M. Birck's letter from 1998 Annual Report
for the full report, visit www.tellabs.com
There can be little doubt that 1998 was one of the more memorable years in Tellabs' 24-year history -- and not all of those memories are the kind our stockholders and employees are likely to recall fondly in future years. 1998 was perhaps the most volatile period in the company's experience, both from the financial perspective of stockholders and the activities and emotions of its people. On balance, however, the year started well and ended well, and in the process once again set revenue and earnings records every quarter.
For the year ended January 1, 1999, sales amounted to $1.66 billion, a nearly 38-percent increase over 1997 sales of $1.2 billion. That performance puts the company in good position to achieve its "stretch" objective set in 1995 of $2B by 2K -- $2 billion in revenue by the year 2000 -- a year ahead of schedule. Net earnings for 1998 amounted to $398 million, which includes several one-time pre-tax items -- a gain on sale of stock held as an investment amounting to $73.4 million, a write-down of the remaining portion of the assets of the Wireless Systems Division (from an earlier acquisition) amounting to $24.8 million, and other acquisition costs that through the year amounted to just under $13 million. Net earnings the prior year amounted to $264 million, which also included a pre-tax gain on sale of investment stock of just under $21 million. On an all-in basis, net earnings for 1998 were just over 51 percent above earnings in 1997. (Excluding the aforementioned items, coincidentally, earnings in 1998 were up just under 50 percent.) On a diluted per-share basis, earnings were $2.07 this year and $1.42 in 1997.
The fourth quarter of 1998 was definitely a record-setter for both revenue and earnings. Sales amounted to $521 million, compared with $354 million in last year's fourth quarter, an increase of just over 47 percent. Net earnings for the quarter amounted to $123 million, up 59 percent over earnings in 1997's fourth quarter of $77.5 million. On a diluted per-share basis, earnings for the fourth quarter were 62 cents this year and 42 cents the year before. There were no non-recurring income or expense items in either fourth quarter.
As has been the case in recent years, revenue growth was driven largely but not entirely by our two flagship products, the TITAN® 5500 digital cross-connect system in North America and the MartisDXXTM managed access and transport system in the rest of the world.
TITAN 5500 system sales were up 38 percent over those in 1997, and MartisDXX system revenue was up 36 percent. Other areas contributed to the revenue numbers, too. Revenue from other members of the TITAN family of digital cross-connect products, all of them of the smaller cross-section "1/0" variety, amounted to just under $100 million, a nearly 28-percent increase over the prior year. Sales of echo cancellers in 1998 amounted to $155 million, a very welcome 76-percent improvement over the prior year, due in no small measure to the addition of Tellabs Virginia (nee Coherent Communications) to the Tellabs family late in the summer. And finally, revenue from the CABLESPAN® product, our still evolving telephony-over-cable system, was up 53 percent over that of 1997, though still at a rather modest $24-million level.
Another increasingly significant part of the revenue picture nowadays is that from customer service, which amounted to more than $74 million in 1998, well over double that of any prior year. Customer service revenue comes primarily from activities involving installation and testing of large systems, primarily the TITAN family of products. The growth of this revenue, and particularly its effect on cost-of-goods-sold, mandates a change in the way we have historically calculated gross margin. In past years, we have calculated gross margin by including customer service revenue but not the costs of deriving that revenue. Beginning in 1999, we will be including those costs in the cost-of-goods-sold line, and because customer service costs generally exceed revenue, the effect will be a reduction in gross margin by several percentage points. (This will be offset by a corresponding drop in SG&A expense, of course.) Gross margin for 1998, calculated the old way, was a remarkable 65 percent and would have been somewhat lower had it been based on this accounting reclassification.
A couple of items on the balance sheet are worthy of note here, too. Inventories at the end of 1998 were $122.4 million, up a little less than 37 percent from a year ago. With sales up by just about that same amount, inventory management was reasonably good, but we did not quite achieve our target of six inventory turns. Receivables at year-end were $481 million, well above $284 million a year ago. There are several contributors to the increase, but the biggest is the very robust revenue number in this year's fourth quarter. Another is a still somewhat rocky adjustment to our SAP information system, which has frustrated both us and our customers at times during the year. We are working on this, as you might imagine, and we expect to report better performance in future communications.
So much for the financial aspects of the year -- let's take a look at a couple of the more interesting events of 1998. Number one in that category is surely the aborted acquisition of CIENA Corporation and its portfolio of dense wavelength-division-multiplexer products. After some pretty intense discussions with the CIENA folks last spring, we announced a merger of the two companies on June 3. Given the importance of optical networking to the telecommunications industry now, our own development activities in the area, and CIENA's strong technology and market position at the time, this seemed like a prudent and timely thing to do. Investors appeared to think so too, despite the rather steep $7-billion price tag.
Unfortunately, the market for these products took some unusual turns during the summer as several big players decided to buy in, and CIENA's market position turned decidedly for the worse. Hoping to avoid burdening the reader with the many twists and turns of this saga (some of which will likely turn up in MBA case studies in the future), suffice to say that we and CIENA mutually agreed to terminate the merger in early September -- just in time for a major "market correction." The result of all this was an agonizing fall in our market capitalization from more than $17 billion late in July to about $6.5 billion in early October. Thankfully, we have now recovered nearly all the lost ground -- and candidly, that market cap in late July may have been a bit robust at the time, even for a company like Tellabs.
To those of our stockholders who stayed with us through that wild ride, and to our employees, all of whom demonstrated remarkable resiliency and perseverance through it all, I say thanks and well done!
The other event of 1998 that merits mention here is much more pleasant to talk about. In February, we announced an agreement to acquire Coherent Communications Systems Corporation, a company headquartered in Ashburn, Virginia. Coherent has been a strong player in the global echo cancellation market for some time. Our belief was that a merger of the two companies would put us in a very competitive position in the world market for products that we believe will find increasing need as "voice-over-anything" telephony takes hold. After the U.S. Department of Justice finally concluded that this was not going to destroy the competitive balance in the industry, the merger took place in early August.
We are delighted to report that our expectations have been more than fulfilled, and Tellabs Virginia is now a valued part of the family. Though prolonged in gestation, this merger looks very much like a winner. We are delighted with the enthusiasm and talent that the NETS (Network Enhancing Technologies Solutions) organization, as the combination of Tellabs Virginia and our former Network Access Systems Division is now known, is bringing to a growing market opportunity.
So, you might ask, what is the future in this challenging and changing industry? Where does Tellabs fit, and what must it do to continue the adventure? Well, there is no denying the impact of the Internet on the industry, its participants and its customers. The stunning growth in Internet traffic in recent years is but the precursor as bandwidth needs everywhere in the network are accelerating. Networks of the future will surely look and behave differently than those that populate all but the most recently constructed networks today. Packet- and cell-based protocols are increasing in number and importance, especially for the fastest-growing component of communications traffic these days, data. Very large "packet handlers," called routers rather than switches, are increasingly finding application in even traditional networks. Surely these trends will continue, but abandoning multibillions of dollars worth of highly reliable hierarchical call-routing and transporting networks is highly unlikely.
Thus the so-called "network of the future" likely won't be composed of any one technology, and for cost reasons it won't be a landscape of overlay networks interoperating at nodes and switch points, either. It will still be hierarchical in nature, we believe, though certainly less so than today's architectures. It will make dramatic use of optical networking strategies, intelligence will be distributed throughout the network, and the ability to efficiently manage all forms of traffic will be crucial. That's the environment Tellabs must be prepared to deal with, and soon. Heretofore, our strengths have been largely in network products like SONET-based digital cross-connect systems, ETSI-based managed network products, time-division access multiplexers and echo cancellers. None of those things will go away in the foreseeable future, but to continue the growth we have seen in the past few years, Tellabs must address itself to the newer technologies.
Development of these new technologies is well under way in our labs, except for one area -- data networking.
We expect to introduce major new products during 1999 in optical networking, in ATM (cell-based) switching and transport, and in combined voice and data access vehicles.
These represent good entrées to the future. To complete the picture, however, we must quickly move into the data-centric packet area, and do so in a way that complements our array of new and existing networking products. That suggests some type of acquisition or joint venture is in order, because there is probably not time to start from scratch and be a factor in this marketplace. Our larger traditional competitors have already taken this step, and those competitors in the "data space" are of course already there. Fortunately, there appear to be some opportunities available for us to do just that. This sets one of our highest priorities for 1999, because with the addition of this technology, Tellabs will indeed be a tough and versatile competitor in this industry. That is our intent.
There are other priorities as well. We must continue to invest in customer satisfaction, and we, like many others, must improve our time-to-market performance. (Time is the relentless enemy of us all, alas!) And we must continue to focus on providing solutions rather than simply products to our customers around the world. I think the people of Tellabs can and will do all of these things, and do them well, which is why I am confident that this adventure will indeed continue. We appreciate you sharing it with us.
Sincerely
Michael J. Birck
President and Chief Executive Officer
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