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We downgrade our recommendation on Tellabs Inc. to Underperform backed by our assessment that the poor performance of the company will continue in the near future. First-quarter 2011 financial results were well below the Zacks Consensus Estimates and the second-quarter 2011 outlook provided by management was disappointing. What is important is that Tellabs’ globally reputed high-margin digital cross-connect products are also showing a downtrend. Therefore, gross margin of the company suffered a set back in the previous quarter and is expected to remain at low-level in the near term.

Tellabs is aggressively targeting the mobile Internet market since its legacy switching products are gradually losing relevance. In the meantime, we do not find any immediate catalyst for the company. Tellabs is facing serious problems in its core wireless backhaul solutions segment. AT&T (T - Analyst Report) was its major customer for its 8800 multi-service router. However, AT&T decided to upgrade its network with pure Ethernet solutions since the company is moving toward deploying 4G LTE networks.  

As a result, AT&T is at present using Ethernet routers of Cisco Systems Inc. (CSCO - Analyst Report) and Alcatel-Lucent (ALU - Analyst Report) instead of Tellabs. During 2010, AT&T generated 35% of total sales of Tellabs and 40% of Data product revenue. We believe loss of businesses from AT&T will have severe consequences on Tellabs’ financials in 2011. We believe loss of revenue from AT&T was primarily attributable to the poor second-quarter 2011 revenue outlook.

Another key challenge for Tellabs is to sustain its business growth, given the economic headwind is still persisting in several parts of the world, especially in the European regions. Tellabs is trying hard to expend its geographic presence emphasising on Brazil, Russia, India, China, and South Africa. However, this strategy will expose the company’s foreign exchange volatility and may result in revenue fluctuations.

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