Tellabs (NASDAQ:TLAB) shares rose by about 10% on Wednesday after it reported sharply higher revenue for the first quarter ending April 1. While the headline results give Tellabs the sheen of a new Ferrari, lifting the hood and poking around reveals that the engine may belong in a Chevette.
Tellabs manufactures networking equipment that is used by all sorts of network operators. Their customers include wireless operators, cable companies, phone companies, and many others. The businesses of most network equipment makers fell off a cliff when the bubble burst in 2000 and 2001, but things have been improving in the past year or so.
So, what is Wall Street so excited about?
Revenue for the quarter was $436 million compared with just $264 million a year ago. At first glance the revenue gains look impressive, but the revenue number got a $128 million boost from Tellabs' acquisition of Advanced Fiber Communications in November 2004. Without the Advanced Fiber revenue, the sales increase would have been a much lower 17%. And despite the increased revenue, earnings actually declined to $700,000 from more than $13 million a year ago.
Besides the decline in earnings I have two concerns.
First, the finished goods component of inventory jumped from $63.6 million at the start of the quarter to $101 million at the end. This is a 59% change, which is much larger than the increase in sales from the previous quarter. This would be quite an impressive feat if it weren't for the fact that it's usually undesirable.
The general goal for most companies is to be able to manufacture or buy some product and then sell and deliver it to a customer, hopefully for a profit. It doesn't work well without that selling part. Many companies' operational problems show up in the inventory number before hitting revenue or earnings.
The second concern has to do with Tellabs' acquisition of Advanced Fiber Communications. AFC sells fiber optic networking products, which sound sexy but carry much lower margins than do Tellabs' other products.
Hopefully the acquisition will be well-integrated and the AFC product line will lead to a larger number of customers who will buy a lot of Tellabs' higher-margin products. This would help prevent the margins from falling through the floor, but there is a real danger that sales will expand, while profitability won't.
If it weren't for the inventory increase, I might be tempted take the risk that the acquisition won't work out and buy a few Tellabs shares. There is the potential for a large gain in this company's share price. For now, though, I intend to remain on the sidelines and see how the situation plays out.
Fool contributor Dan Bloom doesn't own shares of any stock mentioned in this article.
