications Inc. in connection with the merger. Information about the directors and executive officers of Tellabs Inc. and their ownership of Tellabs Inc's stock is set forth in the proxy statement for Tellabs Inc's 2004 annual meeting of stockholders. Investors may obtain additional information regarding the interest to the participants by reading the proxy statement prospectus when it becomes available.

Having said that, I will turn the call over to Krish.

Krish Prabhu, Tellabs - President, Director and Chief Executive Officer

Thank you, Tom, good morning, everyone. We announced third quarter results today. Our revenue was below our expectations. We had indicated to you in our last call that revenue would be 300 million, plus or minus 5. We came in at 284 million and the 15 million miss on revenue was largely related to a manufacturing transition issue we had in Europe, and it is all contained in our managed access products line.

We were transitioning our outsourced manufacturing from a location in Finland to Estonia. And unfortunately in the transition, we could not ramp up to the bigger need we needed to meet, to fulfill some of the orders we had on hand. It was a lot not a component issue, nor was it an audit issue. We hope to get this problem fixed. We have a team working there round-the-clock and we hope to catch up here in this quarter.

Earnings were per expectation at $0.11, though I must clarify and we've done this also in the release, about $0.02 is due to tax refund issue, which Tim Wiggins will elaborate a little bit more. But the difference in the expected earnings of $0.11 versus the operating results of $0.09 is largely related to the margin which we missed because of the revenue miss.

Margins were around 54%. Our model for margin is 55 plus or minus 2%, and it is the 2% is mix related. This quarter, we had lower 8100 product. That is in our managed access category. That was part of the 15 million which we could not ship. We had 7100 revenue which is next generation transport platform that we are launching in an ILEC. We shipped quite a bit of that product this quarter and the earliest shipments had more frames and infrastructure rather than modules. And it's those transponder modules that have higher margins. So as traffic goes under this network, we expect that we will recover good margin on that shipped product.

And then we also a higher component of service business. Our service business as you know traditionally has smaller margins than our product business. Last quarter, if you're comparing our margins this quarter to last quarter, last quarter the margins were unusually high due to a concentration of wireless products, which we had clarified in the last call.

In order to give you some color about the trends in our underlying business, especially we have four moving parts: the transport products, the managed assets products, the voice quality enhancement products and the data products. I will just give you some numbers and then Tim Wiggins will elaborate a little bit more in his presentation.

Our transport products year-to-date for the first three quarters have grown 43% between 2003 and 2004 and that is all related, or primarily related, to the wireless activity we had which we've talked about. Last quarter and this quarter, we’ve had the two highest wireless shipments that we have had in the history of Tellabs, so we have really benefited from the wireless bulidout. Managed access year-to-date is down 9%, voice quality enhancement year-to-date is up 73% again on the strength of wireless and voice over IP, and data, we are still in a start-up mode and I will talk little bit about some of the trail activity.

In the area of managed access, we hope to recover some of the last revenue that we had in the third quarter. We hope to recover in the fourth quarter. Tim Wiggins will give you some guidance as to what we expect in the fourth quarter.

In terms of data, we had indicated earlier that we had nearly a 100 customer engagements, we track our data activity in four phases, starting with customer engagement, a committed trial, initial revenue and follow on revenue. We now have three customers with follow on revenue, we have eight customers with initial revenue, we have 18 customers who have committed to our trial and we have 26 customers who are in various stages of a trial.

So, all in all we are quite pleased with the market traction, of course as you expect and we expect, we would certainly want more revenue but data plays one that has a longer upfront sales cycle especially since we are very focused in our data activity. The AFC merger activities progressing well, we are working closely with them in the integration planning, we anticipate and look forward to a successful close. And you may have noticed, AFC has announced yesterday that their shareholder approval meeting is set for November 30.

I will now ask Tim Wiggins to go over some of this in more detail and I shall come back to answer some of your questions.

Timothy Wiggins, EVP and Chief Financial Officer

Great Krish, thanks and good morning everyone. Compared to year ago levels, our third quarter results followed developing pattern, higher revenue, higher margins and lower expenses combined to drive improved profitability. Whole revenue for the quarter was $284 million and while it’s up16% from the third quarter of 2003 as far our expectation on a sequential basis that I’ll discuss shortly.

Net income amount of $46 million or $0.11per share on both the GAAP and non-GAAP basis. As Krish mentioned, net income was positively affected by tax benefit of approximately $4 million, which includes an $8.5 million benefit associated with the resolution of a recent federal tax audit. The tax benefit contributed about $0.02 of EPS.

While we are discussing EPS, let us talk about GAAP and non-GAAP for a moment. Given the small difference between our GAAP and non-GAAP results this quarter approximately 300,000 in charges, related to previously announced restructuring actions our GAAP and non-GAAP results are basically the same.

In last year’s third quarter, however, our GAAP result included about $48 million in restructurings and other charges. Therefore, the following discussion will include some non-GAAP measures. You will find a reconciliation of these non-GAAP results with our GAAP results in our press release.

This quarter’s net income of $46 million or $0.11 per share can be compared with a non-GAAP net loss of $18 million for $0.04 per share in the third quarter of last year, as a $64 million turn around in net income in a space of twelve months. By way of comparison, last quarter we are in $53 million or $0.13 per share on a non-GAAP basis. We generated $84 million of positive net cash from operating activities during the quarter versus a negative $3 million in the third quarter of ‘03 and a positive $71 million in the second quarter of this year. This quarter’s results show respectable year-over-year growth, total revenue came in below the range of expectations we gave you in July.

The difference can be attributed in large part to some transition issues we encountered as our outsourced international manufacturing operation was relocated from its longtime home in Finland to a different facility in Estonia during the third quarter. Overall, we estimate that this transition or these transition issues inhibited our ability to ship approximately $10 to $12 million of 8100 managed access systems and 6300 next-generation SDH products during the quarter.

The quarter was also affected by lower than anticipated sales to wireless carriers in North America.

The manufacturing situation is similar to what we experienced last year when our North American manufacturing operation was moved to our outsourced partners' facilities. Issues are being addressed and we expect to ship most, if not all, of the 81 and 6300 products in the December quarter.

A lot of income has been spilled over wireless spending in North America this quarter and, like other suppliers, we saw wireless revenue decline sequentially. In all fairness though, this was the second strongest wireless quarter in Tellab's history, exceeded only by the robust prior quarter. Looking forward, it seems that this quarter's results are more in line with where we think the businesses is heading over the near term.

We fully expect that wireless will remain a vibrant part of the Tellabs' storybook for the foreseeable future and we look for continuing strength in 2005 as the industry works through its consolidation issues and more wireless carriers begin to build their networks and support increase minutes of use and deliver new data oriented services.

On a geographic basis, revenues from customers in North America amounted to 66% of total revenue versus 59% in the year-ago quarter and 70% in the second quarter. Revenue from customers in Europe, Middle East, Africa, Latin America and Asia-Pacific regions was down about 2 million year-over-year and up more than 4 million compared to the second quarter of this year.

For the third quarter, transport revenue increased to 138 million, up 31% over the year-ago quarter. Compared with the second quarter, transport sales declined 23 million, primarily as a result of the wireless situation I just described. As a measure of the overall resiliency of the 5500 business, more than 1.4 million T1 equivalents were shipped during the quarter. By way of comparison, we shipped about 800,000 T1 equivalents in the third quarter of 2003 and 1.8 million in the second quarter of this year.

We also began to ship our 7100 Metro DWBM system to an ILEC customer for deployment in the next-generation 10-gig backbone network designed to position them for a triple-play service. For the quarter sales of our managed access products, the Tellabs 8100 Managed Access Platform and the 6300 next-generation SBH platform, along with our Tellabs 2300 Access Platform for cable telephony services amounted to 73 million, 10% below the year-ago quarter and about 3 million below last quarter. The overall revenue decline was driven primarily by the manufacturing transition issues I described earlier, offset partially by a year-over-year increase in sales of the 6300 products.

For the quarter, our voice quality enhancement products came in at 20 million that’s up 29% over the year-ago quarter and 4 million below the second quarter level. This product category includes both stand-alone echo cancellers, primarily for wireless applications and echo solutions designed to be integrated into voice switches.

We addressed the IPM TLS network opportunity with our broadband data products, the Tellabs 8800 Multiservice Router and our 8600 Managed Edge Service Platform for Ethernet services. For the quarter, revenue for the 8800 Platform amounted to 8 million our best quarter today. Revenue from services and solutions amounted to 45 million in the quarter; that's 6 million better than the third quarter of 2003 and about 4 million better than the prior quarter.

Moving to the profitability aspects of our business, gross margins were 54% compared with 46% in the third quarter of '03 and 59% in the second quarter. Product and customer mix shifts caused gross margin to come in at the low-end of our expectations this quarter. When I look at the sequential change, we had about 3.5 points of margin decline related to mix shifts across Tellabs' product lines. Compared with Q2, we sold less high-margin 55 and 8100 products and more lower-margin products, like the 7100 Metro DWDM Platform.

The remaining 1.5 points of margin decline was related to customer shifts within products, as for example, we sold our 6300 next-generation SBH product in more price-competitive regions. Moving ahead, I expect gross margin for the fourth quarter to be flat to slightly down, plus or minus a point or two. Any variability will likely be attributable to changes in mix.

Turning to operating expenses, actual operating expenses came in at 120 million, in-line with expectations. That compares with 131 million in the year-ago quarter and 122 million last quarter. For the quarter, R&D expenses were down 1 million sequentially to 60 million. That amounts to 21% of sales. By way of comparison, R&D accounted for 28% of sales in the year-ago quarter.

As we look forward to the pending acquisition of AFC, we are exploring our ability to reallocate R&D resources in order to address more opportunities in the access space.

SG&A expenses were 57 million, flat with the previous quarter. That equates to 20% of sales versus 24% in the third quarter of 2003. Intangible asset amortization at 4 million was flat with the second quarter of this year, and accounted for the balance in spending.

We have done a good job this year in holding the line on spending. But as we look forward to the fourth quarter, we are targeting flat to slightly up total FX as we exceed and expect the impact of integration costs associated with the pending acquisition of AFC and normal seasonal factors to affect OpEx. All told, this could increase total OpEx by a couple of million dollars sequentially.

Operating income was 33 million positive in the quarter, or 12% of sales versus operating loss of 18.5 million in the third quarter of last year. Other income was 9 million versus 5 million in the second quarter of this year. Our tax provision for the quarter was a benefit of approximately 4 million.

During the quarter, we reached an agreement with the IRS on their audit of our tax returns for the years 1998 to 2000. As a result, we recorded a benefit of approximately 8.5 million in the quarter's provision. Excluding this benefit, we would have recorded a tax expense of approximately 4.5 million, resulting in an effective tax rate of approximately 14%.

Our GAAP effective tax rate for the past couple of years has been impacted by the valuation allowances that we've maintained against our deferred tax assets. As we have discussed in detail in our recently filed S4 for the AFC acquisition, our tax rate post-acquisition will be significantly impacted by acquisition accounting. Generally speaking, we expect to see our effective tax rate return to a level that more closely approximates the combined federal and state tax rates in the mid to upper 30s range.

However, because of our tax loss carryforwards and other deferred tax assets, we anticipate that our cash taxes will continue to be close to zero for our U.S. income until such loss carryforwards are utilized. We encourage you to read our S4 and 2003 annual report for more detail on the accounting implications of our valuation allowances and the potential impact of the pending acquisition of AFC on our future tax rate.

Turning to the balance sheet, day sales outstanding was 57 days, up two days sequentially. Inventory turns decreased to 8.7 times versus 10.1 in Q2 and inventory in terms of dollars totaled 64 million, up from the previous quarter. Cash flow from operations was 84 million and CapEx during the quarter was 9 million compared with 11 in Q2.

At the end of the quarter, our cash and investment balance increased to $1.343 billion, up 101 million from the second quarter. The actual numbers of shares outstanding was approximately 417 million at the end of the quarter and headcount at the end of the quarter stood at approximately 3000, flat with Q2. For the quarter, book-to-bill was below 1.

As I look and take backlog into consideration along with our other internal indicators, we expect fourth quarter revenue to be up sequentially over the third quarter 2004 and range between $300 and $315 million.

At this point, I will open the floor to your questions. Judith, please open the line.

Related:

• The Q&A from this call is here.
• All Networking Stock Blog articles on Tellabs.
• A list of full conference call transcripts available on the Seeking Alpha Network.

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