Equities Research

Cornell Equity Research

ρ
A division of the Parker Center for Investment Research
Johnson Graduate School of Management
Cornell University

Tellabs, Incorporated Stephen T. Chin

Investment Recommendation: BUY May 4, 1999

TLAB - NASDAQ (5/3/99) $113 11/16 DJIA (5/3/99) 11014.69

52 - week range $31 3/8 - $120 1/4 S&P 500 (5/3/99) 1354.63

EPS Forecast
Revenue (1998) $1,660.1 Mil FYE 12/30 1997A 1998A 1999E 2000E
Market Capitalization $22.1 Bil EPS $1.34 $1.93 $2.45 $3.10
Shares Outstanding 194.3 Mil P/E Ratio 84.4x 58.9x 46.4x 36.7x
Rel. P/E 2.3 1.6 1.3 1.0

Dividend Yield 0.00%

Institutional Holdings 70% Current Valuation discount
Avg. Daily Trading Vol. (shares) 2,540,000 Discounted Cash Flow $101 3.3%
EBO Valuation $99 1.2%
Book Value Per Share (12/98) $6.51 (other – Comparables PE/G Ratio) $139 42.2%
Return on Ave. Equity (LTM) 37%
Est. 5-yr. EPS Growth Rate 35% Relative Performance
Trailing: 6 mo. 12 mo. 24 mo.
Rel. to S&P 500 163% 146% 138%
Industry Telecom Equipment Rel. to Telecom Ind 145% 133% 104%

• Assigning a Buy rating on Tellabs with a 12 Month Target Price of $140

• Stock has appreciated over 20% in the last month

• Critical Telecom CAPEX spending continues being revised upwards

• Core product, TITAN remains strong with a 49% year over year increase in sales

• International business growing through MartisDXX product which saw sales increases of
19% year over year

• New product rollouts in 1999 such as Cable Telephony equipment add spice to the mix

• Tellabs reported record 1st Qtr. EPS of $0.52 vs. $0.37 a year ago, up 40% year over year

• Top-Line growth was $479 million or 43% higher year over year

Rating System:
BUY : A strong purchase recommendation with above average long term growth potential
MARKET OUTPERFORM : A purchase recommendation that is expected to marginally outperform the return of the market
MARKET PERFORMER : A recommendation to maintain current positions with the return to match that of the market 1
SELL: A recommendation to sell the security if owned and to short the security if no position exists as it is expected to move to lower levels from current levels
 DISCLAIMER
This report was prepared by a student at Cornell University's S. C. Johnson Graduate School of Management as part
of NBA 510, Cornell Equity Research, under the supervision of Associate Professor Robert Bloomfield. The report
is intended to provide potential recruiters and other interested parties with an example of analytical work performed
by Johnson School students. Cornell Equity Research is not a Registered Investment Advisor. This report is not
intended to provide investment advice, is not an offer to buy or sell or, and is not a solicitation of an offer to buy or
sell the securities mentioned. This report is based on information available to the public and does not purport to be a
complete statement of all data relevant to the securities mentioned and its accuracy cannot be guaranteed. Cornell
University, its investment managers, and individual members of its faculty, staff and student body may from time to
time have long or short positions in, and buy and sell, the securities, or derivatives thereof, of companies mentioned
herein.

Investment Highlights
• Tellabs is the leading provider of Digital Cross Connects (DCS) in North America.
Tellabs’ flagship DCS product, TITAN 5500 is purchased by all of the Regional Bell
Operating Companies as well as AT&T, MCI/WorldCom and Sprint. Bandwidth
management has become increasingly more important for Telecom service providers as on
network traffic continues to spike upwards. Carriers are continuously transition their signals
onto the more effective SONET/SDH architectures. The company holds about a 70% market
share in this critical component of network architecture. In the 4st quarter, TITAN sales were
$284 million versus $211 million last year. The sales mix was 35% for new shipments (more
profitable) and 65% for system add-ons. Bell Atlantic/NYNEX was their major customer
who comprised of approximately 10% of sales. Management indicated potential growth in
the TITAN product of 25% in 1999.

• Strong sales overseas of the MarisDXX product. The company’s Maris product is their
second largest offering and generated $93.2 million in sales versus $81 million last year for a
63% increase. This bodes well for Tellabs as it indicates that International carriers are
making the transition from older circuit switched networks to the new packet switched
networks which are predominant in the United States. Tellabs largest customer in this arena
is Ericson who contributed $12.5 million in sales last quarter. Management has indicated
that they expect to achieve $500 million in sales in 1999.

• Extra traffic created by Wireless Services benefits all core network equipment providers
such as Tellabs. Wireless traffic growth continues to outpace wireline services. Cellular and
PCS providers are continuously upgrading facilities to all digital networks and are looking to
the telecom equipment manufacturers to provide turnkey solutions. The introduction of
“One-Rate” plans from carriers such as AT&T Wireless, Sprint PCS and Nextel have been a
tremendous success. Record numbers of subscribers have been coming on-line due to the
service providers aggressive pricing tactics. This trend forces service providers to increase
coverage areas and capacity levels. Voice quality is a huge issue in the wireless world and
that alone helped Tellabs generate echo canceller sales of $57 million last quarter (119%
increase year over year). Service providers are migrating to Tellabs core Titan product for
interconnecting and managing wireless basestations.

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• Rising Capex Spending Estimates of large Wireline Telecommunication Service Providers
(MCI/WorldCom, AT&T, Sprint, Bell Atlantic, Southwestern Bell, etc.) are being released.
Early estimates of total CAPEX spending for large service providers was in the low $40
billion level. Revised estimates put that number in the high $40 billion level which bodes
well for telecom equipment providers. Fueling the CAPEX spending of large telcos are the
large increases in capacity through the new Wavelength Division Multiplexing technology.
The increase in spending on WDM products heightens the demand for digital cross connects.
Capex spending on the Cable Television Service Providers also appear likely for upward
revisions. This can be attributed to recent success in telephony trials, cable modem
purchases and digital TV. Cable telephony subscribers are estimated to have grown upwards
of 100%.
• Continued Proliferation of the Competitive Local Exchange Companies (CLECs).
Following the Telecommunications Act of 1996, several new hybrid telephone companies
emerged. The increased presence of CLECs who target specific niche markets such as small
businesses have created huge opportunities for telecom equipment companies. The CLEC
market is estimated to generate $6 billion in revenue per year for equipment vendors.
Companies such as Intermedia, Winstar and ICG Communications have invested heavily in
offering value added services and require the network products of telecom equipment
manufacturers. In addition, new startups such as Qwest, Level 3 and Williams are investing
heavily in building out nationwide fiber optic networks for long haul transmission capacity.
These companies require the use of a bandwidth manager found in the TITAN product line.

• Acceptance of cable television’s alternate pipeline into the home. AT&T acquisition of TCI
cable was a profound statement announcing a viable strategy to provide communication
services to consumers. This strategy was further strengthen through AT&T’s joint venture
with Time Warner to provide telephony over the cable television infrastructure. AT&T’s
strategic maneuvers signify that the HFC (Hybrid Fiber Coax) technology is viable which
bodes well for Tellabs. Upgrades to the current cable television network infrastructure are
now an inevitable event. Almost all of the major cable television service providers have data
services commercial and most have telephony services in some advanced phase of beta
testing. The company’s product, Cablespan generated $10 million in sales last quarter.
Tellabs advantage with this product is their ability to support four-port capabilities and may
provide a key feature to capture the AT&T contract.

• Growth of the Internet and increased wireline data demand. Consumer and business
demand for internet service at home and work has increased the number of T-1 and ADSL
that landline service providers have installed. Sales of cross connects and echo cancellers
have the potential of further upside as the RBOC continue to lower pricing of T-1
connections. As more customers purchase high speed services, the need for echo cancellers
for the analog to digital conversions increase. In addition, all of these new digital access lines
must be “cross connected” to the public network.

• International telecommunications growth. Emerging service providers overseas continue

to provide an important source of growth to telecom equipment providers. Overseas, markets
are just starting to become deregulated increasing competition for service, the

3
 telecommunication infrastructure is quite outdated, and telecom equipment spending as a
percentage of GDP is around 1.5% internationally versus 2.5% in the United States. Asia
and Latin America offer the greatest promise since these areas of the world have the lowest
penetration levels.

• Rebuilding investor sentiment following failed takeover attempt of Ciena continues to

move forward. It seems as if Tellabs unsuccessful takeover bid for fiber optic component
manufacturer Ciena occurred ages ago. However, only three quarters have passed since that
event. After creating ill will between shareholders with a premium bid for Ciena (overpaid
by some accounts), Tellabs has since positive news and earnings growth for the last three
quarters. Shareholders appear to be backing management on current projects and expansion
plans.

Risks
• Highly dependent on CAPEX schedule of Telecom and Cable Service Providers. The
success of Tellabs is closely correlated with the continuing trends of the telecom and cable
televisions industries. For the past 5 years, explosive growth in both of these industries has
created strong demand for Tellabs’ products and services. Reliance on those two key
industries to continuously drive consumer and business demand through pricing or new
applications remains an operating risk for Tellabs. Additional competition in both of those
industries has the potential of reducing the spending habits of the large service providers.

• Industry consolidation in Telecommunications and Cable. The number of potential

customers of Tellabs shrinks everytime a blockbuster merger is announced. In just the past
few years the number of RBOCs has gone from seven to only 4. The industry has seen
Southwestern Bell purchase Pacific Bell and Ameritech. Bell Atlantic purchased rival
NYNEX and WorldCom acquired MCI. These large telecom behemoths are all attempting to
use the recognized synergies to reduce capital spending. As Tellabs’ customers get larger,
the company has the potential of losing some of the pricing power that it now enjoys.

• Short product life cycles. In the telecom equipment industry, customers are constantly
seeking modular systems that can be quickly upgraded as the business need dictates. Tellabs
faces the prospect of continuously meeting scheduled rollouts especially for new products in
the cable television infrastructure market. Most of Tellabs cable products are in live test
phases and it will be critical that the company quickly address system problems and rolls out
a commercial product rapidly. The crown jewel being presented to telecom equipment
providers is the AT&T/TCI infrastructure contract. Tellabs will need to continuously prove
to AT&T/TCI that ongoing modifications made to prototype equipment can be satisfied.

• Possible pricing pressures from stiff competition. In the digital cross connect business,
Tellabs faces off squarely against industry behemoths Lucent Technologies and the new
Alcatel. Lucent enjoys a larger staff of R&D engineers (Bell Laboratories) as well as larger
manufacturing facilities. Alcatel challenges Tellabs dominance of the digital cross connect
product through its acquisition of DSC Communications. As the battle for market share
continues, it is possible for Lucent and Alcatel to engage in more aggressive bidding.

4
• International events. Tellabs is primarily a domestic manufacturer of products. However,
the company does rely heavily on international customers who purchase the MartisXX
product. Economic turbulence in Asia and Latin America were significant events last year as
those are the areas of the world that present the greatest growth potential.

• Migration to newer technology platforms such as IP (Internet Protocol). Many telecom

service providers are announcing plans to build next generation networks on the IP based
standard. Currently, all of Tellabs products support SONET/SDH protocols. However, with
the universal acceptance of IP, the industry may be headed for a major transition. Tellabs
will need to address that issue through new products or upgrades. Customers are awaiting
the arrival of optical cross connects due later this year.

Tellabs: Business Summary

Illinois based, Tellabs, Incorporated designs, manufactures, markets voice, video and data
transport and network access systems. The main products offered by Tellabs are digital cross
connects (TITAN), managed digital networks (MartisDXX) and Network Access Systems
(CABLESPAN). Their products are used by the Regional Bell Operating Companies, long
distance phone companies, wireless service providers, cable operators and business end-users.
Tellabs is the leading manufacturer of digital cross connect products which are mainly sold to
domestic customers. The company is one of the largest managed digital networks producers
supporting mostly international customers. After its acquisition of Coherent Communications,
Tellabs has become on of the largest independent producers of echo cancellers. Network Access
systems contains the wild card product, CABLESPAN. This product is in the final testing
phases with customers and Tellabs is believed to be in the running for a significant portion of the
AT&T/TCI equipment contract.

4Q98 Segment Revenue:

Other (Total) Tellabs continues to rely
Total Digital 10% heavily on their core Cross-
Signaling
11% Connect Product. Future
Total Digital
revenue is expected to
Cross-Connect diversify this dependence as
Martis DXX
54% Cable Equipment increases in
25%
demand

5
Tellabs’ Products:
• Digital Cross Connects (TITAN 5500)
TITAN Customer Breakdown
The basic function of a digital cross connect is to
break down or aggregate different signals or lines.
Wireless IXC
For example, the cross connect in its most simplest
& CLEC 20% form collects multiple low speed lines arriving at a
28%
central office and combines them all onto a high
speed line. The cross connect is also responsible
LEC for controlling traffic so that slow speed lines
52%
connect efficiently with high speed lines.

Tellabs’ TITAN digital cross-connect product help telecom service providers reduce equipment
and leased-line costs and guarantee network quality and reliability. Their systems are deployed
in virtually all types of telecommunications networks, including local telephone service, long-
distance networks, wireless networks, private networks, the emerging networks in corporate
America and networks around the world.
As competition intensifies, the more traditional service providers are compelled to upgrade their
networks to cut costs, improve quality and guard against equipment obsolescence. Most major
long-distance and local phone service providers are using TITAN systems to prepare for
convergence in the industry where demand for new wideband and broadband services is
becoming common-place. Tellabs understands that technology is the primary enabler of the
growing service marketplace, and stands ready to provide innovative solutions that utilize the
latest technology.

Managed Digital Networks

• Martis DXX
The Martis DXX system is a complete managed access and transport network system
designed to be used by telecom service providers worldwide for the delivery of both mobile
and general transport network services. This product has been deployed in 44 countries. It is
a complete network solution and offers customers high-capacity cross-connect systems,
flexible multiplexers and high-speed baseband modems. The quality of service can be
measured through real-time, end-to-end monitoring of trunks and customer access lines.
These turnkey solutions also offer a migration path to the next generation technologies such
as Frame Relay and ATM services. Demand for this product is driven by startup firms and
wireless network providers. The customer mix of the Martis DXX are 50/50 CLEC and
wireless providers.

Network Access Systems

• CABLESPAN
Cablespan is the potential crown jewel of Tellabs’ assets. Cablespan is a proprietary product
designed jointly by Tellabs and Advanced Fiber Communications that enables a cable

6
 television service provider to offer telephone services. This unit is basically a network
interface device located right outside a customer’s residence which demodulates income
signals, sends voice to in-home telephone wiring and video to the in-home cable boxes.
• Echo Cancellers
These products are developed internally by Tellabs. Echo is caused by transmission
equipment that must carry voice over 1,000 miles as well as the analog to digital conversion
that take place on both wireline and wireless systems. Tellabs’ echo cancellers are able to
remove all possible echo in long distance communication. Tellabs is further benefiting from
the decision of Telecom service providers to use echo cancellers at all points regardless of
the distance of a call to ensure quality conversations. Gross margins are estimated to be in
the 65% range for the next few years as Tellabs is also able to design the most central piece
of the echo canceller, the DSP, themselves. Estimated Market Share: Ditech 13% Coherent
13% Ericsson 17% Tellabs 22% Lucent 35%
• New Products
New products that Tellabs has in the pipeline include those to support wireless local loop
sales. Other products that are expected to debut in 1999 include those related to optical
networking such as ATM transport and switching of voice and data access.

International Sales:

• The strongest international markets were Europe, the Mideast and Africa. Brazil represents
less than 2% of revenue while China remains a large opportunity. More contracts are
expected from Europe and Latin America in 1999, with Mexico’s Telmex a major
opportunity to monitor.

Tellabs’ Competition:
Tellabs faces intense competition on the wideband and narrowband digital cross connect product
from industry giants, Lucent Technologies, Alcatel and DSC corporation. In the managed access
and transport product line, Tellabs faces competition from Newbridge Networks, Nokia and
Network Equipment. On the network access products front, Tellabs competes with ADC
Telecommunications, Lucent and Ericson.

• Lucent Technologies (NYSE: LU) is by far the largest and most respected Telecom
Equipment Provider. The company has a competitive advantage through its Bell
Laboratories engineering staff. Lucent has the manufacturing capability and resources to
diversify operations into several different areas. The company enjoys strong relationships
will all of the large telecom service providers such as GTE, Bell Atlantic, AT&T, WorldCom
and Sprint. Lucent provides the most critical backbone component, the switch, to all of the
largest providers. Having the ability to create a more economical product to compete with
the digital cross connect is a serious threat to Tellabs.

• France based, Alcatel (NYSE: ALA) has been battling directly with Tellabs for many years
in the cross connect arena. Tellabs has been able to consistently beat Alcatel to the major

7
 contract win despite being underbid. Tellabs has the reputation of possessing higher quality
equipment than Alcatel. However, this all can change quickly as Alcatel recently acquired
U.S. based DSC Communications to assist it in competing for narrowband digital cross
connects.

• Canadian based Newbridge Networks (NYSE: NN) also competes directly with Tellabs in
the production of digital cross connects. Newbridge’s established early dominance of private
line networking and is now pioneering the merging of switching and routing technologies
with the newly announced Siemens / Newbridge Alliance. This industry leading broadband
multi-services architecture provides a formidable competitor to Tellabs.

• ADC Telecommunications (NASDAQ: ADCT) manufactures a variety of transmission and

networking systems as well as broadband connectivity products for fiber-optic, twisted pair,
coaxial and wireless broadband global networks. ADC has a strong position in cable
telephony and is the leader in broadband local loop access equipment.

Tellabs’ Valuation:
Three methods of valuation were used to calculate an intrinsic value for Tellabs.

Comparable / Multiple Company Valuation:

See Table #1.

1999E P/E 2000E P/E 99’ PE/G Ratio 00’ PE/G Ratio

Using Means $93.53 $91.75 $139.52 $138.84

Using Medians $101.20 $89.93 $135.93 $121.87

Both of Tellabs’ estimated P/E ratios reveal that it is at the high end of the industry. Valuing the
company using comparable P/E ratios indicate that Tellabs may have become overvalued.
However, strong industry fundamentals justify a 1999E P/E of 30 and a 2000E P/E of 40. The
company has recently enjoyed a strong price appreciation in price as their major customers,
telecommunication service providers, continue to revise their CAPEX spending upwards.
Demand for internet services continue to surprise telecom service providers and leads to
increased equipment purchases. Tellabs’ stock price has risen over 20% in just over 2 months
amid strong momentum in the telecom equipment sector.

However, when applying the more generally accepted method of valuing growth companies, the
PE/G ratio ( P/E to Growth Rate), the company appears to be undervalued. The high P/E ratio
becomes more reasonable when related to an expected 35% long term growth rate. Their ability
to maintain this 35% long term growth rate will be a stiff challenge after considering the more
well established competitors in their industry, Lucent and Alcatel. Tellabs will need to rely on
their smaller size and nimbleness to overcome the industry giants.

A note regarding the use of comps to value Tellabs:

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It is difficult to find a close comparable to Tellabs as this company is fully diversified in
providing different types of equipment to several telecommunications service providers. Two
companies that possess the closest comparable to Tellabs are industry giants Lucent
Technologies and Alcatel. Both of these companies on much larger than Tellabs and have a
different capital structure as they employ more long term debt. Tellabs employs no meaningful
long term debt in their capital structure. Thus, large discrepancies in ratios such as TEV/EBIT
and TEV/EBITDA will be observed. Thus, the use of comps makes it appear as if two different
industries are being compared, but that is not the case.

EBO Valuation

A value of $98.82 per share (See Table #2) was derived as a fundamental value for TLAB’s
common stock.

An EBO Model assuming a 5 year "growth" period and with a "fade" to 10 years was used as
Tellabs is expected to continually keep up with the changing technologies and rollout products
on a timely basis. More time is required for this company to stabilize revenues and receive a
return on years of aggressive capital spending programs.

The following assumptions were used:

EPS Forecasts:
One year ahead EPS figures were gathered by averaging First Call reports. ($2.45)
Two year ahead EPS figures were gathered by averaging First Call reports ($3.05)

Long Term Growth Rate:

The Five Year Market Guide Average of Analysts = 35%

Book value per share:

Shareholder Equity at the end of FY1998 = $1,264 Mil.
Number of Shares Outstanding at the end of FY 1998 = 194.3 Mil

Discount Rate:
Three methods were considered in calculating a discount rate.

1. Fama-French CAPM risk premia.

To compute an estimated cost of equity, the CAPM risk premium for TLAB’s SIC Code was
added to the current yield on the 30 year long bond.

5.67% + 2.55% = 8.22%

2. Three Factor industry risk premia.

To compute an estimated cost of equity, the three factor risk premium for TLAB’s SIC Code
was added to the current yield on the 30 year long bond.

5.67% + 4.20% = 9.87%

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3. CAPM

Rf + β * (Rm – Rf)

5.67% + (1.9)*(5.4%) = 15.93%

NOTE: Tellabs has no meaningful long term debt in their capital structure. Therefore the cost of
capital is simply their cost of equity. This leads to a large variation in calculated discount rates.
For this instance, I used an average of the three values:

Average of the three methods of computing Re ( 8.22% + 9.87% + 15.93%) / 3 = 11.2%

Target ROE:
A historical 5-year ROE average Tellabs’ SIC Code was used. ROE = 22%

EBO Sensitivity Analysis

Growth Rate

20% 25% 30% 35% 40% 45% 50%

7.0% $141.11 $164.46 $192.50 $226.09 $266.26 $371.27 $401.27

Cost of Capital 8.0% $112.25 $130.84 $153.14 $179.86 $211.81 $249.95 $295.36

9.0% $90.80 $105.83 $123.87 $145.48 $171.33 $202.18 $238.90

10.0% $74.43 $86.75 $101.54 $119.25 $140.44 $165.72 $195.83

11.0% $61.68 $71.89 $84.14 $98.82 $116.38 $137.33 $162.28

12.0% $51.58 $60.12 $70.37 $82.65 $97.33 $114.85 $135.72

13.0% $43.48 $50.67 $59.31 $69.66 $82.03 $96.80 $114.39

14.0% $36.89 $43.00 $50.33 $59.11 $69.61 $82.14 $97.07

15.0% $31.49 $36.70 $42.96 $50.46 $59.42 $70.12 $82.86

The EBO model indicates that Tellabs appears to be fairly valued at its current price of $97.75.
With the wave of consolidation occurring in the Telecom equipment sector it is quite likely that
an acquisition premium has been built into the current price of Tellabs. Lucent Technologies,
Northern Telecom and Cisco have all been on a buying spree and rumors have included Tellabs
as a target of each of these telecom giants.

10
The possibility of Tellabs making an acquisition in the near future is also an event risk. The
company’s failed acquisition of Ciena last year indicates that it is willing to pursue that avenue to
round out their current product mix. An acquisition by Tellabs would increase the risk profile of
the company and could possibly call for an increase in the cost of capital.

DCF Valuation

A value of $101.11 per share (See Table #3) was derived as a fundamental value for TLABs
common stock.

The following assumptions were used:

Discount Rate:
To compute an estimated cost of capital, the same conclusion was arrived at as described in the
EBO description. A value of 11% was used.

Average of the three methods of computing Re ( 8.22% + 9.87% + 15.93% ) / 3 = 11.2%

A terminal multiple of 7 was used to calculate Terminal Value.

The average Price to EBITDA average of Tellabs’ closest comparable, Alcatel gives an average
of 7.0. This value also takes into consideration, TLAB’s leadership position in Digital Cross
Connects and by posting stable earnings and having diversified profit producing assets all around
the world.

DCF Sensitivity Analysis

Terminal Multiple

5x 6x 7x 8x 9x

9.0 $95.10 $107.06 $119.02 $130.98 $142.95

10.0 $87.80 $98.72 $109.64 $120.56 $131.48

Cost of Capital 11.0 $81.16 $91.14 $101.11 $111.08 $121.06

12.0 $75.11 $84.23 $93.35 $102.47 $111.59

13.0 $69.60 $77.94 $86.28 $84.62 $102.97

Investment Summary:
Tellabs was downgraded from our original BUY recommendation at $81 to a Market Outperform
rating purely on valuation. However, when analyzing industry fundamentals, the company is
still a solid investment idea. Tellabs continues to benefit from traffic growth in the core of
telecom service provider’s networks. Management reports that SONET/SDH demand will

11
remain strong for the next few years. This statement comes from a management team that has
consistently met their number over the past 3 years. Although the stock appears pricey at these
levels, TLAB has enjoyed a strong momentum run by continually making higher highs on the
charts. As stated earlier, the wild card in this whole scenario is the growth of cable equipment
infrastructure. Success in this area could richly reward an investment in Tellabs.

12
TABLE #1
Tellabs, Incorporated
Comparable Valuation
3/31/1999

EPS Forecasts Est. 5yr Market Total

Company Last 1999E 2000E Growth Shares Value Enterprise LTM LTM LTM EBIT EBITDA TEV / TEV / 1999 E 2000 E 99' P/E / 00' P/E /
Name Price EPS EPS Rate Out. of Equity Value Sales EBIT EBITDA Margin Margin EBIT EBITDA P/E P/E 5yr growth 5yr growth

ADC Telecom 49.88 1.33 1.64 25% 134.9 6,728.0 6,443.1 $1,379.7 225.7 290.8 16% 21% 28.5 22.2 37.6 30.3 1.503 1.213
Newbridge Networks 33.13 0.73 1.16 27% 176.88 5,859.1 5,628.1 $1,099.5 210.6 308.9 19% 28% 26.7 18.2 45.6 28.6 1.688 1.061
Alcatel 23.50 1.05 1.10 20% 778.75 18,300.6 21,549.5 $30,896.3 1,132.3 2,646.7 4% 9% 19.0 8.1 22.4 21.4 1.122 1.070
Lucent Technologies 111.75 2.32 2.80 22% 1320.3 147,537.9 149,001.9 $30,627.0 4,293.0 5,628.0 14% 18% 34.7 26.5 48.1 40.0 2.236 1.858

Comparable Mean 44,606.4 45,655.7 16,000.6 1,465.4 2,218.6 0.1 0.2 27.3 18.7 38.4 30.1 1.64 1.30
Comparable Median 12,514.3 13,996.3 16,003.3 679.0 1,477.8 0.2 0.2 27.6 20.2 41.6 29.5 1.60 1.14

Tellabs, Inc. 98.56 2.43 3.05 35% 194.3 19,146.1 18,915.4 $1,493.1 563.0 616.56 38% 41% 33.6 30.7 40.5 32.3 1.157 0.923

Implied TEV using Means 15,342.4 11,558.6

Implied TEV using Medians 15,557.8 12,445.4
Less: Preferred 0.0 0.0
Equity
Less: 2.9 2.9
Debt
Add: 233.5 233.5
Cash

Implied Price / Share using $80.17 $60.69 $93.53 $91.75 $139.52 $138.84
Comp. Mean
Implied Price / Share using $81.28 $65.26 $101.20 $89.93 $135.93 $121.87
Comp. Median

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Tellabs’ EBO - Table #2

PARAMETERS FY1 FY2 Ltg

EPS Forecasts 2.45 3.05 35.00% (mean analyst forecasts)
Book value/share (last fye) 6.51
Discount Rate 11.00%
Dividend Payout Ratio 0.000
Next Fsc Year end 1999
Current Fsc Mth (1 to 12) 9
Target ROE (industry avg.) 0.2200

Year 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Long-term EPS Growth Rate 0.3500 0.3500 0.3500 0.3500 0.3500
Forecasted EPS 2.45 3.05 4.12 5.56 7.50 10.13 13.68
Beg. of year BV/Shr 6.510 8.960 12.010 16.128 21.686 29.190 39.321
Implied ROE 0.340 0.343 0.345 0.346 0.347 0.348

(Beg. ROE, from DCF model) 0.376 0.340 0.343 0.345 0.346 0.347 0.348 0.322 0.297 0.271 0.246 0.220
(ROE-r) 0.266 0.230 0.233 0.235 0.236 0.237 0.238 0.212 0.187 0.161 0.136 0.110
(1-k)*(ROEt-1) 0.000 0.376 0.340 0.343 0.345 0.346 0.347 0.348 0.322 0.297 0.271 0.246
1.000 1.376 1.845 2.477 3.331 4.484 6.040 8.141 10.764 13.958 17.742 22.099
0.266 0.317 0.430 0.581 0.786 1.063 1.436 1.728 2.010 2.249 2.405 2.431
0.110 0.110 0.110 0.110 0.110 0.110 0.110 0.110 0.110 0.110 0.110 0.110 0.110
1.110 1.232 1.368 1.518 1.685 1.870 2.076 2.305 2.558 2.839 3.152 3.498
0.000
PV(growth*AROE) 0.24 0.26 0.31 0.38 0.47 0.57 0.69 0.75 0.79 0.79 0.76 0.69
1.24 1.50 1.81 2.19 2.66 3.23 3.92 4.67 5.46 6.25 7.01 7.71

(Assume this yr's AROE forever) 2.18 2.34 2.86 3.48 4.24 5.17 6.29 6.82 7.14 7.20 6.94 6.32
(P/B if we stop est. this period) 3.42 3.84 4.67 5.68 6.90 8.40 10.21 11.49 12.60 13.45 13.95 14.02
24.11 27.04 32.89 40.00 48.65 59.16 71.96 80.95 88.78 94.78 98.30 98.82

6.51 8.96 12.01 16.13 21.69 29.19 39.32 53.00 70.08 90.87 115.50 143.87
2.45 3.05 4.12 5.56 7.50 10.13 13.68 17.08 20.79 24.64 28.36 31.65
0.245 0.350 0.350 0.350 0.350 0.350 0.249 0.217 0.185 0.151 0.116

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Tellabs’ DCF - Table #3

Actual Actual Assumptions Forecast Forecast Forecast Forecast Forecast Forecast Forecast Forecast Forecast Forecast
FISCAL YEAR ENDING 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Sales 1,204 1,699 2,167 2,772 3,604 4,685 5,857 7,321 8,785 10,542 12,124 13,942
Operating expenses: 840 1,161 1,438 1,840 2,396 2,972 3,719 4,648 5,585 6,700 7,718 8,874
Cost of sales 415 539 809 1,036 1,009 1,312 1,640 2,050 2,460 2,952 3,395 3,904
Selling and administrative 230 336 313 401 793 937 1,171 1,464 1,757 2,108 2,425 2,788
Other 0 38 0 0 0 0 0 0 0 0 0 0
Research & Development 158 203 265 339 505 609 761 952 1,142 1,370 1,576 1,812
Depreciation and amort. 31 40 calc as % of beg. PPE 51 65 83 108 141 176 220 264 316 364
Goodwill amortization 6 6 flat 6 6 6 6 6 6 6 6 6 6
Operating income 363 538 728 932 1,208 1,713 2,138 2,673 3,201 3,842 4,406 5,068
Interest expense 0 1 34 83 2 2 2 2 2 2 2 2
Interest Income + Other 37 92 60 111 144 187 234 293 351 422 485 558
Income
Income before tax 400 629 748 954 1,351 1,899 2,370 2,964 3,550 4,262 4,889 5,623
Provision for income taxes 136 192 254 318 473 740 924 1,156 1,385 1,662 1,907 2,193
Net income 264 437 494 636 878 1,158 1,446 1,808 2,166 2,600 2,982 3,430
Add: Int Exp (1-t) 0 1 34 83 2 2 2 2 2 2 2 2
EBI (NOPLAT) 264 438 528 719 880 1,160 1,448 1,810 2,168 2,602 2,984 3,432
Add: Depreciation 31 40 51 65 83 108 141 176 220 264 316 364
(Inc) Dec in other assets 22 29 from B/S (16) (18) (27) (37) (41) (53) (53) (64) (57) (67)
Inc. (Dec.) in other 0 0 from B/S 6 7 9 12 13 16 16 19 17 20
liabilities
Inc. in deferred taxes 2 11 from B/S 1 4 5 6 7 9 9 11 9 11
WCFO (excl. int.) 319 518 570 776 950 1,249 1,567 1,958 2,359 2,831 3,270 3,760
(Inc.) Dec. in A/R 14 (13) from B/S (148) (176) (241) (314) (340) (425) (425) (510) (459) (527)
(Inc.) Dec. in Other C. Assets (15) 9 from B/S (27) (44) (60) (78) (84) (105) (105) (127) (114) (131)
Inc. (Dec.) in A/P 12 7 from B/S 24 24 33 43 47 59 59 70 63 73
Inc. (Dec.) in Other Accruals 31 15 from B/S 26 30 42 54 59 73 73 88 79 91
CFO (excl. int.) 361 536 445 612 724 955 1,249 1,560 1,961 2,353 2,840 3,266
Less: Capital Expenditures, (91) (99) (121) (156) (208) (270) (316) (395) (439) (527) (553) (636)
FCF (free cash flow) 270 436 324 456 516 685 932 1,165 1,522 1,826 2,287 2,629
Terminal value (mult of EBITDA) 7.0 38,062
Total free cash flow 324 456 516 685 932 1,165 1,522 1,826 2,287 40,691

PV of total free cash flows 11.0% 19,416

Less: PV (debt) (3)
Plus: idle assets (liabs) 0
PV of shareholders' equity (in millions) 19,413
Shares outstanding 192
Price per share $101.11

15
Tellabs’ Earning Estimates - Table #4

Earnings Model 1998 1999E 2000E

Q1 Q2 Q3 Q4 Year Q1 Q2 Q3 Q4 Year Q1E Q2E Q3E Q4E Year
Sales:
Titan 5000 200.5 255.2 242.4 281.0 979.1 250.6 311.3 300.6 351.3 1213.8 325.8 404.7 390.7 456.6 1577.9
Martis 78.0 94.0 100.6 131.5 404.1 94.4 114.7 122.7 161.7 493.5 118.0 143.4 153.4 210.3 625.0
Echo Cancellers 51.3 38.0 47.4 60.0 196.7 50.0 55.1 56.9 69.0 231.0 70.0 66.1 68.3 86.3 290.7
Cablespan 1.0 3.0 7.4 12.0 23.4 15.0 18.0 21.1 22.2 76.3 18.8 22.5 26.4 28.9 96.5
Other 16.0 17.5 25.7 36.8 96.0 25.6 30.6 42.4 53.4 152.0 30.7 36.8 50.9 64.0 182.4

Net Sales 346.8 407.7 423.5 521.3 1699.3 435.6 529.7 543.7 657.6 2,166.6 563.3 673.5 689.7 846.0 2,772.5
Cost of Goods Sold 127.6 146.4 146.2 173.5 593.7 172.5 208.2 214.8 265.0 860.4 223.1 264.7 272.4 341.0 1101.1

Gross Profit 219.2 261.3 277.3 347.8 1105.6 263.1 321.6 328.9 392.6 1306.2 340.2 408.8 417.2 505.1 1671.3

SG&A 70.9 79.7 83.7 110.2 344.5 65.3 79.5 76.1 92.1 313.0 84.5 101.0 96.6 118.4 400.5
R&D 45.8 50.4 52.2 59.2 207.6 57.5 65.5 67.0 74.7 264.7 74.4 83.3 85.0 96.1 338.7

Operating Income 102.5 131.2 141.4 178.4 553.5 140.2 176.6 185.8 225.8 728.5 181.3 224.5 235.7 290.6 932.1

Goodwill 1.5 1.4 1.3 1.5 5.7 1.5 1.5 1.5 1.5 6.0 1.5 1.5 1.5 1.5 6.0
Interest Income, Net 5.6 3.7 3.0 5.8 18.1 6.5 6.5 6.5 6.5 26.0 7.0 7.0 7.0 7.0 28.0

Pretax Income 106.6 133.5 143.1 182.7 565.9 145.2 181.6 190.8 230.8 748.5 186.8 230.0 241.2 296.1 954.1
Taxes 34.8 43.4 46.5 59.4 184.1 49.4 61.7 64.9 78.5 254.5 62.6 77.1 80.8 97.7 318.1

Net Income 71.8 90.1 96.6 123.3 381.8 95.9 119.9 125.9 152.3 494.0 124.2 153.0 160.4 198.4 636.0

Diluted Shares 198.3 198.4 195.1 199.3 197.8 194.4 194.5 194.6 194.7 194.6 194.8 194.9 195.0 195.1 195.0

Diluted EPS $0.36 $0.45 $0.50 $0.62 $1.93 $0.49 $0.62 $0.65 $0.78 $2.54 $0.64 $0.78 $0.82 $1.02 $3.26

Margins
Gross Margin 63.2% 64.1% 65.5% 66.7% 65.1% 60.4% 60.7% 60.5% 59.7% 60.3% 60.4% 60.7% 60.5% 59.7% 60.3%
SG&A/Sales 20.4% 19.5% 19.8% 21.1% 20.3% 15.0% 15.0% 14.0% 14.0% 14.4% 15.0% 15.0% 14.0% 14.0% 14.4%
R&D/Sales 13.2% 12.4% 12.3% 11.4% 12.2% 13.2% 12.4% 12.3% 11.4% 12.2% 13.2% 12.4% 12.3% 11.4% 12.2%
Operating Margin 29.6% 32.2% 33.4% 34.2% 32.6% 32.2% 33.3% 34.2% 34.3% 33.6% 32.2% 33.3% 34.2% 34.3% 33.6%
Pretax Margin 30.7% 32.7% 33.8% 35.0% 33.3% 33.3% 34.3% 35.1% 35.1% 34.5% 33.2% 34.2% 35.0% 35.0% 34.4%
Tax Rate 32.6% 32.5% 32.5% 32.5% 32.5% 34.0% 34.0% 34.0% 34.0% 34.0% 33.5% 33.5% 33.5% 33.0% 33.3%
Net Margin 20.7% 22.1% 22.8% 23.7% 22.5% 22.0% 22.6% 23.2% 23.2% 22.8% 22.1% 22.7% 23.3% 23.4% 22.9%

Titan 5000 25.0% 22.0% 24.0% 25.0% 24.0% Titan 5000 30.0% 30.0% 30.0% 30.0% 30.0%
Martis 21.0% 22.0% 22.0% 23.0% 22.1% Martis 25.0% 25.0% 25.0% 30.0% 26.6%
Echo Canclrs -2.5% 45.0% 20.0% 15.0% 17.4% Echo Canclrs 40.0% 20.0% 20.0% 25.0% 25.8%
Cablespan 1400.0% 500.0% 185.0% 85.0% 226.0% Cablespan 25.0% 25.0% 25.0% 30.0% 26.5%
Other 60.0% 75.0% 65.0% 45.0% 58.3% Other 20.0% 20.0% 20.0% 20.0% 20.0%

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