Introduction and Overview of Business

Tellabs designs, develops and supports telecommunications networking products. We generate revenue principally through the sale of these products to communications service providers worldwide as both stand-alone network elements and as elements of solutions integrated under a common network management system. We also generate revenue by providing services to our customers.

Prior to the second quarter of 2012, Tellabs reported results of operations for three reporting segments: Broadband, Transport, and Services. As a result of strategy changes and internal reorganizations at the beginning of the second quarter of 2012, Tellabs is focusing on the growth markets of Packet Optical (primarily our optical portfolio) and Mobile Backhaul (primarily our data portfolio) in addition to the on-going Access and Services businesses. With these strategic adjustments, we changed our reporting segments accordingly. Therefore, beginning with the second quarter of 2012, we have reported in the following four segments: Optical, Data, Access and Services (the Services segment is unchanged).

Optical segment products are primarily used to manage large volumes of telecommunication traffic in metro areas. The Optical segment includes the Tellabs® 7000 series of optical transport systems, as well as the Tellabs® 5000 and 6300 series of transport systems equipped with optical interfaces.

Data segment products are primarily used in mobile backhaul applications, and for business services and various edge routing applications. The Data segment includes the packet-switched Tellabs® 8600 Managed Edge System, the Tellabs ® 8800 Multiservice Router Series, and Tellabs® 9200 Content-Aware Router Series, as well as the Tellabs® 8100 Managed Access System.

Access segment products are primarily used to enable service providers to bundle Internet, video, and voice over high-speed fiber-based networks and in Optical LAN applications. The Access segment includes the Tellabs ® 1000 and 1100 Multi-service Access systems, and the Tellabs® 1600 Optical Network Terminals.

The Services segment includes services that support all phases of the network:
planning, building and operating. The Services segment includes deployment, support, training and professional services for customers of the Optical, Data and Access segments.

Tellabs operates in a dynamic industry. Customer consolidation has resulted in increased pricing pressure. In addition, customer spending is pressured and competition is heightened on a global basis. Some equipment suppliers have also consolidated. Heightened competition by these suppliers has resulted in increased pricing pressure for Tellabs and some of its direct competitors.

Within this backdrop, we continue to transform the Company with new products and services. The Company's strategy is to focus on a product portfolio that addresses the global markets. We expect that executing this strategy of directing resources to create innovative products and services will help customers succeed.

RESULTS OF OPERATIONS

Net loss in the second quarter of 2012 was $4.7 million or $0.01 per share (basic and diluted), compared with net loss of $29.3 million or $0.08 per share (basic and diluted) in the second quarter of 2011. For the first six months of 2012, net loss was $144.5 million or $0.39 per share (basic and diluted), compared with net loss of $53.4 million or $0.15 per share (basic and diluted) in the first six months of 2011. Lower operating expenses and increased gross profit margins reduced the net loss in the second quarter of 2012, compared with the year-ago period, despite lower overall revenue. The net loss in the first six months of 2012 was driven primarily by lower overall revenue and $106.9 million in restructuring and other charges incurred in the first six months of 2012.

Revenue (in millions)



                               Second Quarter                          Six Months
                          2012        2011      Change          2012        2011      Change
       Products        $ 237.4     $ 259.5        (8.5 )%    $ 447.1     $ 531.9       (15.9 )%
       Services           50.7        57.2       (11.4 )%       98.9       107.2        (7.7 )%

       Total revenue   $ 288.1     $ 316.7        (9.0 )%    $ 546.0     $ 639.1       (14.6 )%

Second quarter 2012 compared with second quarter 2011

Total revenue was $288.1 million, compared with $316.7 million, as revenue declined in each operating segment. On a geographic basis, revenue from customers outside North America was $150.2 million (or 52% of total revenue), up 7.7% from $139.5 million (or 44% of total revenue), as revenue increased in all geographic regions outside North America. Revenue from customers in North America (United States and Canada) was $137.9 million (or 48% of total revenue), compared with $177.2 million (or 56% of total revenue).

First six months of 2012 compared with first six months of 2011

Total revenue was $546.0 million, compared with $639.1 million, as revenue declined in each operating segment. On a geographic basis, revenue from customers outside North America was $281.5 million (or 52% of total revenue) compared with $286.8 million (or 45% of total revenue) as increased revenue in the Latin America Caribbean (LAC) region was offset by lower revenue in the Europe, Middle East, Africa (EMEA) region and the Asia Pacific (APAC) region. Revenue from customers in North America was $264.5 million (or 48% of total revenue), compared with $352.3 million (or 55% of total revenue).

Gross Margin



                               Second Quarter                           Six Months
                                                % Point                                % Point
                        2012        2011         Change        2012        2011         Change
       Products         41.0 %      36.3 %          4.7        39.9 %      38.9 %          1.0
       Services         33.1 %      36.7 %         (3.6 )      31.9 %      28.4 %          3.5
       Consolidated     39.6 %      36.4 %          3.2        38.4 %      37.2 %          1.2

Product gross margins, driven by margin improvements within the Optical segment and lower overhead and support costs that were partially offset by lower overall revenue, improved in both periods of 2012. Services gross margins, driven by an adjustment for business taxes on sales transactions involving deployment services in a foreign jurisdiction, declined in the second quarter of 2012 compared with the year-ago period. Services gross margins, driven by lower costs, improved in the first six months of 2012 compared with the year-ago period.

Operating Expenses (in millions)



                                           Second Quarter                 Percent of Revenue
                                      2012        2011      Change           2012          2011
 Research and development          $  58.8     $  83.5     $ (24.7 )         20.4 %        26.4 %
 Sales and marketing                  32.2        40.8        (8.6 )         11.2 %        12.9 %
 General and administrative           19.7        21.0        (1.3 )          6.8 %         6.6 %

 Subtotal                            110.7       145.3       (34.6 )         38.4 %        45.9 %

 Intangible asset amortization         1.0         5.1        (4.1 )
 Restructuring and other charges       0.9          -          0.9

 Total operating expenses          $ 112.6     $ 150.4     $ (37.8 )

                                             Six Months                   Percent of Revenue
                                      2012        2011      Change           2012          2011
 Research and development          $ 125.7     $ 163.8     $ (38.1 )         23.0 %        25.6 %
 Sales and marketing                  68.6        85.5       (16.9 )         12.6 %        13.4 %
 General and administrative           40.8        44.7        (3.9 )          7.5 %         7.0 %

 Subtotal                            235.1       294.0       (58.9 )         43.1 %        46.0 %

 Intangible asset amortization         3.2        10.3        (7.1 )
 Restructuring and other charges     106.9         1.0       105.9

 Total operating expenses          $ 345.2     $ 305.3     $  39.9

In the second quarter of 2012, operating expenses decreased, compared with the year-ago period, due primarily to lower research and development and sales and marketing expenses related to stopping new development of the Tellabs® SMARTCORE 9100 series for mobile packet core.

For the first six months of 2012, lower research and development, sales and marketing and general and administrative expenses were offset primarily by $106.9 million in restructuring and other charges incurred in the first half of 2012. Restructuring and other charges in the second quarter of 2012 are due to facility- and asset-related charges ($2.9 million) offset by reductions for severance ($2.0 million). For the first six months of 2012, restructuring and other charges are due to facility- and asset-related charges ($37.1 million), severance ($22.1 million) and accelerated amortization for abandoned intangible assets ($47.7 million) related to the mobile packet-core technology.

Other Income (in millions)



                                    Second Quarter                         Six Months
                              2012        2011       Change        2012        2011       Change
     Interest income, net   $  1.6      $  3.1      $  (1.5 )    $  3.4      $  6.4      $  (3.0 )
     Other expense, net       (1.1 )      (1.1 )         -         (2.1 )      (1.7 )       (0.4 )

     Total other income     $  0.5      $  2.0      $  (1.5 )    $  1.3      $  4.7      $  (3.4 )

Interest income was down in the second quarter and first half of 2012, compared with the year-ago periods, due to lower interest rates and lower investment balances.

Income Taxes

In the second quarter of 2012, we reported tax expense of $6.8 million, compared with a benefit of $3.9 million in the second quarter of 2011. For the first six months of 2012, we reported tax expense of $10.5 million, compared with a tax benefit of $9.7 million for the first six months of 2011. While we were able to partially recognize tax benefits on domestic losses in 2011, we established a valuation allowance in 2011 for the remaining domestic losses. We did not recognize tax benefits on domestic losses in 2012 as it is more likely than not that they will not be realized. As a result, tax expenses for the second quarter and the first six months of 2012 primarily reflect tax on income from foreign operations. Additionally, tax benefits of $2.8 million and $6.2 million were recognized in the second quarter and first six months of 2011, respectively, from the settlement of audits or expiration of statute of limitations that are not reflected in tax expense in 2012.

Segments

We operate in four business segments: Optical, Data, Access and Services.

Segment Revenue (in millions)



                               Second Quarter                          Six Months
                        2012        2011       Change         2012        2011       Change
       Optical         $ 122.4     $ 127.5        (4.0 )%    $ 226.8     $ 248.4        (8.7 )%
       Data               77.7        92.2       (15.7 )%      147.1       203.6       (27.8 )%
       Access             37.3        39.8        (6.3 )%       73.2        79.9        (8.4 )%
       Services           50.7        57.2       (11.4 )%       98.9       107.2        (7.7 )%

       Total revenue   $ 288.1     $ 316.7        (9.0 )%    $ 546.0     $ 639.1       (14.6 )%

Segment Profit (Loss)* (in millions)

                                   Second Quarter                          Six Months
                            2012       2011        Change         2012       2011        Change
    Optical                $ 29.0     $  21.1         37.4 %     $ 43.8     $  46.5         (5.8 )%
    Data                      5.4       (15.0 )        N/M          0.4       (15.8 )        N/M
    Access                    6.0         8.3        (27.7 )%      12.4        19.4        (36.1 )%
    Services                 17.2        21.6        (20.4 )%      32.4        31.6          2.5 %

    Total segment profit   $ 57.6     $  36.0         60.0 %     $ 89.0     $  81.7          8.9 %

* We define segment profit (loss) as gross profit less research and development expenses. Segment profit (loss) excludes sales and marketing expenses, general and administrative expenses, the amortization of intangibles, restructuring and other charges, and the impact of equity-based compensation.

Second quarter 2012 compared with second quarter 2011

Optical

Revenue from the Optical segment was $122.4 million, compared with $127.5 million. Within this segment, increased revenue from the Tellabs® 7100 series optical transport series and the Tellabs® 6300 managed transport systems was more than offset by lower revenue from the Tellabs® 5000 digital cross-connect systems. Optical segment profit, driven primarily by increased profitability from the Tellabs 7100 optical networking systems and the Tellabs 6300 managed transport systems and lower costs, was $29.0 million, up 37.4% from $21.1 million.

Data

Revenue from the Data segment was $77.7 million, compared with $92.2 million, primarily on lower revenue from the Tellabs 8600 managed edge systems and the Tellabs® 8800 multiservice router series. Data segment profit was $5.4 million, compared with a loss of $15.0 million. The return to segment profitability, despite the lower level of revenue, was driven primarily by lower research and development expenses related to stopping development of the Tellabs SMARTCORE 9100 series.

Access

Revenue from the Access segment was $37.3 million, compared with $39.8 million. Within this segment, increased revenue from the Tellabs® 1600 single-family Optical Network Terminals (ONTs) was more than offset by lower revenue from the Tellabs® 1000 and 1100 access systems. Access segment profit, driven primarily by lower revenue from the Tellabs 1000 and 1100 access systems, was $6.0 million, compared with $8.3 million.

Services

Revenue from the Services segment was $50.7 million, compared with $57.2 million. The decline in segment revenue was driven primarily by lower revenue from deployment services, including the adjustment for business taxes mentioned earlier, and lower revenue from support agreements. Services segment profit, driven primarily by the lower overall level of revenue, was $17.2 million, compared with $21.6 million.

First six months of 2012 compared with first six months of 2011

Optical

Revenue from the Optical segment was $226.8 million, compared with $248.4 million. Within this segment, increased revenue from the Tellabs 7100 optical transport systems and the Tellabs 6300 managed transport systems was more than offset by lower revenue from the Tellabs 5000 digital cross-connect systems. Optical segment profit was $43.8 million, compared with $46.5 million. The decline in segment profit was driven primarily by lower revenue from the Tellabs 5000 digital cross-connect systems, partially offset by improved profitability from the Tellabs 7100 optical transport systems.

Data

Revenue from the Data segment was $147.1 million, compared with $203.6 million, primarily on lower revenue from the Tellabs 8600 managed edge systems and the Tellabs 8800 multiservice router series. Data segment profit was $0.4 million, compared with a loss of $15.8 million. The return to segment profitability, despite the lower level of revenue, was driven primarily by lower research and development expenses related to stopping new development of the Tellabs SMARTCORE 9100 series.

Access

Revenue from the Access segment was $73.2 million, compared with $79.9 million. Within this segment, increased revenue from the Tellabs 1600 single-family ONTs was more than offset by lower revenue from the Tellabs 1000 and 1100 access systems. Access segment profit, driven primarily by the lower level of access-system revenue, was $12.4 million, compared with $19.4 million.

Services

Revenue from the Services segment, driven primarily by lower deployment services revenue, including adjustment mentioned earlier, was $98.9 million, compared with $107.2 million. Services segment profit was $32.4 million, up 2.5% from $31.6 million. The increase in segment profit was driven primarily by improved profitability from support agreements and professional services.

Financial Condition, Liquidity & Capital Resources

Our principal source of liquidity remained cash, cash equivalents and marketable securities of $937.7 million as of June 29, 2012, which decreased by $38.9 million since year-end 2011. Of the total cash, cash equivalents and marketable securities, as of June 29, 2012, $385.2 million was held in subsidiaries outside the United States and is deemed to be permanently reinvested. We do not currently foresee a need to repatriate funds from our non-U.S. subsidiaries. We could elect to repatriate funds held in one or more foreign jurisdictions. If applicable, withholding taxes could reduce the net amount repatriated. During the quarter, we generated $31.9 million in cash from operations, slightly increasing cash, cash equivalents and marketable securities. Cash used for operating activities during the first six months of 2012 amounted to $5.6 million.

During the second quarter of 2012, we distributed $7.3 million to our stockholders through our quarterly cash dividend. We also repurchased four thousand shares of common stock at a cost of $16 thousand under the 10b5-1 plan. During the first half of 2012, we distributed $14.6 million to our stockholders through a cash dividend. We also repurchased eight thousand shares of common stock at a cost of $31 thousand under the 10b5-1 plan.

We provide no assurance as to a future declaration or payment of a cash dividend nor do we provide future assurance of a repurchase of common stock.

We believe that our investments are highly liquid instruments. We may rebalance the portfolio from time to time, which may affect the duration, credit structure, liquidity and future income of investments.

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. Current policy is to use cash, cash equivalents and marketable securities to fund business operations, to expand business, potentially through acquisitions, to repurchase common stock and to pay a cash dividend.

GAAP Sequential Comparisons

We believe that comparing some quarterly Statement of Operations data on a sequential basis provides important supplemental information to management and investors regarding financial and business trends relating to our financial results. Commonly compared sequential comparisons of GAAP data include total revenue, geographic revenue split, and segment revenue and profit.

Second quarter 2012 compared with first quarter 2012

Total revenue, was $288.1 million, up 11.7% from $257.9 million as revenue increased in all four operating segments. Revenue from customers outside North America was $150.2 million (or 52% of total revenue), up 14.4% from $131.3 million (or 51% of total revenue) as increased revenue in the EMEA region and the APAC region more than offset lower revenue in the LAC region. Revenue from customers in North America was $137.9 million (or 48% of total revenue), up 8.9% from $126.6 million (or 49% of total revenue).

Optical

Revenue from the Optical segment was $122.4 million, up 17.2% from $104.4 million. Within this segment, increased revenue from the Tellabs 7100 series optical transport systems offset lower revenue from the Tellabs 6300 managed transport systems and the Tellabs 5000 digital cross-connect systems. Optical segment profit was $29.0 million, up 95.9% from $14.8 million. The increase in segment profit was driven primarily by increased profitability from the Tellabs 7100 series optical transport systems.

Data

Revenue from the Data segment was $77.7 million, up 12.0% from $69.4 million. Increased revenue from the Tellabs 8600 managed edge systems more than offset lower revenue from the Tellabs 8100 managed access systems and the Tellabs 8800 multiservice router series. Data segment profit was $5.4 million, compared with a loss of $5.0 million. The return to segment profit was driven primarily by lower research and development expenses related to stopping development of the Tellabs SMARTCORE 9100 series and increased revenue from the Tellabs 8600 series managed edge systems.

Access

Revenue from the Access segment was $37.3 million, up 3.9% from $35.9 million. Within this segment, increased revenue from the Tellabs 1000 and 1100 access systems more than offset lower revenue from the Tellabs 1600 single-family ONTs. Access segment profit was essentially flat at $6.0 million, compared with $6.4 million.

Services

Revenue from the Services segment was $50.7 million, up 5.2% from $48.2 million. The increase in segment revenue was driven primarily by increased revenue from support agreements. Services segment profit, driven primarily by the increased level of support agreement revenue, was $17.2 million, up 13.2% from $15.2 million.

Non-GAAP Financial Measures and Comparisons

We believe that comparing some quarterly non-GAAP financial measures on a sequential basis provides important supplemental information to management and investors regarding financial and business trends relating to our financial results. Commonly compared non-GAAP financial data includes gross profit as a percentage of revenue, operating expenses, operating earnings, net earnings and net earnings per share. A complete reconciliation between non-GAAP financial measures and the GAAP financial measures, along with an explanation of why we believe non-GAAP measures to be of value to management and investors, is contained in the Reconciliation of Non-GAAP Adjustments section of pages 30 through 33.

Second quarter 2012 compared with first quarter 2012

Non-GAAP gross profit margin increased to 39.9%, compared with 37.4%. The sequential increase was driven primarily by favorable product and customer mix shifts in the Optical segment and higher Data-segment revenue.

Non-GAAP operating expenses were $106.4 million, down from $119.7 million, on lower research and development, sales and marketing, and general and administrative expenses related to stopping development of the Tellabs SMARTCORE 9100 series.

Non-GAAP operating earnings, driven by lower operating expenses and improved gross profit margin, were $8.5 million, compared with a loss of $23.2 million.

Driven primarily by higher revenue, lower operating expenses and improved gross profit margin, non-GAAP net earnings were $6.2 million or $0.02 per share (basic and diluted), compared with a net loss of $15.3 million or $0.04 per share (basic and diluted).

                                 TELLABS, INC.

                   RECONCILIATION OF NON-GAAP ADJUSTMENTS (1)

                                  (Unaudited)



                                                                     Second Quarter 2012                                   Second Quarter 2011
In millions, except per-share data                      As Reported        Adjustments        Non-GAAP        As Reported        Adjustments        Non-GAAP

Revenue
Products                                               $       237.4      $          -       $    237.4      $       259.5      $          -       $    259.5
Services                                                        50.7                 -             50.7               57.2                 -             57.2

Total revenue                                                  288.1                 -            288.1              316.7                 -            316.7


Cost of Revenue
Products (a)                                                   140.0               (0.3 )         139.7              165.3               (0.5 )         164.8
Services (a)                                                    33.9               (0.4 )          33.5               36.2               (0.6 )          35.6

Total cost of revenue                                          173.9               (0.7 )         173.2              201.5               (1.1 )         200.4


Gross Profit                                                   114.2                0.7           114.9              115.2                1.1           116.3

Gross profit as a percentage of revenue                         39.6 %              0.3 %          39.9 %             36.4 %              0.3 %          36.7 %
Gross profit as a percentage of revenue - products              41.0 %              0.2 %          41.2 %             36.3 %              0.2 %          36.5 %
Gross profit as a percentage of revenue - services              33.1 %              0.8 %          33.9 %             36.7 %              1.1 %          37.8 %

Operating Expenses
Research and development (a)                                    58.8               (1.5 )          57.3               83.5               (3.2 )          80.3
Sales and marketing (a)                                         32.2               (0.8 )          31.4               40.8               (1.3 )          39.5
General and administrative (a)                                  19.7               (2.0 )          17.7               21.0               (2.5 )          18.5
Intangible asset amortization (b)                                1.0               (1.0 )            -                 5.1               (5.1 )            -
Restructuring and other charges (c)                              0.9               (0.9 )            -                  -                  -               -

Total operating expenses                                       112.6               (6.2 )         106.4              150.4              (12.1 )         138.3


Operating Earnings (Loss)                                        1.6                6.9             8.5              (35.2 )             13.2           (22.0 )

Operating earnings (loss) as a percentage of revenue             0.6 %              2.4 %           3.0 %            -11.1 %              4.2 %          -6.9 %

. . .