From SSB:
Tellabs, Inc. (TLAB)
TLAB: First Quarter Results -- Part 2 3H (Neutral, High Risk)
Mkt Cap: $4,032.4 mil.
April 17, 2002 SUMMARY
* Tellabs didn't prerelease, but, in our opinion, they
TELECOMMUNICATIONS should have. Revenues came in way below our and First
EQUIPMENT Call expectations. With most estimates for revenues cut
Alex Henderson during the quarter to down roughly 10% Q-Q, Tellabs came
in down 21%.
* Weakness was mainly in the core optical business which
Daryl Armstrong declined by 32%.
* Amazingly, a sharp decline in one of the highest
margin units and the sharp decline in revenues produced
Matthew Gavigan sharply higher gross margins, up 500 PB Q-Q
* Tellabs commentary supports our contention that capex
cuts during 1Q will result in fairly flat spending Q-Q
in 2Q despite the historical seasonal improvement.
Service providers are holding the line on spending Q-Q.
* Tellabs announced a restructuring targeting the
reduction in operating costs of $30 million per quarter
with charges of $130 million for the restructuring and
$110 million for excess inventory and purchase
commitments.
* Trimming revenues but costs offset resulting in same EP
FUNDAMENTALS
P/E (12/02E) 69.6x
P/E (12/03E) 34.8x
TEV/EBITDA (12/02E) 45.7x
TEV/EBITDA (12/03E) 19.0x
Book Value/Share (12/02E) $5.96
Price/Book Value 1.6x
Dividend/Yield (12/02E) NA/NA
Revenue (12/02E) $1,615.0 mil.
Proj. Long-Term EPS Growth 10%
ROE (12/02E) NA
Long-Term Debt to Capital(a) 57.9%
TLAB is in the S&P 500(R) Index.
(a) Data as of most recent quarter
SHARE DATA RECOMMENDATION
Price (4/16/02) $9.74 Current Rating 3H
52-Week Range $42.05-$9.17 Prior Rating 3H
Shares Outstanding(a) 414.0 mil. Current Target Price $11.00
Convertible No Previous Target Price $11.00
EARNINGS PER SHARE
FY ends 1Q 2Q 3Q 4Q Full Year
12/01A Actual $0.29A $0.02A $0.01A $0.03A $0.41A
12/02E Current $0.02A $0.02E $0.04E $0.06E $0.14E
Previous $0.02A $0.02E $0.04E $0.06E $0.14E
12/03E Current $0.04E $0.07E $0.08E $0.10E $0.28E
Previous $0.04E $0.07E $0.08E $0.10E $0.28E
12/04E Current NA NA NA NA NA
Previous NA NA NA NA NA
First Call Consensus EPS: 12/02E $0.14; 12/03E $0.33; 12/04E NA
OPINION
Tellabs didn't prerelease, but we think they should have. The company came
in with revenues down 21% Q-Q with a 32% decline in its flagship optical
line. While the decline in revenues is a mild negative surprise, the
performance of gross margins is almost a considerable surprise given the
revenue results. Despite a sharp decline in Q-Q revenues driven by the most
profitable product sector, gross margins expanded almost 500 BP. While some
help to margins can be expected by the lower service revenues, the product
revenues fell faster than service and represent a negative mix shift.
Management indicated that "very high margin consulting services revenues
helped offset the decline in product margins and that this would not recur".
Further, we certainly would expect negative overhead variance given the
volume decline. Management indicated that the shift to line cards helped
offset the overhead variance in the Titan 5500 line such that Titan margins
remained steady Q-Q, but we note that Titan still declined as a percent of
revenues which should have hurt margins. Management insists it did not use
any of the reserves set up from its prior restructuring, and they insist they
took normal expenses on discretionary reserve accounts during the quarter.
Tellabs Announces Another Restructuring Charge And Plans To Trim Operating
Expenses By $30 Million Per Quarter With Charges Of $240 Million. In
reaction to the tough end market conditions, Tellabs is stepping up its cost
cutting activities with a restructuring charge of $130 million and a write-
off of $110 million for inventory and purchase commitments. We are surprised
by the magnitude of the inventory charges and the charges for purchase
commitments. At this point in the cycle, inventory commitments should have
been highly cautious. Second inventory was down $35 million in the quarter.
Management stated that the commitments date back to 2000. They also promised
to "clearly call out" any gains from inventory utilized from the write-downs
in future periods.
Management Expects To Generate $30 Million In Cost Savings Per Quarter
Starting In 2Q---But Expenses Should Be Up In 2Q Due To Seasonality Even
Though Revenues Are Not Expected To Show The Seasonal Increase, Got That?
Management indicated they expect operating expenses to increase quarter to
quarter in 2Q from 1Q from $167 million just reported to $175 million in 2Q.
The increase reflects seasonality. However, they also indicated the revenues
should be essentially flat quarter to quarter indicating that the service
providers are not inclined to increase spending and they "appear to be
aggressively holding the line on spending". The result is that despite the
cost savings from the restructuring operating expenses are expected to
increase on fairly flat revenues. Presumably the costs of the plant closings
and any disruption with the capacity shifts should be captured by the
restructuring charge.
Management explained the increased cost in 2Q as a reflection of a general
wage increase for employees and the increase in R&D costs associated with
prototypes. We estimate the costs increase during 2Q due to wage hikes at
roughly $10 million Q-Q and prototypes at roughly $5-$10 million quarter-to-
quarter. Management notes that they haven't had a wage increase in 2 years.
We are surprised at the sequential increase in prototype costs and suspect
this might be associated with Ocular.
The Key Take Away From Tellabs Commentary Is That Service Providers Are
Telling Them They Are Going To Hold Spending Levels Into 2Q. Based on
Tellabs management commentary, investors should not anticipate a quarter-to-
quarter increase in spending by the ILECs and large IXCs in 2Q. Despite the
historical seasonal spending increase from 1Q to 2Q, this year, "the service
providers are holding the line on spending going into 2Q." We think this is
an important point and its consistent with our argument that the spending
cuts during 1Q will offset the seasonal patterns. Moreover, a solid portion
of the ILEC spending in 2Q is on outside plant not new equipment.
Tellabs' Revenues Tumble 21% Sequentially. Tellabs' revenues came in at $371
million, representing a 21% sequential decline. This was sharply below First
Call consensus of $428 million. The company reported having two 10% customers
in the quarter. Management estimated that roughly 60% of their revenues
came from the seven largest domestic service providers. Approximately 27%-
30% came from wireless carriers and the residual was derived from emerging
service providers.
* Optical Networking revenues came in at $181 million, down 32% sequentially.
Tellabs noted that roughly 75% of their revenues in the quarter came from
line cards as frame sales tumbled. We believe that Titan 5500 sales came
in around $167 million, down 29% sequentially. The fall-off in Tellabs
6000 series revenues was even more dramatic. We believe that 6000 series
revenues came in at $15 million, down 53% sequentially. This reduction,
although large, was actually buffered by the addition of a new revenue-
generating customer for the Titan 6500. This sharp drop-off is not too
surprising given that we believe they have largely satisfied the initial
agreement with Sprint# (FON, 3M rated by J. Grubman) for the Titan 6500.
* Broadband Access revenues came in at $115 million, coming in flat
sequentially and beating our forecast by $10 million. Tellabs' voice
enhancement revenues came in at $19 million, down 21% sequentially and
below our $22.5 million forecast. Service and solutions revenues came in
at $56 million, representing 15% of the revenue total and showing a 13%
sequential decline. Management noted that the mix of service revenue is
shifting with a higher proportion of sales coming from higher margin
extended warranty contracts and professional services relative to lower-
margin EF&I activities. Management argued that the shift toward
professional services is being driven by layoffs at the service providers
that are using their services in lieu of employing some full-time
employees.
Revising Estimates. As a result of the sharply lower 1Q revenue base, we are
revising our revenue and EPS estimates. For the second quarter, we are
lowering our revenue estimate to $386.4 million, a 4% sequential increase,
but 15% below our prior forecast of $456.8 million. We are maintaining our
2Q EPS estimate of $0.02 per share. For the full year 2002, we are lowering
our revenue estimate to $1.6 billion from $1.87 billion, but we are
maintaining our EPS estimate of $0.14 per share. For the full year 2003, we
are lowering our revenue estimate to $1.69 billion from $2.07 billion. Our
new EPS estimate stands at $0.28 per share, up from $0.35 per share.
Balance Sheet. Tellabs' cash balance at the end of the March quarter was
$912 million, down $190 million sequentially. Although the company generated
approximately $110 million in cash from operations in the quarter, $280
million in cash was used to purchase Ocular Networks. DSOs were down 3 days
sequentially to 60 days. This was primarily due to increased cost collection
efforts which brought accounts receivable down from $331 million in 4Q01 to
$247 million at the end of 1Q02. Inventory turns declined to 2.7x in 1Q02
from 3.3x in 4Q01.
Here is a quick summary of the results:
* Revenue. Tellabs reported revenue of $371.5 million, 15% below our
$437.1 million estimate. This is down 21% sequentially from revenue
of $470 million in 4Q01. The overall revenue shortfall was primarily
attributable to a substantial falloff in demand optical networking
equipment
* Gross Margin. Gross margins for the quarter came in at 47.1%, 5.4
points above our 41.7% forecast. Sequentially, gross margins were up
4.7 points compared to 4Q01 level of 42.4%. We attribute the sharp
increase in gross margins primarily to a mix shift toward higher
margin line cards.
* Research and Development. R&D expenses for the quarter were $90.6
million, below our $93.8 million estimate by $3.2 million. As a
percentage of revenue, this is 24.4% of revenue compared with our
estimate of 21.5% of revenue. Compared with the previous quarter,
this is down $315 thousand from the $90.9 million reported in 4Q01.
* Sales, General and Administrative. Tellabs reported SG&A expenses of
$77.2 million, this is almost $13.6 million below our forecast of
$90.8 million. As a percentage of sales, SG&A was roughly in-line
with our forecast of 20.8%.
* Operating Margin. Tellabs' operating margin for 1Q02 was 1.9%. This
is 248 bps better than our estimate of -0.5%.
* Earning Per Share. EPS came in at $0.02 per share, a penny ahead of
our $0.01 per share estimate and Street consensus.
INVESTMENT THESIS
There's a fundamental belief that the digital cross connect market will be
attacked by next generation optical switching technology and by voice over IP
network conversions, which diminish the need for traditional circuit based
cross connects and move the network topology away from SONET rings, where DCS
s are a mainstay. Tellabs needs to keep its position strong with the ILECs
until it can ramp its Titan 6500 and Occular lines. The persistent weakness
in the Titan 6500 and lack of progress on the Titan 6100 remain concerns.
Companies such as Ciena, Lucent, Nortel, Sycamore and Metro Optix are
targeting the cross connect market with new next gen equipment and represent
a challenge to the Titan digital cross connect products. Near-term the
pressure on Tellabs from the over build of cross connects used to integrate
the regional bells with the CLECs appears to be reversing. The redeployment
of this capacity has been stunting demand for equipment and the elimination
of this overhang should result in a slight improvement in demand going
forward.
COMPANY DESCRIPTION
Tellabs is a leader in the digital cross connect market, as well as in the
voice over cable and the mature echo cancellation businesses. One of the
most salient points in evaluating Tellabs today is its exceptionally deep
penetration and strong relationships with the ILECs and IXCs, which have the
money and capability to continue to build out their infrastructure even as
many CLECs are being caught up in the toughening economic backdrop and
tightening capital markets. |
