ADTRAN Holdings Inc (ADTN) 2004 Q3 法說會逐字稿

Good morning, my name is Michelle, and I will be your conference facilitator today. At this time I would like to welcome everyone to the ADTRAN third 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 key pad. Questions will be taken in the order they are received. If you would like to withdraw your question, press the pound key. Thank you.

During the course of this conference call, ADTRAN representatives expect to make forward-looking statements which reflects 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 in 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 begin your conference.

Thank you, Michelle. I would also like to welcome everyone to ADTRAN's third quarter conference call. As you have probably seen from our press release, although our revenue was up from the prior are years, the revenue for the third quarter was 115.2 million, down from 120.6 million in the second quarter. As we entered the month of September, our quarterly shipments were well ahead of those of the prior quarter. Unfortunately, however, the booking rate in September was well below the prior quarter's equivalent number, which resulted in the overall quarter revenue short fall. Our gross profit for the quarter improved 17 basis points over the second quarter. This was even with the reduced shipping level. Operating expense increased $1.2 million. This was due to testing and OSMINE expenses, increasing a full 2.1 million. The additional expense was due to an increase in new product introductions, and product modifications, especially to support new contract wins. The Company, as usual, continues to gain market share across our diverse product line. At this time, I would like to ask Jim Matthews, our CFO, to provide us with details of the financial information, and especially guidance for the next quarter and the year. Jim?

Thank you, Mark. And good morning, everyone. As disclosed in the press release, revenue for the third quarter was $115.3 million, up from $106.2 million in Q3 of '03, but down from $120.6 million from Q2 of '04. Carrier Networks division revenues were $82.5 million in Q3, up 12% from $73.6 million in Q3 of '03. And comparing Q3 of '04 to the same period last year, HDSL/T1 revenues increased 23%. Enterprise Networks division revenues were $32.8 million in Q3, compared to $32.6 million in Q3 of '03. During the quarter we continued to see increasing revenues from the Company's NetVanta products, partially offset by a decline in traditional products revenue. For the total company, the HDSL/T1 product category revenue was $56.4 million for Q3 of '04, up 23% from 50 -- from $45.9 million in Q3 of '03. Digital Business Transport total reach was $5.3 million in Q3 of '04, down from $7.1 million in Q3 of '03. Systems revenue was $53.5 million in Q3 of '04, up from $53.3 million in Q3 of '03. The slight growth in Systems revenue was a result of increasing new products revenue, partially offset by a decline in traditional products revenue. New product revenues comprised Total Access DSLAM product, Optical Access products, and NetVanta router ethernet switch and VPN products.

Revenues for the international sector for Q2 of '04 was approximately 5.9% of total revenues. Gross margin was 58% of revenue during the third quarter of '04. Compared to 55.5% for Q3 of '03. The increase in gross margin is the result of continuing improvements in manufacturing efficiencies and product cost reductions. Research and development expenses were $18.9 million in Q3 of '04, compared to $15 million in Q3 of '03. A significant portion of this increase over last year relates to Telcordia expenses for Optical access products and an acceleration of Telcordia expenses related to recent DSLAM successes. Selling, general, and administrative expenses were $22.2 million for Q3 of '04, compared to 20.6 million for Q3 of '03. The 1.6 million increase in SG&A expenses relate primarily to expenses associated with the increase in revenue. Other income net of interest expense was $1.4 million in Q3 of '04, compared to 2.4 million in Q3 of '03. The decrease was due to lower interest income earned from lower cash and investment balances, the lower cash and investment balances were a result of share repurchases. Also, last year's other income balance included a cash settlement payment from a foreign customer. Our estimated income tax provision rate for the year through September is now 32.1%, compared to an estimated 32.5% for the first 6 months of 2004. The change in our estimated income tax provision rate for the year was in large part related to firming up 12-month estimates based on actuals to date. These adjustments in the 2004 tax rate resulted in an income tax provision rate of 31.2% for the third quarter. Earnings per share, assuming dilution, for Q3 of '04 were 23 cents, compared to 21 cents for Q3 of '03.

From a balance sheet perspective, inventories held steady. From the prior quarter at about $44 million. Trade accounts receivable decreased $5.3 million to $64.4 million. DSOs came in at 51 days, down from 53 days at the end of the second quarter. Net cash provided by operating activities came in at approximately $19 million for the 3 months ended September 30, 2004. Cash and marketable securities net of debt totaled $289 million, at quarter end, after repurchasing 2.3 million shares of common stock during the quarter for $57.8 million, and paying $6.3 million of dividends. A balance of 1.5 million shares for repurchase remain on the 4 million share repurchase program announced last April.

Now, we would like to discuss guidance for the fourth quarter and for the year 2004. As most of you know, we are a book and ship business, therefore we typically carry very little backlog from quarter to quarter. This factor makes the process of providing meaningful guidance extremely difficult. We are guiding revenue for the fourth quarter of 2004 to range between $115 million and $120 million. We are guiding gross margins to the quarter -- for the quarter to range -- to the range of 57.5% to 58%. We are guiding operating expenses for the third quarter to a range -- to a range of 34% to 35% of revenue, as we anticipate fourth quarter research and development expenditures will be similar in amounts to third quarter levels, due to continued Telcordia expenses for Optical access products and accelerated Telcordia expenses for recent DSLAM successes. This should result in earnings per share between 24 cents and 26 cents for the fourth quarter. For the year, this would translate into revenue guidance ranging between 465 million and $470 million. This reflects a year-over-year increase in revenue of 17 to 19%. For the first 9 months of 2004, revenues for new products were 19% of total revenues. For the year, we are anticipating new product revenues at around 19% of total revenue. New products again comprised outside plant and central office DSLAMs, Optical access products and our NetVanta range of products. We anticipate DSLAMs will continue to lead new product revenues in the fourth quarter, and we anticipate year over year growth in traditional products for the year 2004 to be around 10%, and new products to be around 72%. We are guiding gross margins for the year to be in the area of about 57.5%. We are guiding operating expenses for the total year to be in the area of about 34% of revenue, with other income of -- net of interest expense to be around the range of 1.4% of revenue. We are guiding pre-tax income to be in the area of about 25.2% of revenue for the year. This results in guidance for earnings per share, for the year, of 98 cents to $1.00, and this reflects an increase in net income of approximately 30% to 32% compared to the year 2003. Mark, back to you.

Thank you, Jim. At this time I'd be happy to answer any questions that anyone might have. And Michelle, if you will start the question and answer session, I'd appreciate it.

Thank you. At this time, I would like to remind everyone, in order to ask a question, please press the star one on your telephone key pad. 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 the line of DeVic Area [ph] with Merrill Lynch.

Good morning. The main question I have is on your traditional business, especially the integrated access devices, I would assume that you would have a fairly good handle on that business when you provided guidance in the previous quarter. So I'm curious as to what would you attribute -- what was the weakness -- what do you attribute weakness to in that IAD business and do you so he that weakness as a trend going forward? Thanks.

Okay. Let me start with the end of that. We certainly don't see it as a trend going forward, that's for sure, because during the quarter, we picked up a couple of very significant new customers, increasing our market share in that area even further. I think that when we look at the third quarter, that we see basically two things there, that we had a short fall in a particular customer due to a unique circumstance with that customer, that had no effect whatever as far as our involvement. We also had a timing situation where we think that we had just a lower booking in September for whatever reason, that some of the bookings were probably pushed into the fourth quarter. At this point in time, it is still too early for us to be assured of that. Because we've only -- we've only had one week. But our overall belief is that our market share is increasing still, and the market on a overall basis, maybe not on a week to week basis, but certainly on an overall basis is also increasing.

And Mark, last question is, ADSL 2+. Do you estimate that to be, you know, -- that to dominate the sale of DSL ports going forward, and is there --?

I think there's going to be a transition there, in that you're not going to see all of the -- all of our customers desire or want ADSL 2+ to begin with. Our position with ADSL 2 is that we started shipping that in the third quarter, but in addition to shipping that, what we basically have is a complete product line of ADSL products that is our intent to, as the transition occurs, to offer both HDSL and also HDSL 2+ to our customer base. And so we have started shipping the outside plant 1100 series with ADSL 2+. We've started shipping our 1200 series product, that go into the remote cabinets, in remote terminals, with ADSL+. We have our small and medium size DSLAMs for small and medium-sized COs, excuse me, these are under test and evaluation at this time. We anticipate starting to ship to selected customers that want us to switch to the 2+ during this quarter. Our HDX series of DSLAMs, which is for the larger COs, likewise to the 3,000 series, is under evaluation with HDSL 2+. These products will be able to be shipped in the fourth quarter to those customers that wish to be able to switch over to HDSL 2+. To answer your question about the transition, I think that is going to be the desire on a customer by customer basis. And I am sure that if we look out a period of time, and I would hate to tell you whether that would be 3, 6, or 12 months, that we will see the majority of HDSL probably in the 2+ variety, but I think it is going to be an orderly transition, and it's one that with the actions that I've described to you, I think that ADTRAN is leading. And I apologize, I cut you off in the last of that sentence, did you have another --

Yeah, I was just curious to know, Mark, if are you seeing so much momentum in DSLAM, then why is the percentage of new product as a function of total sales still at 19% for the whole year and --

We have --

-- 19% for nine months?

We explained, I believe, in our press releases, both the first and the second, that part of the short fall of the third quarter was associated with DSLAMs. And that it was associated with not so much the ADSL 2+ as it was moving from a 24 port to a 48 port outside plant box. Many of our customers were waiting for and looking for our delivery to start on a 48 port outside plant. This impacted in the third quarter obviously the outside plant DSL. In addition to that, DSL is far more lumpy than many of the other product lines that we have. And the reason for that is that we have not diversified our customer base as completely with the DSL DSLAMs due to the length of time that we've had it on the market. As you may be aware, we have some DSLAMs win -- DSLAM wins. That is one of the reasons for our increase in Telcordia OSMINE expenses that we don't anticipate will actually start real volume production until the very end of the year or the start of next year. So as we diversify our customer base, the lumpiness in the DSLAM area is going to improve significantly, and so when you take the lumpiness that we saw, that we don't attribute to anything other than just the fact that it was lumpy in the third quarter, coupled with some of our customers, waiting on the 48 port OSP, it resulted, as we said, in a lowering of the DSLAM revenue for the fourth quarter from what was anticipated. That, of course, would affect the new product percentages and in fact bring them down to the 19% that you quoted.

Thank you.

Next question?

Your next question comes from the line of Rick Church of Unterberg, Towbin.

Thanks, and good morning. Mark, can you just, just to elaborate, with regards to the guidance that you've given for flat to slightly up, in a typical seasonally strong fourth quarter, can you talk about, is that driven partly by this transition to 2+, maybe on the higher end the 3000 and the HDX systems? Or is it by IAD? Or what's actually driving the guidance?

The thing that is driving the guidance more than anything else is the -- the experience of the last 30 days, which was quite a surprise to us. We would expect that at this point in time that we would of course have had a much stronger third quarter and so basically if you look at what we have done, is that we have basically said that we anticipate that our revenues will be in a growth mode between the third and the fourth, but we just really don't have enough information to tell you or to be more explicit than to say that if we shipped 115 in the third, that we anticipate 115 to 120 in the fourth. As you can well imagine, the slow down in bookings in September was quite a surprise, and we cannot definitively say whether that was a two or three-week type of thing, or whether it will have some effect on us going into the fourth quarter. So it is more uncertainty, Rick, than it is anything else.

And when you say slow down in bookings, are you talking specifically to the DSLAM product? Or is it broader-based?

Rick, it pretty much -- it was broader-based, and in the slow down, is in relationship to the strength that we saw in the second -- in the third -- during the month of July, so basically, what we saw was that going from August to September was flat. Where we normally anticipate a significant uptick between July -- between August and September . And it was not really centered in any one thing that particular slow down, no.

But HDSL, as I understand it, is holding up? Or is that also part of the --

No HDSL is -- Jim, you have the numbers, I believe you said it was up 20-something percent?

Yes, over last year, and sequentially, Mark, HDSL was up about -- about a million and a half, roughly.

But then I mean going into Q4, the bookings pattern for HDSL, when I say broader-based, HDSL is also in the softer bookings going into Q4?

No.

Okay.

HDSL was up 23% year over year, and as Jim said, it was up -- for the quarter?

Right, up sequentially about 1point -- roughly about 1.5 million.

So it was not one of the contributors to the softness that is obvious, okay?

Okay.

And we have -- so we only have about 6 days, I believe it is, worth of bookings in the fourth quarter, and with that amount of time, we just really can't tell you anything about the fourth quarter because we don't know.

If I could, just quickly, ask, SBC has laid out their fiber to the node strategy. If that trend is not an initial component in the trials for fiber to the node, how does this affect ADTRAN's business with SBC in your view?

In our view, there are going to be some field trials at SBC is going to be running, either at the very end, but more than likely in the first quarter or so of next year. We have been deeply involved with SBC in regard to their planning. We are probably not going to be major participants in the field trials that are going to be run. And most of the activity in this area is going to be for economics, for take rate studies, and for a number of activities, all right? We have a very strong position, as you're well aware, in selling to SBC. When the final network is configured, and we believe there will be a significant RFQ process before real production shipments begin, we think that we will be a strong participant in the architecture of the final network. In fact, I think if you take a look at the network architecture, you will find the ADTRAN-type hardware is a very, very significant portion of the overall architecture, pretty much in any of these -- any of these network configurations. And I can assure you that it is our intent to be a significant provider when the time -- when the proper time comes to supply production hardware.

Thank you.

Your next question comes from the line of Andy Schopick with Nutmeg Securities.

Thank you. And good morning. A couple of question, Mark. I just wanted to ask if you were aware of comments that Merrill Lynch had made recently about the DSL market, predicting the DSL market to drop 15% per year through 2007, reflecting approximately 15% annual decline in subscriber additions and about 5% annual decline in DSL port pricing. Any comments on that in terms of your own observations of the market?

Yes, I happened to read that report, and I disagree with not only that, but quite a few other things that were in that particular report. I believe that was our first question, and we made some comments in regards to some of that. The decline in DSL marketplace, I think that the comments in regards to extension of fiber, having a negative effect on the current architecture and the current DSL products that are out there, over an extended period of time, is of course correct. We are going to introduce fiber. We're going to introduce new technology into the network, as time proceeds, and there is no question at all about that occurring. I would say that that transition usually occurs a little bit slower than people predict. I would also say that if you looked at ADTRAN's history, as that transition occurs, we transition our hardware from the old architecture to the new architecture, similar in nature to the activities that I described to you that is going on with ADSL 2+, which is a technology that -- and you brought up the SBC. There is going to be a DSL component of that architecture in that network that, by the time we get to production hardware, ADTRAN definitely plans to be involved in. And so I tend to disagree with the assertion that over the next 12 months, or 24 months, we're going to see a 15% decline in DSL revenue. However, if that turns out to be true, I think that you'll find that in the current configuration, that ADTRAN's -- already wins in that market for increasing significantly our market share, will be greatly in excess of that 15%, even if it does turn out to be correct. And if that decline is due to a cannibalization, which I really don't see occurring in the next 12 months, however, past that, of course, yes. That I think that you'll find that the ADTRAN hardware will be cannibalizing ADTRAN hardware, which has been the technique that we like to use here as technology improves and speeds and performance improve always going forward.

Any comment at all about the new IP-oriented triple play infrastructure equipment, the competition to what extent you're seeing it from Alcatel or Fujitsu, and some of the claims that are being made by some of the [inaudible] Fuji, in the marketplace today?

I really don't want to go into -- certainly not claims and statements that competitors make. I think that a offline conversation at some point in time with Tom Stanton would be appropriate for you, Andy, as well as offline conversations with the intended users of that equipment.

Great. Thank you, Mark.

All right. You're welcome. Next question?

Your next question comes from the line of Jason Ader with Thomas Weisel.

Hi. Good morning. Just wanted to make sure I understood the commentary on the bookings disappointment in September. You said it was broad-based, except HDSL? Is that right?

Jason, that's pretty well correct, yes.

And then what was the big surprise to you beyond that, was just how quickly some of the customers wanted the 48 port? Because I guess the original press release from a week or so ago when you guys preannounced, I a thought a lot of people had the impression that had to do with the ship from ADSL to ADSL 2+, and now you're saying it more has to do with 24 port to 48 port shift, is that right?

Jason, both of those characteristics were there. In my personal opinion, it was more to do with the 48 port than it was the ADSL 2.

Okay. Great. I just wanted to make sure I understood that. And from the Telcordia approval that you're going through right now, could you give us a sense of how many customers both in the Optical access product and in the remote DSLAMs are currently in the approvals process?

Let me sort of explain what this is. This is an OSMINE. It's a software inventory, configuration, and control system, is the best that I can define. It is required by all four of the RBOCs. Different RBOCs may require different degrees of OSMINE for different products. But all four require OSMINE, and the activity that is going on, with them, is for all four of those -- of the RBOCs. OSMINE is usually a requirement for a high deployment -- or really serious deployment of products. When you have a minor or a niche-type of product, then many times, you can ship production -- or some production quantities without OSMINE, without some of the Telcordia approvals, but for serious volume shipments, do you normally need this approval cycle. Which, as we said, really got heated up, because we accelerated to the best we were able to, the approval process, which by the way is a 9 month to a year process. And we're getting close to the end of it. We think we'll be through pretty much by the end of this year.

Could you give us a sense of how many customers in the optical access are, you know, how many RBOC customers are actually working through this process with you?

The RBOCs themselves really don't work through the process with you. You work directly with Telcordia, and then the RBOCs use the output of Telcordia. We would -- in the optical area, all 4 -- are -- are looking at the product, 2 more so than the other 2.

Okay.

But we would anticipate that we would be selling this product -- these products with the OSMINE approval ultimately to all 4 RBOCs.

And then, Jim, just a couple of -- just a housekeeping question on the tax rate. What was the tax rate guidance for Q4? And then also for 2005, can you give us a sense of where you think the tax rate might be?

For '04, I think we have to assume the year to date rate that we now have going through September, okay? Now that's barring any additional changes. In terms of '05, Jason, you know, we need to wait until we get into guidance for '05 in the January conference call, but I think we can assume that it will be something higher given a higher pre-tax income number.

Okay. Thanks.

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

Thank you. A couple of questions. Just real quickly, do you have the 10% customers this quarter and their size?

Nikos, yes, SBC came in at 23%. Sprint came in at 17%. And Verizon came in at 10%.

Okay. Thank you for that. Second question is, on the new product, I just want to make sure I got this right. I think you said year to date, the new products are 19% of total sales?

Right.

Okay. For the quarter, obviously DSLAM was down sequentially, based on the commentary, what were the trends in NetVanta and OPTI? Were they still up sequentially or were they flat or down?

NetVanta was up sequentially. And OPTI was basically flat. Again, awaiting OSMINE approvals.

Okay. Okay. So as you look out to the fourth quarter, your flat to slightly up guidance, do you think the OSMINE approval or process will continue to impact the OPTI and DSLAM -- I'm sorry, yes, the opti and the DSLAM products in the fourth quarter? Or do you think those get resolve and they should be back to some kind of sequential growth?

I'm not sure -- excuse me, Jim, but I'm not sure that the OSMINE activity had a negative influence. It withheld the positive influence, Nikos, that we think we're going to get once we have that OSMINE approval. The -- but the approval itself -- we didn't have it in the first or second quarter, just like we didn't have it in the third, and I'm not convinced that lacking that approval, it didn't allow us to have a positive impact, but it wasn't anything negative.

Okay.

Do you follow what I'm trying to say?

Yeah.

And I'm may not be very clear with it.

Okay. So really then, if we look at these ongoing OSMINE milestones, et cetera, that you're trying to hit, you don't see that as being an impact for the performance of the DSLAM or OPTI product in the fourth quarter?

Not as it relates to past history. Whenever we get through, then we should have a positive boost.

Okay. Okay. And just one last question. On ADSL 2+ versus ADSL, can you comment on what difference, if any, there is on the price report and the gross gross margin for the ADSL 2+ versus ADSL? Would we see any change in your price report or gross margin report?

Not significantly, but, Nikos, that is sort of competitive information and I don't want to get too specific about it, if you don't mind.

Okay. All right. Thank you.

Your next question comes from the line of Rodge Roddus [ph] with Jefferies & Company.

Hi, it's actually George Notter at Jefferies & Company. The question I had, had to do with gross margins, I guess you're guiding sequentially down, maybe just a little bit if we just take the midpoint on the gross margin guidance, but my assumption is that you shouldn't see any new HDSL pricing reductions, I think certainly those probably kick in the first part of the year next year, maybe get a little bit more revenue here in the quarter sequentially. Certainly another quarter worth of product cost reduction activities. Is the down sequential gross margin guidance then more about conservatism, or is there a product mix shift here that's driving that? You know, any kind of flavor there would be great.

George, this is Jim. I would probably characterize it more as conservatism. Although it is somewhat consistent with the third quarter gross margins.

Got it. And then I guess also, just shifting gears a little bit, on the DSLAM side of the business, you certainly are going through these OSMINE activities, is it fair to say that some of these OSMINE activities might help you in multiple applications within specific accounts, you know, small and medium-sized DSLAM deployments perhaps as well as certainly the outside plant DSLAM piece?

Yes, and I think that the larger DSLAMs is where the -- also the large impact is going to be. That's really where it's needed more.

Got it. Okay. Thanks very much.

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

Thank you very much. I've got three questions. Two hopefully very easy. And the third one hopefully I will try to be as concise as I can. The easy ones first. If you could repeat the commentary on the share buyback, essentially what the status is. The second one is on the NetVanta products, we've been watching that to see when you reach the 5% of sales milestone. On the lower sales level, that probably gets a little bit easier, if you could tell us where you are now and what your thoughts are in terms of the fourth quarter? Then the final question, looking at the DSLAM business, some of the comments you've made today suggest that perhaps the first quarter of 2005, for that line, could be meaningfully better than the fourth quarter if we take into account what I think you're talking about, is one, the OSMINE, two is really the fact that there's opportunity for more outside plant activity, and the third which you didn't talk about but I would like to get some color on is whether or not there is really an upgrade cycle out in '05 to shorten the loop lengths that provide you another opportunity to grow that business. Thanks.

Okay. Let me -- let's start with the -- with the last one, and work back. There is a potential of increased business in the first quarter. However, one of the most unpredictable things in this business that there ever can possibly be is the start of meaningful volume production with a new product, with one of our telco customers. And so yes, we should be completing towards the end of this quarter, the end of the year, certainly, the OSMINE process, to translate that, then, into meaningful production shipments, is just something that's very, very difficult timing to predict. It would be nice to think it would be in the first quarter. If, on the other hand, it occurred in the second quarter, and the increase was significant, I'd be just as happy as I could be. Let me go -- step back one question to the NetVanta. It has not reached the 5% of total company sales yet. Although we are definitely on our way. And it continues to grow on a quarter after quarter after quarter basis. We're pleased with the progress we're making, and look at that as a very significant long-term win for the Company. Jim, you have the buyback numbers?

Sure. And Simon, the buyback numbers were 2.3 million shares repurchased in the quarter. So that leaves remaining about 1.5 million.

It's -- just going back to my first question, please, on the DSLAM opportunities, one of the things I'm trying to quantify is basically an upgrade cycle. Certainly we've heard the debate about slowing growth rates for DSL net adds but one of the factors I'm struggling to quantify is basically upgrading existing ADSL customers to ADSL 2+. Certainly that's something that doesn't start until '05. Any sense of how to put some framework around that?

Simon, no. That is strictly a customer by customer thing. And the only hope of trying to get a handle on that would be to talk to each individual RBOC from a planning standpoint. I really can't be of too much help.

Well, do you see that as at least a second half '05 growth opportunity? Or is it farther out?

I think it may be further out. Except now, I need to understand for sure what you're talking about upgrading.

Basically of customers who are receiving plain old ADSL today --

I think that you're going to not see a large increase there without the additional increase of fiber in that loop to some degree. In other words ADSL 2+, whenever you have fiber in part of that loop, you're going to see a significant need for and use of. In the current architecture, you will be able to get a higher rate, but only on a percentage of your customers. And I just am not -- I don't -- I just don't know what kind of a percentage upgrades that you would really be able to see at that point.

Thank you very much.

Okay.

Your next question comes from the line of Rege King with WR Hambrecht.

Great, thank you. Jim, first of all, I was hoping that you could -- we could talk about the R&D expenses again, the $4 million uptick. I think you said that -- in the commentary, that 2.1 million was related to the OSMINE. Is that correct?

That's correct.

And Jim, should we expect this about the same sort of rate as we go into the December quarter?

In terms of R&D expenses, that is what our guidance assumes.

Okay. And then on the gross margin, Jim, 58% of uptick of gain, and it looks like there was some mixed shift, unfavorable mix shift on the DSL or in the DSLAM business. You can help me understand was it an incremental cost reduction that you guys had during the quarter, or was it mostly product mix that you had during the quarter that added to the gross margin this quarter?

Well, Rege, we have cost reduction going across the vast majority of our products. It is a continuing thing. So that -- I mean that's the larger driver of it.

Okay.

The product mix, Rege, was negative.

Right. That's what I'm trying to understand, actually, Mark. It seems like there was an unfavorable product mix, but then you had the cost reduction made up for the gross margin during the quarter. And then Mark, we've talked a little bit about some potential opportunities with some of the IOCs. Have you guys actually been able to take advantage of any of this? Have you seen any new business opportunities for yourself in that market?

Yes, we're seeing a broadening acceptance, really, of our products, yes.

Okay. Great. Thank you.

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

Good morning, guys. A couple of questions. First, I was wondering if you might be able to explain the -- when you look at the major customers, Verizon looks like it dropped fairly substantially, 5 or 6 million sequentially in terms of revenues, and yet, they're not a big DSLAM customer, so can you kind of explain that aberration? And then secondly, I wanted to get a little more detail on the products that are under going the OSMINE approvals. Are those all existing products? Or are there some new products that are -- that haven't been released otherwise? And you know, once we get through the end of this year, does that 2 million of OSMINE go away? Or are there going to be additional products that will be subject to the OSMINE process?

Jim, let me try that. And --

Okay.

The -- Verizon, when we look at that decline, about the only answer we have to it is one of two things. Just the normal timing variances that occur. r the second reason is we don't know, in that it was quite a surprise to us, too, when we pull those numbers together and realized that we had a significant decline in Verizon, a lot of that being in HDSL. Now, what that says is that we had strength elsewhere enough in HDSL to overcome that. And to, you know, bring the overall contribution of ADSL up to a positive thing. The answer that I think is correct on the Verizon's percentage in the third quarter is nothing but timing. If we look at the OSMINE questions that you have, we think there will be a significant fall-off in OSMINE expenses in the first quarter. e don't think that they will fall off to what they were a year ago, but we definitely think there will be a significant fall-off from what we are having to spend in the third and fourth quarter, where we really believe that the third quarter would be the high point. And a slight reduction maybe in the fourth quarter, a significant reduction, I'm certainly hoping, in the first. The products that are there is multiple DSLAM products, both product revisions as well as first time through type of new products. In the OPTI area, there, we have a significant new addition. Our first OPTI product was a terminal, as you remember, where the need for OSMINE on a SONET terminal is not as significant as the need for a full multiplexer. Our second 1600 multiplexer in the OPTI line, however, is a product that absolutely requires OSMINE for us to have a significant volume production capability in regards to it. It is then in the OPTI area, the product that is most significant, as far as opportunity and as far as cost. Does that answer those two questions for you somewhat?

Yeah, I just have one additional question, if I could. In terms of in the future architectures, what are you guys doing on the -- for the video piece of the triple play offering?

There is an awful lot of competitive goings-on in that area. I would not want to be extremely specific. However, I can assure you that we are there, that we are participating. That we are participating in work with our customers that from a technology standpoint that includes, of course, ADSL 2+ that it includes VDSL, that includes all of the different technologies that different people are looking at to use for that application. And we are trying to place ourselves in a position that, as the technology matures, as it becomes available, in a volume production oriented mode, that we will be there and we will participate.

Okay. Thank you.

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

Thank you. Mark, three or four years ago, as we entered the downturn, did your enterprise IAD sales precede the weakness that you subsequently saw in traditional HDSL/T1?

Todd, I don't know. I would have to go back and look. Our IAD business at that point in time was relatively young. And I think that what we -- what we normally do see, however, or have in the past, is the enterprise DSU/CSU types of business. That used to precede the T1 carrier business by about a quarter in both its moves up and down. But not the IAD. Because that is more a product that is sold, it's by the enterprise division, but it's sold into carrier space. Even though it's [inaudible], it's a still carrier.

Just a follow-up, what are your enterprise, you know, T1 termination product trends recently, trying to use that as potentially an indicator for what your HDSL trends might be, given that you saw some pretty significant weakness at Verizon?

Todd, I am doing the same thing, and what we have is we have a multi-year decline in DSU/CSU wide area network type products except it has nothing more to do with the overall economy type of things that you're looking at. It's more a shift where those products are being built into routers. And so we see our NetVanta and IAD business increase in that they have the routers built in. And we have the older legacy products in a long-term decline that are now those functions being built into routers and IAD types of things. I did not -- I looked for the same thing that you're talking about and I didn't see any indication. In fact, it looked to me like those sales were flat. So I don't think that we can look at the Verizon decline in T1 and say that this is an industry trend because on an overall basis, we saw HDSL as one of the strongest product segments going from the second to the third quarter. I think it was lumpiness, timing, and customer specific, not indicative of an overall trend. Does that answer your question, Todd?

Yes, it does. Thank you, Mark.

Your next question comes from the line of Joanna Makris of Harkness.

Hi, there. Most of my questions have been answered, but I did want to ask quickly what type of assumptions you have on the HDSL/T1 business sort of sequentially in your Q4 revenue guidance? Are you sort of looking at flattish or what type of trends are you looking at?

Joanna, we don't have the -- that kind of crystal ball. We -- basically, we're looking for flat to up, or very similar to the overall guidance.

Thank you.

Michelle, I think that we have time maybe for one last question.

Your final question comes from the line of Gina Sockolow with Buckingham.

Hi, this is Ben Kadlec for Gina. I know you have touched on this on the Q&A, but I was wondering how much of the -- how much you can link the relationship to the higher R&D expenses and the revenue short fall, and implications for the future? And then I just have a quick question on the enterprise and carrier mix, if you could just give that to me again? I missed it. Thanks.

Ben, I'm not sure I -- maybe I'm getting tired, but I didn't catch that first question.

Okay. If you can just touch on the relationship between your higher R&D expenses in the quarter, and if there is any relationship between that and your revenue short fall?

Okay. The answer is no. In that the higher R&D expenses, as we said over half of it was testing and this OSMINE process. And that is going to allow us a incremental production add going forward, we believe, if we didn't believe that, we obviously wouldn't be spending this kind of money. But since we haven't had it -- that approval, in the past, then the shipments that we have had in the past have not been of the volume and of the type that the OSMINE was mandatory. So there really wasn't a negative effect to the best of my knowledge of any way in the third quarter that was associated with the higher expenses.

Okay. I guess that -- my question was whether the -- you were trying to ramp R&D to make up for some business that you missed?

No, no, no.

Okay.

No. This is an approval of -- it's not really an approval process. It is having your products included in a software system that handles configuration control and inventory and -- for the telcos. And so you have to have your products, the standard software that is used modified to include your products in the inventory and control system.

Okay. Thank you. And briefly, the enterprise carrier mix? I missed that.

Jim, do you have that?

Sure. Enterprise revenues for the quarter were $32.8 million, and carrier networks division revenues were $82.5 million.

Okay. Thanks a lot.

Okay. I really appreciate everybody taking the time -- and we've gone over an hour now -- to be with us this morning, and to allow us to go over the progress of ADTRAN, our favorite subject. I look forward to having another conference call, I guess it will be in January. And I look forward to, at that point in time, discussing our year-end and the fourth quarter's performance, so we'll talk with everybody at that point in time. Thank you very much for taking the time to be with us this morning.

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