Introduction and Overview of Business

Tellabs designs, develops and supports telecommunications networking products. We generate revenue principally through the sale of these products as stand-alone network elements and as elements of integrated solutions to communications service providers worldwide. We also generate revenue by providing services to our customers. We operate in three business segments:
Broadband, Transport and Services.

The Broadband segment includes access, managed access and data product portfolios that facilitate the delivery of bundled consumer services, wireline business services and wireless communications.

• Revenue from access products is driven by consumer demand for the triple-play of bundled voice, video and high-speed Internet/data services as traditional telecommunications companies and cable service operators compete to be the sole provider of these services to consumers and businesses.

• Revenue from managed access products is driven by the need to provide business-oriented voice, video and high-speed Internet/data services and wireless communications.

• Revenue from data products is driven by demand for wireless and wireline carriers to deliver next-generation business services and wireless services.

The Transport segment includes digital cross-connect systems, optical networking systems and voice-quality enhancement products. These products enable service providers to generate revenue from business services, manage bandwidth, add network capacity when and where it is needed, and improve voice quality. Revenue from the Transport segment is driven by the needs of service providers to deliver wireless services, business services and consumer services.

The Services segment includes deployment, support, training, systems integration and network design/consulting services. Revenue from deployment, support, training and systems integration services arises primarily from the sales of products and continues to represent the majority of Services revenue, while network design/consulting services is the fastest growing part of the Services portfolio.

Tellabs operates in a dynamic industry. Customer consolidation has reduced overall industry capital spending, which together with a lack of consolidation on the part of network equipment companies, has resulted in increased pricing pressure. In addition, customer spending is pressured and competition is heightened by the global economic situation.

Within this backdrop, we continue to transform the company with new products and services. The company is evolving from a business based primarily on the circuit-switched Time Division Multiplexing (TDM) technology used in our digital cross-connect and managed access products to a business based on the packet-switching and Internet Protocol (IP) technology used in our optical networking, access and multiservice data products. These new products are taking root as service providers transform their networks with next-generation capabilities. Some of these products carry gross profit margins lower and some carry gross profit margins higher than the corporate average. While we have significantly improved the profitability of these products over time, the mix of products in any given quarter can affect overall profitability.

Management continues to define and implement initiatives to improve our overall performance. On February 5, 2009, and July 6, 2009, management initiated restructuring plans as we align our costs with customer spending and current market conditions. These restructuring plans primarily implement workforce reductions. However, as a consequence of the Company's increased focus on growth markets and growth products, we expect to hire people with different skill sets as needed around the world.

RESULTS OF OPERATIONS

For the second quarter of 2009, revenue was $385.4 million, compared with $432.5 million in the second quarter of 2008. For the first six months of 2009, revenue was $747.1 million, compared with $896.6 million in the comparable period of 2008. In both periods, revenue declined in all segments.

Consolidated gross profit margin in the second quarter of 2009 was 43.5%, up 8.8 percentage points from 34.7% in the second quarter of 2008. On a six-month basis, consolidated gross margin was 43.8%, up 7.2 percentage points from 36.6% in 2008. The increase in gross margin across both time periods is primarily the result of Broadband-segment mix shifts and profitability improvements.

Operating expenses in the second quarter of 2009, including $6.0 million in intangible asset amortization and $4.1 million in restructuring and other charges, were $143.0 million, down $15.0 million from $158.0 million in the second quarter of 2008. Excluding intangible asset amortization and restructuring and other charges, our operating expenses decreased by $14.1 million. On a six-month basis, operating expenses, including $12.0 million in intangible asset amortization and $10.8 million in restructuring and other charges, were $294.0 million, down $28.5 million, compared with the first six months of 2008. Excluding intangible asset amortization and restructuring and other charges, our operating expenses decreased by $26.0 million during the first six months of 2009.

The reduction in operating expenses across both periods came primarily in research and development costs and represents the company's continuing efforts to improve profitability by aligning our costs with customer spending and market conditions.

Net earnings for the second quarter of 2009 were $15.7 million or $0.04 per share (basic and diluted) compared with $39.0 million or $0.10 per share (basic and diluted) in the same period of 2008. (In the second quarter of 2008, we had a tax benefit of $34.8 million or $0.09 per share [basic and diluted] related to the resolution of federal income tax audits for the years 2001 through 2005.) Net earnings for the first six months of 2009 were $22.2 million or $0.06 per share (basic and diluted) compared with $55.6 million or $0.14 per share (basic and diluted) for the first six months of 2008.

Revenue (in millions)



                               Second Quarter                     Six Months
                            2009      2008   Change          2009      2008   Change
         Products        $ 329.0   $ 372.2    (11.6 %)    $ 637.0   $ 780.2    (18.4 %)
         Services           56.4      60.3     (6.5 %)      110.1     116.4     (5.4 %)

         Total revenue   $ 385.4   $ 432.5    (10.9 %)    $ 747.1   $ 896.6    (16.7 %)

Overall product revenue decreased in both periods as increased revenue from data products was offset by lower revenue from other products. The improvement in data revenue was driven by increased customer demand and the acceptance from two customers for deployments. In the Services segment, the revenue decline primarily reflects a lower level of deployment services revenue, partially offset by an increase in professional services revenue.

On a geographic basis, revenue from customers in North America (United States and Canada) was $229.5 million in the second quarter of 2009, down 20.1% from the year ago quarter. On a six-month basis, North America revenue totaled $476.5 million, down 25.2% from the comparable period in 2008. Revenue from customers outside North America was $155.9 million in the second quarter of 2009, up 7.4% from the year ago quarter. For the first six-months of 2009, revenue from customers outside North America was $270.6 million in 2009, up 4.2% from a year ago.

Gross Margin



                               Second Quarter                          Six Months
                                             % Point                               % Point
                         2009      2008       Change           2009      2008       Change
          Products       45.0 %    34.7 %       10.3           45.4 %    37.7 %        7.7
          Services       34.8 %    34.8 %         -            34.4 %    29.0 %        5.4
          Consolidated   43.5 %    34.7 %        8.8           43.8 %    36.6 %        7.2

The improvement in products gross margin for both periods reflects more revenue from data products and profitability improvements to access products and optical networking products. The increase in services gross margin between the first six months of 2009 and the comparable period in 2008 reflects improved gross margins from deployment services.

Operating Expenses (in millions)



                                         Second Quarter                 Percent of Revenue
                                      2009      2008   Change         2009            2008
 Research and development          $  66.3   $  78.6   $(12.3 )       17.2 %          18.2 %
 Sales and marketing                  40.9      43.2     (2.3 )       10.6 %          10.0 %
 General and administrative           25.7      25.2      0.5          6.7 %           5.8 %

 Subtotal                            132.9     147.0    (14.1 )       34.5 %          34.0 %

 Intangible asset amortization         6.0       5.6      0.4
 Restructuring and other charges       4.1       5.4     (1.3 )

 Total operating expenses          $ 143.0   $ 158.0   $(15.0 )

                                           Six Months                   Percent of Revenue
                                      2009      2008   Change         2009            2008
 Research and development          $ 135.8   $ 159.3   $(23.5 )       18.2 %          17.8 %
 Sales and marketing                  83.3      86.6     (3.3 )       11.1 %           9.7 %
 General and administrative           52.1      51.3      0.8          7.0 %           5.7 %

 Subtotal                            271.2     297.2    (26.0 )       36.3 %          33.1 %

 Intangible asset amortization        12.0      11.2      0.8
 Restructuring and other charges      10.8      14.1     (3.3 )

 Total operating expenses          $ 294.0   $ 322.5   $(28.5 )

Decreased operating expenses in the second quarter and the first six months of 2009 reflect savings from previously announced cost-reduction programs. Restructuring and other charges of $4.1 million for the second quarter of 2009 and $10.8 million for the first six months of 2009 primarily reflect severance, facility- and asset-related charges.

Other Income (in millions)



                                    Second Quarter                  Six Months
                                 2009     2008   Change        2009     2008   Change
         Interest income, net   $ 5.7   $ 10.5    $(4.8 )    $ 10.9   $ 20.4   $ (9.5 )
         Other income, net        0.5      1.7     (1.2 )        -       2.3     (2.3 )

         Total other income     $ 6.2   $ 12.2    $(6.0 )    $ 10.9   $ 22.7   $(11.8 )

Interest income, net, declined due to lower interest rates during the second quarter and the first six months of 2009, compared with the year-ago periods.

Income Taxes

We recorded income tax expense of $15.0 million for the second quarter and $22.0 million for the first six months of 2009, compared with income tax benefits of $34.6 million and $27.3 million for comparable periods in 2008.

The increase in income tax expense in 2009 reflects the absence of a $34.8 million benefit recorded in the second quarter of 2008 for the favorable resolution of income tax audits; an increase in earnings from foreign operations taxed at normal rates; and the absence of a tax benefit on domestic losses due to the valuation allowance maintained against our domestic deferred tax assets.

Segments

Segment Revenue (in millions)



                               Second Quarter                     Six Months
                            2009      2008   Change          2009      2008   Change

         Broadband       $ 210.2   $ 231.5     (9.2 %)    $ 388.5   $ 433.6    (10.4 %)
         Transport         118.8     140.7    (15.6 %)      248.5     346.6    (28.3 %)
         Services           56.4      60.3     (6.5 %)      110.1     116.4     (5.4 %)

         Total revenue   $ 385.4   $ 432.5    (10.9 %)    $ 747.1   $ 896.6    (16.7 %)

Segment Profit* (in millions)



                                  Second Quarter                     Six Months
                                2009     2008   Change          2009      2008   Change

      Broadband              $  57.4   $ 23.1    148.5 %     $  91.7   $  31.8    188.4 %
      Transport                 26.3     30.8    (14.6 %)       66.1     110.0    (39.9 %)
      Services                  20.2     22.0     (8.2 %)       39.2      35.7      9.8 %

      Total segment profit   $ 103.9   $ 75.9     36.9 %     $ 197.0   $ 177.5     11.0 %

*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, and the impact of equity-based compensation (which contains restricted stock and performance stock units granted after June 30, 2006, and stock options).

Broadband

Revenue

Revenue from the Broadband segment was $210.2 million in the second quarter of 2009, compared with $231.5 million in the prior-year quarter. For the first six months of 2009, Broadband segment revenue was $388.5 million, compared with $433.6 million in the first six months of 2008. In both periods, increased revenue from data products was offset by lower managed access and access revenue.

Data product revenue was $106.6 million in the second quarter of 2009, up 139.6% from $44.5 million in the second quarter of 2008 and up 69.2% from $63.0 million in the first quarter of 2009. The increase in data revenue between the first quarter of 2009 and the second quarter of 2009 is primarily attributable to customer acceptance of two data deployments and reflects equipment shipped in prior quarters. On a six-month basis, data revenue was $169.6 million, up 92.9% from $87.9 million in the comparable period of 2008. In both periods, revenue also benefited from the continuing rollout of our next-generation wireless backhaul solution in multiple geographies.

Managed access revenue was $35.1 million in the second quarter of 2009, compared with $83.4 million in the second quarter of 2008. For the first six months of 2009, managed access revenue totaled $86.3 million, compared with $142.2 million in the comparable period of 2008. Revenue from both the Tellabs® 8100 managed access system and the Tellabs® 6300 SDH transport system declined in both periods.

Access revenue will likely continue to decline year over year as several key customers transition to alternate network architectures. Access revenue was $68.5 million in the second quarter of 2009, compared with $103.6 million in the second quarter of 2008. For the first six months of 2009, access revenue totaled $132.6 million, compared with $203.5 million in the comparable period of 2008.

Segment Profit

Broadband segment profit was $57.4 million in the second quarter of 2009, up from $23.1 million in the second quarter of 2008. For the first six months of 2009, Broadband segment profit was $91.7 million, up from $31.8 million in the comparable period of 2008. The increase in segment profit for both time periods was primarily due to a higher level of data revenue, profitability improvements on access products, a lower level of access product revenue with lower profitability, and lower research and development costs.

Transport

Revenue

Revenue from the Transport segment was $118.8 million in the second quarter of 2009, compared with $140.7 million in the second quarter of 2008. For the first six months of 2009, Transport revenue was $248.5 million, compared with $346.6 million in the comparable period of 2008. Revenue from digital cross-connect and optical networking systems declined in both periods.

During the second quarter of 2009, approximately 23% of Tellabs® 5500 digital cross-connect product revenue came from new systems, system expansions and system upgrades, compared with 17% in the second quarter of 2008. The remaining balances consisted of port-card growth on the installed base.

Segment Profit

Transport segment profit was $26.3 million in the second quarter of 2009, compared with $30.8 million in the second quarter of 2008. Segment profit for the first six months of 2009 was $66.1 million, compared with $110.0 million for the first six months of 2008. The decrease for the quarter and the first six months of 2009 was primarily related to lower sales of cross-connect products.

Services

Revenue

Revenue from the Services segment was $56.4 million for the second quarter of 2009, compared with $60.3 million in the second quarter of 2008. On a six-month basis, revenue from the Services segment was $110.1 million in 2009, compared with $116.4 million in the first six months of 2008. The decline in both periods primarily reflects a lower level of deployment services revenue, partially offset by an increase in professional services revenue.

Segment Profit

Services segment profit was $20.2 million for the second quarter of 2009, compared with $22.0 million in the second quarter of 2008. For the first six months of 2009, Services segment profit was $39.2 million, compared with $35.7 million in the comparable period of 2008. The decrease for the second quarter of 2009 was due to lower deployment services revenue. On a six-month basis, improved gross margins for deployment services drove the increase in segment profit.

Financial Condition, Liquidity & Capital Resources

Our principal source of liquidity remained our cash, cash equivalents and marketable securities of $1,242.7 million as of July 3, 2009, which increased by $58.4 million during the quarter and $90.6 million since year-end 2008. The increase in cash, cash equivalents and marketable securities for the first six months of 2009 reflects $108.0 million in cash generated from operating activities, partially offset by cash used for capital expenditures.

The majority of our investments are backed by governments or government agencies. During the quarter, we added some high quality industrial corporate bonds to our investment portfolio. We believe that all our investments are highly liquid instruments. We may rebalance our portfolio from time to time, which may affect the duration, credit structure and future income of our investments.

During the second quarter of 2009, we repurchased 3,766 shares of our common stock at a cost of $19,000 under previously announced share repurchase programs. On August 6, 2009, our Board of Directors directed management to actively repurchase up to $200 million of our common stock over the next four quarters under the November 2007 authorized program. We provide no assurance as to the amount of repurchases to be made or the actual purchase prices.

Based on historical performance and current forecasts, we believe the company's cash, cash equivalents and marketable securities will satisfy working capital needs, capital expenditures and other liquidity requirements related to existing operations for the next 12 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.

Off-Balance Sheet Arrangements

None.

Critical Accounting Policies

There were no material changes in our critical accounting policies during the quarter.

Outlook for Third Quarter

We expect third quarter 2009 revenue to be flat to up by a mid-single-digit percentage compared with the second quarter of 2009. We expect gross margin for the third quarter to be 40%, plus or minus a point or two, as a result of product mix. We expect our third quarter 2009 operating expenses, excluding restructuring charges, to be flat to slightly below second quarter of 2009 levels.

Forward-Looking Statements

This Management's Discussion and Analysis and other sections of this Form 10-Q, including the statements under the caption "Outlook for Third Quarter", contain forward-looking statements made pursuant to the safe harbor provisions of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These statements reflect management's expectations, estimates and assumptions, based on current and available information at the time the document was prepared. These forward-looking statements include, but are not limited to, statements regarding future events, plans, goals, objectives and expectations. The words "anticipate," "believe," "estimate," "target," "expect," "predict," "plan," "possible," "project," "intend," "likely," "will," "should," "could," "may," "foreseeable," "would" and similar expressions are intended to identify forward-looking statements. Forward-looking statements are not guarantees of future performance and involve risks, uncertainties and other factors that may cause our actual performance or achievements to be materially different from any future results, performance or achievements expressed or implied by those statements. Important factors that could cause our actual results to differ materially from those in forward-looking statements include, but are not limited to: overall negative economic conditions generally and disruptions in credit and capital markets, including specific impacts of these conditions on the telecommunications industry; financial condition of telecommunications service providers, equipment vendors and contract manufacturers, including any impact of bankruptcies; the impact of customer and vendor consolidation; new product acceptance; product demand and industry capacity; competitive products and pricing; competitive pressures from new entrants to the telecommunications industry; initiatives to improve profitability that may have financial consequences, including further restructuring charges and the ability to realize anticipated savings under such cost-reduction initiatives; exiting businesses and product areas; impairment charges and other cost cutting initiatives and related charges and costs; manufacturing efficiencies; research and new product development; protection of and access to intellectual property, patents and technology; ability to attract and retain highly qualified personnel; availability of components and critical manufacturing equipment and capacity; foreign economic conditions, including currency rate fluctuations; the regulatory and trade environment; the impact of new or revised accounting rules or interpretations, including revenue recognition requirements; availability and terms of future acquisitions; divestitures and investments; uncertainties relating to synergies; charges and expenses associated with business combinations and other transactions; and other risks and future factors that may be detailed from time to time in the Company's filings with the SEC. For a further description of such risks and future factors, see Item 1A of this filing and Item 1A of our most recently filed Form 10-K. Our actual future results could differ materially from those predicted in such forward-looking statements. In light of the foregoing risks, uncertainties and other factors, investors are advised not to rely on these forward-looking statements when making investment decisions. These factors are not intended to be an all-encompassing list of risks and uncertainties that may affect the operations, performance, development and results of our business. We undertake no obligation to publicly update or revise any forward-looking statements to reflect changed assumptions, the occurrence of anticipated or unanticipated events or changes to future results over time. The foregoing discussion should be read in conjunction with the risk factors, financial statements and related notes and Management's Discussion and Analysis included in our Annual Report on Form 10-K for the year ended January 2, 2009.