ADTRAN Holdings Inc (ADTN) 2004 Q1 法說會逐字稿

Good morning, my name is Chasity and I'll be your conference facilitator today. At this time, I would like to welcome everyone to the ADTRAN first quarter earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. If you would like to ask a question during this time, simply press star one on your telephone keypad. Questions will be taken in the order they are received. If you would like to withdraw your question, press the pound key.

During the course of this conference call, ADTRAN representatives expect to make from forward-looking statements which reflect management's best judgment based on factors currently known; however, these statements involve risks and uncertainties including the successful development and market acceptance of new products, the degree of competition and the market for such products, the product and channel mix, component costs, manufacturing efficiencies and other risks detailed in our annual report on Form 10-K for the year ended December 31, 2003. Such risks and uncertainties could cause actual results to differ materially from those in the forward-looking statements which may be made during this call.

Speaking on today's call from ADTRAN are Mr. Mark Smith, Chairman and Chief Executive Officer; Mr. Howard Thrailkill, President and Chief Operating Officer; and Mr. Jim Matthews, Senior Vice President and Chief Financial Officer. Mr. Smith, you may now begin your conference.

Thank you. Welcome to ADTRAN's first quarter conference call. I assume that everyone has seen our first quarter press release, and I'm obviously pleased to be able to discuss those kind of results today. In fact, it's been five years since our growth rate exceeded the seasonal slowdown we always experience in the first quarter. And that has resulted in sequential quarter-to-quarter growth. The first quarter was also for us a record, in both our revenue and our earnings. A 32% revenue increase and 95% net income increase both year over year, accurately describes the progress at ADTRAN that we've made over the last year.

So obviously we are very pleased to be here this morning and talk to you about our Company and I would like Jim Matthews, our Chief Financial Officer to go over the results with you in detail and also at this time to provide you with some ongoing guidance for the next quarter and for the year. Jim?

Mark, thank you very much and good morning, everyone. As disclosed in the press release, revenue for the first quarter was $114 million, up 32% from $86.2 million in Q1 of 2003. Carrier Networks Division revenues were $78.2 million in Q1 up 35% from $57.8 million in Q1 of 2003. Comparing Q1 '04 to the same period last year, revenue increases in this division occurred across multiple product categories with their larger increases coming from DSLAM, Optical Access, HDSL and M13 multiplexer products as we continue to gain market share in these and other areas.

Enterprise Networks Division revenues were $35.9 million in Q1 up 27% from $28.4 million in Q1 of 2003. Revenue increases in the Enterprise Networks Division occurred across traditional and new markets. For the total Company, systems were $55 million in Q1 2004, up 79% from $30.7 million in Q1 of '03. The growth in systems revenue was a result of increasing new product revenues comprising Total Access DSLAM products and optical access products in NetVanta router ethernet switch and VPN products.

Revenue growth and systems was also the result of increasing sales of Total Access and ATLAS multiplexers, M13 multiplexer products and integrated access devices. The ACSL T-1 product category was $53 million for Q1 of '04 up 11% from $47.6 million in Q1 of '03. Digital business transport total reach was $6 million in Q1 of '04, down from $7.9 million in Q1 of 2003. Revenue from the international sector approximated 4.6% of total revenue. Gross margin was 57.5% of revenue during the first quarter of 2004 compared to 54.6% for Q1 of '03. The increase in gross margin is a result of continuing improvements in manufacturing efficiencies and product cost reductions.

Research and development expenses were $14.8 million in Q1 '04, compared to $14.3 million in Q1 of '03. Selling, general and administrative expenses were $22.3 million for Q1 of '04, compared to $20.2 million in Q1 of '03. The $2.1 million increase in SG&A expense relate to sales and marketing expenses associated with the increase in revenue for the quarter. Other income net of interest expense was $1.8 million in Q1 of 2004 compared to $2.2 million in Q1 of '03. Other income net of interest expense was lower primarily due to lower interest rates.

Our income tax provision rate for the quarter was 32.5%. This represents a 180 basis points increase from the 30.7% net tax provision rate in 2003. This increase is primarily due to our increased level of estimated pre-tax earnings for 2004 compared to 2003 reducing the effect of R&D tax credits and state incentive credits for 2004. Earnings per share assuming dilution for Q1 of '04 were 25 cents compared to 14 cents for Q1 of '03. This reflects a 94% increase in net income for the first quarter of 2004 compared to the same period last year.

From a balance sheet perspective, inventories increased $4.4 million to $44.4 million as we anticipate increasing business activity during the year. The trade accounts receivable increased to $66.7 million. DSOs came in at 53 days, up from 42 days at December 30, '03. The increase in DSOs in Q1 of 2004 compared to Q4 of 2003, relates to the variations in revenue linearity in the two quarters. That is to say revenue increased during the latter half of Q1, as is typical for Q1, and revenue decreased during the latter half of Q4. Net cash provided by operating activities came in at approximately $28 million for the three months ended March 31, 2004. Cash and marketable securities net of debt totalled $352 million at quarter end.

Now we would like to discuss guidance for the second quarter and for the year 2004. As most people know, we are a book-and-ship business, therefore we typically carry very little backlog from quarter to quarter. Considering this factor alone makes the process of providing meaningful guidance extremely difficult; however, we continue to see clear indications of increasing activity levels across our customer base and across our product categories resulting in increasing revenue momentum in both traditional and new markets. Observing these trends with continuing evidence of an improving macro environment, we believe revenues will increase meaningfully this fiscal year.

For the second quarter of 2004, we are guiding revenue to range between $117 million and $120 million. This reflects an increase in revenue for the second quarter of 29% to 33% compared to the same period last year. We are guiding gross margins to be in the 56% to 57% range as they begin to settle towards our 55% target gross margin in subsequent quarters. We are guiding operating expenses for the second quarter to range between 31% and 32% of revenue. Also, we are guiding interest income net of interest expense to be in the range of $1.4 million to $1.5 million.

With an anticipated tax rate of approximately 32.5% for the second quarter, this should result in earnings per share between 24 cents and 26 cents for the quarter. This reflects an increase in net income of approximately 63% to 77% from the second quarter of 2003. For the year 2004, we are guiding revenue to be in the range of $475 million to $485 million. This increases the low end of our revenue guidance by $10 million. This reflects a year-over-over increase in revenue of 20 to 22%.

During the year, we are anticipating continuing increases in revenue reflecting the positive affect of improvements in Enterprise demand due to an improving economic environment, in addition to increasing fraction of new products in new products and continuing market share gains in traditional markets. For the first quarter of 2004, revenues for new markets were a healthy 19% of total revenues. We believe this is a very good opening quarter as we march toward achieving our guidance for new market revenues of 21% to 23% of total revenues for the year.

Products for new markets comprised outside plant and central office DSLAMs, optical access products and our NetVanta range of products comprising, access routers, ethernet switches and VPN products. We anticipate DSLAMs will continue to lead new product revenues in 2004 as we continue to anticipate carriers will deploy significant quantities of outside plant DSLAMs in addition to continuing deployments of central office DSLAMs to meet the demand from an increasing DSL subscriber base.

For the first quarter of 2004, revenue for traditional markets grew 14% from the first quarter of 2003. For the year we guided a net increase in traditional markets revenue over approximately 6.8%. We anticipate net traditional market growth will continue to be led by our HDSL range of products in the Carrier Networks Division and integrated access devices in the Enterprise Networks Division. We are guiding gross margins for the total year to be in the area of 56% as gross margins may settle towards 55% range in the third and fourth quarters as we anticipate price reductions in strategic areas to grow market share.

We are guiding operating expenses for the total year to be in the area of about 31.5% of revenue with other income net of interest expense ranging from 1.2% to 1.3% of revenue. We are guiding pre-tax income to be in the area of about 25.5% of revenue for the year. We are guiding a net tax provision rate of 32.5% for the year. This results in an increase in our guidance for earnings per share from a range of 91 cents to 96 cents to a range of 97 cents to $1. This reflects an increase in net income of approximately 33% to 38% from the year 2003.

Mark, back to you.

Thank you, Jim. From Jim's discussion, you can see that our new products initiatives are providing the growth that we have been anticipating and have been seeing. With revenue growth, however, in our traditional products gaining 14.5% year over year, we now are finally able to add our new product revenue to an increasing rather than a declining base of legacy business. As the macro environment in our marketplace has improved, we believe we stand very, very well to take a competitive advantage at this point in time in our market and find our Company strength to be very well positioned to look forward into the future.

Operator, at this point in time, I think it would be appropriate to start into the question-and-answer session, if you could then have the first question for us.

Thank you. At this time, I would like to remind everyone, in order to ask a question, please press star then the number one on your telephone keypad. If you are using a speaker phone, please pick up your handset before asking your question. Please hold for your first question. Your first question comes from Mark from RBC Capital Markets.

Thank you. Can you just discuss the notion of market share gains. Who are you gaining market share from and how important is it to gain share and does that mean the gross margins can settle to 55% sooner than expected?

Okay, Mark, the market share gains is the way that, with all of our Legacy products, that we have been picking up revenue on a relative basis over the last three years. Since we have a very diversified portfolio of products, then we have to talk about the individual products areas to be able to discuss where these gains come from. The Legacy area, the largest area there, of course, is HDSL. Our major competitor in that is AGC Telecom and we have picked up, of course, market share there over the last few years in significant amounts. In the new product area, as we've discussed before, the major competition that we have in the DSL world is from Alcatel and once again, we have picked up considerable market share there. As you can see when you look at individual products, the market share gains in that particular product tends to be a unique competitor in each individual case.

As far as a competitive nature of our gross margin and our overall profit, as we have a strategy of generating internal growth with market share gains being a major portion of it, this does not truly lead to a significant contraction in margins because when we start, basically start the process, the competitive process, we have a significant cost advantage to begin with. We have said over an extended period of time that our budget, of course, for gross margin is 25, 25.5. As you know we are above that at this point. We feel that we will reduce our pricing at those points in time. To do so would provide us with a strategic advantage allowing us to generate more than normal market share gains. We are not going to do that just for the sake of doing it, however.

As far as the timing on the reduction or potential reduction from current levels down to the 25, 25.5 gross margin, I would at this point in time see no pricing action in the competitive marketplace to lead me to believe this reduction will occur sooner rather than later. I think from what we are seeing in the marketplace that a slow and careful use of the competitive advantage that we have at this time is probably what we're going to see stretching over the next year. I hope that answered your question.

Got it. That's helpful. Thank you, Mark. Thank you, Jim.

Thank you. Your next question comes from the line of Timm Bechter with Legg Mason.

Mark and Jim, good morning. My question has to do with momentum and revenues. Looks like the HDSL T-1 actually went down a little bit sequentially while systems more than made up the difference. Just curious as far as RBOC customer base, in particular, how that looks as far as the systems, the DSL primarily there, I guess, SBC, Qwest in particular if you could talk to those two. And then how does the HDSL market appear to be going in terms of unit growth?

All right, Tim, the thing that you see as we attempted to verbally describe in the first quarter is basically two things going on simultaneously and, of course, we report the net of the two. The first is that we always see in the first quarter seasonal negative factors as far as revenue. Over the years I tend to look at these as having basically two underlying reasons. One is that with the holidays, we just seem to have a dead period as far as bookings and activity in the first two weeks of January, starting the quarter off very weak and never being able to truly recover the loss of those first two weeks.

The second reason for the seasonality as I have seen it over the years is that it's just not logical for people to be installing, for a number of reasons, new telecommunication services in the first quarter at the same rate as they would the rest of the year due to weather factors. One would attempt in moving into a new building or new area. To do that, any time other than the first quarter. If one is a carrier and going to schedule an upgrade to outside plant, to facilities on the outside, once again, it would be logical for these schedules not to be as heavy in the first quarter as they would be other times of the year.

Those are the factors then that have caused, in my opinion, the seasonality to affect, as it certainly did this year, our Legacy products, such as HDSL, bringing those on a sequential basis down from the fourth quarter's run rate to the first quarter. At the same time, however, the internal growth, especially in the new products area, this year was able to overcome those seasonal factors and the strength especially as you pointed out in the DSL area, that that increasing level of activity overcame the seasonal factors, not only for just the systems area, but overcame it enough to drive the entire Company's revenue positive for the quarter rather than negative. Timm, does that help you with that?

That does. If I could follow up a little bit?

You sure can.

Would you say then that Qwest maybe was kind of the kick that made the systems category higher than what it was in the fourth quarter or is it more than that?

It's more than that, Timm. However, there is no question that the sale of our outside plant, DSL system, was a significant factor. It was not, however, the only factor.

I guess the only other follow-up I would have, Mark, would be if indeed, the first couple weeks of the quarter were fairly weak and figuring that all the weeks of this quarter that we are in now are going to not be weak, why can't we have a little bit higher guidance than what you gave?

Because he who tries to predict the future by reading a crystal ball normally gets his feet cut on the broken glass.

A little bit of caution there?

There's a little bit of realistic caution in that what we are projecting is a significant percentage increases, and, yes, we would love to see the numbers turn out higher than, I guess the upper range for the second quarter is $120 million, which if I have my numbers in my head halfway right turns out to be about 5% increase quarter over quarter, good heavens, if we could do that forever, I think we would all jump up and down.

I would agree. Thanks, Mark. I'll let somebody else have it.

Okay.

Thank you. Your next question comes from the line of Todd Koffman with Raymond James.

Thank you. Congratulations on a very good quarter, Mark.

Thank you, Todd.

Just as a follow up on that product question. Are there any remaining undecided large carrier DSLAM opportunities still out there and, if yes, what would the timing of that vendor selection process be?

At this point, Todd, we are shipping the six out of the seven largest carriers, DSLAMs in the United States. We are shipping in high production volumes to five out of the seven. We, quite frankly, see increases from our existing customers of a significant nature across the board from a potential basis. Your question then, of course, goes to the one or two that we are not at this point in time doing DSLAM business. Of course, we're doing a significant amount of other business with.

We think that we have a product offering that places us very, very well to gain significant business in those top-tier carriers that we are currently not selling DSLAMs into. There's no way in the world that I would attempt to predict the timing on a carrier's decision process. I would think that over this year that the attractiveness of our products would give us a very good chance that by the end of the year we would be able to make the statement that we were shipping in high volume production to all seven out of the seven or hopefully, all ten out of the top ten carriers which, obviously would include all four of the regional RBOCs. But exactly the details of when that might occur, I would be hopelessly lost, Todd, trying to estimate.

Thank you.

Thank you. Your next question comes from the line of Eric Buck with Janco Partners.

Good morning, I have two things. First, I was hoping you could give us a little more granularity on the new product contribution in the quarter, either in dollars or percentage of sales and compare that to the fourth quarter stand alone. I know prior you have given us full-year new product in '03 but not in fourth quarter. And if you could talk about that in terms of how much is DSLAM versus the routers and the optical multiplexers.

And, secondly, kind of a broader question in terms of your outside DSLAM product offering. I was wondering if you could describe in detail the application where that product makes particular sense relative to alternative ways of deploying DSL and maybe give us a sense of what percentage of that Telco access lines you think meet those criteria.

Jim, if you'll take the first half of that, I'll take the second.

Sure, Eric. As far as the sequential increase in new products, we are looking at roughly about just over a $7 million sequential increase from Q4 to Q1 in new product revenues. As far as contribution of each of the three areas would no doubt DSLAM had the lead as far as contribution followed again by optical access and by our NetVanta range of products. We actually saw sequential increases from Q4 in all three of those areas.

What was the total in terms of new products in the quarter?

The total for new products was roughly $21.2 million in Q1.

Okay, great. Thanks.

Okay. As far as the outside plant, let me since we have about 150 people on here, let me give you a real brief description of this. What we have there is a product that either can be locally powered or line powered. At this point in time it provides a DSLAM capability that can be located very close to the customer, fed either out of the central office or fed out of a remote terminal, being line powered out of the central office or at a remote terminal or line-powered or being locally powered. It is temperature and environmentally hardened. That says that it can go in fact a pedestal and does not even have to be inside of a remote terminal enclosure.

It can be mounted on a pole, but more normally mounted in a pedestal. It allows a tremendous amount of flexibility in getting the actual DSLAM close to the end customer in environments that otherwise would be difficult or impossible to provide service to an end customer simply because that customer would be too far away from either the central office or from a remote terminal.

So in very general terms, that's the functionality of a outside plant equipment that we are supplying. And off the top of my head, I do not have the numbers involved. In fact, the deployment objectives and techniques are changing as far as some of the priorities. We think changing in our direction, by the way, and so it would be very, very difficult to give you percentages, but offline I would assume we could provide some information for you.

Thank you. Your next question comes from the line of Sanjiv Wadhwani with Piper Jaffray.

Thanks so much. Jim, quick question for you. I'm presuming the slippage you had in DSL from last quarter, most of that shipped this quarter, if you could just sort of give an update over there. And then second question, is it fair to assume that DSL sort of remains about greater than 50% of your new product revenues, any sort of ballpark of that revenue stream would be helpful. Thanks.

Sanjiv, the second part of your question, yes, I would say is just greater than 50% of overall. Also in terms of the issue discussed in Q4, that is very much behind us.

Got it. Thanks so much.

Thank you. Your next question comes from the line of Marcus Kupferschmidt with Lehman Brothers.

Hey, good morning, guys. Just a couple of questions just to make sure I understand the guidance a little bit better. Just to understand, I know that obviously, there's a lot of book and ship and that makes visibility very tough to predict. But in terms of the June quarter guidance, should we assume you're kind of optimistic that we get some improvement in the kind of traditional products and then we kind of continue to expect momentum in the new products? Or is there any base assumptions we should think in terms of how you get to the June guidance? And I have one follow-up.

No, I think that's something that the underlying base improves and we are able to then continue to add new product growth on top of it. That's correct.

Okay, great. And then, I guess in terms of looking for the new, is there anything where you temper some of your outlook because there was a bit of, we'll call it catch-up in the March quarter because there were some delays from the December quarter in terms of some shipments to one customer? Is there anything we should think about there?

I don't think so, because as we discussed before, the single order that was moved over from fourth to first was relatively small and did not have that big of a material effect. So, no, I think that what we saw in the first quarter was just underlying strength that was strong enough to overcome the normal seasonality that we saw in the first quarter in a number of areas.

Very encouraging. And I just had one other additional question just in terms of talking about strategic pricing to try and win market share. Should we assume that ADTRAN engaged in any of this behavior during this past March quarter or is that something where it's really looking to do much more in the second half as assumed in the guidance?

Not really. In the first quarter what we always have is a significant number of long-term contracts that human nature being what it is, price changes that are built and these price changes are always a reduction in price that are built into these long-term contracts are usually triggered on the 1st of January. And so what we have, as far as talking about the changes in gross margin, is we are continually in a cost reduction campaign at ADTRAN to reduce our costs and then to pass those costs on to our customers. As is always the case, the completion of a cost reduction cycle on any one product does not always match exactly with the RFQ cycle or with a competitive bidding cycle for that product with our customers. The opportunity, therefore, that we have at this point is when an RFQ or a bidding cycle comes to us that may be two or three or four months prior to our having available the next generation of cost-reduced products available.

It allows us to simply price down the learning curve knowing full well that in three months that we will have a new generation at a lower cost to us which will match our overall Company objectives, and that really is the best way in my opinion for you to look at our statements that we would use in a strategic manner, the advantage that we have of being slightly above our corporate goals in gross margins to aid us in the competitive atmosphere in the future. It allows us to forward price when we have a known future cost reduction coming and not feel bad or not be in a squeeze on profits by doing that. Does that help the philosophical concept of what I'm talking about?

Yeah, this is very helpful and I guess as you talk to your engineering team you constantly keep them busy always thinking about additional cost reductions?

Of course. Of course. And it is obvious that their successful conclusion of cost reductions and a bidding cycle doesn't always coincide optimally. One would wish they did, but they don't. And so it just gives us flexibility in that pricing.

Great. Thanks very much. Very helpful.

Thank you. Your next question comes from the line of Bill Choi with Kaufman Brothers.

Thank you. Good morning. I'm wondering, Jim, if you could provide some color on linearity of sales and orders in the quarter and whether your guidance which is indicating 2.6% to 5% sequential revenue growth is assuming kind of flat linearity from the March month.

Jim?

Sure, the March quarter, Bill, as you know is typically more back-end loaded than others. Again, given the reasons that Mark explained earlier in the call. So January was low and March was higher. In terms of the second quarter, and really the other quarters within the fiscal year, month-to-month is pretty much random as far as linearity. But never to the point of how the March quarter is in terms of being more backend loaded. Hopefully that answers your question, Bill.

It kind of does. Is there any percentage you can put into what the March quarter looked like?

I actually don't have that before me, Bill, no.

Okay. Just another quick question. In terms of lead time, your ability to deliver on an order, typically for your mature products like T-1, I guess is seven days, can you give something comparable for the newer products including DSLAMs and optical products?

Mark, would you like for me to respond to that?

Yeah, why don't you.

Okay. Bill, we try to stick to the same range of 7 to 10 days for all of our products. As we gain more experience in terms of order flow, we can better predict what will happen in the near term and plan our supply chain accordingly. We are always focused on maintaining that perhaps pretty much worst case lead time of 7 to 10 days.

That is definitely true with the exception of the brand new products that are entering the marketplace for the first time.

The DSLAMs, are they also manufactured in your Huntsville, Alabama or are they shipped from Mexico or China?

Both.

Yes.

So from, in all locations?

Primarily either in Huntsville or in China.

Okay. Thanks.

Thank you. Your next question comes from the line of Nikos Theodosopoulos with UBS.

Hi, a couple of quick questions. You mentioned inventory went up sequentially. What product categories was that in?

Nikos, it was primarily in DSLAMs.

Primarily in DSLAMs. Okay. And do you have the 10% customers in the quarter?

Yes, we do. SBC, 22%; Verizon, 16%; Sprint, 15%.

Okay. And, Mark, a question for you. It's been about a year, give or take, on your Enterprise initiative with an Advanta product offering and I see your adding to that product portfolio recently with new products, how would you characterize your success? How would you grade yourself in this initiative right now? Are you happy with it or not happy? What are you looking to do there over the next year? Thank you.

Nikos, I would characterize it as an entry that's normal for us as far as entering a new product area. It takes us historically about a year in the Enterprise space for us to be able to get a new product out into the market established. This is a significant departure from some of the wider network-only type of products we had in the past is taking a little bit longer. Plus what this entry requires, as any new space requires, it's not a single product that we introduced, as you stated over a year ago, but it takes a full line of products to be able to supply multiple needs of your customers in a product space.

So I would say that, and I don't know how to grade, but I would say progress in the area is going along about as we had suspected, we are seeing sequential growth in a lot of our EN activities. In fact EN in general, we saw seasonality factors we've been talking about in the NetVanta area, that product overcame -- its underlying strength overcame the seasonality. Also it was up and the new products that we introduced, we feel we have some very, very unique products.

We're extremely happy and anticipating the combo which simply puts a router and a switch in the same chassis to where no longer do you have to have multiple boxes if you're going to do it economically for multiple vendors and routers and switches, you can do it all in the same chassis. So I'm very happy with the progress we are making, and I look at us gaining momentum significantly as we go through the next year in that product area.

Okay. And just one last quick one. Back on the DSLAM side. Do you have a feel for what percentage of your business right now is shipping out lightly filled chassis, versus a recurring line card buildout on your install base? Is it still more chasis oriented or is the line card business now dominating the business? Do you have a feel for that?

Nikos, no, I don't. When we send out the chassis, I think the average is 30-35%. That's about right, isn't it, Jim?

Yes, it is. And we are beginning and had been receiving orders for additional line cards.

Okay. Thank you.

Thank you. Your next question comes from the line of Michael Perica with Brean Murray.

Thank you. Quick question, Mark, regarding the optical Access products. How many of the seven largest carriers are you shipping that product to? I know you mentioned six or seven on the DSLAM side. And second question for Jim real quick, I apologize if you already mentioned this in prepared remarks, what was the combination from Sealec [ph] in the quarter? Thanks.

On the optical question, to be honest with you, I don't know. But if you would check with Tom Stanton, I'm sure he could give you an answer to that, but I just don't have that information.

Will do. Thanks.

Michael, on your Sealec [ph] question for the first quarter, we were at approximately 15%.

And what is that compared to year ago quarter, if you have that quick?

Oh, goodness. Michael, I think it was higher. I don't have that before me.

Okay.

Versus the fourth quarter, though, we were at between 16% and 17%.

Excellent. Thank you.

Thank you. Your next question comes from the line of Joe Noel with Pacific Growth Equity.

Hi, guys. You might have covered this already but I was hoping you can get a little more specific on it. On the high density CO side DSLAMs, can you review where you are as far as trials and installations are concerned?

Once again, I think you'd be better off to talk to Tom Stanton on that offline, in that we are making significant progress, but I hate to try to answer that question without the latest information for you.

Great. Okay, I'll check with him. Thanks.

Thank you. Your next question comes from the line of Tina Sockolow with Buckingham Research.

Thank you, that's Gina. Two questions. First, quickly, can you tell us why the deferred tax went down, the net deferred tax long and short term, on the balance sheet went down sequentially. And I have another question.

Jim?

We did have and perhaps you are talking in terms of receivables or payables, Gina?

The received asset, the deferred tax asset went down $9 million and then the payables went down $1.5 million, so the net.

Right, right. It went down -- well, we were in, before entering the quarter, we were in a significant net receivable position on taxes. That was basically recovered in the first quarter in terms of a refund. So in essence we actually overpaid a bit in terms of deposits last year and got the refund in first quarter.

Okay. So it's nothing to do with R&D tax credits or anything like that?

No. No.

Okay, thanks. And then the other question is, it seems that there's an increasing software content on your new products, VPN securities from NetVanta, does this improve the gross margins or does this help offset your ability to absorb lower pricing to gain market share or is there some other play that's going on?

In general, what it does is that it helps in the gross margin error. I keep telling our people in engineering that so much of the development activity is truly in software content and we have well over half of our engineering resources working in software, firmware or in that general area of development. And I keep telling you that's where our engineering and development activity is, but when we introduce a product, it's the hardware that we really sell. And so, therefore, the time and effort that we put in bringing our hardware costs down is where, over an extended period of time, that we really get the advantage in our cost of sales versus our competitor that may not spend as much time in the hardware area to bring costs down as we would.

Uh-huh.

So the higher software content makes the general product category tend to have higher gross margins for the product. Our efforts to bring down our hardware costs is the effort that is enabling us, I believe, over a long period of time, to have excellent gross margins as well as to have very, very attractive selling prices.

So as the mix of new products was higher, software and feature content improved. If you come out with a new product, say, that has IP packet processing and optical interface, more than a switch, a 2.5 switch, would this be also, is this feasible, first of all, and if so, would this be improving the gross margin or would that have a low volume issue at first and then have a software?

The answer to both your questions is that, yes, we would be looking at doing this. And, yes, these types of products would have the effect of increasing gross margins. And with the exception of very, very front-end type of expediting costs, then our new products usually generate even in the lower volumes that you see to start with, they usually generate higher gross margins.

In the first quarter, we were hit with some expediting charges on some of our new product shipments in the form of airfreight coming in from the Orient rather than coming in by boat, and that was a significant cost difference, obviously. Those are the kinds of additional costs that we see normally on a new product that comes to market. However, the newer product just by definition is normally more cost-effective for us to produce, and after we get over this very, very front-end type of expense, we normally see higher gross margins on the new ones than we do on the older Legacy products.

So as you ship the manufacturing, you design a manufacturing and bring the prototype, the on prototype stage over here for manufacturing, that's the expediting charges?

No, what it amounts to is that the first shipments of a new product, as you change from one generation to the next or as you come out with a new product, that is where your schedule is being pushed absolutely the most as you have engineering changes and engineering still involved with the product itself. And those are where the brand new products, that is where you end up usually being hit with what I call expediting charges of which freight has become a significant portion.

Okay. Thank you. And nice quarter.

Okay. Thank you.

Thank you. Your next question comes from the line of Simon Leopold with Morgan Keegan.

Thank you. I have a handful of hopefully quick easy questions. First on the NetVanta line, the switches, routers, firewall and such, have you broken through the milestone of 5% of sales for the quarter. Second question is regarding the Opti-3 and MX products, how much of the revenue in the quarter is concentrated in a large or two large customers. And the final one I have is regarding the DSL opportunities and your guidance. There are a couple of big RBOC, RFPs out there for line-powered DSL and fiber-fed DSL for reaching deeper into the network, and I'm just trying to get a sense of how much of those opportunities are baked into your guidance and how much of your guidance is on existing contracts? Thanks a lot.

Okay. I'll answer your first and third and the second, I don't know. The first, no. We have not reached the 5% of revenue level with the NetVanta line, but we are absolutely headed in that direction. And once again as we answer a different question, we are pleased with the progress we are making. The Opti-3, the breakout of those sales between customers, there is a lot of multiple customers in there. The percentages I don't have unless, Jim, you have.

I don't have those either, Mark.

The DSL, we do not have in our guidance any particular order or any particular customer being added, we think that we'll have a continuing increase in both customers and in business, but there's no one large opportunity out there that we have included in our guidance. And one of the things in relationship to these opportunities that are always out there and, yes, they are out there now, is that it's a whole lot easier to classify them where you might think that you stand, than it is to classify them as to when you think that any new business might actually get into the manufacturing cycle. That is a very significant delta that is extremely difficult to predict is the timing.

Mark, to understand that a little bit more, when you look at your forecasting of this DSL opportunity, is it based on sort of a pipeline analysis and expected values? Is that a fair way to think about it?

It is not based on pipeline as far as backlog because we basically have none. It is based on anticipated revenue generation from existing customers and a general feel for whether new customers are coming into the particular area or whether you already have such a market share that that's not a significant portion of it. But you're just, you're not in a position and it's not a good idea usually to attempt to add into your guidance or your backlog calculations a new order that you have not been awarded much less try to anticipate when that order would actually turn into fruition.

Okay. Thank you very much.

Thank you. Your next question comes from the line of John Anthony with Fulcrum.

Good morning. A few quick questions. Is there any way to quantify, going back to a previous question, how much of the upside in Q1 on DSLAMs came from organic growth of DSL subs versus just a general buildout of DSL capacity?

DSL subs, you've lost me.

In other words, how much of your Q1 strength in DSLAMs came from the carriers just building out capacity to meet their milestones versus a possible delta in subscriber growth from the fourth quarter to the first quarter of DSL net adds?

That would be very, very difficult, John. Now I understand subs. Very, very difficult to try to take the business we have and quantify it in relationship to the motives as to why it was purchased.

Okay.

I just don't know. I just don't have even a feel for that, John.

Is there a sense, could you quantify it relative to your guidance for the full year, how much of that you expect to be -- how much of your guidance in your conviction of your DSLAM, the opportunity for the DSLAM do you think is going to be related to actual growth in DSL subscribers this year?

I think that those products like our outside plant products and like the smaller DSLAMs that are used in remote terminals, that you can logically say those are being built-out network to be able to reach new subscribers, that our larger DSLAMs going into COs, that in that case it is both new subscriber increases along with buildouts to smaller seals, but there I would think that the overall might be tilted towards the subscriber growth. In all cases, adds, and this is where we really don't know, adds to existing hardware would be due to subscriber growth.

Okay. Would you also be willing to comment a little bit more about what your expectations are for international growth this year?

Howard?

Mark, that's very difficult to predict. What we've been concentrating on is to be putting into place our access shelves. We currently have our shelves in about a dozen countries world wide. Most of them are installed with fewer line cards than we experienced domestically. So we're seeing a mix of both new customers and additions for existing customers. We're still in a cycle where we're doing a lot of testing and early product acceptance with these kinds of products. So it's very difficult to predict how fast this market is going to grow.

Howard, I think we spent domestically at least two or three or four years pushing our chassis just like you're talking about that we've been accomplishing on the international basis into the domestic network. And then after a period of time, all of that effort started to really show fruits in increased market share first with HDSL and then using the same chassis increased market share or entering into the DSL market. And I think that what we're doing internationally is following the same identical game plan as what we did domestically to get ourselves embedded and to then start generating the revenue increases that came from all the initial work.

Actually, we were seeing that same kind of thing internationally. I would comment further that we are seeing both TDM and ATM installations, but more recently we're starting to do our first IP deployments out of the shelf, so kind of some interesting prospects in this area.

What about NetVanta internationally?

It's in the early stages, I think it's way too early to say. We've got a lot of interest. I just got back from overseas myself on a big NetVanta application. So I'm encouraged but it's way early in the game for making predictions.

Operator, I think we'll take one more question. We've just about run out of time.

Okay. Your final question from the line of Andy Schopick with Nutmeg Securities.

I had already given up. Thank you very much. Mark, I'm going to ask you if you could describe or characterize, compare, perhaps the opportunity for the Company with respect to SBC and Verizon. How or in what areas does that opportunity kind of differ for the Company?

Andy, we for obvious reasons have a policy of not commenting on specific customers. Just something that's not a good idea and it's something our customers frown on and for obvious reasons. They'd like to make their own press announcements and not have us do it. About the only thing I can say and be happy to is both SBC and Verizon are and have been very, very good customers of ADTRAN. We look to a future with both of them as being very long-term, valuable customers.

You've proven that over the years.

Jim pointed out they're number one and number two.

Sure.

You will see in any one product area that as we introduce a new product, and it makes no difference what that is, on the carrier side, that we're not going to more than likely be able to introduce that in both of those accounts simultaneously. That we will win, for example, a DSL contract with one and an Opti-3 contract with the other, or in the past an HDSL with one and not the other. However, if you look at the situation over an extended period of time, we like to think that with time we end up supplying our main corporate products to both of those accounts. And I think that that is obvious for them to end up being our number one and number two account.

Okay, Mark. Can I ask Jim a couple of quick questions?

Sure.

Jim, I was reviewing your 10-K a couple of weeks ago so I want to ask you a couple of things from the K. I noticed that under contractual obligations you have purchase obligations of about $28 million for this year. Haven't seen that before. Does that relate to outsourcing or contract manufacturers?

Somewhat, and that's nothing out of the norm, Andy. It's part of a new disclosure requirement, but a part of our normal purchase order commitment process.

Okay. Also with respect to reserves and provisions, I notice that there was a reduction, full-year reduction in the inventory reserve of about $1.3 million, which I assume flowed through the cost of goods sold or back into gross margin last year, were there any recoveries of previous reserved inventory in this quarter?

No, there weren't, Andy. What our policy is is that we look at our reserve from month-to-month and quarter-to-quarter and reassess the need for adjustment.

Sure.

Also for month-to-month and quarter-to-quarter we identify inventory that is obsolete and we scrap it. And, I don't recall the number, but the number that we wrote off in terms of scrap was well in excess of that number for the year.

But there was a reduction in your reserve provision.

Yes.

Also, there was a significant reduction in the inventory.

There was a reduction in our inventory as well.

Any comment in general about the policy for increased sales, allowances or bad debt reserves this year in relation to increased systems business and reliance on our resellers, distributors, et cetera?

Well, we value our reserve for bad debt, if I'm answering your question, on a specific identification basis. We review that again on a monthly basis and make the necessary adjustments. We don't anticipate any further adjustments at least here in the near term.

How about sales allowances in general?

Sales allowances in terms of?

In terms of sales through third parties.

I'm not quite sure what the question is. Is it in regards to potential returns?

Yes.

We currently have agreements with our customers that substantially restrict returns. On occasion we do allow returns from a stock balancing approach with our distributors, but at the same time we require offsetting orders.

Okay.

And that's how we maintain our revenue recognition.

Thanks.

All right. Andy, thank you. And I'd like to thank everybody. We've gone now about ten minutes past our normal one hour, but we had quite a few people on today and a significant number of very good questions we were happy to answer. And so once again I'd like to thank everybody for the time that you have spent keeping up to date on the progress of ADTRAN. We appreciate your interest in our company. We look forward to any of you that we will see tomorrow at our stock holders meeting and we also look forward to our conference call this time next quarter. Until then, we thank you very much.

Thank you for participating in today's conference. You may now disconnect.