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Tellabs Taps AFC's Growth

Light Reading
News Analysis
Light Reading
7/26/2005

Tellabs Inc. (Nasdaq: TLAB; Frankfurt: BTLA) CEO Krish Prabhu highlighted the fiber access market today as he walked analysts through the vendor's impressive second-quarter results, which hit $463 million in sales and generated $41 million in profits on a GAAP basis (see Tellabs Ups Q2 Revenues).

The company's access division -- essentially the AFC business acquired last year -- was the star performer, contributing $144 million in sales, up 23 percent from a year earlier (see AFC Reports Q2 Results).

On a pro forma basis, Tellabs produced net income of $58 million or 13 cents per share in the second quarter, up from $26 million or 6 cents a share in the first quarter of 2005. This beat consensus analyst estimates by 4 cents a share, according to Reuters. The pro forma results excluded restructuring costs and some other special items.

These better-than-expected results pushed the company's share price up by 52 cents, more than 5 percent, to $9.41 in early morning trading.

But the AFC story isn't all rosy: In addition to producing some high-profile accounts, the acquisition has brought some technical, operational, and customer relationship challenges for Tellabs (see Rough Week for AFC and Tellabs Secures BellSouth Biz).

Prabhu admitted that Tellabs has had to recall some optical line terminals (OLTs) from "a customer" -- commonly known to be Verizon Communications Inc. (NYSE: VZ) -- because of a technical issue that was causing instability.

"We have been working with this customer to ensure better than five nines reliability in our fiber access products, and so decided to recall some units that needed a component replacement that has now made the product extremely stable. This hasn't had any material impact on our financial results," the CEO told this morning's earnings conference call.

And it's not just the OLTs that have been acting up a bit. According to Prabhu, delivering mass volumes of the AFC 610X optical networking terminal (ONT) has been problematic, to the point where Verizon pulled back its rollout and Tellabs incurred a vendor liability charge in the first quarter.

The 610X's shortcomings have been apparent for some time, which is why Tellabs acquired Vinci in the final hours of 2004 (see Tellabs Vacuums Up Vinci). Now Prabhu says tests of the Vinci 611 ONT have gone well, and that "the customer" is due to shift from the old product to the new one during the current quarter.

How will this effect profitability? The product shift isn't expected to have any immediate impact on the company's gross margins, which stood at 45 percent, the vendor's annual target, in the second quarter. Prabhu noted that, while other products in the access division, both for copper and fiber access, generated gross margins "in our target range," the ONTs are "at or near zero percent gross margins at this stage." This isn't expected to change any time soon.

Prabhu, responding to analyst questions, also shared details of the company's shifting staffing levels. The current headcount is 3,700, up from 3,500 last year. But the AFC acquisition came with 1,000 staff, which means 800 positions have been culled in the past year (see Tellabs: 'Au Revoir Miramar', Notes From Naperville and Headcount: Mama Mia!).

With access delivering $144 million in revenues, that left the rest of the company -- Tellabs' transport, managed access, and broadband data divisions -- contributing $319 million, up from $304 million a year ago, when the firm posted net profit of $50 million (see Tellabs Revenue Grows to $304M). The numbers were also up from the first quarter of this year (see Tellabs Reports Q1 Revenue Rise ).

Merrill Lynch & Co. Inc. analyst Tal Liani noted that while a strong quarter had been expected, Tellabs had exceeded expectations. Operating expenses, at $148 million, were down by 4 percent sequentially and lower than the expected $155 million, while the sequential increase in gross margin to nearly 45 percent from 42 percent was largely down to a better performance by the access division.

Tellabs projects revenues and gross margins to be flat in the third quarter, though Prabu admitted that the company could have been more aggressive in its outlook, as access sales should continue to rise as the RBOCs continue their fiber network expansion, while transport system revenues from mobile operators, which had been variable during the past year due to carrier consolidation and one major project, had stabilized.

— Ray Le Maistre, International News Editor, Light Reading

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