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**Contents**

 

**Financial Highlights**We have one of theindustry’s strongest financial positions. We will build our business on oursolid balance sheet.

 

**1              Letter toStockholders from Mike Birck**

We will connect customerstoday and tomorrow.

 

**4              Connectingwith Investors’ Questions**

Chairman and Co-FounderMichael J. Birck answers investors’ frequently asked questions.

 

**5              FourReasons to Invest in Tellabs**

 

**6              Strategiesfor Profitable Growth**

We will build our future onour strong core business, carrier-class data and adjacent new markets.

 

**12           Board ofDirectors 13           Officers 14           Management’s Discussion andAnalysis 19           Reports of Management &Independent Auditors 21           Consolidated FinancialStatements 25           Notes to ConsolidatedFinancial Statements 42           11-Year Summary of SelectedFinancial Data**

**44           TellabsSolutions and Applications46           Investor Information48           Glossary of Technical Terms**

 

**Tellabs(NASDAQ: TLAB) delivers technology that transforms the way the worldcommunicates.****TM**

Tellabs experts design, develop, deploy and support our solutions fortelecom service providers in more than 100 countries. More than two-thirds oftelephone calls and Internet sessions in several countries, including theUnited States, flow through Tellabs equipment. Our product portfolio providessolutions in next-generation optical networking, managed access, carrier-classdata, voice quality enhancement and cable telephony. For details, visitwww.tellabs.com.

 

**FinancialHighlights**

Tellabs fiscal years ended January 2, 2004, and December 27, 2002.

 
| **(Dollars in millions, except  per-share data)** |   | **2003*** |      | **2002*** |   | **Change** |   |
|---------------------------------------------------|--------|-----------|-----------|-----------|--------|------------|--------|
| Net sales                                         |   | **$**     | **980**   |      | $      | 1,317      |   | -26 | % |
| Gross profit                                      |   | **$**     | **354**   |      | $      | 487        |   | -27 | % |
| Operating loss                                    |   | **$**     | **(265**  | )         | $      | (330       | )      | 20 | % |
| Loss before  income taxes                         |   | **$**     | **(245**  | )         | $      | (328       | )      | 25 | % |
| Net loss                                          |   | **$**     | **(242**  | )         | $      | (313       | )      | 23 | % |
| Loss per share                                    |   | **$**     | **(0.58** | )         | $      | (0.76      | )      | 24 | % |
| Total cash and  short-term investments            |   | **$**     | **1,123** |      | $      | 1,019      |   | 10 | % |
| Total assets                                      |   | **$**     | **2,608** |      | $      | 2,706      |   | -4 | % |
| Total  liabilities                                |   | **$**     | **389**   |      | $      | 415        |   | -6 | % |
| Stockholders’  equity                        |   | **$**     | **2,219** |      | $      | 2,290      |   | -3 | % |
| Net cash  provided by operating activities        |   | **$**     | **150**   |      | $      | 178        |   | -16 | % |
| Working capital                                   |   | **$**     | **1,291** |      | $      | 1,359      |   | -5 | % |
| Research and  development expenditures            |   | **$**     | **286**   |      | $      | 341        |   | -16 | % |
| Return on equity                                  |   | **-10.7** | **%**     | -13.2     | %      | 19         | %      |
| Average number  of common shares outstanding      |   | **413.1** |      | 411.4     |   | 0          | %      |
| Number of  employees                              |   | **3,515** |      | 4,828     |   | -27        | %      |

 

No cash dividends per common share were paid.

Certain reclassifications have been made inthe 2002 year end balance sheet to conform to the year end 2003 presentation.

 

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* Includesrestructuring and other one-time charges of $173 million and $304 million in2003 and 2002, respectively ($161 million and $297 million after-tax or $0.39and $0.72 per diluted share, respectively).

 

**On the cover:**Jeff Pluto and Mei Ling Waldorf, group marketing managers, focus onbringing next-generation solutions to Tellabs’ international customers.

 

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**Michael J. Birck**Chairman andCo-Founder

 

 

**We help customers connect today and tomorrow.**

** **

**Dear Fellow Stockholders, Employees and Friends,**

 

For Tellabs, 2003 was a year of revenue erosion,layoffs, facility closings and red ink. All this was accompanied by no smallamount of frustration. Yet Tellabs — and the telecom industry — ended the yearon a relatively optimistic note. Perhaps the long cold telecom winter isfinally showing signs of abating. If spring is indeed on the horizon, it willbe greeted with even greater enthusiasm than the first warm breezes over theicy plains of the Midwest.

 

Tellabs’ performance improved throughout 2003. Revenueincreased sequentially in each of the last three quarters of the year. In thefourth quarter, although we lost 6 cents a share, earnings  — excluding restructuring and other charges— were 3 cents a share. As you see on the facing page, the company reportedtotal 2003 revenue of $980 million, a decrease of about 26% from 2002 revenueof more than $1 billion. Including a little more than $170 million ofrestructuring and other charges, net loss for the year amounted to $242 millionor 58 cents a share, down from the 2002 net loss of $313 million or 76 cents ashare.

 

Excluding restructuring charges, our operatingexpenses decreased each quarter as the company matched resources and capacityto industry demand. The effect of reducing our operating expenses, however, wasa smaller organization with fewer employees, fewer facilities and restructuringexpenses that resulted in reported losses for the year.

 

Despite the red ink, our company performed fairly wellduring 2003. We made and implemented some very difficult decisions, includingthe outsourcing of our manufacturing operations and closing of severalfacilities. We acquired Vivace Networks, a company in San Jose with

 

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impressive credentials and a portfolio of products that provides apathway for us into data networking, a multi-billion-dollar market growing atdouble-digit rates worldwide. We clarified our strategies and laid thegroundwork for future profitable growth. And through all of the challenges of2003, we preserved our enviable balance sheet, actually increasing our cash andshort-term investments balance to more than $1.1 billion despite theacquisition of Vivace for cash. We still have zero debt.

 

**Tellabs 2003Quarterly Revenue**

In millions of dollars

 

 

Tellabs revenue grew sequentially in each ofthe last three quarters of 2003, perhaps a sign that the long cold telecomwinter is finally abating.

 

Unquestionably, the recent losses and layoffs haveproduced large negative numbers that have been dismaying to stockholders andchallenging to Tellabs. Making a company smaller exacts a terrible toll onpeople, those directly affected certainly, but those indirectly affected, too.We are determined to put an end to those things and to shift Tellabs fromdefense to offense in 2004.

 

It appears that with some stability seeminglyreturning to the telecom industry around the world, data-oriented technologiesthat promise significant operating efficiencies are beginning to supplanttraditional circuit-based network architectures. This is a big change for manytelecom service providers, and no less of a change for equipment suppliers inthe industry. Fortunately, Tellabs has successfully navigated its way through afew of these kinds of momentous changes in the past — from analog to digital,from electronics to optics — and I believe we will do so quite successfullyonce again. Our vision statement says it quite succinctly: “Tellabs willdeliver to customers technology that transforms the way the world communicatesTM.”

 

The Vivace acquisition and our development activitiesin Finland and Denmark are focused specifically on addressing one of ourprimary strategies for growth, which is to set the standard in carrier-classdata networking.

 

Our other two strategies are also forward-looking andno less challenging. One involves energizing our core business, primarilyoptical networking and managed access, and the other looks toward expansion ofour product and service activities into new markets adjacent to our current markets.As you’ll see on the following pages, we can report progress on all frontsduring 2003, and we anticipate continuing improved performance during 2004.

 

Although our visibility remains limited, in 2004 weexpect Tellabs revenue to grow. We are targeting an operating profit andpositive net income for 2004, excluding restructuring charges. These aremilestones along our path to profitable growth over the next year.

 

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Our employees, industry, customers and investors havebeen through some bleak times of late, and one hopes things are on the verge ofat least a modest recovery. Thus I believe the time is now right for newleadership to take the reins and guide this company forward to the next level.As you are likely aware, I noted when I returned to the CEO role in mid-2002that new leadership would be sought within a couple of years. Now that we havebeen through the worst of the restructuring efforts and the future looksconsiderably better than it has for a couple of years, at least, it is time toset the stage for the future.

 

With that in mind, last fall I asked our board ofdirectors to seriously address the always challenging task of CEO succession.They have done that successfully.

 

 

On February 12, we welcomed our new chief executive officer andpresident, Krish Prabhu, to Tellabs (see page 12 for a brief biography).

 

Tellabs’ new CEO is not new to our industry, ourcustomers or the investment community. Krish Prabhu began what I expect will bea long and productive tenure with Tellabs in mid-February. He has alreadydemonstrated the leadership skills that made him an obvious choice by ourBoard, and I am delighted that he is here. Stockholders attending our annualmeeting in April will have the opportunity to meet Krish and talk with him. Andas I think you know, I will stay active in the business as chairman of theboard for at least a while.

 

These have been trying times for all of us. I am mostgrateful to our stockholders for their support and perseverance as we and theindustry dealt with some rather significant structural problems, not all ofwhich are yet fully resolved. And I am grateful for and impressed with the wayour employees have managed to deal with the complex and emotional issues ofdownsizing, restructuring and redirection. I have great confidence in ouremployees — and in the resiliency of this troubled but vitally importantindustry of which we are a part.

 

I believe our best days are still ahead of us. I amconfident we have the right customers, the right people, and the rightstrategies to return Tellabs to profitable growth in the years ahead.

 
| Sincerely,               |
|--------------------------|
|                     |
|                     |
| /s/ Michael J.  Birck    |   |
| **Michael J. Birck**     |
| Chairman and  Co-Founder |
| February 12,  2004       |

 

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**Connecting with investors’ questions**

 

Chairman and Co-Founder Michael J. Birck answers investors’ frequentlyasked questions.

 

**Q. Whenwill Tellabs become profitable again?**

 

**A.** It appears we’ve reached the bottom ofthe telecom recession, as our revenues stabilized and we achieved threequarters of sequential revenue growth in 2003. Our targets for 2004 are revenuegrowth, operating profitability and positive net income.

 

**Q. Whatwill drive Tellabs’ future growth?**

 

**A.**Tellabs will derive growth fromenergizing our core business, building our carrier-class data business andexpanding into new markets that logically extend our core business.

 

Our core businessincludes optical transport, managed access, next-generation SDH andvoice-quality enhancement. We’re invigorating our core business worldwide bycost-engineering products, adding key features such as new data capabilities,and developing new products such as the Tellabs 5500 NGX transport switch andTellabs®6345 switch node.

 

We strengthened ourposition in the rapidly growing global data market in June through theacquisition of Vivace Networks, now known as Tellabs San Jose, and itsdifferentiated carrier-class data solution called the Tellabs 8800 intelligentmulti-service routers. In mid-2004 we will introduce a sophisticated new dataplatform developed by Tellabs Finland, the Tellabs 8600 managed edge system.

 

And we’re pursuingadjacent new markets that will enable us to expand our business with currentcustomers. With $1.1 billion in cash and short-term investments and zero debt,we have the resources to acquire or develop technologies that deliver value toour customers and shareholders.

 

**Q. How will Tellabs evolve from its key technology ofTDM (time division multiplexing, the format of voice networks) to IP/MPLS(Internet Protocol/Multi-Protocol Label Switching), the format of new datanetworks?**

 

**A.**Aggressively. The point is, we havesuccessfully managed migrations to new technologies before — from analog todigital, from electronics to optics — and the transition from circuits topackets is one to which we’ll bring all our resources and experience to bear.

 

First, we can taptremendous data resources from our core business, given our years of experiencewith Ethernet-over-SDH and Voice-over-Internet Protocol technologies. Second,we’ve added more than 100 IP/MPLS experts through the addition of Tellabs SanJose, and we’re hiring more. Third, we are purposefully investing millions ofdollars in training our engineers, developers, marketers and sales force aroundthe world in topics such as IP/MPLS. Today, we are already first in ourindustry to offer complete, carrier-class data solutions that integrate Layer 1transport, Layer 2 switching and Layer 3 routing capabilities — which is whatcustomers tell us they really need.

 

**Q. What do all these technical terms mean?**

 

**A.**For a complete list of definitions, turnto the glossary on page 48.

 

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**Four reasons to invest in Tellabs**

 

**1 Connectingwith great customers**

 

Over 29 years, Tellabshas built enduring relationships with the world’s leading telecom serviceproviders by putting customers first. As we look to the future, we’re workingclosely with customers such as BellSouth, Telkom SA and TeliaSonera, so in ournext generation of equipment we can build in solutions to customers’ mostvexing problems.

 

**2Connecting through our people**

 

Our employees’ integrityand ingenuity make Tellabs a most trusted and capable partner for customers. In2003, Tellabs engineers won 38 patents for new technologies and applications.Long-time customers such as TELUS, SBC Communications and Verizon presentedawards to recognize Tellabs’ performance.

 

**3 Thetechnology to connect most phone calls and Internet sessions today**

 

Today, Tellabs equipmenthandles most Internet sessions and phone calls in the United States and severalother countries. Leading local, long-distance and wireless companies have madeTellabs the North American market leader in bandwidth management. We areleveraging an installed base of more than 4,100 Tellabs 5500 systems to helpmigrate our customers to next-generation networks. Tellabs solutions operate inmore than 250 telecom networks in more than 100 countries, including a newIP/MPLS network for the world’s largest telecom carrier, NTT Communications ofJapan.

 

**4 Thefinancial strength to connect with the future**

 

Tellabs’ balance sheet isrock-solid, with more than $1.1 billion in cash and short-term investments andzero debt. That gives us the means to invest in internal R&D andacquisitions to develop the next-generation solutions our customers need todayand will need tomorrow.

 

**1****Connecting with great customers**

 

**2****Connecting through our people**

 

**3****The technology to connect most phone calls and Internetsessions today**

 

**4****The financial strength to connect with the future**

 

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**Tellabs connects with customers’ needs today and tomorrow**

 

The strength of our core business has enabled Tellabs to survive thetelecom winter of the past three years. Our core business includes opticaltransport, managed access, next-generation SDH, and voice-quality enhancement.Tellabs solutions make it easy for customers to lower costs, provide telecomservices today, and migrate smoothly to new technologies tomorrow.

 

In 2003, our core business stabilized, and we achievedsequential revenue increases in the second, third and fourth quarters. Ourmarket-leading share in the North American digital cross-connect market grew to71%, according to industry analyst firm RHK. International customers orderedmore than 300 new Tellabs® 6350 switch nodes within one year of its launch, markingthe fastest-selling new product in Tellabs’ history.

 

Late in 2003, we sharpened our competitive edge byoutsourcing Tellabs’ manufacturing worldwide through Sanmina-SCI and Elcoteq.Outsourcing reduced our parts costs, decreased inventory levels by $133million, and freed up capital and management attention.

 

Along our path back to profitability, we also reducedannual operating expenses by $197 million last year. In 2003 we invested $286million or 29% of revenue in research and development to ensure a robust,competitive portfolio of solutions.

 

**DigitalCross-Connect 2003 Market Share—North America**

 

 

Tellabs leads the North American digitalcross-connect market, where our share increased to 71%.

 

[Source: RHK, February 2004] 

 

In 2004, our focus is to energize our core business aswe enhance current products with features customers need today and tomorrow.For example:

 

**• We pack morecapacity into the same space.**In North America, we increased optical-shelfdensity in the Tellabs 5500 system sixfold, while switching capacity in the Tellabs5500 NGX multiplied fourfold. And we expanded the capacities of our coreinternational products, the Tellabs 6300 and Tellabs 8100 series, with newEthernet enhancements.

 

**• We reduce the needfor network elements.** The redesigned Tellabs 7100 optical transport systemintroduces technology that reduces customers’ maintenance and equipment costs.For example, multiple data services can be consolidated on a single wavelength,without the need for additional equipment. And by extending the product’s opticalreach 300%, we address even more service provider applications.

 

**• We simplify datamigration and lower the costs of delivering data.** New interfaces on theTellabs 8100 system make it easy for customers to add data services such asEthernet. With Ethernet-over-SONET on the Tellabs 5500 NGX platform andEthernet-over-SDH on the Tellabs 6300 series, we enable customers to deliverdata efficiently over existing networks.

 

Left: Tellabs employees such as (left toright) Lucia Leung, Derek Sutherland and Vijai Bahadur work to improve our coreproducts.

 

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**Our fresh approach to data connects customers withprofitability**

 

Data is the fastest-growing type of telecom traffic on our customers’networks. In June we expanded our data activities by acquiring Vivace Networksof San Jose. In late 2003, we also announced the new Tellabs 8600 managed edgeseries, developed by Tellabs Finland, which will be available internationallyin mid-2004. In the data market, we focus on four key applications — Ethernetservices, IP virtual private networks, Layer 2 virtual private networks withinternetworking, and IP/MPLS (Internet Protocol/Multi-Protocol Label Switching)service networks.

 

Today most of our customers share the same problem:although data is growing quickly, it’s much less profitable than voice. Out ofnecessity, carriers initially built their data networks with routers designedfor use in a corporate environment — products that were never designed withtelecom service providers in mind. This problem provides the opportunity forTellabs to set the standard for carrier-class data equipment explicitlydesigned to meet telecom service providers’ needs. For example:

 

**• We build inreliability.** Just as we do in our core products, we back up criticalcomponents to ensure all the traffic gets through. Our competitors don’t.

 

**• We enable customersto provide differentiated data services.** Our products provide customerswith a path to improved profitability by enabling them to offer premium dataservices. And our products enable guaranteed Quality of Service. Ourcompetitors’ don’t.

 

**• To install newservices, just point and click.**Our customers’ technicians will use asimple graphic interface on the new Tellabs 8600 system when it’s time toinstall or change a data service. Our solutions don’t require customers to takemonths of expensive data training. Our competitors’ do.

 

**• We positioncarriers to migrate smoothly to new data formats.** Older data networksdeliver frame relay, ATM (asynchronous transfer mode) and Internet access usingvarious overlay networks, while newer networks focus on IP/MPLS convergedservices. The Tellabs 8800 system delivers all these capabilities in a singlenetwork element, and enables our customers to cost-effectively transition tothe newer technology and avoid continuing investment in the old. Ourcompetitors don’t.

 

That’s why the world’s largest telecom carrier, NTTCommunications of Japan, selected the Tellabs 8800 series for the world’slargest metro Ethernet over IP/MPLS network. And why the leading U.S. Internetbackbone, MCI, uses the Tellabs 8800 series to exchange Internet traffic withpeers.

 

**Growth of Data Equipment Market**

in millions of dollers

 

 

Tellabs data solutions address a marketexpected to more than double to $6 billion by 2006.

 

[Source: Infonetics Research, November 2003]

 

Left: The world’s largest metro Ethernet overIP/MPLS network and the U.S.’ busiest Internet backbone rely on the Tellabs8800 solution, developed by Tellabs San Jose employees such as (left to right)Malyadri Jaladanki, Paula Atchison and Albert Fong.

 

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**We’re working on new ways to connect with customers**

 

Tellabs plans to expand our business into adjacent markets that willadd new dimensions to our relationships with customers. Over the years, we’vebuilt strong relationships not only with the largest U.S. telecom carriers, butalso with carriers who operate more than 250 networks around the world.

 

As our customers’ needs change, we’re working closelywith them to identify areas of mutual opportunity to enrich our relationships.With more than $1.1 billion in cash and short-term investments and zero debt,we have the financial strength to acquire and develop products that best fitcustomers’ needs. We’re guided by key observations on current industry trends:

 

**• Voice-over-InternetProtocol (VoIP) demand is growing.** Telecom carriers and cable-TV operatorsare starting to implement VoIP technologies that provide traditional telephoneservices over lower-cost IP networks. Today Tellabs’ data and voice-qualityenhancement equipment play roles in this trend, and we’re exploring additionalopportunities in this space.

 

**• The “triple play”of voice, data and video is driving growth.**Both telecom carriers andcable-TV operators are working to offer customers a “triple play” of voice,data and video services. That requires new investments, primarily in the accessportion of the network that extends all the way into businesses and homes.Cable operators are also making strides into the $150-billion business servicesmarket with advanced data service offerings. We bring customers relevantexperience in the business and residential access markets.

 

**• Mobile and wirelessservices keep growing.**End-user demand for mobile phones, wireless data andcameraphones, combined with the transition from 2G to 3G technologies, is drivinggrowth in the wireless sector. In 2003, more than one-third of our NorthAmerican business came from cellular carriers. In international markets, wepartner with Ericsson and Nokia to provide wireless transport infrastructure.Now we’re exploring new ways to add value for wireless customers worldwide.

 

As we explore these possibilities, we’re carefullylistening to our customers’ challenges and revenue opportunities, brainstormingwith customers about future network architectures and solutions, and exploringways to extend our relationships with customers.

 

Left: Scott Steele is among the Tellabsemployees working to logically extend our core business into new growthmarkets.

 

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**Board of Directors**

** **

** **

**Michael J. Birck,** 66, chairman and co-founder. Chairman since 2000, chief executiveofficer 2002–2004, chief executive officer and president 1975–2000. Director ofengineering at Wescom Inc. 1968–1975. Director, Molex Incorporated, IllinoisTool Works. M.S.E.E., New York University; B.S.E.E., Purdue University. Tellabsdirector since 1975.

 

**Bo Hedfors,** 60, founder and president Hedfone Consulting, Inc. (telecommunicationsand Internet consulting) since 2002. President, global wireless infrastructurebusiness at Motorola 1998–2002. President and CEO of Ericsson, Inc. 1994–1998;chief technology officer of LM Ericsson 1990–1993; president of HoneywellEricsson Development Co. 1984–1986. Director, Openwave Systems, Inc. andSwitchCore AB. M.S.E.E., Chalmers University of Technology. Tellabs directorsince 2003.

 

 

**Mellody L. Hobson,** 34, president and director of Ariel Capital Management, LLC/ArielMutual Funds since 2000. Senior vice president and director of marketing atAriel Capital Management, Inc. 1994–2000; vice president of marketing at ArielCapital Management, Inc. 1991–1994. A.B., Princeton University, Woodrow WilsonSchool. Tellabs director since 2002.

 

 

**Fred A. Krehbiel,**62, co-chairman of the board of Molex Incorporated since 1999; co-chiefexecutive officer 1999–2001; chief executive officer 1988–1999; chairman of theboard 1993–1999. Director, Northern Trust Corporation, DeVry, Inc., W.W.Grainger. B.A., Lake Forest College. Tellabs director since 1985.

 

 

**Michael E. Lavin,** 58, Midwest area managing partner KPMG LLP 1993–2002; partner1977–2002; various management and staff positions 1967–1976. Director, People’sEnergy Corporation. B.A., University of Wisconsin. Tellabs director since 2003.

 

 

**Stephanie Pace Marshall, Ph.D.,** 58, founding president, Illinois Mathematicsand Science Academy since 1986. Ph.D., Loyola University; M.A., University ofChicago; B.A., Queens College. Tellabs director since 1996.

 

 

**Krish A. Prabhu,** 49, chief executive officer and president since 2004. Partner, MorgenthalerVentures 2001–2004. Chief operating officer of Alcatel Telecom 1999–2001; chiefexecutive officer of Alcatel USA 1997–1999; various senior management positionsat Alcatel 1991–1997; various management and research and development positionsat Rockwell Network Transmission Division (now Alcatel) 1984–1991. Ph.D. andM.S.E.E., University of Pittsburgh; M.S., Indian Institute of Technology; B.S.,Bangalore University. Tellabs director since 2004.

 

 

**William F. Souders,** 75, chairman and chief executive officer of Emery Air FreightCorporation 1988–1989; executive vice president and director at XeroxCorporation 1974–1986. B.A., Lake Forest College. Tellabs director since 1990.

 

 

**Jan H. Suwinski,** 62, professor of Business and Operations at Cornell University, JohnsonGraduate School of Management since 1997; executive vice president,OptoElectronics Group, Corning Incorporated 1990–1996; various executive andoperations positions, 1965-1990. Director, Thor Industries, Inc., Ohio CasualtyGroup. M.B.A. and B.M.E., Cornell University. Tellabs director since 1997.

 

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**Officers**

** **

** **

**Michael J. Birck,** 66, chairman and co-founder. Chairman since 2000, chief executiveofficer 2002–2004, chief executive officer and president 1975–2000. Director ofengineering at Wescom Inc. 1968–1975. Director, Molex Incorporated, IllinoisTool Works. M.S.E.E., New York University; B.S.E.E., Purdue University. Tellabsdirector since 1975.

** **

** **

**Nadalie S. Bosse,** 46, executive vice president, enterprise services since 2003. Vicepresident – global operations, customer services 2001–2003. Consultant,Northridge Group 2000–2001; vice president – new product introduction andbilling at SBC/Ameritech 1995–2000; various operations, sales, engineering andcustomer service positions at AT&T 1980–1994. M.B.A., University of Kansas;B.S.I.E., Kansas State University.

** **

** **

**Anders Gustafsson,** 43, executive vice president and president – Tellabs Internationalsince 2002. Executive vice president and president – global sales 2000–2002.Vice president and general manager – Europe, Middle East and Africa 2000;various senior sales and management positions at Motorola, 1992–2000. M.B.A.,Harvard Business School; M.S.E.E., Chalmers University of Technology.

** **

** **

**Krish A. Prabhu,** 49, chief executive officer and president since 2004. Partner,Morgenthaler Ventures 2001–2004. Chief operating officer of Alcatel Telecom1999–2001; chief executive officer of Alcatel USA 1997–1999; various seniormanagement positions at Alcatel 1991–1997; various management and research anddevelopment positions at Rockwell Network Transmission Division (now Alcatel)1984–1991. Ph.D. and M.S.E.E., University of Pittsburgh; M.S., Indian Instituteof Technology; B.S., Bangalore University. Tellabs director since 2004.

** **

** **

**James M. Sheehan,** 41, general counsel, executive vice president and secretary since 2002.Vice president and deputy general counsel 2000–2002; director and assistantgeneral counsel 1995–2000. J.D., University of Illinois College of Law; B.S.,University of Illinois.

** **

** **

**Timothy J. Wiggins,** 47, executive vice president and chief financial officer since 2003.Executive vice president and chief financial officer at Chicago Bridge &Iron Company, N.V. 1996–2001; various senior financial and operating managementpositions at Fruehauf Trailer Corporation and Autodie Corporation 1988–1996;senior manager at Deloitte, Haskins and Sells, (now Deloitte & Touche)1979–1988. Certified Public Accountant; B.S., Michigan State University.

** **

**Board ofDirector Structure and Process**

** **

Tellabs is managed by andunder the direction of its board of directors.

** **

Each director who is notan officer of the Company is paid an annual retainer of $30,000 plus a fee of$1,500 and expenses for each board of director meeting attended in person and$1,000 for each substantive telephonic board of director meeting. No fees werepaid for attendance at committee meetings in 2003.

** **

Commencing in 2004,committee members receive a fee of $1,000 for each committee meeting attendedin person and $500 for each substantive telephonic committee meeting. Also thechairperson of the Audit and Ethics Committee receives an annual retainer of$4,000 beginning in 2004. No annual retainer is paid to the Chairman of the Boardor the chairpersons of other committees.

** **

The board has an Auditand Ethics Committee, a Nominating and Governance Committee and a CompensationCommittee. Members of the Audit and Ethics Committee are Michael Lavin –Chairman, Mellody Hobson, Fred Krehbiel and William Souders. Nominating andGovernance Committee members are Jan Suwinski – Chairman, Bo Hedfors, MichaelLavin and Stephanie Pace Marshall. Compensation Committee members are WilliamSouders – Chairman, Mellody Hobson, Stephanie Pace Marshall and Jan Suwinski.

** **

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**Management’s Discussion and Analysis**

 

**Introduction& Overview of Business**

 

We deliver technology that transforms the waythe world communicates. Our experts design, develop, deploy and support oursolutions in telecom networks in more than 100 countries. More than two-thirdsof telephone calls and Internet sessions in several countries, including theUnited States, flow through our equipment. Our product portfolio providessolutions in next-generation optical networking, managed access, carrier-classdata, voice quality enhancement and cable telephony. Tellabs’ three strategiesfocus on energizing the core business, setting the standard in carrier-classdata and expanding into adjacent markets.

 

Wegenerate revenue principally through the sale of hardware and software, both asstand-alone products and as elements of integrated systems, to many of theworld’s largest and strongest carriers. In addition, we generate revenue byproviding installation and professional services related primarily to our ownproducts and systems.

 

WithinNorth America the majority of our revenue is derived from optical networkingproducts, principally digital cross-connect systems. Demand for these productsis sensitive to end-user demand for bandwidth, industry capacity utilizationand competing technologies.

 

OutsideNorth America the majority of our revenue arises from managed access andtransport systems. Demand for these products, as in North America, is sensitiveto end-user demand for bandwidth, industry capacity utilization and competingtechnologies.

 

Servicesrevenue comes from two primary sources: network construction and professionalservices such as network deployment, traffic management, support services andtraining. Network construction revenue, which comprises over half of allrevenue from services, primarily arises from sales of our optical networkingproducts in North America. As a result, it has tended to increase or decreasein similar proportion to the increase or decrease in revenue from thoseproducts.

 

Followingyears of unprecedented growth, the demand for telecommunications equipmentbegan to decline precipitously in early 2001 as a result of unexpected marketdeclines, industry overcapacity, an unfavorable regulatory environment, andexcessive debt loads among many carriers. As a consequence, we experienced a71% revenue decline over the period 2001 to 2003, and we incurred a net loss ineach of those years. As market conditions deteriorated, we responded with aseries of restructuring plans designed to match our manufacturing capacity andexpenses with demand in order to restore profitability and renew growth. Weclosed manufacturing facilities in Ireland and Texas in 2001 and additional facilitiesin Ireland and New York in 2002. We reduced headcount by 61%, from 8,900 during2001 to 3,500 at the end of 2003. We exited a significant portion of the officespace that we leased and owned in the United States, and we consolidated themajority of our non-manufacturing workforce into our headquarters facility inNaperville, Illinois. We also reviewed our product portfolio and cutback orstopped development efforts on some products.

 

Further,in the second-half of 2003, we committed to outsource the majority of ourremaining manufacturing activities. Manufacturing operations located inBolingbrook, Illinois, U.S.A., were outsourced to Sanmina-SCI Corporation, anindependent electronics manufacturing service (EMS), and manufacturingoperations located in Espoo, Finland, were transferred to Elcoteq NetworkCorporation, a Finland-based EMS. We expect to benefit from outsourcing throughlower component prices due to each EMS’s purchasing power and through lowermanufacturing costs due to their lower labor rates. The manufacturingoperations in Illinois ceased at the end of October 2003, and the manufacturingoperations in Finland were transferred to Elcoteq at the beginning of January2004.

 

Asa result of the restructuring activities, we recorded restructuring charges forseverance costs, facilities shutdown costs and other obligations. The declinein product demand over the 3-year period also had a significant impact on thevalue of our inventory, resulting in the need to record reserves for excess andobsolete inventory and excess purchase commitments. We also recorded reservesfor other impaired and surplus assets in each of the years 2001–2003. Thosecharges were significant in amount, and we encourage readers to refer to theanalysis contained in a later section of this report for an expanded discussionof the charges. (See Note 3, *Restructuring and Other Charges,* on page 26.)

 

During2003, we acquired Vivace Networks, a leading developer of flexible,high-performance multi-service IP (Internet Protocol) edge switches, for$130.3 million in cash and employee stock options. The move brought twocomplementary new products to Tellabs that, together with data products beingdeveloped in Finland, enable us to expand into the high-growth global service 

 

14

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provider, edge router and switch markets. Vivace Networks, a 4-year-oldcompany based in San Jose, California, recognized its first customer revenue in2002.

 

Ourgoal is to return to profitable growth, and we are committed to taking actionsthat are necessary to achieve that goal. These actions could include additionalworkforce reductions, facilities closures, outsourcings, acquisitions, jointventures or other actions. If any of these actions are taken, it is possiblethat we would be required to recognize additional charges. We will recordadditional restructuring and other charges over the next few quarters relatedto the actions and restructurings implemented in prior quarters. We estimatethat $8 million to $12 million will be recorded in the first quarter of 2004,and $1 million to $2 million in later quarters.

 

**Results ofOperations**

 

**2003 Compared with 2002**

 

For the full year 2003, our net loss was$241.6 million, or $0.58 per share, including $172.6 million, or $0.39 pershare after tax, in charges related to restructuring activities, inventories,and the previously mentioned outsourcing of manufacturing operations. Thiscompares with a net loss of $313.1 million, or $0.76 per share, in 2002, including$303.7 million, or $0.72 per share after tax, in charges related torestructuring activities, inventories, and a write down of certain equityinvestments in technology start-ups. The year-over-year decline in net loss wasdriven by significantly lower operating expenses, partially offset by theimpact of lower revenue on gross profit.

 

*Revenue*

 

Total revenue declined by 26%, from $1,317.0million in 2002 to $980.4 million in 2003. Nearly the entire decline occurredin North America where revenue dropped from $916.4 million in 2002 to $597.8million in 2003. Revenue within North America was 61.0% of total revenue in2003 compared with 69.6% of total revenue in 2002. International revenue of$382.6 million in 2003 was down slightly from $400.6 million in 2002.

 

In2003 we recategorized our product offerings into three product areas: opticalnetworking; next generation SDH transport products and managed access systems;and other products.

 

Revenuefrom optical networking products, our principal product offerings in NorthAmerica, was $419.4 million in 2003, compared with $579.0 million in2002. The portion of optical networking product revenue from new products(Tellabs® 5500 NGX, Tellabs® 6500 and Tellabs® 7100 systems) for 2003 was$34.8 million versus $79.5 million for 2002. The decline wasattributable primarily to the Tellabs 6500 system, which has not currentlygained broad market acceptance.

 

Nextgeneration SDH transport products and managed access systems, our principalproduct offerings outside North America, accounted for $276.3 million inrevenue compared with $287.2 million in 2002. The decrease was the result oflower revenue from the Tellabs® 6370 system(formerly the Tellabs 7200 system), partially offset by higher revenue fromTellabs® 6300 managed transport systems. Newinternational products (Tellabs® 6340, Tellabs® 6350 and Tellabs 6370 systems) accounted for $56.7 million of revenuein 2003 compared with $57.7 million in 2002.

 

Revenuefrom Other Products, which includes the Tellabs® 2300 telephony distribution system, the Tellabs® 3000 voice-quality enhancement systems, the Tellabs® 8800 intelligent multi-service router series, and miscellaneousproducts, was $134.4 million for 2003 compared with $271.5 million for 2002.The decline was primarily the result of lower sales of the Tellabs 2300 system.

 

Professionalservices revenue for 2003 was $150.3 million, compared with $179.2 millionfor 2002. The decline in services revenue is attributable to a decrease ininstallation-related services due to the lower level of overall product sales,offset slightly by an increase in other value-added services, such as supportagreements and professional services.

 

*Gross Profit*

 

Total gross profit was $354.0 million, or36.1% of revenue, in 2003, compared with $486.5 million, or 36.9% of revenue in2002. The previously mentioned restructuring and inventory-related chargesreduced gross profit in 2003 by $95.4 million, or 9.7% of revenue, and by$99.7 million, or 7.6% of revenue in 2002. The negative impact fromrestructuring and inventory-related charges on 2003 margin compared with 2002was partially offset by favorable product mix. Because manufacturingoutsourcing occurred late in 2003, it did not have significant impact onmargin.

 

*Operating Expenses*

 

Operating expenses declined $197.7 million to$618.5 million in 2003 from $816.2 million in 2002. Of the decline, $91.8million was due to a reduction in restructuring charges ($77.2 million in 2003vs. $169.0 million in 2002), and the balance of the decline was due tolower headcount-related expenses due to workforce reductions; lowerdepreciation, amortization, and facilities expense due to prior restructuringactions; and implementation of expense control initiatives across our business.

 

15

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*Interest Income*

 

Interest income remained flat at approximately$33.4 million for both 2003 and 2002 due to slightly higher cash and cashequivalent balances during 2003 partially offset by lower prevailing interestrates.

 

*Other Expenses, Net*

 

Other expenses decreased from $30.5 million in2002 to $12.9 million in 2003. The decrease was primarily the result of reducedimpairment charges for certain strategic equity investments in 2003.

 

*Effective Tax Rate*

 

For each of 2002 and 2003, we recorded a smalltax benefit on our consolidated pre-tax losses. The relatively low effectivetax rate for each of the years reflects our inability, under generally acceptedaccounting principles, to record a tax benefit for the majority of our domesticlosses. (See Note 12, *Income Taxes,*****on page 37.)

 

**2002 Compared with 2001**

 

The net loss for 2002 increased to $313.1million from $182.0 million in 2001 driven mainly by significantly lowerrevenue across all of our product lines. Restructuring charges,inventory-related charges, and asset impairment charges contributedsignificantly to the losses in each year.

 

*Revenue*

 

The majority of the revenue decline occurredin our optical networking products where revenue dropped from $1,202.8 millionin 2001 to $579.0 million in 2002 as a result of the market conditionspreviously discussed.

 

Asreported in 2002, broadband access product sales totaled $455.0 millioncompared with $538.0 million in 2001. The 15.4% decline in broadbandaccess products sales was primarily the result of reduced sales of the Tellabs® 8100 managed access system. Sales of our voice-quality enhancementproducts totaled $69.3 million for 2002, down 49.6% from 2001’s $137.6 million,mainly due to lower sales of echo cancellation products.

 

Netservices and other revenues for 2002 totaled $213.7 million compared with$327.5 million for 2001. The 34.7% decrease was due to decreased revenue fromnetwork construction services which is closely tied to product sales,particularly in North America.

 

Saleswithin North America for 2002 decreased approximately 46.0% compared with 2001and accounted for approximately 69.6% of total sales. Sales outside NorthAmerica decreased approximately 21.0% compared with 2001 and accounted forapproximately 30.4% of total sales. The international market continued to playan increasingly important role for Tellabs as the Asia Pacific region accountedfor roughly 30% of global capital expense spending for the industry. In 2002,for the first time in our history, approximately one half of our top 20customers worldwide came from countries outside the United States.

 

*Gross Profit*

 

Total gross profit in 2002 was $486.5 million,or 36.9% of sales, compared with $763.2 million, or 34.7% of sales in 2001.Restructuring and inventory-related charges reduced gross profit by $99.7million, or 7.6% of revenue in 2002 and $256.4 million, or 11.7% of revenue in2001. The year-over-year improvement in margin was due to the decline inrestructuring and inventory-related charges, partially offset by product mix.

 

*Operating Expenses, Net*

 

Operating expenses for 2002 were $816.2million compared with $1,042.6 million in 2001. The improvement in operatingexpenses was primarily due to workforce reductions, lower facilities costs, andour focus on reducing controllable spending.

 

*Interest Income*

 

Interest income for 2002 was $33.3 millioncompared with $46.8 million in 2001. The decline was mainly the result of lowerprevailing interest rates and lower average balances for cash, cash equivalentsand marketable securities in 2002.

 

*Other Expenses, Net*

 

Total other expenses for 2002 amounted to$30.5 million compared with $11.7 million in 2001. The increase was mainly theresult of impairment charges for certain strategic equity investments.

 

*Effective Tax Rate*

 

Our effective tax rate was 4.5% for 2002, and25.7% for 2001. The decrease in the tax rate is primarily due to the $87.7million valuation allowance on the U.S. net deferred tax asset that we recordedduring 2002. (See Note 12, *Income Taxes,*on page 37.)

 

**FinancialCondition, Liquidity and Capital Resources**

 

Our principal source of liquidity remained ourcash and equivalents and short-term investments, which increased by $103.8million during 2003. The increase was due primarily to the receipt of $168.0million in U.S. tax refunds and the positive impact of the strengthening Euroversus the U.S. dollar, offset by the cash paid to acquire Vivace Networks.Cash and equivalents decreased by $207.7 million while the amount of short-terminvestments increased by $311.5 million. The changes reflect our decisionto modify the investment portfolio mix for our European 

 

16

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operations, moving away from highly liquidcash equivalents and into higher-yielding short-term investments.

 

Approximatelyone-half of the $1,123.0 million in funds was generated by offshore operationsand remains invested offshore because we consider these funds to be permanentlyre-invested. In the event the funds are needed for investment purposes in theUnited States, some additional foreign withholding taxes and U.S. federalincome taxes might be payable. The amount of the taxes will depend on foreignwithholding tax rates and our tax position in the United States at the time thefunds are repatriated. We believe that any such taxes would not have asignificant impact on our liquidity.

 

Webelieve that the current level of working capital, particularly cash andshort-term investments, is sufficient to meet our normal operating requirementsfor the foreseeable future. Further, we believe that sufficient resources existto support our future growth and strategic needs, including funding theremaining short-term obligations under the restructuring programs, includingcurrently available cash, cash generated from future operations, short-term orlong-term financing or equity offerings.

 

Ourcurrent policy is to retain our earnings to provide funds for operating andexpanding our business. We do not anticipate paying a cash dividend in theforeseeable future.

 

**Off-BalanceSheet Arrangements**

 

None.

 

**ContractualObligations**

 

At January 2, 2004, our contractualobligations were:

 

PaymentsDue in Fiscal

 
| **(In millions)**             |   | **2004** |   | **2005** |   | **2006** |   | **2007** |   | **2008** |   | **Thereafter** |   | **Total  Obligations** |   |
|-------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------------|--------|------------------------|--------|
| Purchase  obligations*        |   | $        | 101.2  |     | $      | —   |   | $        | — |     | $      | —         |   | $                      | — |   | $ | — |   | $ | 101.2 |   |
| Operating lease obligations** |   | 11.9     |   | 7.2      |   | 5.4      |   | 3.5      |   | 3.1      |   | 9.8            |   | 40.9                   |   |
| Total  obligations            |   | $        | 113.1  |     | $      | 7.2      |   | $        | 5.4    |     | $      | 3.5            |   | $                      | 3.1    |   | $ | 9.8 |   | $ | 142.1 |   |

 

----

*   Weuse several contract manufacturers and suppliers to provide manufacturingservices for our products. During the normal course of business, in order toreduce manufacturing lead times and ensure adequate component supply, we enterinto agreements with certain contract manufacturers and suppliers that allowthem to procure inventory based upon criteria defined by us. As of January 2,2004, we had purchase commitments for inventory of approximately $101.2million. These purchase commitments are expected to be fulfilled within oneyear.

** Includesan immaterial amount for capital lease obligations.

 

**CriticalAccounting Policies**

 

The methods, estimates, and judgments that weuse in applying our accounting policies can have a significant impact on theresults we report in the consolidated financial statements. Some of theseestimates require difficult and subjective judgments, often as a result of theneed to estimate matters that are inherently uncertain. We believe our mostcritical accounting estimates are the allowance for excess or obsoleteinventory (E&O), the assessment of recoverability of goodwill, and thevaluation allowance for deferred tax assets.

 

Wehave discussed the development and selection of these critical accountingpolicies and estimates with the Audit and Ethics Committee of the Board ofDirectors, and the committee has approved them.

 

*Inventory Valuation*

 

Inventory balances at January 2, 2004 (in millions):

 
| Gross inventory        |   | $    | 97.1   |   |
|------------------------|--------|------|--------|--------|
| Allowance for  E&O |   | 55.3 |   |
| Net inventory          |   | $    | 41.8   |   |

 

We determine inventory cost using the first-in, first-out method andvalue the inventory at the lower of cost or market, with market determined byreference to current replacement cost. In addition, we use estimates of futuredemand for individual components of raw materials and finished goods todetermine the amount of inventory that should be considered E&O.Specifically, we compare on-hand piece parts and finished goods quantities tofuture product demand and usage requirements. Generally, we record a valuationallowance of 100% for inventory quantities in excess of two-years expectedusage. When the quantity on-hand falls between one- and two-years worth

 

17

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of demand, we apply a number of factors to determine the appropriate E&Oamount. When the inventory quantity on-hand is less than forecasted demand forthe next 12 months, no allowance is recorded.

 

Becauseour visibility to future product demand is limited, our forecast of inventoryusage is necessarily subjective. If actual demand for specific products is lessthan forecasted demand, then it is possible that additional quantities ofE&O inventory would be generated; therefore, there can be no assurance thatadditional valuation allowances for E&O will not be required in the future.

 

*Goodwill*

 

We currently have recorded approximately$552.3 million of goodwill, including $93.5 million added in 2003 from theVivace Networks acquisition and $267.1 million added in 2002 from the OcularNetworks acquisition.

 

SFAS142, *Goodwill andOther Intangible Assets,* which became effective in 2002, eliminatedthe amortization of goodwill. Instead, we are required to evaluate goodwillannually for impairment, or more frequently if impairment indicators arepresent. Goodwill must be allocated to each reporting unit (defined as itsreporting segment for external reporting purposes, or one level lower dependingon various factors) and tested for impairment at the reporting unit level.Segments are generally determined by the way a company manages and measures itsbusiness, with particular weight given to the manner in which results ofoperations are reported internally and the measures provided to, and used by,our chief decision-maker. Historically, we have reported results of operationsin a single segment, and we test for goodwill impairment by treating Tellabs asa single reporting unit.

 

Becausewe report operating results as a single reporting unit, we utilize thecomparison of our market capitalization and book value as an indicator of potentialimpairment. At October 31, 2003, the date of our annual impairment review, theclosing price of Tellabs’ stock was $7.53 per share and the net book value was$5.15 per share. Since the market price exceeded the net book value, noadditional impairment testing was required and no impairment charge wasrecorded.

 

*Valuation Allowance for Deferred Tax Assets*

 

Deferred tax assets arise when we recognizecharges or expenses in the current period’s financial statements that will notbe allowed as income tax deductions until future periods. The term *deferred tax assets*also includes unused tax net operating losses and unused tax credits that areallowed under the tax law to be carried forward and used in future years. Atthe end of 2003, we had $300.7 million of gross deferred tax assets on ourbalance sheet, a large portion of which relate to restructuring chargesrecorded during the last two years and to unused net operating losses.

 

Accountingrules permit our deferred tax assets to be carried on our balance sheet at fullvalue as long as it is “more likely than not” that the deductions, losses, orcredits will be used in the future. Alternatively, we are required to record avaluation allowance against the deferred tax assets via a charge to income taxexpense if the test cannot be met. The accounting rules state that a companywith a recent history of losses would have a difficult, perhaps impossible,time supporting a position that utilization of its deferred tax assets was morelikely than not to occur. Because of our recent history of losses we determinedthat it was appropriate to record a valuation allowance against our domesticdeferred tax assets in 2002 and to continue to record a valuation allowance in2003. (See Note 12, *IncomeTaxes,*on page 37.)

 

Weare currently not able to forecast when an earnings improvement of sufficientsize will occur for us to reverse any of the valuation allowances that we haverecorded.

 

**Outlook**

 

We believe that industry conditions, inparticular capital spending by our customers, may be stabilizing in contrast tothe last three years. If this assessment is correct we may experience anincrease in revenue in 2004. We expect our customers to continue to focus onreducing their operating costs, including maximizing returns from networkassets and selecting the lowest cost solutions for network growth. This focuswould mean a continuation of the competitive pricing environment that hasnegatively impacted our margins over the last few years and may also limit theopportunities to introduce new products and services.

 

Weexpect that demand might exceed supply in the first quarter of 2004 and beyondfor some component parts that are required to manufacture our products.Therefore, our ability to sustain or grow our revenue and gross profit willalso depend upon our ability to procure sufficient component parts and meetdelivery commitments to our customers. At this time, we do not know if acomponent shortage will occur or the potential impact, if any, on our futureresults.

 

18

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**Management Statement of Financial Responsibility**

** **

The financial statements of Tellabs, Inc., andsubsidiaries have been prepared under the direction of management in conformitywith generally accepted accounting principles. In the opinion of management,the financial statements set forth a fair presentation of the consolidatedfinancial condition of Tellabs, Inc., and subsidiaries at January 2, 2004, andDecember 27, 2002, and the consolidated results of its operations for the yearsended January 2, 2004, December 27, 2002, and December 28, 2001.

 

Wemaintain accounting systems and related internal controls which, in the opinionof management, provide reasonable assurances that transactions are executed inaccordance with management’s authorization, that financial statements areprepared in accordance with generally accepted accounting principles, and thatassets are properly accounted for and safeguarded.

 

Ethicaldecision-making is fundamental to our management philosophy. Managementrecognizes its responsibility for fostering a strong ethical climate so thatour affairs are conducted to the highest standards of personal and corporateconduct. Employee awareness of these objectives is achieved through key writtenpolicy statements and training.

 

TheBoard of Directors has appointed four of its non-employee members as an Auditand Ethics Committee. This committee meets periodically with management and theindependent auditors, who have free access to this committee without managementpresent, to discuss the results of their audit work and their evaluation of theinternal control structure and the quality of financial reporting.

 

 
| /s/ Michael J. Birck                                |   |
|-----------------------------------------------------|--------|
| Michael J. Birck                                    |
| Chairman of the Board and  Chief Executive Officer* |
|                                                |
|                                                |
| /s/ Timothy J. Wiggins                              |   |
| Timothy J. Wiggins                                  |
| Executive Vice President  and                       |
| Chief Financial Officer                             |
|                                                |
| January 21, 2004                                    |

 

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* OnFebruary 12, Tellabs named Krish Prabhu chief executive officer and president;Michael J. Birck continues as chairman of the board.

 

19

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**Report of Independent AuditorsTo the Board of Directors and Stockholders of Tellabs, Inc.**

 

We have audited the accompanying consolidatedbalance sheets of Tellabs, Inc., and subsidiaries as of January 2, 2004, andDecember 27, 2002, and the related consolidated statements of operations,stockholders’ equity and cash flows for each of the three years in the periodended January 2, 2004. These financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on thesefinancial statements based on our audits.

 

Weconducted our audits in accordance with auditing standards generally acceptedin the United States. Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree from material misstatement. An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements. Anaudit also includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

 

Inour opinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of Tellabs, Inc., andsubsidiaries at January 2, 2004, and December 27, 2002, and the consolidatedresults of their operations and their consolidated cash flows for each of thethree years in the period ended January 2, 2004, in conformity with accountingprinciples generally accepted in the United States.

 

Asdiscussed in Note 5 to the financial statements, the Company changed its methodof accounting for goodwill and other intangible assets in 2002.

 
| /s/ Ernst & Young, LLP |   |
|----------------------------|--------|
|                       |
| Ernst & Young, LLP     |
| Chicago, Illinois          |
| January 21, 2004           |

 

 

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**Consolidated Statements of Operations**

 
| **(In  millions, except per-share data)**       |   | **Year Ended  1/2/04** |       | **Year Ended  12/27/02** |   | **Year Ended  12/28/01** |   |
|-------------------------------------------------|--------|------------------------|------------|--------------------------|--------|--------------------------|--------|
|                                            |   |                   |       |                     |   |                     |   |
| **Net Sales**                                   |   |                   |       |                     |   |                     |   |
| Product and other                               |   | **$**                  | **830.1**  | ** **               | $      | 1,137.8                  |   | $ | 1,860.4 |   |
| Services                                        |   | **150.3**              | ** ** | 179.2                    |   | 339.3                    |   |
|                                            |   | **980.4**              | ** ** | 1,317.0                  |   | 2,199.7                  |   |
|                                            |   |                   | ** ** |                     |   |                     |   |
| **Cost of Sales**                               |   |                   | ** ** |                     |   |                     |   |
| Product and other                               |   | **513.0**              | ** ** | 697.7                    |   | 1,165.4                  |   |
| Services                                        |   | **113.4**              | ** ** | 132.8                    |   | 271.1                    |   |
|                                            |   | **626.4**              | ** ** | 830.5                    |   | 1,436.5                  |   |
|                                            |   |                   | ** ** |                     |   |                     |   |
| **Gross Profit**                                |   | **354.0**              | ** ** | 486.5                    |   | 763.2                    |   |
|                                            |   |                   |       |                     |   |                     |   |
| Operating expenses                              |   |                   | ** ** |                     |   |                     |   |
| Marketing                                       |   | **143.5**              | ** ** | 168.8                    |   | 249.0                    |   |
| Research and development                        |   | **286.1**              | ** ** | 335.2                    |   | 422.7                    |   |
| General and administrative                      |   | **99.1**               | ** ** | 129.0                    |   | 151.3                    |   |
| Restructuring and other charges                 |   | **77.2**               | ** ** | 169.0                    |   | 192.2                    |   |
| Acquired in-process R&D                     |   | **—**             | ** ** | 5.4                      |   | —                   |   |
| Goodwill amortization                           |   | **—**             | ** ** | —                   |   | 24.6                     |   |
| Intangible asset amortization                   |   | **12.6**               | ** ** | 8.8                      |   | 2.8                      |   |
|                                            |   | **618.5**              | ** ** | 816.2                    |   | 1,042.6                  |   |
|                                            |   |                   | ** ** |                     |   |                     |   |
| **Operating Loss**                              |   | **(264.5**             | **)**      | (329.7                   | )      | (279.4                   | )      |
|                                            |   |                   |       |                     |   |                     |   |
| Interest income                                 |   | **33.4**               | ** ** | 33.3                     |   | 46.8                     |   |
| Interest expense                                |   | **(0.7**               | **)**      | (0.9                     | )      | (0.5                     | )      |
| Other expenses, net                             |   | **(12.9**              | **)**      | (30.5                    | )      | (11.7                    | )      |
|                                            |   | **19.8**               | ** ** | 1.9                      |   | 34.6                     |   |
|                                            |   |                   | ** ** |                     |   |                     |   |
| **Loss Before Income Tax**                      |   | **(244.7**             | **)**      | (327.8                   | )      | (244.8                   | )      |
| Income tax                                      |   | **(3.1**               | **)**      | (14.7                    | )      | (62.8                    | )      |
| **Net Loss**                                    |   | **$**                  | **(241.6** | **)**                    | $      | (313.1                   | )      | $ | (182.0 | ) |
|                                            |   |                   | ** ** |                     |   |                     |   |
| **Loss per Share**                              |   |                   | ** ** |                     |   |                     |   |
| **Basic**                                       |   | **$**                  | **(0.58**  | **)**                    | $      | (0.76                    | )      | $ | (0.44 | ) |
| **Diluted**                                     |   | **$**                  | **(0.58**  | **)**                    | $      | (0.76                    | )      | $ | (0.44 | ) |
|                                            |   |                   | ** ** |                     |   |                     |   |
| **Average number of common shares outstanding** |   | **413.1**              | ** ** | 411.4                    |   | 409.6                    |   |

 

The accompanying notes are an integral part ofthese statements.

 

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**Consolidated Balance Sheets**

 
| **(In  millions, except share amounts)**                                                                                              |   | **1/2/04**  |        | **12/27/02** |   |
|---------------------------------------------------------------------------------------------------------------------------------------|--------|-------------|-------------|--------------|--------|
|                                                                                                                                  |   |        | ** **  |         |   |
| **ASSETS**                                                                                                                            |   |        |        |         |   |
| **Current  Assets**                                                                                                                   |   |        | ** **  |         |   |
| Cash and cash equivalents                                                                                                             |   | **$**       | **245.9**   | ** **   | $      | 453.6 |   |
| Investments in marketable securities                                                                                                  |   | **877.1**   | ** **  | 565.6        |   |
| Accounts receivable, net of allowance of $5.4 and $12.2                                                                               |   | **196.7**   | ** **  | 216.8        |   |
| Inventories                                                                                                                           |   |        | ** **  |         |   |
| Raw materials                                                                                                                         |   | **12.5**    | ** **  | 92.4         |   |
| Work in process                                                                                                                       |   | **4.1**     | ** **  | 15.5         |   |
| Finished goods                                                                                                                        |   | **25.2**    | ** **  | 66.6         |   |
|                                                                                                                                  |   | **41.8**    | ** **  | 174.5        |   |
| Income taxes                                                                                                                          |   | **22.7**    | ** **  | 174.8        |   |
| Miscellaneous receivables and other current assets                                                                                    |   | **114.6**   | ** **  | 31.2         |   |
| **Total  Current Assets**                                                                                                             |   | **1,498.8** | ** **  | 1,616.5      |   |
| **Property,  Plant and Equipment**                                                                                                    |   |        | ** **  |         |   |
| Land                                                                                                                                  |   | **26.7**    | ** **  | 26.8         |   |
| Buildings and improvements                                                                                                            |   | **227.7**   | ** **  | 289.3        |   |
| Equipment                                                                                                                             |   | **389.2**   | ** **  | 454.1        |   |
|                                                                                                                                  |   | **643.6**   | ** **  | 770.2        |   |
| Accumulated depreciation                                                                                                              |   | **(327.8**  | **)**       | (349.3       | )      |
|                                                                                                                                  |   | **315.8**   | ** **  | 420.9        |   |
| **Goodwill**                                                                                                                          |   | **552.3**   | ** **  | 455.7        |   |
| **Intangible  Assets, Net**                                                                                                           |   | **107.8**   | ** **  | 70.1         |   |
| **Other  Assets**                                                                                                                     |   | **132.8**   | ** **  | 142.5        |   |
| **Total  Assets**                                                                                                                     |   | **$**       | **2,607.5** | ** **   | $      | 2,705.7 |   |
|                                                                                                                                  |   |        | ** **  |         |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                        |   |        | ** **  |         |   |
| **Current  Liabilities**                                                                                                              |   |        | ** **  |         |   |
| Accounts payable                                                                                                                      |   | **$**       | **47.8**    | ** **   | $      | 77.4 |   |
| Accrued liabilities                                                                                                                   |   |        | ** **  |         |   |
| Compensation                                                                                                                          |   | **34.9**    | ** **  | 50.9         |   |
| Payroll and other taxes                                                                                                               |   | **6.2**     | ** **  | 7.2          |   |
| Accrued restructuring and other charges                                                                                               |   | **64.8**    | ** **  | 85.4         |   |
| Other                                                                                                                                 |   | **54.1**    | ** **  | 36.4         |   |
| **Total  Current Liabilities**                                                                                                        |   | **207.8**   | ** **  | 257.3        |   |
| **Accrued  Long-Term Restructuring Charges**                                                                                          |   | **44.8**    | ** **  | 45.5         |   |
| **Income  Taxes**                                                                                                                     |   | **100.1**   | ** **  | 82.9         |   |
| **Other  Long-Term Liabilities**                                                                                                      |   | **35.5**    | ** **  | 29.7         |   |
| **Stockholders’  Equity**                                                                                                        |   |        | ** **  |         |   |
| Preferred stock: authorized 5,000,000 shares of $.01 par value; no  shares issued and outstanding                                     |   | **—**  | ** **  | —       |   |
| Common stock: authorized 1,000,000,000 shares of $.01 par value;  417,859,719 and 415,440,414 shares issued, including treasury stock |   | **4.2**     | ** **  | 4.1          |   |
| Additional paid-in capital                                                                                                            |   | **556.8**   | ** **  | 543.6        |   |
| Deferred compensation expense                                                                                                         |   | **(9.5**    | **)**       | (19.3        | )      |
| Treasury stock, at cost: 3,250,000 shares                                                                                             |   | **(129.6**  | **)**       | (129.6       | )      |
| Total accumulated other comprehensive income (loss)                                                                                   |   | **95.5**    | ** **  | (52.0        | )      |
| Retained earnings                                                                                                                     |   | **1,701.9** | ** **  | 1,943.5      |   |
| **Total  Stockholders’ Equity**                                                                                                  |   | **2,219.3** | ** **  | 2,290.3      |   |
| **Total  Liabilities and Stockholders’ Equity**                                                                                  |   | **$**       | **2,607.5** | ** **   | $      | 2,705.7 |   |

 

The accompanying notes are an integral part ofthese statements.

 

22

----

 

**Consolidated Statements of Stockholders’ Equity**

 
|                                                                           |   | **1/2/04** |   | **12/27/02** |        | **12/28/01** |   |
|--------------------------------------------------------------------------------|--------|------------|--------|--------------|-------------|--------------|--------|
| **(In  millions)**                                                             |   | **Shares** |   | **Amount**   |        | **Shares**   |   | **Amount** |   | **Shares** |   | **Amount** |   |
| **Common  Stock**                                                              |   |       |   |         |        |         |   |   |   |   |   |   |   |   |   |   |
| Balance at beginning of year                                                   |   | 415.4      |   | $            | 4.1         |         | 413.5  |   | $ | 4.1 |   | 411.2 |   | $ | 4.1 |   |
| Stock options exercised                                                        |   | 2.5        |   | 0.1          |        | 1.9          |   | — |   | 2.3 |   | — |   |
| Balance at end of year                                                         |   | 417.9      |   | 4.2          |        | 415.4        |   | 4.1 |   | 413.5 |   | 4.1 |   |
|                                                                           |   |       |   |         |        |         |   |   |   |   |   |   |   |
| **Additional  Paid-In Capital**                                                |   |       |   |         |        |         |   |   |   |   |   |   |   |
| Balance at beginning of year                                                   |   |       |   | 543.6        |        |         |   | 496.0 |   |   |   | 441.9 |   |
| Stock options exercised                                                        |   |       |   | 4.3          |        |         |   | 4.8 |   |   |   | 41.0 |   |
| Stock retention programs                                                       |   |       |   | —       |        |         |   | 0.3 |   |   |   | 2.7 |   |
| Employee stock awards                                                          |   |       |   | 0.1          |        |         |   | 0.1 |   |   |   | 0.3 |   |
| Stock compensation from acquired company                                       |   |       |   | 2.4          |        |         |   | — |   |   |   | — |   |
| Fair value of options issued in acquisition                                    |   |       |   | 6.4          |        |         |   | 42.9 |   |   |   | 7.1 |   |
| Other                                                                          |   |       |   | —       |        |         |   | (1.0 | ) |   |   | — |   |
| Stock compensation from restructuring activities                               |   |       |   | —       |        |         |   | 0.5 |   |   |   | 3.0 |   |
| Balance at end of year                                                         |   |       |   | 556.8        |        |         |   | 543.6 |   |   |   | 496.0 |   |
|                                                                           |   |       |   |         |        |         |   |   |   |   |   |   |   |
| **Deferred  Compensation**                                                     |   |       |   |         |        |         |   |   |   |   |   |   |   |
| Balance at beginning of year                                                   |   |       |   | (19.3        | )           |         |   | (1.4 | ) |   |   | — |   |
| Unearned compensation from options issued in acquisitions                      |   |       |   | (1.4         | )           |         |   | (29.3 | ) |   |   | (1.4 | ) |
| Amortization                                                                   |   |       |   | 11.2         |        |         |   | 10.5 |   |   |   | — |   |
| Other                                                                          |   |       |   | —       |        |         |   | 0.9 |   |   |   | — |   |
| Balance at end of year                                                         |   |       |   | (9.5         | )           |         |   | (19.3 | ) |   |   | (1.4 | ) |
|                                                                           |   |       |   |         |        |         |   |   |   |   |   |   |   |
| **Treasury  Stock**                                                            |   |       |   |         |        |         |   |   |   |   |   |   |   |
| Balance at beginning of year                                                   |   | 3.3        |   | (129.6       | )           | 3.3          |   | (129.6 | ) | 3.0 |   | (126.5 | ) |
| Shares purchased                                                               |   | —     |   | —       |        | —       |   | — |   | 0.3 |   | (3.1 | ) |
| Balance at end of year                                                         |   | 3.3        |   | (129.6       | )           | 3.3          |   | (129.6 | ) | 3.3 |   | (129.6 | ) |
|                                                                           |   |       |   |         |        |         |   |   |   |   |   |   |   |
| **Accumulated  Other Comprehensive Income (Loss)**                             |   |       |   |         |        |         |   |   |   |   |   |   |   |
| Balance at beginning of year                                                   |   |       |   | (52.0        | )           |         |   | (160.1 | ) |   |   | (130.5 | ) |
| Unrealized holding gains on marketable securities arising during  period       |   |       |   | 2.4          |        |         |   | 8.9 |   |   |   | 5.8 |   |
| Less:  Reclassification adjustment for (gains) losses included in net earnings |   |       |   | (8.9         | )           |         |   | (7.1 | ) |   |   | 7.6 |   |
| Net unrealized holding gains (losses) on marketable securities                 |   |       |   | (6.5         | )           |         |   | 1.8 |   |   |   | 13.4 |   |
| Foreign currency translation adjustment                                        |   |       |   | 151.5        |        |         |   | 107.0 |   |   |   | (37.4 | ) |
| Deferred income  tax related to items of other comprehensive income (loss)     |   |       |   | 2.5          |        |         |   | (0.7 | ) |   |   | (5.6 | ) |
| Balance at end of year                                                         |   |       |   | 95.5         |        |         |   | (52.0 | ) |   |   | (160.1 | ) |
|                                                                           |   |       |   |         |        |         |   |   |   |   |   |   |   |
| **Retained  Earnings**                                                         |   |       |   |         |        |         |   |   |   |   |   |   |   |
| Balance at beginning of year                                                   |   |       |   | 1,943.5      |        |         |   | 2,256.6 |   |   |   | 2,438.6 |   |
| Net loss                                                                       |   |       |   | (241.6       | )           |         |   | (313.1 | ) |   |   | (182.0 | ) |
| Balance at end of year                                                         |   |       |   | 1,701.9      |        |         |   | 1,943.5 |   |   |   | 2,256.6 |   |
| **Total  Stockholders’ Equity**                                           |   |       |   | **$**        | **2,219.3** | ** **   |   |   | **$** | **2,290.3** | ** ** |   |   | **$** | **2,465.6** |   |

 

The accompanying notes are an integral part ofthese statements.

 

23

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**Consolidated Statements of Cash Flow**

 
| **(In  millions)**                                                               |   | **Year Ended  1/2/04** |       | **Year Ended  12/27/02** |   | **Year Ended  12/28/01** |   |
|----------------------------------------------------------------------------------|--------|------------------------|------------|--------------------------|--------|--------------------------|--------|
| **Operating Activities**                                                         |   |                   | ** ** |                     |   |                     |   |
| Net loss                                                                         |   | **$**                  | **(241.6** | **)**                    | $      | (313.1                   | )      | $ | (182.0 | ) |
| Adjustments to reconcile net loss to net cash provided by operating  activities: |   |                   | ** ** |                     |   |                     |   |
| Restructuring and other charges                                                  |   | **172.6**              | ** ** | 268.4                    |   | 448.6                    |   |
| Depreciation and amortization                                                    |   | **110.2**              | ** ** | 142.6                    |   | 157.5                    |   |
| Tax benefit associated with stock option exercises                               |   | **1.6**                | ** ** | 2.0                      |   | 20.1                     |   |
| Purchased in-process research & development                                  |   | **—**             | ** ** | 5.4                      |   | —                   |   |
| Provision for doubtful accounts                                                  |   | **(13.6**              | **)**      | (25.4                    | )      | 42.0                     |   |
| Deferred income taxes                                                            |   | **(14.9**              | **)**      | 110.0                    |   | (94.9                    | )      |
| Loss on investments                                                              |   | **4.0**                | ** ** | 30.0                     |   | 13.1                     |   |
| Deferred compensation                                                            |   | **11.2**               | ** ** | 10.5                     |   | —                   |   |
| Net changes in assets and liabilities, net of effects from  acquisitions:        |   |                   | ** ** |                     |   |                     |   |
| Accounts receivable                                                              |   | **47.1**               | ** ** | 162.0                    |   | 424.7                    |   |
| Inventories                                                                      |   | **143.8**              | ** ** | 113.2                    |   | (27.3                    | )      |
| Miscellaneous receivables and other current assets                               |   | **(87.1**              | **)**      | (12.1                    | )      | 8.0                      |   |
| Long-term assets                                                                 |   | **2.0**                | ** ** | (32.3                    | )      | (65.6                    | )      |
| Accounts payable                                                                 |   | **(34.1**              | **)**      | 9.2                      |   | (91.1                    | )      |
| Accrued restructuring and other charges                                          |   | **(84.2**              | **)**      | (191.6                   | )      | (64.4                    | )      |
| Accrued liabilities                                                              |   | **(16.9**              | **)**      | (29.6                    | )      | (56.2                    | )      |
| Income taxes                                                                     |   | **154.9**              | ** ** | (66.0                    | )      | (120.0                   | )      |
| Long-term  liabilities                                                           |   | **(5.1**               | **)**      | (5.4                     | )      | 6.8                      |   |
| **Net Cash Provided by Operating  Activities**                                   |   | **149.9**              | ** ** | 177.8                    |   | 419.3                    |   |
| **Investing  Activities**                                                        |   |                   | ** ** |                     |   |                     |   |
| Acquisition of property, plant and equipment, net                                |   | **(9.5**               | **)**      | (34.1                    | )      | (208.2                   | )      |
| Payments for purchases of investments                                            |   | **(2,287.8**           | **)**      | (697.0                   | )      | (424.0                   | )      |
| Proceeds from sales and maturities of investments                                |   | **2,009.8**            | ** ** | 543.5                    |   | 714.0                    |   |
| Payments for  acquisitions, net of cash acquired                                 |   | **(122.6**             | **)**      | (291.7                   | )      | (130.8                   | )      |
| **Net  Cash Used for Investing Activities**                                      |   | **(410.1**             | **)**      | (479.3                   | )      | (49.0                    | )      |
| **Financing Activities**                                                         |   |                   | ** ** |                     |   |                     |   |
| Proceeds from issuance of common stock                                           |   | **5.9**                | ** ** | 2.8                      |   | 20.9                     |   |
| Purchase of treasury stock                                                       |   | **—**             | ** ** | —                   |   | (3.1                     | )      |
| Proceeds from notes payable                                                      |   | **—**             | ** ** | —                   |   | 0.5                      |   |
| Payments of  notes payable                                                       |   | **—**             | ** ** | (8.8                     | )      | —                   |   |
| **Net  Cash Provided by (Used for) Financing Activities**                        |   | **5.9**                | ** ** | (6.0                     | )      | 18.3                     |   |
| **Effect  of Exchange Rate Changes on Cash**                                     |   | **46.6**               | ** ** | 59.2                     |   | (16.0                    | )      |
| **Net (Decrease) Increase in Cash and Cash Equivalents**                         |   | **(207.7**             | **)**      | (248.3                   | )      | 372.6                    |   |
| **Cash and Cash Equivalents at Beginning of Year**                               |   | **453.6**              | ** ** | 701.9                    |   | 329.3                    |   |
| **Cash  and Cash Equivalents at End of Year**                                    |   | **$**                  | **245.9**  | ** **               | $      | 453.6                    |   | $ | 701.9 |   |
| **Other Information**                                                            |   |                   | ** ** |                     |   |                     |   |
| Interest paid                                                                    |   | **$**                  | **—** | ** **               | $      | 1.4                      |   | $ | 0.7 |   |
| Income taxes (refunded) paid, net                                                |   | **$**                  | **(146.1** | **)**                    | $      | 23.9                     |   | $ | 151.0 |   |

 

The accompanying notes are an integral part ofthese statements.

 

24

----

 

**Notes to Consolidated Financial Statements**

 

**1. Summaryof Significant Accounting Policies**

 

**Nature of Business**

 

We operate as one business segment in thedesign, assembly, marketing and servicing of a diverse line of communicationsequipment used in public and private networks worldwide.

 

**Principles of Consolidation**

 

Our consolidated financial statements includethe accounts of Tellabs and our subsidiaries. All intercompany balances andtransactions have been eliminated.

 

Thepreparation of the financial statements in conformity with generally acceptedaccounting principles requires us to make estimates and assumptions that affectamounts reported in the financial statements and accompanying notes. Actualresults could differ from those estimates.

 

**Cash Equivalents**

 

We consider all highly liquid debt instrumentspurchased with original maturities of three months or less to be cashequivalents.

 

**Fair Value of Financial Instruments**

 

The financial instruments consist of cash andcash equivalents, accounts receivable, accounts payable, marketable securitiesand cost-basis investments. The carrying value of the cash and cashequivalents, accounts receivable and accounts payable are reasonable estimatesof their fair value. The fair value of marketable securities is estimated basedon quotes from brokers or current rates offered for instruments with similarcharacteristics. (See Note 7, *Derivative Financial Instruments,*on page 32.)

 

**Inventories**

 

Inventories are stated at the lower of cost ormarket. Cost is determined by the first-in, first-out method.

 

**Property, Plant and Equipment**

 

Property, plant and equipment is recorded atcost. Depreciation is computed using both the declining-balance andstraight-line methods. Buildings are depreciated over 25 to 40 years,improvements over 7 years and equipment over 3 to 10 years.

 

**Stock Options**

 

Under the provisions of SFAS No. 123, *Accounting for Stock-BasedCompensation,* and SFAS No. 148, *Accounting for Stock-Based Compensation—Transition andDisclosure—an amendment of SFAS No. 123,* we have elected to continueto apply Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*.Accordingly, in most cases, no compensation cost has been recognized for ourfixed stock option plan grants. If we had elected to recognize compensationexpense for our stock-based compensation plans consistent with the methodsprescribed by SFAS No. 123, net earnings and net earnings per share wouldhave been changed to the pro forma amounts shown below:

 
| **(In millions, except  per-share data)**                                                                                                  |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Net loss                                                                                                                                   |   |     |   |     |   |     |   |
| As reported                                                                                                                                |   | $        | (241.6 | )        | $      | (313.1   | )      | $ | (182.0 | ) |
| Add: stock-based employee compensation expense included in reported  net earnings, net of related tax effects                              |   | 11.2     |   | 10.5     |   | —   |   |
| Less: Total stock-based employee compensation expense determined under  fair value based method for all awards, net of related tax effects |   | (62.6    | )      | (129.6   | )      | (121.4   | )      |
| Pro forma net loss                                                                                                                         |   | $        | (293.0 | )        | $      | (432.2   | )      | $ | (303.4 | ) |
| Loss per common share                                                                                                                      |   |     |   |     |   |     |   |
| As reported                                                                                                                                |   | $        | (0.58  | )        | $      | (0.76    | )      | $ | (0.44 | ) |
| Pro forma                                                                                                                                  |   | $        | (0.71  | )        | $      | (1.05    | )      | $ | (0.74 | ) |

 

The fair value of options was estimated on thedate of grant using the Black-Scholes option pricing model with the followingweighted-average assumptions for grants in 2003, 2002 and 2001:

 
|                    |   | **2003** |   | **2002** |   | **2001** |   |
|-------------------------|--------|----------|--------|----------|--------|----------|--------|
| Expected volatility     |   | 73.4     | %      | 72.2     | %      | 64.8     | %      |
| Risk-free interest rate |   | 3.0      | %      | 2.8      | %      | 4.9      | %      |
| Expected life in years  |   | 5.1      |   | 5.9      |   | 7.0      |   |
| Expected dividend yield |   | 0.0      | %      | 0.0      | %      | 0.0      | %      |

 

The pro forma amounts disclosed above may notbe representative of future disclosures because the estimated fair value ofstock options is amortized to expense over the vesting period, and additionaloptions may be granted in future years. In addition, the Black-Scholes optionpricing model was developed for use in estimating the fair value of tradedoptions that have no vesting restrictions and are fully transferable. Itrequires the use of assumptions that are subjective, such as the expectedvolatility of the exercise price and the expected remaining life of the option.Since our options have significantly different characteristics from tradedoptions,

 

25

----

 

and since the changes in the subjective inputassumptions can result in materially different fair value estimates, in ouropinion, the existing option pricing models do not necessarily provide areliable single measure of the fair value of the options and do not give ameaningful comparison of companies in a given industry. (See Note 10, *Stock Options,*onpage 34.)

 

**Income Taxes**

 

Deferred tax assets and liabilities arerecognized for the future tax consequences attributable to differences betweenthe financial statement carrying amounts of existing assets and liabilities andtheir respective tax bases at enacted tax rates when such amounts are expectedto be realized or settled. Valuation allowances are provided if, based on theweight of available evidence, it is more likely than not that some or all ofthe deferred tax assets will not be realized. (See Note 12, *Income Taxes,*onpage 37.)

 

**Goodwill and Intangible Assets**

 

In accordance with SFAS No. 142, *Goodwill and OtherIntangible Assets,* we review the valuation of goodwill andindefinite lived intangible assets at least annually. Intangible assets withfinite lives are amortized over their estimated useful lives. We utilize thecomparison of our market capitalization and book value as an indicator ofpotential impairment. Prior to adoption of SFAS No. 142 in the firstquarter of 2002, we amortized goodwill over terms ranging from 7 to 20 yearsusing the straight-line method.

 

**Revenue Recognition**

 

Product revenue is recognized when allsignificant contractual obligations have been met, including the terms of theshipment, and collection of the resulting receivable is reasonably assured.Revenue for maintenance and support services is recognized ratably over thecontract period. All other service revenue is recognized upon completion.

 

**Earnings Per Share**

 

In accordance with SFAS No. 128, *Earnings Per Share,*earningsper share are based on both the weighted-average number of shares and theweighted-average shares adjusted for assumed conversions of stock options. (SeeNote 15, *EarningsPer Share,*on page 40.)

 

**Foreign Currency Translation**

 

The financial statements of our subsidiariesare generally measured using the local currency as the functional currency. Forthese subsidiaries, assets and liabilities are translated at exchange rates ineffect at the balance sheet date and income and expenses are translated atweighted average exchange rates during the year. The effect of translating asubsidiary’s stockholders’ equity in U.S. dollars is recorded as a cumulativetranslation adjustment in the equity section of the Consolidated BalanceSheets.

 

**Foreign Currency Transactions**

 

Foreign currency transaction gains and lossesresulting from changes in exchange rates are recognized in Other Expense. Netgains (losses) of $(1.8) million, $(5.9) million, and $2.2 million wererecorded in 2003, 2002 and 2001, respectively.

 

**Reclassification of Prior Year Amounts**

 

Certain reclassifications have been made tothe pre-2003 financial statements to conform to the 2003 presentation.

 

**2. NewAccounting Pronouncements**

 

In January 2003, the FASB issued FIN 46, *Consolidation of VariableInterest Entities*. FIN 46 requires a variable interest entity to beconsolidated by an equity investor if that investor is subject to a majority ofthe risk of loss from the variable interest entity’s activities, is entitled toreceive a majority of the entity’s residual returns, or both. Thisinterpretation will be adopted during our first quarter of 2004 and is notexpected to have a material impact on our Consolidated Statements ofOperations, Balance Sheets or Cash Flows.

 

InJune 2003, the FASB issued SFAS No. 149, an *Amendment of Statement 133 on Derivative Instrumentsand Hedging Activities*. SFAS 149 amends and clarifies financialaccounting and reporting for hedging activities and derivative instruments,including certain derivative instruments embedded in other contracts.

 

InMay 2003, the FASB issued SFAS 150, *Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity*. SFAS 150 establisheshow an issuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity.

 

SFAS149 and 150 were adopted during our third quarter and did not have a materialimpact on our Consolidated Statements of Operations, Balance Sheets or CashFlows.

 

**3.Restructuring and Other Charges**

 

In 2003, we approved plans to furtherrestructure our operations due to the continuing difficult market conditions inthe telecommunications industry. The major components of the restructuringinclude the outsourcing of both of our manufacturing operations: North Americanmanufacturing operations located in Bolingbrook, Illinois,

 

26

----

 

and International manufacturing operations,located in Espoo, Finland. Other major components of our restructuringactivities included workforce reductions and the closure and consolidation ofexcess facilities. The major charges included in the restructuring were forworkforce reductions, accelerated depreciation of plant and equipment, thewrite-off of fixed assets, the revaluation and write-off of inventories, and anaccrual for excess inventory purchase commitments. The outsourcing of ourmanufacturing operations resulted in the layoff of approximately 300 employeesin the United States, the transfer of 200 employees from the Internationalmanufacturing operations to our outsourcer (the severance, if any, for which weare liable for a period of time), the above-mentioned accelerated depreciationon related plant and equipment, and the closure of our North Americanmanufacturing facility in Bolingbrook, Illinois. The remaining Bolingbrookemployees were relocated to Illinois facilities. The manufacturing operationsin North America ceased at the end of October 2003 and the Internationalmanufacturing operations were ceased at the beginning of January 2004.

 

In2002, we approved plans to restructure our operations including a realignmentof worldwide inventory levels to match customer demand, which resulted in thewrite-off of excess inventories and an accrual for excess inventory purchasecommitments; workforce reductions; the closure and consolidation of excessfacilities, including manufacturing facilities in Ronkonkoma, New York, andShannon, Ireland, along with the write-off of related fixed assets; and anadjustment of the reserves for excess leased facilities from our 2001restructuring programs in light of current economic conditions.

 

Weexpect to incur an additional $9.0 million to $14.0 million in restructuringand other charges during the first half of 2004.

 

Belowis an analysis of the restructuring and other charges expensed during 2003,2002 and 2001 by major income statement classifications:

 
| **Income Statement  Classification**        |   | **Description**                                     |       | **2003** |       | **2002** |       | **2001** |       |
|---------------------------------------------|--------|-----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **(In  millions)**                          |   |                                                | ** ** |     | ** ** |     | ** ** |     | ** ** |
| Net product sales                           |   | Reversal of SALIX revenue                           |       | $        | —     |     | $          | —   |       | $ | 6.2 |   |
| Product cost of sales                       |   | Inventory adjustments                               |       | 49.4     |       | 53.2     |       | 120.3    |       |
|                                        |   | Excess purchase commitments                         |       | 23.2     |       | 58.1     |       | 127.0    |       |
|                                        |   | Accelerated depreciation on buildings and equipment |       | 23.7     |       | —   |       | —   |       |
|                                        |   | Disposal of  manufacturing equipment and other      |       | 1.0      |       | —   |       | 2.9      |       |
|                                        |   | Subtotal Cost of Sales                              |       | 97.3     |       | 111.3    |       | 250.2    |       |
|                                        |   |                                                |       |     |       |     |       |     |       |
| Adjustments to prior reserves               |   | Reversal of excess purchase commitments accrual     |       | (1.9     | )          | (11.6    | )          | —   |       |
|                                        |   | Total Cost of  Sales                                |       | 95.4     |       | 99.7     |       | 250.2    |       |
|                                        |   | Total Gross  Profit                                 |       | 95.4     |       | 99.7     |       | 256.4    |       |
| Restructuring and other charges             |   | Severance and related  expenses                     |       | 33.7     |       | 51.3     |       | 46.9     |       |
|                                        |   | Consolidation of excess  leased facilities          |       | 1.2      |       | 44.7     |       | 59.5     |       |
|                                        |   | Disposal of property, plant and equipment           |       | 22.6     |       | 67.3     |       | 55.6     |       |
|                                        |   | Accelerated depreciation on buildings and equipment |       | 24.8     |       | —   |       | —   |       |
|                                        |   | Other obligations                                   |       | 3.7      |       | 12.6     |       | 30.2     |       |
|                                        |   | Subtotal Operating Expenses                         |       | 86.0     |       | 175.9    |       | 192.2    |       |
| Adjustments to prior restructuring reserves |   | Reversal of excess  severance                       |       | (1.4     | )          | (6.2     | )          | —   |       |
|                                        |   | Reversal of excess  facilities consolidation        |       | —   |       | (0.7     | )          | —   |       |
|                                        |   | Additional proceeds from fixed asset disposals      |       | (5.0     | )          | —   |       | —   |       |
|                                        |   | Reversal of other obligations                       |       | (2.4     | )          | —   |       | —   |       |
|                                        |   | Total Operating Expenses                            |       | 77.2     |       | 169.0    |       | 192.2    |       |
| Net restructuring and other charges         |   |                                                |       | $        | 172.6      |     | $          | 268.7    |       | $ | 448.6 |   |

 

27

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The following table displays our restructuringand other charges activity during 2003 and the status of the reserves atJanuary 2, 2004:

 
| **Description  of reserve**               |   | **Balance  12/27/02** |       | **Additional  Reserves** |       | **Cash  Activity** |       | **Non-Cash  Activity** |       | **Balance  1/2/04** |       |
|-------------------------------------------|--------|-----------------------|------------|--------------------------|------------|--------------------|------------|------------------------|------------|---------------------|------------|
| **(In  millions)**                        |   |                  | ** ** |                     | ** ** |               | ** ** |                   | ** ** |                | ** ** |
| Inventory write-offs                      |   | $                     | —     |                     | $          | 49.4               |       | $                      | —     |                | $          | (49.4 | ) | $ | — |   |
| Excess purchase commitments               |   | 30.0                  |       | 23.2                     |       | (16.2              | )          | 1.4                    |       | 38.4                |       |
| Severance and related expenses            |   | 9.5                   |       | 33.7                     |       | (29.1              | )          | (0.6                   | )          | 13.5                |       |
| Consolidation of excess leased facilities |   | 81.8                  |       | 1.2                      |       | (28.9              | )          | 0.7                    |       | 54.8                |       |
| Disposal of property, plant and equipment |   | —                |       | 23.6                     |       | —             |       | (23.6                  | )          | —              |       |
| Accelerated depreciation                  |   | —                |       | 48.5                     |       | —             |       | (48.5                  | )          | —              |       |
| Other                                     |   | 9.6                   |       | 3.7                      |       | (10.0              | )          | (0.4                   | )          | 2.9                 |       |
|                                      |   | $                     | 130.9      |                     | $          | 183.3              |       | $                      | (84.2      | )                   | $          | (120.4 | ) | $ | 109.6 |   |

 

**Inventory adjustments and excess purchase commitments**

 

Due to a slowdown in customer spending levelsduring the year and a review of our inventory levels during outsourcingactivities, we had to write down the value of our inventories and relatednon-cancelable inventory purchase commitments for excess amounts. Included inproduct cost of goods sold during 2003 were charges of $72.6 million related tothe write-down of inventories and accruals for non-cancelable inventorypurchase commitments. North American manufacturing outsourcing resulted in a$7.4 million charge, International manufacturing outsourcing resulted in a$10.9 million charge, and $54.3 million was recorded prior tomanufacturing outsourcing to write down excess and obsolete inventory andaccrue for non-cancelable inventory purchase commitments. The inventoryadjustments were recorded as a reduction to inventory, while the reserve forexcess non-cancelable purchase commitments was recorded to accrued restructuringand other charges.

 

Includedin product cost of goods sold during 2002 were charges of $111.3 millionrelated to the write-off of inventories and accruals for non-cancelableinventory purchase commitments deemed to be excess as a result of the continuedslowdown in customer spending levels. These charges related primarily to abuildup in common components and piece parts that were a direct result of thelower forecasted overall product demand. The inventory write-offs were recordedas a reduction to inventory, while the reserve for excess non-cancelablepurchase commitments was recorded to accrued restructuring and other charges.

 

**Severance and related expenses**

 

As a result of the outsourcing of ourmanufacturing operations and our goal to align our employee levels withexpected manpower needs, we recorded charges totaling $33.7 million forseverance pay and related fringe benefits for the reduction of approximately1,500 employees worldwide in 2003. We expect to pay the remainder of theseverance costs by the end of the second quarter of 2004. We also reversed $1.4million in severance expense due to changes in the estimated severance andrelated costs from prior restructuring programs.

 

Resultingfrom our 2002 restructuring initiatives, we recorded charges totaling $51.3million for severance pay and related fringe benefits for the reduction ofapproximately 2,000 employees worldwide. Also during the year, $6.2 million ofseverance reserves were reversed due to changes in estimated severance and relatedcosts from prior restructuring programs.

 

**Consolidation of excess leased facilities**

 

Also as a result of the outsourcing of ourmanufacturing operations and reduced manpower needs, we recorded $1.2 millionin charges related to the consolidation of excess facilities in 2003.

 

During2002, we recorded $44.7 million in charges related to the consolidation ofexcess facilities. These charges consist mainly of $20.4 million for additionalreserves for facilities vacated under the 2001 restructuring programs, $13.6million for lease cancellation and non-cancelable lease costs associated withthe closure of the Ronkonkoma, New York, manufacturing facility and theconsolidation of a number of smaller locations under the April 2002restructuring, and $10.5 million for lease cancellation and non-cancelablelease costs primarily associated with the consolidation of Reston, Virginia,operations with Ashburn, Virginia, operations. 

 

28

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Approximately $0.7 million of the 2002 chargewas also reversed in 2002 as it related to originally estimated equipment leasepayments that will no longer be paid. We expect to utilize the remainingreserve for excess leased facility charges.

 

**Accelerated depreciation on building and equipment**

 

During 2003, due to a change in the estimatedlives of certain buildings and equipment because of the outsourcing of ourNorth American manufacturing operations, we recorded $48.5 million inaccelerated depreciation on the related building and equipment. Of this amount,$23.7 million was charged to cost of sales during the year with the remaining$24.8 million charged to operating expenses. The building and equipment arerecorded at their estimated recoverable amount at January 2, 2004.

 

**Disposal of property, plant and equipment and other**

 

Our review of property, plant and equipmentneeds during the restructuring activities indicated assets that would be soldor disposed of. We recorded a loss of $23.6 million in 2003 related to thedisposal of this property, plant and equipment. The property, plant andequipment consisted primarily of manufacturing equipment, lab and dataequipment, and computer software. This equipment is disposed of primarily byconducting periodic open bid auctions with items sold to the highest bidders.In the second quarter of 2003, we reduced the expense related to the disposalof property, plant and equipment by $5.0 million to reflect the receipt ofsales proceeds in excess of the original estimates.

 

Werecorded a loss of $67.3 million related to the disposal of property, plant andequipment as part of our 2002 restructuring programs. Property, plant andequipment consisted of leasehold improvements, manufacturing equipment, lab anddata equipment and furniture associated with the closure of the Ronkonkoma, NewYork, and Shannon, Ireland, plants, and the consolidation of a number ofsmaller locations. The total charges were determined by writing down fixedassets to be sold to the lower of their carrying amount or fair value lesscosts to sell, while writing down fixed assets that were abandoned to salvagevalue in accordance with SFAS No. 144.

 

**Other obligations**

 

In 2003, we recorded $3.7 million in chargesfor other obligations that arose as a direct result of our 2003 restructuringactivities. These charges represent non-cancelable agreements for softwarelicenses that have been deemed excess due to workforce reductions and productroadmap changes.

 

In2002, we recorded $12.6 million in charges for other obligations that arose asa direct result of our restructuring activities. These charges include $4.7million for the write-down of the Shannon, Ireland, facility, $4.3 million forthe expected repayment of incentive grants and $3.6 million of othermiscellaneous fees.

 

Ofthe remaining $109.6 million reserves as of January 2, 2004, $64.8 million isclassified as short-term as it is expected to be paid in the next 12 months.The long-term balance of $44.8 million will be paid over the remaining terms ofthe facility leases which expire at various times through 2011.

 

**4. BusinessCombinations**

 

In June 2003, we acquired 100% of theoutstanding preferred and common stock of Vivace Networks, Inc.,  a developer of flexible, high performancemulti-service routers, for $130.3 million ($122.6 million, net of cashacquired) plus liabilities assumed. We believe this acquisition brings twocomplementary products that enable us to expand into the high-growth globalservice provider multi-service router market. Goodwill and intangible assets fromthis acquisition were $93.5 million and $37.5 million, respectively, based onan independent appraisal. The intangible asset is being amortized over aseven-year useful life using the straight-line method.

 

Wehave entered into an employee retention incentive program which will awardshares of our stock worth $10.0 million to eligible employees if certainemployment targets are met over a two-year timeframe. The cost of this programwill be recognized ratably over the two-year time period.

 

Componentsof the purchase price were as follows:

 
| **(In  millions)**                    |   |   |        |
|---------------------------------------|--------|--------|-------------|
| Cash paid to equity holders           |   | $      |  124.6 |   |
| Fair value of stock options exchanged |   | 6.4    |        |
| Acquisition costs                     |   | 0.7    |        |
|                                  |   | 131.7  |        |
| Deferred compensation                 |   | (1.4   | )           |
| Total                                 |   | $      |  130.3 |   |

 

The Black-Scholes option valuation model wasused to determine the fair value of the Tellabs stock options exchanged. Thedeferred compensation expense represents the intrinsic value of the unvestedstock options on the acquisition date, which will be recognized over theremaining vesting period of the options.

 

29

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Theallocation of the purchase price is as follows:

 
| **(In millions)**                                                   |   |   |   |
|---------------------------------------------------------------------|--------|--------|--------|
| Goodwill                                                            |   | $      | 93.5   |   |
| Intangible assets subject to amortization—developed technology |   | 37.5   |   |
| Other assets                                                        |   | 16.7   |   |
| Total Assets                                                        |   | 147.7  |   |
| Total Liabilities                                                   |   | 17.4   |   |
| Purchase Price                                                      |   | $      | 130.3  |   |

 

InJanuary 2002, we acquired 100% of the outstanding voting stock of OcularNetworks, Inc. (“Ocular”), a developer of optical solutions for themetropolitan (“metro”) optical networking market, for $323.0 million. Webelieved that by acquiring Ocular it extended the addressable market for ourproducts within the metro optical network. Ocular’s product offeringscomplement our offerings by focusing on small to mid-size tier 2 and 3 centraloffices, a market opportunity that has previously not been addressed by us.Goodwill and intangible assets from this acquisition were $267.1 million and$64.4 million, respectively, based on an independent appraisal. The intangibleasset is being amortized over a 10-year useful life using the straight-linemethod. In-process research and development costs of $5.4 million were expensedduring the first quarter of 2002.

 

Componentsof the purchase price were as follows:

 
| **(In millions)**                                |   |   |   |
|--------------------------------------------------|--------|--------|--------|
| Cash paid to Ocular stockholders                 |   | $      | 278.5  |   |
| Fair value of stock options exchanged            |   | 42.9   |   |
| Payable to former Ocular restricted stockholders |   | 28.5   |   |
| Acquisition costs                                |   | 2.4    |   |
|                                             |   | 352.3  |   |
| Deferred  compensation expense                   |   | (29.3  | )      |
| Total                                            |   | $      | 323.0  |   |

 

TheBlack-Scholes option valuation model was used to determine the fair value ofthe Tellabs stock options exchanged. The deferred compensation expenserepresents the intrinsic value of the unvested Ocular stock options on theacquisition date, which will be recognized over the remaining vesting period ofthe options. Also included in the purchase price was a payable of$28.5 million to former holders of restricted Ocular stock awards thatwere given to certain key employees. On the acquisition date, the restrictedstock award holders exchanged these awards for the right to receive $28.5million in cash, which we agreed to pay out either immediately, if certainpre-defined conditions are met, or over the original vesting period of theawards. All of this liability has been paid as of January 2, 2004.

 

Theallocation of the purchase price is as follows:

 
| **(In millions)**                                                   |   |   |   |
|---------------------------------------------------------------------|--------|--------|--------|
| Goodwill                                                            |   | $      | 267.1  |   |
| Intangible assets subject to amortization—developed technology |   | 64.4   |   |
| Purchased in-process research and development costs                 |   | 5.4    |   |
| Fair value of assets acquired                                       |   | 8.2    |   |
| Total Assets                                                        |   | 345.1  |   |
| Total Liabilities                                                   |   | 22.1   |   |
| Purchase Price                                                      |   | $      | 323.0  |   |

 

Theseacquisitions were financed with cash on hand and are accounted for under thepurchase method of accounting. The operating results of the businesses havebeen included in the accompanying consolidated results of operations from theirdate of acquisition. Pro forma combined results of operations assuming theacquisitions had occurred at the beginning of the year are not being presentedsince they would not differ materially from reported results. In addition, weestimate that goodwill will not be deductible for tax purposes.

 

**5. Goodwilland Intangible Assets**

 

During the first quarter of 2002, we adoptedSFAS No. 142, *Goodwilland Other Intangible Assets*. SFAS No. 142 eliminates theamortization of goodwill and intangible assets with indefinite useful lives.SFAS No. 142 requires that these assets be reviewed for impairment atleast annually. Intangible assets with finite lives will continue to beamortized over their estimated useful lives, which for the company, range from7 to 10 years, on a straight-line basis. The weighted average amortizationperiod is 8.4 years.

 

Therehas been no impairment of our goodwill or intangible assets with indefiniteuseful lives since the adoption of this Statement. However, there can be noassurance that future impairment tests will not result in a charge to earnings.

 

30

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Beloware the results of operations for 2001, with the pro-forma results ofoperations adjusted to exclude goodwill amortization expense.

 
| **(In millions, except  per-share amounts)** |   | **Year Ended  12/28/01** |   |
|----------------------------------------------|--------|--------------------------|--------|
| Net loss                                     |   | $                        | (182.0 | ) |
| Add back: After-tax goodwill amortization    |   | 21.5                     |   |
| Pro-forma loss                               |   | $                        | (160.5 | ) |
| Loss per share                               |   | $                        | (0.44  | ) |
| Add back: Goodwill amortization              |   | 0.05                     |   |
| Pro-forma loss per share                     |   | $                        | (0.39  | ) |
| Average number of common shares outstanding  |   | 409.6                    |   |

 

Thegross carrying amount and accumulated amortization of intangible assets subjectto amortization, which consisted of developed technology assets, was$124.9 million and $17.1 million as of January 2, 2004, and$87.4 million and $17.3 million as of December 27, 2002, respectively. Theaggregate amortization expense for these assets for the years ending January 2,2004, December 27, 2002, and December 28, 2001, was $12.6 million,$8.8 million, and $2.8 million, respectively.

 

Theestimated amortization expense for each of the next five years is as follows:

 
| **(In  millions)** |   |   |   |
|--------------------|--------|--------|--------|
| 2004               |   | $      | 15.5   |   |
| 2005               |   | $      | 15.5   |   |
| 2006               |   | $      | 13.9   |   |
| 2007               |   | $      | 11.8   |   |
| 2008               |   | $      | 11.8   |   |

 

**6.Investments**

 

Available-for-sale marketable securities areaccounted for at market prices, with the unrealized gain or loss, less deferredincome taxes, shown as a separate component of stockholders’ equity. At January2, 2004, and December 27, 2002, they consisted of the following:

 
| **(In millions)**                           |   | **Amortized  Cost** |   | **Unrealized  Gain/(Loss)** |   | **Market  Value** |   |
|---------------------------------------------|--------|---------------------|--------|-----------------------------|--------|-------------------|--------|
| **2003**                                    |   |                |   |                        |   |              |   |
| State and municipal securities              |   | $                   | — |                        | $      | —            |   | $ | — |   |
| Preferred and common stocks                 |   | 46.1                |   | 1.6                         |   | 47.7              |   |
| U.S. government and agency debt obligations |   | 377.9               |   | 0.9                         |   | 378.8             |   |
| Corporate debt obligations                  |   | 253.2               |   | 0.5                         |   | 253.7             |   |
| Foreign government obligations              |   | 172.2               |   | (0.6                        | )      | 171.6             |   |
| Foreign bank obligations                    |   | 25.3                |   | —                      |   | 25.3              |   |
|                                        |   | $                   | 874.7  |                        | $      | 2.4               |   | $ | 877.1 |   |
| **2002**                                    |   |                |   |                        |   |              |   |
| State and municipal securities              |   | $                   | 149.9  |                        | $      | 1.6               |   | $ | 151.5 |   |
| Preferred and common stocks                 |   | 47.9                |   | 1.5                         |   | 49.4              |   |
| U.S. government and agency debt obligations |   | 212.5               |   | 4.9                         |   | 217.4             |   |
| Corporate debt obligations                  |   | 57.4                |   | 2.4                         |   | 59.8              |   |
| Foreign government obligations              |   | 15.9                |   | 0.1                         |   | 16.0              |   |
| Foreign bank obligations                    |   | 71.5                |   | —                      |   | 71.5              |   |
|                                        |   | $                   | 555.1  |                        | $      | 10.5              |   | $ | 565.6 |   |

 

Wealso maintain investments in start-up technology companies and partnershipsthat invest in start-up technology companies. These investments are recorded inOther Assets at cost, which approximates fair market value. At January 2, 2004,and December 27, 2002, these investments totaled $15.0 million and $9.0million, respectively. During 2001, we recorded a $12.8 million pre-tax gain onthe sale of a certain equity investment.

 

Weconduct a quarterly review of each investment in our portfolio, includinghistorical and projected financial performance, expected cash needs and recentfunding events. Other-than-temporary impairments are recognized if the marketvalue of the investment is below its cost basis for an extended period of timeor the issuer

 

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hasexperienced significant financial declines or difficulties in raising capitalto continue operations. Other-than-temporary impairments were $3.3 million forthe year ended January 2, 2004, $29.6 million for the year ended December 27,2002, and $25.9 million for the year ended December 28, 2001.

 

**7.Derivative Financial Instruments**

 

We conduct business on a global basis inseveral major currencies and are subject to risks associated with fluctuatingforeign exchange rates. In response to this, we developed a foreign currencyexposure management policy with the objective of mitigating financial exposureto changing foreign exchange rates resulting from monetary assets andliabilities recorded in non-functional currencies that are expected to besettled in one year or less. We utilize derivatives, primarily foreign currencyforward contracts, to manage our foreign currency exposure. We do not engage inhedging specific individual transactions, but rather use derivatives to manageoverall exposure levels for a specific currency. Gains and losses related tothese derivatives are recorded in the Consolidated Statement of Operations eachperiod.

 

Foreigncurrency forward contracts are executed monthly, one week before the end of theperiod. As a result of this timing, additional nonfunctional foreign currencytransactions can occur during the last week of the period that could cause ourhedge percentage at the end of the period to be greater or less than the 100%target. We enter into forward exchange contracts only to the extent necessaryto meet our overall goal of minimizing nonfunctional foreign currencyexposures. We do not enter into hedging transactions for speculative purposes.Our foreign currency exposure management policy and program was amended during2003 to allow for 100% (90% in prior years) hedges of the calculated exposure.

 

Inaccordance with SFAS No. 133, all forward exchange contracts are recorded onthe balance sheet at fair value. Forward foreign exchange contracts receivableare included in Other Current Assets, while forward foreign exchange contractspayable are included as part of Accrued Liabilities in the Consolidated BalanceSheet. Changes in the fair value of these instruments are included in earnings,as part of Other Expenses, in the current period. We had a net gain of $17.0million and $5.5 million on forward exchange contracts in 2003 and 2002,respectively. Net losses on forward exchange contracts were $4.7 million for2001. Our current hedging practices do not qualify for special hedge accountingtreatment as prescribed in SFAS No. 133 since hedges of existing assets orliabilities that will be re-measured with changes in fair value reportedcurrently in earnings are specifically excluded.

 

Derivativefinancial instruments involve elements of market and credit risk not recognizedin the financial statements. The market risk that results from theseinstruments relates to changes in the foreign currency exchange rates, which isgenerally offset by movements in the value of the underlying assets orliabilities being held by us. Credit risk relates to the risk of nonperformanceby a counter party to one of our derivative contracts. We do not believe thereis a significant credit risk associated with our hedging activities because thecounter parties are all large international financial institutions with highcredit ratings. In addition, we also limit the aggregate notional amount ofagreements entered into with any one financial institution in order to mitigatecredit risk.

 

Thetable that follows presents a summary of the notional value of forward exchangerate contracts for each currency in which we have hedged exposure at January 2,2004, and December 27, 2002. The principal currencies we currently hedgeare the British pound, Canadian dollar, Danish kroner, Euro, Mexican peso andU.S. dollar. The notional values maturing in 2004 and 2003 are the U.S. dollarvalues of the agreed-upon amounts in each foreign currency that will bedelivered to a third party on the agreed-upon date.

 

32

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| **(In millions)**                                                         |   | **Notional  Value  of Exposure** |   | **Notional  Value  Maturing in 2004** |   |
|---------------------------------------------------------------------------|--------|----------------------------------|--------|---------------------------------------|--------|
| Forward contracts at January 2, 2004:                                     |   |                             |   |                                  |   |
| Related forward contracts to sell foreign currencies for Euro             |   | $                                | 128.6  |                                  | $      | 96.7 |   |
| Related forward contracts to buy foreign currencies for Euro              |   | 1.9                              |   | 1.3                                   |   |
| Related forward contracts to sell foreign currencies for Danish kroner    |   | 8.3                              |   | 5.8                                   |   |
| Related forward contracts to sell foreign currencies for British pound    |   | 17.5                             |   | 17.6                                  |   |
| Related forward contracts to buy foreign currencies for British pound     |   | 0.6                              |   | 0.4                                   |   |
| Related forward contracts to buy foreign currencies for U.S. dollar       |   | 1.6                              |   | 3.9                                   |   |
| Related forward contracts to sell foreign currencies for U.S. dollar      |   | 72.3                             |   | 59.0                                  |   |
| Related forward contracts to buy foreign currencies for Brazilian real    |   | 0.4                              |   | 0.4                                   |   |
| Related forward contracts to sell foreign currencies for Canadian  dollar |   | 37.9                             |   | 36.7                                  |   |
| Related forward contracts to buy foreign currencies for Thai baht         |   | 3.3                              |   | 3.1                                   |   |
| Total                                                                     |   | $                                | 272.4  |                                  | $      | 224.9 |   |

 
| **(In millions)**                                                      |   | **Notional  Value  of Exposure** | ** ** | **Notional Value  Maturing in 2003** | ** ** |
|------------------------------------------------------------------------|--------|----------------------------------|------------|--------------------------------------|------------|
| Forward contracts at December 27, 2002:                                |   |                             |       |                                 |       |
| Related forward contracts to sell foreign currencies for Euro          |   | $                                | 105.6      |                                 | $          | 88.3 |   |
| Related forward contracts to sell foreign currencies for Danish kroner |   | 4.7                              |       | 5.4                                  |       |
| Related forward contracts to sell foreign currencies for British pound |   | 7.0                              |       | 5.6                                  |       |
| Related forward contracts to buy foreign currencies for British pound  |   | 1.1                              |       | 0.9                                  |       |
| Related forward contracts to buy foreign currencies for U.S. dollar    |   | 2.1                              |       | 1.4                                  |       |
| Related forward contracts to sell foreign currencies for U.S. dollar   |   | 14.2                             |       | 12.7                                 |       |
| Total                                                                  |   | $                                | 134.7      |                                 | $          | 114.3 |   |

 

Pursuantto our policy we entered into the above contracts immediately prior to therespective year ends. Accordingly, the fair value of such contracts at January2, 2004, and December 27, 2002, is not material. The fair value of a forwardcontract is the difference between the forward contract rate at the date thecontract is entered into and the spot rate at the period end, multiplied by thenotional value of the contract.

 

**8. Assets Held for Sale**

 

Asa result of the North American manufacturing outsourcing plan in 2003, wedecided to sell the land and building of our main manufacturing facility inBolingbrook, Illinois. The 2003 year-end carrying amount for the land, buildingand improvements was within the estimated market range for the property. Theproperty is being actively marketed, and is expected to be sold before the endof 2004. The property was reclassified from long-lived assets to current assetsin 2003.

 

Wealso decided to sell the land and building of the Vitikka facility in Espoo,Finland, as part of our 2003 restructuring efforts. The 2003 year-end net bookvalue of the land, building and improvements was below the estimated marketrange for the property. The property is being actively marketed, and isexpected to be sold before the end of 2004. The property was reclassified fromlong-lived assets to current assets in 2003.

 

Asa result of prior restructuring efforts, we committed to sell certain land,buildings and improvements in Lisle, Illinois, and Round Rock, Texas, withcarrying amounts at the end of 2002 totaling $13.1 million. The carrying valueof the land, buildings and leasehold improvements approximated their fair valueless costs to sell, which was determined based on the quoted market prices ofsimilar assets; therefore, no impairment loss was recorded in 2002. In 2003, itwas determined that the properties were not sellable at the current book value,and $9.5 million of impairment losses were recorded in the second quarter of2003. We finalized the sale of the Lisle facility in February 2004. The RoundRock facility is still being actively marketed.

 

The$18.2 million total carrying value of the properties held for sale is includedin the Miscellaneous Receivables and Other Current Assets in the 2003Consolidated Balance Sheet.

 

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**9. ProductWarranties**

 

We offer warranties for all of our products.The specific terms and conditions of those warranties vary depending upon theproduct sold. We provide a basic limited warranty, including parts and labor,for all products for a period ranging from 1 to 5 years. Factors that enterinto the estimate of our warranty liability include the number of unitsshipped, historical and anticipated rates of warranty claims, and cost perclaim. We periodically assess the adequacy of our recorded warranty liabilitiesand adjust the amounts as necessary. On the Consolidated Balance Sheet, theshort-term portion of the warranty reserve is included in Other CurrentLiabilities, while the long-term portion is included in Other Long-TermLiabilities. Our product warranty liabilities are as follows:

 
| **(In millions)**                               |   | **1/2/04** |   | **12/27/02** |   | **12/28/01** |   |
|-------------------------------------------------|--------|------------|--------|--------------|--------|--------------|--------|
| Balance at beginning of year                    |   | $          | 13.9   |         | $      | 14.4         |   | $ | 11.4 |   |
| Accruals for product warranties issued          |   | 11.6       |   | 8.5          |   | 9.3          |   |
| Settlements made during the year                |   | (6.0       | )      | (9.0         | )      | (6.3         | )      |
| Balance at end of year                          |   | $          | 19.5   |         | $      | 13.9         |   | $ | 14.4 |   |
|                                            |   |       |   |         |   |         |   |
| **Balance sheet classification at end of year** |   |       |   |         |   |         |   |
| Other current liabilities                       |   | $          | 6.4    |         | $      | 6.2          |   | $ | 6.7 |   |
| Other long-term liabilities                     |   | 13.1       |   | 7.7          |   | 7.7          |   |
| Total product warranty liabilities              |   | $          | 19.5   |         | $      | 13.9         |   | $ | 14.4 |   |

 

**10. StockOptions**

 

AtJanuary 2, 2004, we had 11 stock-based compensation plans. Under these plans,we typically grant options to purchase our common stock at no less than 100percent of the market price on the date the option is granted. Optionsgenerally become exercisable on a cumulative basis at a rate of 25% on each ofthe first through fourth anniversaries of the grant date and have a maximumterm of five, seven or ten years. Beginning in 2003, the exercisability ratewas changed for option grants on a cumulative basis at a rate of 20% in each ofthe first two years anniversaries and 60% in the third anniversary of the grantdate. A total of 145,908,246 shares were authorized for grant under the plansof which 24,701,201 are available for grant as of January 2, 2004. Certainplans also provide for the granting of stock appreciation rights (SARs) inconjunction with, or independently of, the options under the plans. The SARsare typically assigned 5- or 10-year terms. At January 2, 2004, there were165,998 SARs outstanding under the plans. At January 2, 2004, the exerciseprices of our outstanding SARs ranged from $4.07 to $70.06.

 

34

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Asummary of the status of our option plans as of January 2, 2004, December 27,2002, and December 28, 2001, and of changes during the years ending on thesedates is presented in the following chart:

 
|                                                           |   | **2003**   |       | **2002**                               |       | **2001**   |        |
|----------------------------------------------------------------|--------|------------|------------|----------------------------------------|------------|------------|-------------|
|                                                           |   | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** **  | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding—beginning of year                             |   | 42,333,868 |       | $                                      | 22.49      |       | 37,926,204  |   | $ | 30.95 |   | 26,203,871 |   | $ | 34.31 |   |
| Granted                                                        |   | 10,374,119 |       | $                                      | 6.57       |       | 16,781,435  |   | $ | 5.23 |   | 17,890,236 |   | $ | 25.81 |   |
| Exercised                                                      |   | (2,409,640 | )          | $                                      | 2.57       |       | (2,144,053  | ) | $ | 1.35 |   | (2,265,958 | ) | $ | 9.24 |   |
| Forfeited                                                      |   | (9,057,429 | )          | $                                      | 23.31      |       | (10,229,718 | ) | $ | 29.98 |   | (3,901,945 | ) | $ | 42.61 |   |
| Outstanding—end of year                                   |   | 41,240,918 |       | $                                      | 19.35      |       | 42,333,868  |   | $ | 22.49 |   | 37,926,204 |   | $ | 30.95 |   |
|                                                           |   |       |       |                                   |       |       |        |   |   |   |   |   |   |
| Exercisable at end of year                                     |   | 20,450,233 |       |                                   |       | 17,278,637 |        |   |   | 14,307,655 |   |   |   |
| Available for grant                                            |   | 24,701,201 |       |                                   |       | 25,688,260 |        |   |   | 29,780,548 |   |   |   |
|                                                           |   |       |       |                                   |       |       |        |   |   |   |   |   |   |
| Weighted-average fair value of options granted during the year |   | $          | 4.15       |                                   |       |       | $           | 4.31 |   |   |   | $ | 16.85 |   |   |   |
|                                                                |        |            |            |                                        |            |            |             |  |  |  |  |  |  |  |  |  |  |  |  |

 

Optionsoutstanding and exercisable as of January 2, 2004, by price range are asfollows:

 
|                          |   | **Outstanding** |       | **Exercisable**                                     |       |
|-------------------------------|--------|-----------------|------------|-----------------------------------------------------|------------|
| **Range of  Exercise Prices** |   | **Shares**      | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $0.00 – $7.06            |   | 20,155,434      |       | 8.5                                                 |       | $ | 5.71 |   | 4,185,434 |   | $ | 4.11 |   |
| $7.07 – $14.13           |   | 1,140,213       |       | 5.6                                                 |       | $ | 8.48 |   | 613,309 |   | $ | 8.51 |   |
| $14.14 – $21.19          |   | 10,312,658      |       | 5.3                                                 |       | $ | 16.44 |   | 7,430,076 |   | $ | 16.36 |   |
| $21.20 – $28.25          |   | 1,181,061       |       | 2.9                                                 |       | $ | 25.32 |   | 1,181,061 |   | $ | 25.32 |   |
| $28.26 – $35.31          |   | 220,168         |       | 5.2                                                 |       | $ | 32.93 |   | 165,168 |   | $ | 33.18 |   |
| $35.32 – $42.38          |   | 223,653         |       | 5.5                                                 |       | $ | 39.03 |   | 145,487 |   | $ | 38.84 |   |
| $42.39 – $49.44          |   | 410,800         |       | 5.6                                                 |       | $ | 47.08 |   | 342,380 |   | $ | 47.21 |   |
| $49.45 – $56.50          |   | 2,958,171       |       | 5.7                                                 |       | $ | 51.06 |   | 2,414,023 |   | $ | 51.19 |   |
| $56.51 – $63.56          |   | 4,465,860       |       | 5.4                                                 |       | $ | 61.70 |   | 3,823,657 |   | $ | 61.68 |   |
| $63.57 – $70.63          |   | 172,900         |       | 4.4                                                 |       | $ | 69.52 |   | 149,638 |   | $ | 69.52 |   |
| $0.00 – $70.63           |   | 41,240,918      |       | 6.8                                                 |       | $ | 19.35 |   | 20,450,233 |   | $ | 27.92 |   |

 

35

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**11. EmployeeBenefit and Retirement Plans**

 

Our employees may voluntarily participate inthe Tellabs Advantage Program and upon meeting eligibility requirements, wewill match (dollar-for-dollar) up to the first 3% (from January 1, 2003 – June30, 2003) or 4% (from July 1, 2003 – December 31, 2003) of the employee’scontribution rate. Both employee and employer contributions are immediatelyvested. The investment election for the employee’s contribution isemployee-driven and our match follows this election. In addition, the employeemay elect to change this investment election and reallocate assets on a dailybasis. Although the Tellabs Stock Fund is one of several funds offered toparticipants, at no time do we direct the investment of an employee’s 401(k)contribution or our match into any one fund offered under the Program. We maintainsimilar plans for the benefit of eligible employees at our Finland and Denmarksubsidiaries.

 

UntilJuly 1, 2003, we contributed to a retirement plan under the Program consistingof a money purchase plan and a profit sharing plan for which, upon meetingeligibility requirements, all employees become eligible participants. Eachquarter, we contributed an amount equal to 5% of a participant’s quarterlysalary, subject to the terms set forth in the Program. This quarterlycontribution was entirely funded by us. Of the 5% contribution, 4.5% wasdeposited into a money purchase plan and invested per the participant’sdirection into the funds offered under the Program with the exception of theTellabs Stock Fund. The participant may not direct any portion of this 4.5%into the Tellabs Stock Fund. Participants were allowed to change their moneypurchase plan investment elections at any time and may continue to reallocatethe investments among the same funds available under the Program (with theexception of the Tellabs Stock Fund) on a daily basis. Contributions to theprofit sharing plan were suspended as of July 1, 2003.

 

Theinvestment of the remaining 0.5% of this quarterly 5% contribution (10% of ourretirement contribution) was deposited into the profit sharing plan and wasdirected by us into the Tellabs Stock Fund and still may not be reallocatedunless the participant is age 55 or older. We believe that it is valuable to usand our stockholders for all employees to have a stake in our financial future.Contributions to the profit sharing plan were suspended as of July 1, 2003.

 

EffectiveJuly 1, 2003, we instituted a Discretionary Company Contribution. Thiscontribution is declared by the Board of Directors and is funded entirely byus. The amount of the contribution is based on a percent of pay for a specificperiod as declared by the Board. All full-time active employees are immediatelyeligible to receive this contribution and the investment of these funds followsthe participants’ elections on file for the Program. This contribution isimmediately vested. The Board of Directors declared a 2% contribution for thethird and fourth quarters of 2003.

 

Ourcontributions to the Program and profit-sharing plans were $20.0 million, $16.2million and $17.2 million for 2003, 2002 and 2001, respectively. Ourcontributions to the retirement plan were $5.9 million, $6.7 million and $14.4million for 2003, 2002 and 2001, respectively.

 

Weprovide a deferred income plan that permits certain officers and management employeesto defer portions of their compensation. All deferrals prior to September 2,2001, are guaranteed a fixed return. In September 2001, the plan was amended tooffer multiple investment funds whose investment returns are based on marketperformance; therefore, all deferrals on or after September 2, 2001, can alsobe transferred into the amended plan and invested in the new fund options.Funds invested prior to September 2, 2001, can also be transferred into theamended plan. The deferred income obligation is included in Other Long-TermLiabilities and adjusted, with a corresponding charge (or credit) tocompensation expense, to reflect changes in the fair value of the amount owedto the employee. We fund any payments from the deferred income plan from ourinvestment in corporate-owned life insurance policies. The cash surrender valueof such policies is recorded in Other Assets.

 

Wemaintain an employee stock purchase plan. Under the plan, employees elect towithhold a portion of their compensation to purchase our common stock at fairmarket value. We match 15% of each employee’s withholdings. Compensationexpense is recognized for the amount that we contribute to the plan through ourmatching of participant withholdings.

 

Wehave a program to award shares of our common stock to employees in recognitionof their past service. Each full-time employee who has worked for a continuous5-, 10-, 15-, 20- or 25-year period is awarded 10, 15, 25, 50 or 75 shares,respectively. When an employee stock award is granted, compensation expense ischarged for the fair market value of the shares issued.

 

Wehave an employee retention program under which certain employees are entitledto a specific number of shares of our stock over a vesting period.

 

Wemaintain a defined-benefit retiree medical plan. Under the plan, which wasimplemented in 1999, we provide qualified retirees with a subsidy to offsettheir

 

36

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medicalcosts and allow the retirees to participate in the Company-sponsored healthcareplan. In 2003, 2002 and 2001, we contributed $2.0 million, $2.4 million and$2.2 million, respectively, to our defined-benefit retiree medical plan.

 

Thefollowing table summarizes plan assets, obligations, and assumptions of the retireemedical plan as of December 31, 2003:

 
| **(In millions)**                                                |   |   |       |
|------------------------------------------------------------------|--------|--------|------------|
| **Change in  benefit obligation during 2003**                    |   |   |       |
| Accumulated postretirement benefit obligation, December 31, 2002 |   | $      | 7.9        |   |
| Service cost                                                     |   | 0.9    |       |
| Interest cost                                                    |   | 0.5    |       |
| Plan amendments                                                  |   | — |       |
| Actuarial (gain) loss                                            |   | 1.6    |       |
| Benefits paid                                                    |   | (0.3   | )          |
| Curtailment                                                      |   | (2.0   | )          |
| Accumulated postretirement benefit obligation, December 31, 2003 |   | $      | 8.6        |   |
|                                                             |   |   | ** ** |
| **Change in  plan assets during 2003**                           |   |   |       |
| Assets at fair value, December 31, 2002                          |   | $      | 6.4        |   |
| Return on plan assets                                            |   | 0.1    |       |
| Company contributions                                            |   | 2.0    |       |
| Benefits paid                                                    |   | — |       |
| Assets at fair value, December 31, 2003                          |   | $      | 8.5        |   |
|                                                             |   |   | ** ** |
| **Reconciliation  of prepaid (accrued) cost**                    |   |   |       |
| Funded status of the plan                                        |   | $      | (0.1       | ) |
| Unrecognized prior service cost                                  |   | 1.6    |       |
| Unrecognized net (gain) loss                                     |   | 1.2    |       |
| (Accrued) prepaid cost                                           |   | $      | 2.7        |   |
|                                                             |   |   | ** ** |
| **Components  of net periodic benefit cost**                     |   |   |       |
| Service cost                                                     |   | $      | 0.9        |   |
| Interest cost                                                    |   | 0.5    |       |
| Expected return on assets                                        |   | (0.4   | )          |
| Amortization of:                                                 |   |   |       |
| Unrecognized prior service cost                                  |   | 0.2    |       |
| Unrecognized net (gain) loss                                     |   | — |       |
| Net periodic postretirement benefit cost                         |   | $      | 1.2        |   |
| Additional costs due to restructure                              |   |   |       |
| Curtailment                                                      |   | — |       |
| Special termination benefits                                     |   | 0.2    |       |
| Total cost for 2003                                              |   | $      | 1.4        |   |

 

Weincurred additional costs of $0.2 million in 2003 for certain extra benefitspaid to terminated or retired employees. We expect to contribute $1.6 millionto our retiree medical plan in 2004.

 

Weamortize the prior service cost using a straight-line method over the averageremaining years of service to full eligibility for benefits of the activeretiree-medical plan participants.

 
| **Weighted-average assumptions as  of December 31, 2003** |   |   |   |
|-----------------------------------------------------------|--------|--------|--------|
| Discount rate used to determine benefit costs             |   | 6.75   | %      |
| Discount rate used to determine benefit obligation        |   | 6.00   | %      |
| Expected long-term rate of return on assets               |   | 5.00   | %      |

 

Thereis no trend rate assumption required for this plan, because all liabilities arerelated to a fixed-dollar subsidy, and are not related to medical claims.Therefore, any change in future medical inflation trends or assumptions willhave no effect on the liabilities of this plan.

 

Theplan’s assets are invested 100% in short-term interest-bearing cash accounts.Historical markets are studied and long-term historical relationships betweenequities and fixed-income are preserved consistent with the widely acceptedcapital market principle that assets with higher volatility generate a greaterreturn over the long run. Current market factors such as inflation and interestrates are evaluated before long-term capital market assumptions are determined.The long-term portfolio return is established via a building block approachwith proper consideration of diversification and rebalancing. Peer data andhistorical returns are reviewed to check for reasonability and appropriateness.

 

**12. IncomeTaxes**

 

Components of our earnings before income taxesare as follows:

 
| **(In millions)** |   | **Year Ended  1/2/04** |   | **Year Ended  12/27/02** |   | **Year Ended  12/28/01** |   |
|-------------------|--------|------------------------|--------|--------------------------|--------|--------------------------|--------|
| Domestic source   |   | $                      | (250.8 | )                        | $      | (330.2                   | )      | $ | (263.5 | ) |
| Foreign source    |   | 6.1                    |   | 2.4                      |   | 18.7                     |   |
| Total             |   | $                      | (244.7 | )                        | $      | (327.8                   | )      | $ | (244.8 | ) |

 

37

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Theprovision for income tax expense (benefit) consisted of the following:

 
| **(In millions)**        |   | **Year Ended  1/2/04** | ** ** | **Year Ended  12/27/02** | ** ** | **Year Ended  12/28/01** | ** ** |
|--------------------------|--------|------------------------|------------|--------------------------|------------|--------------------------|------------|
| Current:                 |   |                   |       |                     |       |                     |       |
| Federal                  |   | $                      | (5.7       | )                        | $          | (132.3                   | )          | $ | 3.9 |   |
| State                    |   | 0.4                    |       | (1.4                     | )          | (1.8                     | )          |
| Foreign                  |   | 17.1                   |       | 26.2                     |       | 33.6                     |       |
|                     |   | 11.8                   |       | (107.5                   | )          | 35.7                     |       |
|                     |   |                   |       |                     |       |                     |       |
| Deferred:                |   |                   |       |                     |       |                     |       |
| Federal                  |   | —                 |       | 89.1                     |       | (95.1                    | )          |
| State and foreign        |   | (14.9                  | )          | 3.7                      |       | (3.4                     | )          |
|                     |   | (14.9                  | )          | 92.8                     |       | (98.5                    | )          |
| Total income tax benefit |   | $                      | (3.1       | )                        | $          | (14.7                    | )          | $ | (62.8 | ) |

 

Federalincome taxes at the statutory rate are reconciled with our income tax provisionas follows:

 
| **(In percentages)**                              |   | **Year Ended  1/2/04** | ** ** | **Year Ended  12/27/02** | ** ** | **Year Ended  12/28/01** | ** ** |
|---------------------------------------------------|--------|------------------------|------------|--------------------------|------------|--------------------------|------------|
| Statutory U.S. income tax (benefit) rate          |   | (35.0                  | )%         | (35.0                    | )%         | (35.0                    | )%         |
| State income tax, net of federal benefits         |   | 1.4                    |       | 1.7                      |       | (2.4                     | )          |
| Research and development credit                   |   | —                 |       | (0.7                     | )          | (5.1                     | )          |
| Foreign earnings taxed at different rates         |   | 0.4                    |       | 9.0                      |       | 15.2                     |       |
| Loss on investment in securities                  |   | (2.5                   | )          | —                   |       | —                   |       |
| Benefit attributable to foreign sales corporation |   | —                 |       | —                   |       | (0.8                     | )          |
| Loss on investment in subsidiary                  |   | 0.6                    |       | (5.1                     | )          | —                   |       |
| Valuation allowance on net deferred tax assets    |   | 30.8                   |       | 25.4                     |       | —                   |       |
| Settlement of prior-year tax matters              |   | 2.8                    |       | —                   |       | —                   |       |
| Other – net                                  |   | 0.2                    |       | 0.2                      |       | 2.5                      |       |
| Effective income tax benefit rate                 |   | (1.3                   | )%         | (4.5                     | )%         | (25.6                    | )%         |

 

Deferredtax assets (liabilities) for 2003 and 2002 consisted of the following:

 
| **(In millions)**                        |   | **Balance at  1/2/04** | ** ** | **Balance at  12/27/02** | ** ** |
|------------------------------------------|--------|------------------------|------------|--------------------------|------------|
| Deferred tax assets                      |   |                   |       |                     |       |
| NOL and tax credit carryforwards         |   | $                      | 201.6      |                     | $          | 57.0 |   |
| Inventory reserves                       |   | 22.2                   |       | 24.5                     |       |
| Accrued liabilities                      |   | 11.6                   |       | 15.1                     |       |
| Deferred compensation plan               |   | 7.9                    |       | 7.6                      |       |
| Deferred employee benefit expenses       |   | 5.0                    |       | 5.7                      |       |
| Fixed assets and depreciation            |   | 10.4                   |       | 0.5                      |       |
| Restructuring accruals                   |   | 36.2                   |       | 44.3                     |       |
| Other                                    |   | 5.8                    |       | 18.2                     |       |
| Gross deferred tax assets                |   | $                      | 300.7      |                     | $          | 172.9 |   |
|                                     |   |                   |       |                     |       |
| Deferred tax liabilities                 |   |                   |       |                     |       |
| Amortizable intangibles                  |   | $                      | (25.3      | )                        | $          | (17.9 | ) |
| Unrealized gain on marketable securities |   | (1.0                   | )          | (3.6                     | )          |
| Other                                    |   | (0.7                   | )          | —                   |       |
| Gross deferred tax liabilities           |   | (27.0                  | )          | (21.5                    | )          |
| Valuation allowance                      |   | (257.4                 | )          | (152.5                   | )          |
| Net deferred tax asset/(liability)       |   | $                      | 16.3       |                     | $          | (1.1 | ) |

 

Thenet deferred income tax asset increased from a liability of $1.1 million atDecember 27, 2002, to an asset of $16.3 million at January 2, 2004. The$17.4 million change in the net deferred tax balance is primarilyattributable to net operating losses in foreign jurisdictions.

 

**Deferred Tax Valuation Allowance**

 

SFAS No. 109, *Accounting for Income Taxes*, requires that avaluation allowance be established when it is more likely than not that all ora portion of a deferred tax asset will not be realized. Prior to December 27,2002, we established valuation allowances only for future tax benefits fromcertain state net operating losses, credits with relatively short carryforwardperiods, and certain foreign net operating losses. At December 27, 2002,we determined it appropriate to establish a full valuation allowance againstour remaining U.S. deferred tax assets. For the year ended January 2, 2004, wecontinued to maintain a full valuation allowance on our U.S. deferred taxassets. Until an appropriate level of profitability is attained, we expect tocontinue to record a full valuation allowance on future U.S. and certainnon-U.S. tax benefits.

 

38

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*Summary of Carryforwards*

 

We have carryforward U.S. federal and statenet operating losses and research and development credits. The value of theseassets increased from $37.7 million as of December 27, 2002, to $174.4 millionas of January 2, 2004. Of this increase, $47.4 million was attributable to the2003 acquisition of Vivace Networks, Inc., and $89.3 million was relatedto 2003 federal and state net operating loss carryforwards and research anddevelopment tax credits. The state net operating loss carryforwards and creditswill expire at various dates between 2004 and 2023, a majority of which willexpire between 2012 and 2023. The federal net operating loss and research anddevelopment tax credit carryforwards will expire at various dates between 2020and 2023.

 

Wehave net operating loss carryforwards relating to certain non-U.S. subsidiariesfor which a full valuation allowance has been previously established. The valueof these assets was $9.4 million at January 2, 2004, compared with $19.3million at December 27, 2002. We also have net operating losses relating toother non-U.S. subsidiaries for which deferred tax assets exist which are notreduced by a valuation allowance. The value of these assets was $11.8 millionat January 2, 2004, compared with zero at December 27, 2002. The non-U.S. netoperating loss carryforwards will expire at various dates between 2004 and2013.

 

Ingeneral, the reversal of a valuation allowance results in an income taxbenefit. However, at January 2, 2004, $65.8 million of the valuation allowanceis attributable to deferred tax assets that if realized, will first reducegoodwill, other intangible assets of acquired subsidiaries, and then income taxexpense.

 

*Investment in Foreign Operations*

 

Deferred U.S. income taxes and foreignwithholding taxes are not provided on the undistributed cumulative earnings offoreign subsidiaries because such earnings are considered to be permanentlyinvested in those operations. The undistributed cumulative earnings of foreignsubsidiaries that are considered permanently invested were $720.5 million atJanuary 2, 2004.

 

*Audits*

 

We are subject to tax examinations andpotential assessments in various jurisdictions. Currently, the Internal RevenueService is examining our federal income tax returns for 1998 through 2000. Wedo not expect the outcome of these examinations to have a material effect onour consolidated results of operations, consolidated financial position, orcash flow.

 

**13. ProductGroup and Geographical Information**

 

We manage our business in one operatingsegment. Consolidated net sales by current product group designations are asfollows:

 
| **(In millions)**                       |   | **2003** |   | **2002** |   | **2001** |   |
|-----------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Optical Networking                      |   | $        | 419.4  |     | $      | 579.1    |   | $ | 1,202.8 |   |
| Next-Gen SDH and Managed Access Systems |   | 276.3    |   | 287.2    |   | 395.6    |   |
| Other Products                          |   | 134.4    |   | 271.5    |   | 262.1    |   |
| Services                                |   | 150.3    |   | 179.2    |   | 339.2    |   |
| **Total**                               |   | $        | 980.4  |     | $      | 1,317.0  |   | $ | 2,199.7 |   |

 

During2003, revenues from a single customer accounted for 21.3% of consolidated netsales. During 2002, revenues from a single customer accounted for 17.4% ofconsolidated net sales, and a second customer accounted for 11.2% ofconsolidated net sales. In 2001, revenues from a single customer accounted for18.4% of consolidated net sales, and a second customer accounted for 10.1% ofconsolidated net sales.

 

Consolidatednet sales by country, based on the location of the customers, are as follows:

 
| **(In millions)**      |   | **2003** |   | **2002** |   | **2001** |   |
|------------------------|--------|----------|--------|----------|--------|----------|--------|
| United States          |   | $        | 588.8  |     | $      | 904.3    |   | $ | 1,679.2 |   |
| Other geographic areas |   | 391.6    |   | 412.7    |   | 520.5    |   |
| **Total**              |   | $        | 980.4  |     | $      | 1,317.0  |   | $ | 2,199.7 |   |

 

Long-livedassets by country are as follows:

 
| **(In millions)**      |   | **2003** |    | **2002** |   |
|------------------------|--------|----------|---------|----------|--------|
| United States          |   | $        | 921.3   |     | $      | 922.0 |   |
| Finland                |   | 119.4    |    | 99.0     |   |
| Denmark                |   | 51.2     |    | 45.1     |   |
| Other geographic areas |   | 16.9     |    | 23.1     |   |
| **Total**              |   | $        | 1,108.8 |     | $      | 1,089.2 |   |

 

**14.Commitments**

 

We have a number of operating lease agreementsprimarily involving office space, buildings and office equipment. These leasesare non-cancelable and expire on various dates through 2012. As of January 2,2004, 

 

39

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future minimum lease commitments undernon-cancelable leases are as follows:

 
| **(In millions)**            |   |   |   |
|------------------------------|--------|--------|--------|
| 2004                         |   | $      | 11.9   |   |
| 2005                         |   | 7.2    |   |
| 2006                         |   | 5.4    |   |
| 2007                         |   | 3.5    |   |
| 2008                         |   | 3.1    |   |
| 2009 and thereafter          |   | 9.8    |   |
| Total minimum lease payments |   | $      | 40.9   |   |

 

Rentalexpense for the years ended January 2, 2004, December 27, 2002, and December28, 2001, was approximately $15.0 million, $16.5 million and$26.5 million, respectively.

 

**15. Earnings Per Share**

 

The following chart sets forth the computationof loss per share:

 
| **(In millions, except per-share  data)**                                                                           |   | **2003** |   | **2002** |   | **2001** |   |
|---------------------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Numerator:                                                                                                          |   |     |   |     |   |     |   |
| Net loss                                                                                                            |   | $        | (241.6 | )        | $      | (313.1   | )      | $ | (182.0 | ) |
| Denominator:                                                                                                        |   |     |   |     |   |     |   |
| Denominator for basic loss per share – weighted-average shares  outstanding                                    |   | 413.1    |   | 411.4    |   | 409.6    |   |
| Effect of dilutive securities:                                                                                      |   |     |   |     |   |     |   |
| Employee stock options and awards                                                                                   |   | —   |   | —   |   | —   |   |
| Denominator for diluted loss per share – adjusted weighted-average  shares outstanding and assumed conversions |   | 413.1    |   | 411.4    |   | 409.6    |   |
| Loss per share, basic and diluted                                                                                   |   | $        | (0.58  | )        | $      | (0.76    | )      | $ | (0.44 | ) |

 

UnderGAAP, dilutive securities are not included in the computation of dilutedearnings per share when a company is in a net loss position.

 

40

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**16.Quarterly Financial Data (unaudited)**

 

Selected quarterly financial data for 2003 and2002 are as follows:

 
| **(In millions, except per-share  data)** |   | **First  Quarter** |   | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |   | **Total** |   |
|-------------------------------------------|--------|--------------------|--------|---------------------|--------|--------------------|--------|---------------------|--------|-----------|--------|
| **2003**                                  |   |               |   |                |   |               |   |                |   |      |   |
| Net sales                                 |   | $                  | 222.5  |                | $      | 234.1              |   | $                   | 244.5  |      | $      | 279.3 |   | $ | 980.4 |   |
| Gross profit                              |   | $                  | 93.5   |                | $      | 44.5               |   | $                   | 93.2   |      | $      | 122.8 |   | $ | 354.0 |   |
| Net loss                                  |   | $                  | (42.9  | )                   | $      | (110.7             | )(1)   | $                   | (64.8  | )(2)      | $      | (23.2 | )(3) | $ | (241.6 | ) |
| Loss per share*                           |   | $                  | (0.10  | )                   | $      | (0.27              | )(1)   | $                   | (0.16  | )(2)      | $      | (0.06 | )(3) | $ | (0.58 | ) |
|                                      |   |               |   |                |   |               |   |                |   |      |   |
| **2002**                                  |   |               |   |                |   |               |   |                |   |      |   |
| Net sales                                 |   | $                  | 371.5  |                | $      | 344.6              |   | $                   | 288.1  |      | $      | 312.8 |   | $ | 1,317.0 |   |
| Gross profit                              |   | $                  | 175.0  |                | $      | 49.4               |   | $                   | 119.0  |      | $      | 143.1 |   | $ | 486.5 |   |
| Net earnings (loss)                       |   | $                  | 5.3    | (4)                 | $      | (142.8             | )(5)   | $                   | (91.1  | )(6)      | $      | (84.5 | )(7) | $ | (313.1 | ) |
| Earnings (loss) per share*                |   | $                  | 0.01   | (4)                 | $      | (0.35              | )(5)   | $                   | (0.22  | )(6)      | $      | (0.21 | )(7) | $ | (0.76 | ) |

 

----

*                 The per share computation for the year is aseparate, annual calculation. Accordingly, the sum of the quarterly per shareamounts do not necessarily equal the per share amounts for the year.

(1)          Net loss and loss per share include $80.4 million pre-tax restructuringand other charges.

(2)          Net loss and loss per share include $47.9 million pre-tax restructuringand other charges.

(3)          Net loss and loss per share include $44.3 million pre-tax restructuringand other charges.

(4)          Net earnings and earnings per share include $5.4 million pre-tax acquiredin-process research and development costs.

(5)          Net loss and loss per share include $219.1 million pre-tax restructuringand other charges.

(6)          Net loss and loss per share include $68.0 million pre-tax restructuringand other charges and a $29.6 million pre-tax loss for the impairment ofcertain equity investments.

(7)          Net loss and loss per share include $18.5 million reversal of pre-taxrestructuring and other charges and a $87.7 million deferred tax valuationallowance.

 

41

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**11-Year Summary of Selected Financial Data (Unaudited)**

 
| **(In millions, except per-share, employee  and stockholder data)**                                         |   | **2003(****4)** | ** ** | **2002(****5)** | ** ** | **2001(****6)** | ** ** | **2000** | ** ** |
|-------------------------------------------------------------------------------------------------------------|--------|-----------------|------------|-----------------|------------|-----------------|------------|----------|------------|
| **Statement  of Earnings Data**                                                                             |   |            |       |            |       |            |       |     |       |
| Net sales                                                                                                   |   | $               | 980.4      |            | $          | 1,317.0         |       | $        | 2,199.7    |   | $ | 3,387.4 |   |
| Gross profit                                                                                                |   | $               | 354.0      |            | $          | 486.5           |       | $        | 763.2      |   | $ | 1,835.4 |   |
| Operating profit (loss)                                                                                     |   | $               | (264.5     | )               | $          | (329.7          | )          | $        | (279.4     | ) | $ | 995.0 |   |
| Earnings (loss) before income taxes and cumulative effect of change in  accounting principle                |   | $               | (244.7     | )               | $          | (327.8          | )          | $        | (244.8     | ) | $ | 1,109.4 |   |
| Earnings (loss) before cumulative effect of change in accounting  principle                                 |   | $               | (241.6     | )               | $          | (313.1          | )          | $        | (182.0     | ) | $ | 760.0 |   |
| Net earnings (loss)                                                                                         |   | $               | (241.6     | )               | $          | (313.1          | )          | $        | (182.0     | ) | $ | 730.8 |   |
| Earnings (loss) per share before cumulative effect of change in  accounting principle, assuming dilution(1) |   | $               | (0.58      | )               | $          | (0.76           | )          | $        | (0.44      | ) | $ | 1.82 |   |
| Earnings (loss) per share, assuming dilution(1)                                                             |   | $               | (0.58      | )               | $          | (0.76           | )          | $        | (0.44      | ) | $ | 1.75 |   |
| Average number of common shares outstanding, assuming dilution(1)                                           |   | 413.1           |       | 411.4           |       | 409.6           |       | 418.4    |       |
| **Balance  Sheet Data**                                                                                     |   |            |       |            |       |            |       |     |       |
| Total assets                                                                                                |   | $               | 2,607.5    |            | $          | 2,705.7         |       | $        | 2,865.8    |   | $ | 3,073.1 |   |
| Total liabilities                                                                                           |   | $               | 388.1      |            | $          | 415.4           |       | $        | 400.2      |   | $ | 445.5 |   |
| Stockholders’ equity                                                                                   |   | $               | 2,219.3    |            | $          | 2,290.3         |       | $        | 2,465.6    |   | $ | 2,627.6 |   |
| **Other  Information**                                                                                      |   |            |       |            |       |            |       |     |       |
| Net cash provided by operating activities                                                                   |   | $               | 149.9      |            | $          | 177.8           |       | $        | 419.3      |   | $ | 426.1 |   |
| Working capital                                                                                             |   | $               | 1,291.1    |            | $          | 1,359.2         |       | $        | 1,625.1    |   | $ | 1,910.0 |   |
| Long-term debt                                                                                              |   | $               | —     |            | $          | —          |       | $        | 3.4        |   | $ | 2.9 |   |
| Research and development expenditures(2)                                                                    |   | $               | 286.1      |            | $          | 340.6           |       | $        | 422.7      |   | $ | 412.4 |   |
| Return on invested capital                                                                                  |   | -16.7           | %          | -14.6           | %          | -12.5           | %          | 51.8     | %          |
| Return on equity                                                                                            |   | -10.7           | %          | -13.2           | %          | -7.1            | %          | 31.3     | %          |
| Stock price at year-end                                                                                     |   | $               | 8.36       |            | $          | 7.43            |       | $        | 15.79      |   | $ | 56.50 |   |
| Price/earnings ratio                                                                                        |   | N/M             |       | N/M             |       | N/M             |       | 32.3     |       |
| Number of employees at year-end                                                                             |   | 3,515           |       | 4,828           |       | 7,334           |       | 8,643    |       |
| Number of stockholders(3)                                                                                   |   | 6,659           |       | 6,397           |       | 5,845           |       | 5,367    |       |

 

----

(1)          Restated to reflect two-for-one stock splits in 1999, 1996, 1995 and1994, and a three-for-two stock split in 1993.

(2)          1996 research and development expenditures do not include acquiredin-process research and development costs of $74.7 million.

(3)          Represents the number of stockholders at the record date for theCompany’s annual meeting of stockholders.

(4)          Includes restructuring and other charges of $172.6 million ($161.4million, after-tax, or $0.39 per diluted share).

(5)          Includes restructuring and other charges, acquired in-process researchand development costs and investment write-downs, of $303.7 million ($296.6million, after-tax, or $0.72 per diluted share).

(6)          Includes restructuring and other charges of $448.6 million ($321.6million, after-tax, or $0.79 per diluted share).

(7)          Not restated for pooling-of-interests merger with SALIX Technologies,Inc., as such amounts are not significant.

(8)          Not restated for pooling-of-interests mergers with SALIX Technologies,Inc., NetCore Systems, Inc., and Coherent Communication Systems Corporation assuch amounts are not significant.

 

42

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| **(In millions, except per-share,  employee  and stockholder data)**                                        |   | **1999** |    | **1998** |   | **1997** |   | **1996** |    | **1995** |   | **1994(****7)** |   | **1993(****8)** |   |
|-------------------------------------------------------------------------------------------------------------|--------|----------|---------|----------|--------|----------|--------|----------|---------|----------|--------|-----------------|--------|-----------------|--------|
| **Statement of Earnings Data**                                                                              |   |     |    |     |   |     |   |     |    |     |   |            |   |            |   |
| Net sales                                                                                                   |   | $        | 2,322.4 |     | $      | 1,706.1  |   | $        | 1,280.9 |     | $      | 925.4           |   | $               | 680.5  |   | $ | 524.7 |   | $ | 320.5 |   |
| Gross profit                                                                                                |   | $        | 1,382.3 |     | $      | 1,000.0  |   | $        | 761.3   |     | $      | 533.4           |   | $               | 376.2  |   | $ | 280.8 |   | $ | 164.3 |   |
| Operating profit (loss)                                                                                     |   | $        | 731.8   |     | $      | 484.4    |   | $        | 379.8   |     | $      | 183.6           |   | $               | 168.8  |   | $ | 106.0 |   | $ | 32.0 |   |
| Earnings (loss) before income taxes and cumulative effect of change in  accounting principle                |   | $        | 802.1   |     | $      | 577.7    |   | $        | 417.2   |     | $      | 190.3           |   | $               | 175.6  |   | $ | 104.2 |   | $ | 35.8 |   |
| Earnings (loss) before cumulative effect of change in accounting  principle                                 |   | $        | 549.7   |     | $      | 391.5    |   | $        | 275.5   |     | $      | 127.6           |   | $               | 123.3  |   | $ | 76.2 |   | $ | 30.5 |   |
| Net earnings (loss)                                                                                         |   | $        | 549.7   |     | $      | 391.5    |   | $        | 275.5   |     | $      | 127.6           |   | $               | 123.3  |   | $ | 76.2 |   | $ | 32.0 |   |
| Earnings (loss) per share before cumulative effect of change in  accounting principle, assuming dilution(1) |   | $        | 1.32    |     | $      | 0.96     |   | $        | 0.69    |     | $      | 0.32            |   | $               | 0.32   |   | $ | 0.20 |   | $ | 0.09 |   |
| Earnings (loss) per share, assuming dilution(1)                                                             |   | $        | 1.32    |     | $      | 0.96     |   | $        | 0.69    |     | $      | 0.32            |   | $               | 0.32   |   | $ | 0.20 |   | $ | 0.09 |   |
| Average number of common shares outstanding, assuming dilution(1)                                           |   | 417.0    |    | 408.9    |   | 401.1    |   | 393.1    |    | 387.6    |   | 362.7           |   | 353.9           |   |
| **Balance Sheet Data**                                                                                      |   |     |    |     |   |     |   |     |    |     |   |            |   |            |   |
| Total assets                                                                                                |   | $        | 2,354.6 |     | $      | 1,651.9  |   | $        | 1,250.1 |     | $      | 786.8           |   | $               | 581.0  |   | $ | 407.4 |   | $ | 328.8 |   |
| Total liabilities                                                                                           |   | $        | 307.1   |     | $      | 247.4    |   | $        | 257.9   |     | $      | 158.2           |   | $               | 127.1  |   | $ | 104.2 |   | $ | 121.8 |   |
| Stockholders’ equity                                                                                   |   | $        | 2,047.5 |     | $      | 1,404.5  |   | $        | 992.2   |     | $      | 628.6           |   | $               | 453.9  |   | $ | 303.2 |   | $ | 207.0 |   |
| **Other Information**                                                                                       |   |     |    |     |   |     |   |     |    |     |   |            |   |            |   |
| Net cash provided by operating activities                                                                   |   | $        | 452.2   |     | $      | 239.3    |   | $        | 219.1   |     | $      | 185.5           |   | $               | 103.0  |   | $ | 114.7 |   | $ | 16.6 |   |
| Working capital                                                                                             |   | $        | 1,511.4 |     | $      | 1,054.9  |   | $        | 685.0   |     | $      | 374.7           |   | $               | 283.9  |   | $ | 148.0 |   | $ | 64.3 |   |
| Long-term debt                                                                                              |   | $        | 9.4     |     | $      | 3.3      |   | $        | 3.1     |     | $      | 2.9             |   | $               | 3.9    |   | $ | 4.9 |   | $ | 2.9 |   |
| Research and development expenditures(2)                                                                    |   | $        | 311.0   |     | $      | 224.1    |   | $        | 171.9   |     | $      | 113.7           |   | $               | 86.5   |   | $ | 68.7 |   | $ | 51.0 |   |
| Return on invested capital                                                                                  |   | 55.3     | %       | 57.4     | %      | 57.3     | %      | 51.6     | %       | 46.6     | %      | 41.0            | %      | 19.8            | %      |
| Return on equity                                                                                            |   | 31.8     | %       | 32.7     | %      | 34.0     | %      | 23.6     | %       | 32.6     | %      | 29.9            | %      | 17.1            | %      |
| Stock price at year-end                                                                                     |   | $        | 64.19   |     | $      | 34.28    |   | $        | 27.38   |     | $      | 19.75           |   | $               | 9.25   |   | $ | 6.97 |   | $ | 2.89 |   |
| Price/earnings ratio                                                                                        |   | 48.6     |    | 35.7     |   | 39.7     |   | 61.7     |    | 28.9     |   | 34.9            |   | 32.1            |   |
| Number of employees at year-end                                                                             |   | 7,068    |    | 5,073    |   | 4,394    |   | 3,418    |    | 2,814    |   | 2,565           |   | 2,370           |   |
| Number of stockholders(3)                                                                                   |   | 5,504    |    | 4,371    |   | 3,725    |   | 3,035    |    | 2,685    |   | 1,832           |   | 1,685           |   |

 

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**TellabsSolutions and Applications**

 
| **Products**                                                     |   | **Examples of Customers**                                                                                                                                                                                                                                                            |   | **Markets**      |   | **Business Benefits**                                                                                                                           |   | **Partners**                                     |   | **Competitors**                                              |
|------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------------|--------|--------------------------------------------------------------|
|                                                             |   |                                                                                                                                                                                                                                                                                 |   |             |   |                                                                                                                                            |   |                                             |   |                                                         |
| **Digital Cross-Connect**                                        |   |                                                                                                                                                                                                                                                                                 |   |             |   |                                                                                                                                            |   |                                             |
| Tellabs®  5320 and Tellabs®5500 digital cross-connects |   | BellSouth, Nextel, Sprint, U.S. Cellular, Verizon                                                                                                                                                                                                                                    |   | NA               |   | Evolves a network for lower operating and capital  costs and quick revenue generation through simple, automated service  provisioning           |   | Walker and Associates, Inc.                      |   | Alcatel, Lucent                                              |
|                                                             |   |                                                                                                                                                                                                                                                                                 |   |             |   |                                                                                                                                            |   |                                             |   |                                                         |
| **Transport Switching and Optical Transport**                    |   |                                                                                                                                                                                                                                                                                 |   |             |   |                                                                                                                                            |
| Tellabs®  5500 NGX transport switch                         |   | Frontier, ITXC, Verizon                                                                                                                                                                                                                                                              |   | NA               |   | Integrates digital cross-connect, transport and data  technology into one cost-effective platform for a seamless next-generation  migration     |   |                                             |   | Alcatel                                                      |
|                                                             |   |                                                                                                                                                                                                                                                                                 |   |             |   |                                                                                                                                            |   |                                             |   |                                                         |
| Tellabs® 6300  managed transport system                     |   | China Unicom, Embratel, Fastlink, Metronet, NII  Holdings, Inc., Saudi Telecom Company, Sonofon, Telekom Malaysia, Telenor,  Telkom SA Ltd., Vodacom (Pty) Ltd.                                                                                                                      |   | EMEA LAC APAC    |   | Carrier-class system that integrates next-generation  Ethernet, SDH and DWDM elements to easily manage the edge and core of the  network        |   | Ericsson, Fibcom, Grintek, Motorola, Nokia, STEC |   | Alcatel, ECI, Huawei, Lucent, Marconi, Nortel,  Siemens, ZTE |
|                                                             |   |                                                                                                                                                                                                                                                                                 |   |             |   |                                                                                                                                            |   |                                             |   |                                                         |
| Tellabs®  6500 transport switch                             |   | Sprint, Verizon                                                                                                                                                                                                                                                                      |   | NA               |   | Broadband cross-connect platform that eliminates the  need for separate overlay networks, reducing costs and floor space                        |   |                                             |   | Alcatel, Ciena, Lucent, Nortel                               |
|                                                             |   |                                                                                                                                                                                                                                                                                 |   |             |   |                                                                                                                                            |   |                                             |   |                                                         |
| Tellabs®  7100 optical transport system                     |   | BellSouth, DTAC, ITXC, Sprint                                                                                                                                                                                                                                                        |   | NA EMEA LAC APAC |   | Simple, cost-effective transport for high-bandwidth  services using Coarse and Dense Wavelength Division Multiplexing technology                |   |                                             |   | Alcatel, Ciena, Lucent, Nortel                               |
|                                                             |   |                                                                                                                                                                                                                                                                                 |   |             |   |                                                                                                                                            |   |                                             |   |                                                         |
| Tellabs®  7120 NGX advanced transport node                  |   | ATX Communications, Centennial PR, Frontier, ITXC,  Metro PCS                                                                                                                                                                                                                        |   | NA               |   | Reduces capital and operational costs as the  smallest, lowest cost next-generation add/drop multiplexer with Ethernet data  capabilities       |   | White Rock Networks                              |   | Alcatel, Cisco, Fujitsu, Lucent, Nortel                      |
|                                                             |   |                                                                                                                                                                                                                                                                                 |   |             |   |                                                                                                                                            |   |                                             |   |                                                         |
| **Managed Access**                                               |   |                                                                                                                                                                                                                                                                                 |   |             |   |                                                                                                                                            |   |                                             |
| Tellabs®  8100 managed access system                        |   | Embratel, Fastlink, Lebanese Ministry of  Telecommunications, NII Holdings, Inc., Orascom Telecom Algeria, Orascom  Telecom Tunisia, Saudi Telecom Company, Telekom Austria AG, Telekom Malaysia,  TeliaSonera, Telkom SA Limited, Telmex, Vodacom (Pty) Ltd., Vodacom South  Africa |   | EMEA LAC APAC    |   | Transports business services and mobile traffic  through a central management system and provides up to 70% savings through  network automation |   | Ericsson, Grintek, Nokia                         |   | Alcatel, Cisco, Lucent, Marconi                              |

 

----

NA = North America

EMEA = Europe, Middle East and Africa

LAC = Latin America and the Caribbean

APAC = Asia Pacific

 

44

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| **Products**                                                           |   | **Examples of Customers**                                                                                                            |   | **Markets**       |   | **Business Benefits**                                                                                                                                                 |   | **Partners** |   | **Competitors**                                        |
|------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------|--------|--------------------------------------------------------|
|                                                                   |   |                                                                                                                                 |   |              |   |                                                                                                                                                                  |   |         |   |                                                   |
| **Data Networking**                                                    |   |                                                                                                                                 |   |              |   |                                                                                                                                                                  |   |         |
| Tellabs® 8600 managed edge  system                                |   | System  generally available in mid-2004                                                                                              |   | EMEA LAC APAC     |   | New  IP/MPLS-based system designed for environments with stringent requirements  for network availability and operational efficiency                                  |   |         |   | Alcatel,  Ciena, Cisco, Juniper, Lucent, Nortel        |
| Tellabs® 8800 intelligent  multi-service routers                  |   | MCI, NTT  Communications                                                                                                             |   | NA EMEA LAC  APAC |   | Integrates  transport, switching and routing capabilities to cost-effectively migrate Frame  Relay, ATM data and Ethernet networks to new profitable IP/MPLS services |   |         |   | Alcatel,  Ciena, Cisco, Juniper, Lucent, Nortel        |
|                                                                   |   |                                                                                                                                 |   |              |   |                                                                                                                                                                  |   |         |   |                                                   |
| **Cable/MSO Networks**                                                 |   |                                                                                                                                 |   |              |   |                                                                                                                                                                  |   |         |
| Tellabs® 2300 telephony  distribution system                      |   | Liwest  Kabelmedien, RCN, Telesystem Tirol                                                                                           |   | NA EMEA LAC  APAC |   | Integrates  delivery of video, voice and data services over a hybrid-fiber coax (cable)  network                                                                      |   |         |   | ADC, Arris                                             |
|                                                                   |   |                                                                                                                                 |   |              |   |                                                                                                                                                                  |   |         |   |                                                   |
| **Voice-Quality Enhancement**                                          |   |                                                                                                                                 |   |              |   |                                                                                                                                                                  |   |         |
| Tellabs® 3000 voice-quality enhancement systems                   |   | Fastlink,  Nextel, Orange Slovensko, a.s., SingTel, Telmex, Telstra, T-Mobile (U.S. and  Germany), Vodafone Omnitel, Zhejiang UNICOM |   | NA EMEA LAC  APAC |   | Echo and  voice quality control, helping digital wireless and long-distance service  providers improve network customer services, call quality and VoIP  performance  |   |         |   | Ditech, NMS                                            |
|                                                                   |   |                                                                                                                                 |   |              |   |                                                                                                                                                                  |   |         |   |                                                   |
| **Tellabs Services**                                                   |   |                                                                                                                                 |   |              |   |                                                                                                                                                                  |   |         |
| Deployment Services, Professional Services,  Support Services Training |   | Embratel,  Nextel, NII Holdings, Inc., Sprint, TeliaSonera, Telmex, Verizon                                                          |   | NA EMEA LAC  APAC |   | Reduces costs,  mitigates risks, optimizes network investments, and helps carriers generate  revenue quickly and efficiently                                          |   |         |   | Alcatel,  Lucent, ADC, Cisco, Juniper, Fujitsu, Nortel |

 

45

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**Informationfor Our Investors**

** **

Ownership Structure and Investor Rights

Stockholder class and voting rights: All Tellabs stockholders areentitled to one vote for each share held. Only stockholders of record as ofFeb. 23, 2004, the record date for the annual meeting determined by the boardof directors, are entitled to receive notice of, to attend and to vote at theannual meeting.

 

Votes cast in person or by proxy at the annual meeting of stockholderswill be tabulated by the inspectors of election appointed for the meeting whodetermine whether a quorum, a majority of the shares entitled to be voted, ispresent.

 

Stockholders owning more than 5% of the company:

AXA Group

Barclays Global Investors

Michael J. Birck

 

Stockholder Logistics

If you have a question for the board of directors, would like to make astockholder proposal or nominate a director for the board, contact Jim Sheehan,Tellabs general counsel, executive vice president and secretary at+1.630.798.8800.

 

For inclusion in the Company’s proxy statement for the Tellabs 2005Annual Meeting of Stockholders, proposals of stockholders must be received byJim Sheehan, Secretary of the Company, no later than November 20, 2004.

 

To nominate one or more directors for consideration at the 2005 annualmeeting, a stockholder must provide notice of the intent to make suchnomination(s) by personal delivery or by mail to the Secretary of the Company,no later than November 20, 2004. The Company’s bylaws set specific requirementsthat such written notice must satisfy. Copies of those requirements will besent to any stockholder upon written request.

 

**Code of ethics, certificate ofincorporation and bylaws**

Tellabs adopted a code of ethics applicable to its officers, directorsand employees. Tellabs’ Integrity Policy, certificate of incorporation andbylaws are available online at tellabs.com/investors.

 

**Important dates for stockholders toknow:**

(Dates subject to change)

 
| **First  Quarter 2004**  |   |                                          |
|--------------------------|--------|-----------------------------------------------|
| Record Date              |   | Monday, February 23                           |
| Earnings Call            |   | Tuesday, April 20 (7:30 a.m. Central time)    |
| Annual Meeting           |   | Thursday, April 22                            |
|                     |   |                                          |
| **Second  Quarter 2004** |   |                                          |
| Earnings Call            |   | Wednesday, July 21 (7:30 a.m. Central time)   |
|                     |   |                                          |
| **Third  Quarter 2004**  |   |                                          |
| Earnings Call            |   | Thursday, October 21 (7:30 a.m. Central time) |

 

46

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We’re here to help you

You can contact Tom Scottino in our Investor Relations Department at+1.630.798.3602. You can also get additional investor information online attellabs.com/investors.

 

Transfer Agent

Computershare Investor Services serves as the stock transfer agent forTellabs. If you need to transfer stock, change ownership, report lost or stolencertificates, or change your address, please contact Computershare InvestorServices at +1.312.360.5389.

 

Requests for information

Additional information is available without charge. For additionalcopies of annual reports, 10-Ks, 10-Qs or other financial information, pleasecontact:

Secretary

Tellabs, Inc.

One Tellabs Center

1415 West Diehl Road

Naperville, IL 60563

U.S.A.

Or visit: sec.gov

 

Stock trading information

Tellabs stock is traded in the United States, listed on the NasdaqStock Market under the symbol TLAB. It appears in most daily newspaper stocktables as Tellabs. Tellabs is a component of the Nasdaq 100 Index and theStandard & Poor’s 500 Index.

 

Annual Meeting

The 2004 Annual Meeting of Stockholders will be held at 2 p.m. Centraltime on Thursday, April 22, 2004, at:

The Signature Room at

Seven Bridges

6440 Double Eagle Drive

Woodridge, IL 60517

U.S.A.

Doors will open at 1 p.m.

 

Internet users can hear a simultaneous live webcast of the annualmeeting at tellabs.com.

 

Electronic voting

As an added convenience, stockholders can vote their proxy by mail orvia the Internet at proxyvote.com.

 

Independent auditors

Ernst & Young LLP,

Chicago, IL U.S.A.

 

The Tellabs Foundation

The Tellabs Foundation supports nonprofit organizations in the priorityareas of education, environment and health. For an annual report on corporateand foundation community activities, contact Meredith Hilt atmeredith.hilt@tellabs.com.

 

Trademarks

All trademarked or registered trademark product names used herein arethe property of Tellabs or one of its affiliates in the United States and/or inother countries. All other product or company names used herein may be theproperty of their respective companies.

 

Worldwide locations

Please visit the “Contact Us” section on tellabs.com for the mostup-to-date, complete information on Tellabs’ global presence.

 

For information:

In Asia Pacific

Phone: +65.6336.7611

Fax: +65.6336.7622

 

In Europe, Middle East and Africa

Phone: +44.870.238.4700

Fax: +44.870.238.4851

 

In Latin America and the Caribbean

Phone: +1.954.839.2800

Fax: +1.954.839.2828

 

In North America

Phone: +1.630.798.8800

Fax: +1.630.798.2000

 

**How to reach us**

One Tellabs Center

1415 West Diehl Road

Naperville, IL 60563 U.S.A.

Phone: +1.630.798.8800

Fax: +1.630.798.2000

tellabs.com

 

 

Report printed entirely on recycled paper.This annual report costs $1.60 per copy, or less than half the industry averageof $3.73 per copy. ©2004 Tellabs, Inc. All rights reserved. Printed in U.S.A.

 

**Common Stock Market Data**

 
|           |   | **2003**  |       | **2002**  |   |
|----------------|--------|-----------|------------|-----------|--------|
|           |   | **High**  |       | **Low**   |   | **High** |   | **Low** |   |
| First Quarter  |   | **9.730** | ** ** | **5.070** |   | 17.470 |   | 10.100 |   |
| Second Quarter |   | **8.740** | ** ** | **5.260** |   | 10.650 |   | 5.540 |   |
| Third Quarter  |   | **8.280** | ** ** | **5.850** |   | 7.640 |   | 4.000 |   |
| Fourth Quarter |   | **8.800** | ** ** | **6.770** |   | 10.110 |   | 4.150 |   |

 

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**Glossary of Technical Terms**

** **

**Access**— The process and systems by which users or devices interact with acommunications network.

 

**Asynchronous Transfer Mode (ATM)** — High speed transmission technology. Ahigh-bandwidth, low-delay, packet-like switching and multiplexing technique.

 

**Backbone** — The main high capacity paths within a communications network.

 

**Bandwidth**— The width or carrying capacity of a communications channel.

 

**Broadband** — A high-bandwidth fiber optic, coaxial or hybrid line with morecapacity than a standard voice-grade phone line, capable of carrying numerousvoice, data and video channels simultaneously.

 

**Carrier-class** — Equipment that’s designed for the telecom service providers, meetingtheir needs for reliability and ease of migration to new technologies.

 

**Connectivity** — Network capability that enables different devices to communicate witheach other.

 

**Data**— Network traffic other than voice.

 

**Dense wavelength division multiplexing (DWDM)** — Technology that splits single opticalsignals on fiber optic cables into several independent wavelengths, or colors, thus expanding the carryingcapacity of fiber optic networks.

 

**Digital**— An alternative to traditional analog communications, digital systemstransport information in the binary 1s and 0s format, like computer code, toimprove clarity and quality.

 

**Digital cross-connect**— A specialized high-speed data channelswitch, which connects transmission paths based on network needs (rather thancall by call). Digital cross-connects manage and route network traffic, andcombine, consolidate and segregate signals to maximize efficiency.

 

**End office/Local exchange** — The switching facility closest to theend-user.

 

**Ethernet** — A data network standard that connects computers, printers,workstations, terminals and servers within the same building, campus ormetropolitan area.

 

**Ethernet-over-SDH/Ethernet-over-SONET** — Industry standards that enable Ethernetdata traffic to be mapped to SDH or SONET networks.

 

**Fiber optic cable**— High-capacity cable that uses laser light traveling along a glassfiber to transmit communications signals.

 

**Frame relay** — Data-oriented switching interface standard that transmits bursts ofdata over wide area networks (WANs).

 

**Gigabit Ethernet** — A high-speed, standardized data format used to implement wide areadata networks.

 

**Internet**— The world’s largest decentralized network of computers and networkservers.

 

**Intranet**— A private computer network based on Internet protocols.

 

**Internet protocol (IP)** — Common name given to a set of protocolsdeveloped to allow cooperating computers to share information across a network.

 

**Layer 2**— The switching or data link portion of the network.

 

**Mobile**— Refers to networks that use radio rather than cables.

 

**Multi-Protocol Label Switching (MPLS)**— A packet switching standard that enablesmultiple traffic types within a data stream to be given levels of priority,implementing quality of service.

 

**Multiservice** — The capability of simultaneously transporting a variety ofcommunications services (e.g., ATM, Ethernet or IP).

 

**Network** — A system of equipment and connections for the transmission of signalsthat carry voice, data and/or video. Networks can be local, such as thosemaintained by providers of local long distance, cable, or wireless telephoneservices, or long-distance, such as those maintained by providers ofconnections and transport between local networks.

 

**Next Generation**— Describes emerging technologies.

 

**Optical transmission**— A technology that transmits signals as lightover fiber optic cable.

 

**Quality of Service**— The ability to ensure integrity of traffic moving across a network,especially important for real-time transmissions.

 

**SDH (synchronous digital hierarchy)** — Transport format for transmittinghigh-speed digital information over fiber optic facilities outside of NorthAmerica, comparable to SONET.

 

**SONET (synchronous optical network)**— Transport format for sending high-speeddigital signals through fiber optics in North America, comparable to SDH.

 

**Switch**— A device that establishes and routes communications paths.

 

**Transport** — The process of moving voice, data or video across communicationsnetworks.

 

**Virtual concatenation** — Technology that combines SONET or SDHchannels to transport data more efficiently and optimize networks.

 

**Virtual Private Network (VPN)** — An connection that enables businesses tosecurely transmit their own voice, data and/or video traffic over a publicnetwork (e.g., owned by a phone company or Internet provider) at a lower costthan a dedicated private network.

 

**Voice-over-Internet Protocol (VoIP)** — A category of hardware and software thatenables people to transmit voice traffic over the Internet.

 

**Voice-quality enhancement** — A technique that isolates and filters outunwanted signals and sounds such as echo and background noise.

 

**Wireline** — Refers to networks that use cables rather than radio.

 

**Wireless** — Refers to networks that use radio rather than cables.

 

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**On the back cover:**Soon Yee Ming and Bryan Tan from Tellabs Asia Pacific Region discussdata strategy with Liyan Wang from Tellabs San Jose.

 

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