Introduction and Overview of Business

Tellabs designs, develops, deploys and supports telecommunications networking products around the world. Our product portfolio includes solutions for wireline and wireless transport, access networking, broadband data, optical transport and voice-quality enhancement.

We generate revenue principally through the sale of telecommunication products, both as stand-alone products and as elements of integrated systems, to communications service providers worldwide. We also generate revenue by providing services related primarily to our own products and systems.

The Broadband segment includes the access, managed access and data product portfolios that facilitate the delivery of bundled triple-play services and next-generation wireline and wireless services. We earn revenue from the Broadband segment globally. Revenue from access products is earned primarily in North America for the support of copper-based and fiber-based networks. Access product revenue is driven by consumer demand for the triple-play of bundled voice, video and high-speed Internet/data services in addition to competition among traditional telecommunications companies and cable service operators to be the sole provider of triple-play services. Revenue for managed access products is earned primarily outside North America. Managed access product revenue is driven by business services for voice and high-speed data as well as network access services for wireless communications. Revenue from data products is earned globally. Data product revenue is driven by consumer demand for wireless and wireline carriers to deliver business services and next-generation wireless services.

The Transport segment includes digital cross-connect systems, packet transport systems and voice quality enhancement products. These products enable service providers to manage bandwidth, improve voice quality and transport traffic by adding capacity when and where it is needed. Revenue from the Transport segment is primarily earned in North America. Transport product revenue is driven by the needs of service providers to support wireless services, business services for enterprises and triple-play voice, video and data services for consumers.

The Services segment delivers deployment, support, professional consulting, training and systems integration services to Tellabs customers. These services support various phases of the network including planning, installation and on-going support. Revenue from the Services segment is earned globally. Deployment service revenue makes up almost half of Services revenue, which arises primarily from sales of transport products in North America, and tends to lag product sales by approximately one fiscal quarter. In addition, revenue comes from support agreements, professional consulting and training.

We operate in a dynamic industry in which both our customers and competitors have consolidated, creating more pricing pressure. In the first nine months of 2008, North American wireless customers purchased at reduced levels, particularly the Tellabs® 5500 digital cross-connect system, thus adversely affecting our overall revenue and profitability. It is not clear whether or when these customers will resume spending at previous levels.

We continue to transform the company from a business based primarily on the circuit-switched Time Division Multiplexing (TDM) technology used in digital cross-connect and managed access products to a business based on packet-switching and Internet Protocol (IP) technology used in converged transport, access and multi-service data products. These products are taking root as service providers transform their networks to next-generation capabilities. Some of these products carry gross profit margins lower than our historical average. The mix of products can affect overall profitability in any given quarter.

On April 2, 2008, we announced the discontinuation of our gigabit passive optical network (GPON) next-generation fiber access activities with one large North American carrier. We also announced, on April 8, 2008, the discontinuation of our investment in the Tellabs® 8865 GPON optical line terminal (OLT) for fiber access networks, for which this carrier was the initial targeted customer. While our fiber access revenues declined in the first quarter, we have a strong embedded base of fiber access equipment in carrier networks and remain committed to the fiber access business, including the Tellabs ® 1100 multi-service access products, which include GPON capabilities.

Management continues to prepare and implement initiatives to improve overall performance. On January 21, 2008, we committed to a plan to bring operating expenses as well as cost to produce products and deliver services in line with current revenue and market conditions. On April 30, 2008, management initiated a plan to consolidate several facilities as a result of the discontinuation of the Tellabs® 8865 OLT and headcount reductions announced in September 2007 and January 2008. On October 20, 2008, management initiated a restructuring plan that resizes Tellabs' business to reflect market conditions. Restructuring actions include reducing future investment in access products and freeing up resources to focus on data and transport products. To further improve financial performance and fund growth initiatives, we plan to free up resources to create innovative products and services that help customers succeed.

RESULTS OF OPERATIONS

For the third quarter of 2008, revenue was $424.1 million, down 7.4% from $457.9 million in the third quarter of 2007 due to revenue declines in the Broadband and Transport segments. Year-to-date, revenue was $1,320.7 million, down 8.6% from $1,444.3 million in 2007. Revenue declines in the first nine months of 2008 from the Broadband and Transport segments were partially offset by higher revenue in the Services segment.

Consolidated gross margin was 38.2% in the third quarter, an increase of 6.7 percentage points from 31.5% in the third quarter of 2007, which was the result of an improved product and services mix as well as the realization of cost reductions. On a nine-month basis, consolidated gross margin improved by 1.2 percentage points to 37.1% from 35.9% in 2007, which was the result of an improved product mix and cost reductions.

Operating expenses increased by $981.1 million to $1,144.2 million in the third quarter of 2008, compared with $163.1 million in the third quarter of 2007 as a result of a goodwill impairment charge of $988.3 million. Excluding the goodwill impairment charge and restructuring and other charges, operating expenses decreased by $10.7 million, led by savings from the previously announced cost-reduction program pursuant to which we expect to reduce annual costs and expenses by approximately $100 million by 2009. On a nine-month basis, operating expenses were $1,466.7 million, up $981.0 million compared with the first nine months of 2007 as a result of the goodwill impairment charge. Excluding the goodwill impairment charge and restructuring and other charges, operating expenses decreased by $24.9 million, led by savings from the previously announced cost-reduction program.

Net loss for the third quarter of 2008 was $998.5 million or $2.51 per share compared with net earnings of $3.6 million or $0.01 per share (basic and diluted) in the same period of 2007. Net loss for the nine-month period in 2008 was $942.9 million or $2.35 per share compared with net earnings of $58.7 million or $0.13 per share (basic and diluted) for the first nine months of 2007. The net loss in both 2008 time periods was the result of a goodwill impairment charge of $988.3 million.

Revenue (in millions)



                              Third Quarter                      Nine Months
                           2008      2007   Change           2008        2007   Change
        Products        $ 368.8   $ 402.4     (8.3 )%   $ 1,149.0   $ 1,281.4    (10.3 )%
        Services           55.3      55.5     (0.4 )%       171.7       162.9      5.4 %

        Total revenue   $ 424.1   $ 457.9     (7.4 )%   $ 1,320.7   $ 1,444.3     (8.6 )%

Revenue from products decreased $33.6 million in the third quarter of 2008 compared with the third quarter of 2007. On a nine-month basis, revenue from products decreased $132.4 million compared with the first nine months of 2007. The decrease for both time periods was due to lower Broadband segment and Transport segment revenue. Broadband segment revenue benefited from data and managed access product-portfolio revenue growth but was offset by lower access product revenue. Revenue declines in the Transport segment for both time periods were due to lower revenue from digital cross-connects. Revenue from the Tellabs® 7100 optical transport system (OTS) was significantly higher for the first nine months of 2008 from the comparable period in 2007 and was flat in the third quarter of 2008 compared with the third quarter of 2007.

Services revenue slightly decreased by $0.2 million in the third quarter of 2008 compared with the same period in 2007. On a nine-month basis, services revenue increased $8.8 million compared with the first nine months of 2007. For the first nine months, professional and support services revenue increased, which offset the decrease in deployment services revenue.

On a geographic basis, revenue from customers in North America (United States and Canada) was $263.8 million in the third quarter of 2008, down 18.8% from the year ago quarter. Revenue from customers outside North America was $160.3 million in the third quarter of 2008, up 20.6% from the year ago quarter. On a nine-month basis, North America revenue was $900.6 million, down 16.6% from a year ago. Revenue from customers outside North America was $420.1 million, up 15.2% from a year ago. For the quarter and first nine months of 2008, revenue from customers outside North America benefited from the strengthening of the Euro against the U.S. Dollar and from growth in our business outside North America.

Gross Margin



                                 Third Quarter                  Nine Months
                                             % Point                       % Point
                           2008     2007      Change     2008     2007      Change
            Products       38.5 %   31.8 %       6.7 %   38.0 %   36.4 %       1.6 %
            Services       36.3 %   29.7 %       6.6 %   31.3 %   31.4 %      (0.1 )%
            Consolidated   38.2 %   31.5 %       6.7 %   37.1 %   35.9 %       1.2 %

Products gross margin improved in the third quarter compared with the same period in 2007 primarily due to cost reductions on the Tellabs 7100 OTS and the Tellabs® 1600 Optical Network Terminal (ONT) and a product mix with higher data and managed access product revenue. For the first nine months of 2008, overall product gross margin increased compared with the same period in 2007. The increase was primarily due to margin improvements, which includes the Tellabs 7100 OTS and Tellabs ® 1600 ONT, but was partially offset by a product mix with fewer digital cross-connects but more data and managed access products.

Services gross margin increased in the third quarter but was about flat in the first nine months of 2008, compared with the same periods in 2007. The increase in the third quarter reflects growth in higher margin professional services and support services revenue coupled with a decline in lower margin deployment services revenue. The flat year-to-date results reflect continued investment in our services business outside the United States.

Operating Expenses (in millions)



                                           Third Quarter               Percent of Revenue
                                        2008      2007    Change         2008           2007
 Research and development          $    74.0   $  86.6   $ (12.6 )       17.4 %         18.9 %
 Sales and marketing                    42.9      41.8       1.1         10.1 %          9.1 %
 General and administrative             23.7      23.5       0.2          5.6 %          5.1 %

 Subtotal                              140.6     151.9     (11.3 )       33.2 %         33.2 %

 Intangible asset amortization           6.2       5.6       0.6
 Restructuring and other charges         9.1       5.6       3.5
 Goodwill impairment                   988.3        -      988.3

 Total operating expenses          $ 1,144.2   $ 163.1   $ 981.1

                                            Nine Months                Percent of Revenue
                                        2008      2007    Change         2008           2007
 Research and development          $   233.3   $ 256.4   $ (23.1 )       17.7 %         17.8 %
 Sales and marketing                   129.5     132.0      (2.5 )        9.8 %          9.1 %
 General and administrative             75.0      74.8       0.2          5.7 %          5.2 %

 Subtotal                              437.8     463.2     (25.4 )       33.1 %         32.1 %

 Intangible asset amortization          17.4      16.9       0.5
 Restructuring and other charges        23.2       5.6      17.6
 Goodwill impairment                   988.3        -      988.3

 Total operating expenses          $ 1,466.7   $ 485.7   $ 981.0

Operating expenses increased by $981.1 million to $1,144.2 million in the third quarter of 2008, compared with $163.1 million in the third quarter of 2007. Excluding the goodwill impairment and restructuring and other charges, operating expenses decreased by $10.7 million. For the first nine months of 2008, operating expenses increased by $981.0 million to $1,466.7 million compared with $485.7 million in the same period in 2007. Excluding the goodwill impairment and restructuring and other charges, operating expenses decreased by $24.9 million. Decreased operating expenses in the third quarter and the first nine months of 2008 reflect savings from the previously announced cost-reduction program despite the negative impact of the strengthening of the Euro against the U.S. Dollar.

Restructuring and other charges for the third quarter of 2008 primarily reflect accelerated depreciation and fixed asset write- downs due to the consolidation of several facilities and the discontinuation of the Tellabs 8865® optical line terminal announced in April 2008. For the first nine months of 2008, restructuring and other charges primarily consist of severance and facility-related costs and reflect cost-reductions from the $100 million program, announced in the first quarter of 2008, as well as the previously mentioned consolidation of several facilities announced in April 2008.

$100 million Cost-Reduction Program

On January 21, 2008, management initiated a program to improve gross profit margins and reduce operating expenses. Through restructuring plans announced since September 2007 and other cost savings initiatives, approximately $100 million in annual savings by 2009 is expected to be achieved, including approximately $75 million from operating expenses and $25 million from overhead costs of products and services. In addition, a portion of the savings from the October 2008 restructuring plan will be used to reinvest in growth areas of the business.

Other Income (in millions)



                                       Third Quarter                      Nine Months
                                 2008       2007      Change       2008       2007      Change
        Interest income, net   $  8.3     $ 13.1     $  (4.8 )   $ 28.7     $ 38.3     $  (9.6 )
        Other expense, net       (7.3 )     (2.4 )      (4.9 )     (5.0 )     (1.8 )      (3.2 )

        Total                  $  1.0     $ 10.7     $  (9.7 )   $ 23.7     $ 36.5     $ (12.8 )

Interest income, net, was lower in the third quarter of 2008 and first nine months of 2008 compared with 2007 due to lower interest rates and lower invested balances. We expect interest income, net, to decline in future periods as the result of interest rate decreases across several broad markets as we continue to reposition our portfolio to preserve capital. Other expense, net, was higher in the third quarter compared with the same period in 2007 due primarily from losses on the sale of investments in marketable securities of $4.5 million. The year-to-date expense includes a charge of $1.4 million for an other-than-temporary impairment from investments in marketable securities and the write-down of a long-term equity investment.

Income Taxes

For the third quarter of 2008 we recorded an income tax expense of $17.5 million compared with an income tax benefit of $11.7 million for the third quarter of 2007. For the first nine months of 2008 we recorded an income tax benefit of $9.8 million compared with income tax expense of $9.9 million for the first nine months of 2007. The tax expense for the third quarter reflects the impact of establishing a valuation allowance against our domestic deferred tax assets, the absence of a tax benefit associated with the goodwill impairment, and the absence of a benefit from the research and development credit. The tax benefit for the first nine months of 2008 reflects the $34.8 million tax benefit related to the resolution of federal income tax audits for the period 2001 through 2005 that was recorded in the second quarter.

Segments

Segment Revenue (in millions)



                              Third Quarter                      Nine Months
                           2008      2007   Change           2008        2007   Change
        Broadband       $ 259.3   $ 279.2     (7.1 )%   $   692.9   $   744.3     (6.9 )%
        Transport         109.5     123.2    (11.1 )%       456.1       537.1    (15.1 )%
        Services           55.3      55.5     (0.4 )%       171.7       162.9      5.4 %

        Total revenue   $ 424.1   $ 457.9     (7.4 )%   $ 1,320.7   $ 1,444.3     (8.6 )%

Segment Profit* (in millions)



                                    Third Quarter                  Nine Months
                                 2008     2007   Change        2008      2007   Change
        Broadband              $ 48.5   $ 23.1    110.0 %   $  80.3   $   7.5    970.7 %
        Transport                21.7     21.5      0.9 %     131.7     213.4    (38.3 )%
        Services                 20.8     17.1     21.6 %      56.5      53.4      5.8 %

        Total segment profit   $ 91.0   $ 61.7     47.5 %   $ 268.5   $ 274.3     (2.1 )%

* We define segment profit as gross profit less research and development expenses. Segment profit excludes sales and marketing expenses, general and administrative expenses, the amortization of intangibles, restructuring and other charges, the impact of equity-based compensation (which contains restricted stock and performance stock units granted after June 30, 2006, and stock options), and the goodwill impairment charge.

Broadband

Revenue

Revenue from the Broadband segment was $259.3 million in the third quarter of 2008, down $19.9 million from the prior-year quarter. For the first nine months of 2008, revenue from the Broadband segment was $692.9 million, down $51.4 million from the first nine months of 2007. For both time periods, lower access product revenue was partially offset by growth from data and managed access products.

Access revenue decreased to $113.2 million in the third quarter of 2008 from $157.0 million in 2007. On a nine-month basis, access revenue decreased to $316.7 million in 2008 from $412.8 million in 2007. Access revenue was lower and will likely continue to decrease as several key customers began transitioning to alternative network architectures. Approximately 74% of access revenue came from fiber-based platforms in the third quarter of 2008, with the balance coming from copper-based platforms.

Managed access revenue increased to $78.5 million in the third quarter of 2008 from $65.2 million in the same quarter of 2007. For the first nine months of 2008, managed access revenue increased to $220.7 million from $211.0 million in the first nine months of 2007. Revenue increased in both 2008 time periods due to higher Tellabs® 6300 SDH transport product revenue in several regions partially offset by lower revenue from the Tellabs®8100 managed access system.

Data product revenue was $67.6 million in the third quarter of 2008, up 18.6% from $57.0 million in the third quarter of 2007. For the first nine months of 2008, data product revenue was $155.5 million, up 29.0% compared with the first nine months of 2007. Revenue increased in both time periods as customers migrate to next generation networks.

Segment Profit

Broadband segment profit was $48.5 million in the third quarter of 2008, compared with $23.1 million in the third quarter of 2007. For the first nine months of 2008, Broadband segment profit was $80.3 million, an increase of $72.8 million from $7.5 million in the comparable period of 2007. Segment profit increased in the third quarter and first nine months of 2008 primarily due to higher volume of managed access and data products and reduced research and development expenses.

Transport

Revenue

Revenue from the Transport segment was down $13.7 million to $109.5 million in the third quarter of 2008, compared with $123.2 million in the third quarter of 2007, due primarily to lower revenue from digital cross-connects. On a nine-month basis, transport revenue was down $81.0 million to $456.1 million, compared with the same period in 2007. Revenue was lower from digital cross-connect products, partially offset by growth from the Tellabs 7100 OTS.

During the third quarter of 2008, approximately 17% of the Tellabs 5500® digital cross-connect product revenue came from new systems, system expansions and system upgrades. This percentage was approximately 31% for the first nine months of 2008. The remaining balances consisted of port-card growth on the installed base.

Segment Profit

Transport segment profit was $21.7 million in the third quarter of 2008 compared with $21.5 million in the third quarter of 2007. Segment profit was flat due to lower digital cross-connect revenue offset by Tellabs 7100 OTS gross margin improvements. Segment profit for the first nine months of 2008 was $131.7 million, compared with $213.4 million for the first nine months of 2007. Segment profit decreased from lower revenue from digital cross-connects, partially offset by higher revenue and improved gross margins from the Tellabs 7100 OTS.

Services

Revenue

Revenue from the Services segment was $55.3 million for the third quarter of 2008, compared with $55.5 million in the third quarter of 2007. During the quarter, services revenue declined slightly due to lower deployment services revenue, offset by an increase in support and professional services. On a nine-month basis, revenue from the Services segment was $171.7 million in 2008, an increase from $162.9 million in the first nine months of 2007. For the first nine months, professional and support services revenue increased, which more than offset lower deployment services revenue.

Segment Profit

Services segment profit was $20.8 million for the third quarter of 2008, compared with $17.1 million in the third quarter of 2007. For the first nine months, Services segment profit was $56.5 million in 2008, compared with $53.4 million in 2007. The increase for the third quarter and nine months was due to a decline in lower profit deployment services revenue and an increase in higher profit professional services and support services revenue.

Financial Condition, Liquidity & Capital Resources

Our principal source of liquidity remained our cash, cash equivalents and marketable securities of $1,167.1 million as of the end of the third quarter of 2008, which decreased by $29.2 million during the quarter and $51.4 million since year-end 2007. Cash used for operating activities was $11.2 million in the third quarter of 2008. For the first nine months of 2008, we generated $129.7 million in cash from operating activities, up $3.7 million over the first nine months of 2007. The decrease in cash, cash equivalents and marketable securities in the third quarter of 2008 was driven primarily by the impact of the strengthening U.S. dollar on our foreign cash, cash equivalents and marketable securities and working capital balances. The year-to-date decrease reflects cash used to repurchase our common stock and cash used for capital expenditures, partially offset by cash from operating activities.

During the third quarter of 2008, we actively balanced our investment portfolio with the goal of capital preservation. Currently, about 90% of the portfolio is invested in government or government-agency bonds and notes. Substantially all of our investments are highly liquid instruments.

During the third quarter of 2008, we repurchased 66,571 shares of our common stock at a cost of $0.4 million. On a year-to-date basis, we repurchased 21.8 million shares of our common stock at a cost of $143.4 million. Since the beginning of the second quarter of 2008, we significantly reduced share repurchases as we re-evaluate uses of cash as we work to position the company for future growth, and in light of capital market conditions. Although we may resume our repurchase activity at levels experienced in prior periods, we provide no assurance that we will not change our repurchase activity in the future.

Based on historical performance and current forecasts, we believe the company's cash and marketable securities will satisfy working capital needs, capital expenditures and other liquidity requirements related to existing operations for the next twelve months. Future available sources of working capital, including cash, cash equivalents, and marketable securities, cash generated from future operations, short-term or long-term financing, equity offerings or any combination of these sources, should allow us to meet our long-term liquidity needs. Our current policy is to use our liquidity, financial strength and stability to fund business operations, to expand business, potentially through acquisitions, or to repurchase our common stock. We do not anticipate paying a cash dividend in the foreseeable future.

Goodwill and Intangible Assets

In accordance with the provisions of SFAS 142, Goodwill and Other Intangible Assets, we review goodwill annually for impairment, unless potential interim indicators exist that could result in impairment. Because market capitalization was less than book value for a sustained period and the continuation of challenging market conditions, we performed an interim step one analysis on all three operating segments: Broadband, Transport and Services. The fair values of each of the operating segments for goodwill impairment testing were estimated using the expected present value of future cash flows, using estimates, judgments and assumptions that management believed were appropriate for the circumstances.

Based on the step one analysis, we determined the fair values of the Broadband and Transport segments to be less than the carrying values, requiring a step two . . .