ADTRAN Holdings Inc (ADTN) 2005 Q3 法說會逐字稿

Good morning, my name is Nicky, 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. [OPERATOR INSTRUCTIONS]. Thank you.

During the course of the conference call, ADTRAN representatives expect to make 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 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 T-K [sic] for the year ended December 31, 2004. Such risks and uncertainties could cause actual results to differ materially from those in the forward-looking statements which may be made during the call. Speaking on today's call from ADTRAN are Mr. Tom Stanton, Chief Executive Officer; Mr. Danny Windham, President and Chief Operating Officer; and Mr. Jim Matthews, Senior Vice President and Chief Financial Officer. Mr. Stanton, you may begin your conference.

Thank you, Nicky. And good morning, everyone. Welcome to our third quarter 2005 conference call. As Nicky mentioned with me today are Danny Windham, our President and Chief Operating Officer, and Jim Matthews, our Senior Vice President and Chief Financial Officer. I am very proud to report that we recorded excellent results this quarter in many respects. We reported record quarterly revenue of 149 million and record quarterly operating income of 49 million. These levels are a result of our proven strategy of leveraging our engineering capabilities, distribution channels, and customer base to enter new markets and grow market share.

Many of you are familiar with our primary growth areas comprising Broadband Access products, Optical Access products, and NetVanta Enterprise products. Combined, these areas contributed at record levels in the third quarter. These areas accounted for about 28% of our revenue stream in the third quarter, as we continued to gain momentum. The size of each of these markets is measured in multiple billions of dollars and represents significant growth opportunity for our Company. We anticipate that over time these categories will represent the majority of our revenue streams as we continue to gain market share, introduce additional products, and expand applications within each of these categories. Additionally, we continue to take advantage of leadership positions in our traditional product areas. In the third quarter, we achieved record revenue levels in our HDSL/T1 product category. A market we continue to dominate by providing best value with continuing enhancements to solidify our position in this area. HDSL will continue to be the primary solution for enterprise connectivity and we are well-positioned to hold the vast majority of this market for the foreseeable future. We also witnessed sequential revenue growth in integrated access devices in M13 Multiplexer products.

Our revenue growth in the third quarter was broad-based across product categories and customer categories, as well. We witnessed strong growth across our RBOC, non-RBOC carrier customer bases, our Enterprise customer base, and growth, both domestically and internationally. Of course, our results were also positively affected by our ability to continue to leverage our operating model. Going forward, we believe our primary growth areas will continue to see strength based on market share gains related to both current and future product introductions. Our traditional product areas will continue to track on a macro level with enterprise demand, wireless network expansions, and wireline capacity upgrades. All of which, were strong in the third quarter. I would like Jim Matthews to review our results and our guidance for the fourth quarter. We will then open the conference call for questions. Jim?

Thank you, Tom. And good morning, everyone. Revenue for the third quarter was $149.2 million, up 25% from $118.9 million from Q2 of '05, and up 29% from $115.3 million in Q3 of '04. For the total Company, systems revenue was a record $80.3 million in Q3 of '05, up 28% from $62.8 million in Q2 of '05, and up 50% from $53.5 million in Q3 of '04. The sequential growth in systems revenue was primarily due to an increase in DSLAM, Optical Access, M13 Multiplexer and Integrated Access Device revenues. Comparing Q3 '05 to the same period last year, the increase in systems revenue was primarily due to an increase in DSLAM, Optical Access, NetVanta, and M13 Multiplexer revenues. HDSL/T1 product category revenue was a record $65.5 million for Q3 '05, up 22% from $53.6 million in Q2 of '05, and up 16% from $56.4 million in Q3 of '04.

Digital Business Transport Total Reach was $3.3 million in Q3 of '05, up from 2.4 million in Q2 of '05, and down from $5.3 million in Q3 of '04. Carrier Networks division revenues were a record $113.5 million for Q3, up 27% from $89.3 million in Q2 of '05, and up 38% from $82.5 million in Q3 of '04. The sequential increase in Carrier Networks division revenues was due to an increase in systems, HDSL, DBT Total Reach revenues. Comparing Q3 '05 to the same period last year, the increase in Carrier Network division revenues was due to an increase in systems and HDSL revenue, partially offset by a decrease in DBT Total Reach revenue. Enterprise Networks division revenues were $35.7 million in Q3, up 20% from 29.6 million in Q2 of '05, and up 9% from $32.8 million in Q3 of '04. The sequential increase in Enterprise Networks division revenues was primarily due to an increase in systems and T1 revenue. Comparing Q3 '05 to the same period last year, the increase in Enterprise Networks division revenues was primarily due to an increase in systems and T1 revenue, as well.

Revenue from the International sector was $19.4 million for Q3 of '05, up from $15.6 million in Q2 of '05, and up from $6.9 million in Q3 of '04. Gross margin was 59.9% of revenue during the third quarter of '05 compared to 57.6% for Q3 of '04. The increase in gross margin percentage is primarily the result of favorable product mix, continuing improvements in manufacturing efficiencies, and product cost reductions. Research and Development expenses were $15.1 million in Q3 of '05 compared to $18.9 million in Q3 of '04. The decrease was primarily due to higher Telcordia expenses incurred in '04 relating to Optical Access products and accelerated approvals for DSLAM products. Selling, general, and administrative expenses were 25 million for Q3 of '05 compared to $21.8 million in Q3 of '04. This increase is primarily due to increased selling costs relating to increased revenues. Other income, net of interest expense, was $2.4 million in Q3 of '05 compared to 2.4 million in Q2 of '05. Earnings per share assuming dilution for Q3 of '05 were $0.42 compared to $0.23 for Q3 of '04.

From a balance sheet perspective, inventories increased $7 million from the prior quarter to approximately $54 million. However, inventory turns increased due to higher revenues in the third quarter. Net trade accounts receivable increased approximately $8 million to $72 million due to increased revenues. However, DSOs came in at 44 days for the third quarter, down from 49 days for the second quarter of 2005 due to improved collections. Net cash provided by operating activities came in at approximately $43 million for the three months into September 30, 2005. Unrestricted cash and marketable securities totaled $345 million at quarter end, after paying 6.8 million in dividends during the quarter.

Now, we'd like to discuss guidance for the fourth quarter of '05. We are guiding revenue for the fourth quarter of '05 to a range of 139 million to $143 million, and earnings per share to a range of $0.37 to $0.39. And this leaves a full-year guidance of $512 million to 506 -- $516 million for revenue, and $1.26 to $1.28 for earnings per share for 2005. Tom, back to you.

Okay, Nicky, I think we're ready for questions.

[OPERATOR INSTRUCTIONS]. Your first question comes from Rich Church of Unterberg.

Thanks. Good morning. Nice quarter, guys. Tom, could you talk us through the M13 and the IADs strength and give us some indication on where that goes going forward? Is that part of the reason for the sequential revenue guidance?

Sure. Well, M13 -- the usage of M13 is fairly broad based. We sell M13s to our traditional RBOC market, to the CLEC marketplace, and to the wireless marketplace. So I would say that we probably saw strength across-the-board in those different segment areas. IADs, let me let Danny take that.

Rich, our IADs are sold primarily to our CLEC customer base. And what we have seen in that customer base beginning in 2005 is that customer base has begun the transition to migrate their networks to an IP-based network architecture. In Q3 we introduced our ID; that is, SIP compatible and goes into those OPI network architectures that's part of the encouraging outlook for Q4. And we also saw an increase ID revenues Q2 to Q3, which is our traditional TDM products selling into that marketplace.

And just in terms of the sequential guidance for revenues to come down in Q4, what's really driving that? Is that more than HDSL-type of issue?

No, I wouldn't really try to characterize that as a particular product segment. The way I would look at it is we saw a tremendous growth from Q2 to Q3. And to plan for that growth as, you know, after one quarter kind of behind our belt, I think, is probably a little aggressive. And also fourth quarter tends to be one of those quarters that can fall depending on what happens in December, one way or another. So I would say we're just trying to take a good realistic look at it.

Okay. And last question, could you -- now that DSLAM and OPTI and NetVanta are becoming more significant parts of your business, could you give us the breakdown of those pieces?

Well, Rich, what we can do is continue to give the same level of granularity we have in the past. DSLAMs continue to lead in the three growth categories followed by Optical Access, followed by NetVanta. And as Tom mentioned for the quarter, we're up to 28% of total revenue. And this would equate on a year-to-date basis to the nine months at about 25% of total revenue.

Okay, thank you.

So we saw a nice sequential increase there.

Your next question comes from the line of Cobb Sadler of Deutsche Bank.

Okay, thanks a lot guys. Nice quarter. So with the strength that you're seeing in the M13 mocks, IADs, and then on the new product side a minimum in the optical business, DSL router products doing well, you've got some new products coming out. I mean, why can't you do -- and I know you won't get into 2006 guidance, but why could you not do at least as much in annualized in 2006 as you have the second half of 2005?

Boy, it's real tough to answer that question without getting into 2006 guidance. So I would leave it because you know we will have that guidance. We will be providing guidance on our fourth-quarter conference call about 2006. But in general, I would just say that you're absolutely right. That we saw very broad-based strength and what we're looking at doing is making sure that, that was -- that that -- the base of that strength is something that we can plan on going forward, which we feel comfortable with. But trying to model something based off of a very, very strong singular quarter just -- just doesn't seem like something we want to do at this time. So we're comfortable with where we are.

Okay. And then just a follow-up question on your wireless backhaul product, the 410, I think the product name is. What -- could you talk about any traction you've seen there from wireless carriers?

Sure. Well, that product is relatively new and, in fact, we introduced kind of a family of products around the middle of this year. And we are now shipping all of those families; I think there are three separate actually product segments within that and really good acceptance. I mean, we're fairly early in the cycle. Of course, we sell a large number of different types of product to wireless carriers. And that being one of them. But really good acceptance at this point in its life cycle.

Okay, and how large do you think that overall market is in North America? Have you sized it yet?

I haven't seen anybody try to put an exact number on it, but it's a large piece. If you look at the backhaul market, which is difficult in itself to model because some of those services are actually bought from the wireline carrier, it's a difficult market. But it's a good-sized market. It's definitely worth something a company our size going after aggressively.

Thanks a lot.

Your next question comes from the line of Vivek Arya of Merrill Lynch.

Thank you and good morning. Tom, I'm curious about the fourth quarter guidance and I just wanted to press a little bit more on that. Your inventories were up almost 15% sequentially. December is usually a strong quarter for wire LAN equipment. Why do you anticipate your topline to decline? And if the decline comes, is it because of weakness in the traditional areas or the new areas? If you could give us some comment on that.

Well, the fourth quarter for us is not -- I mean, its always been historically one of those that can be up or can be down. December is really, of course, the swing month there. As far as our inventories are concerned, I mean, our revenue growth in the first half, I think we're projecting somewhere on the order of 30% growth from first half to second half of '05. So I think that our inventory level just kind of reflects the fact that we are now at kind of a different operating level than we were in the first half. And I think Jim had mentioned on his notes that turns are down. And we're comfortable where our inventory level is actually.

I see. And then if you were to see the decline in the December quarter, you know, you mentioned that it's difficult to call. Where would it be difficult to call, in the new areas or in the legacy areas?

Here again, that's a good question. When we have seen the decline in the past you would see it typically in our traditional area. But, of course, the traditional area made up a larger percentage of our revenue base during those periods of time anyways. So that's a tough one to say. If we have a really cold winter and things slow down, then I would expect it probably more in our traditional base.

Even though some of the outside plan DSLAMs are going into an outside type of deployment?

And you bring up a very valid point. I mean, outside plan DSLAM is a very new market. It is one that is basically just now in the mode of actually taking off and being deployed by some of the larger carriers. So that's one that I can't tell you the seasonality of that market because that market didn't exist two years ago. So you may see some softness in the outside plan DSLAM. But I would say, in general, what we're looking at is fourth quarter being one of those that sometimes we exceed, sometimes we don't. So --.

Got it.

Okay.

Oh, actually one last question. This is for Jim. Jim, what is the long-term operating model? It looks like your gross margins and operating margins are at record highs. How much more leverage is there in the business model now?

Vivek, they're certainly at record highs. And I think when we get into guidance for next year, we can kind of give some more visibility as far as the operating model goes. But at this point, we haven't changed it from our longer term model.

Which is?

Which is 25% pretax.

25. Okay, Thank you.

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

Yes, thank you. A couple of questions. In your commentary on the new products being 28% of sales, on the sequential growth, I didn't hear NetVanta mentioned. Was that product up sequentially and is it still over 5% of sales?

Nikos, the NetVanta numbers were not up Q3 over Q2, they were down slightly. However, the NetVanta product family is still continuing to build momentum, and if you look at Q3, NetVanta had a strong third quarter. It probably has a lot more to do with how strong Q2 was -- what happened in Q2. Instead of what didn't happen in Q3. Q3 was still the second-largest NetVanta quarter that we have ever had by a large amount.

Okay. Were there any -- would you say that it was just more the strength in Q2, there weren't any product transitions or anything like that? It was just more of coming off a tougher comp?

That is true. In fact, if you looked at the growth in Q2 over Q1, the growth was a large amount. And so it made building off of that Q2 base a little more difficult in Q3.

Okay. And can you give a mix of the outside plant versus CO DSLAMs? Historically the central office DSLAMs were over 50%. Is that still the case or has now the outside plant DSLAMs more than 50%?

I would think the right way to characterize them at this point in time is that they're basically 50/50.

Okay, about 50/50. Okay, and I think during the quarter you guys had talked about some of the non-RBOC ILEC customers, like Alltel a couple of quarters where it's a 10% customer. If you look at that customer group, the non-RBOC/ILEC, how big is that as part of your business? Is that a meaningful piece, or is it a small piece? How would you characterize it?

Well, I would definitely characterize it as a meaningful piece. Because if you get into that non-RBOC, I mean, the RBOC, of course, is the top four. You get into the Alltels and the Sprints and the Cincinnati -- I mean the CenturyTels and those Frontiers and that classic customer, and they have tremendous buying power. So --.

Are they bigger than your CLEC exposure, which is running about 15%? I'm just trying to get a sense of how big that group of customers are for you.

I would say that the -- kind of the independents and non-RBOCs are actually larger than the CLEC piece of business that we do.

Okay. And my last question is on the 10% customers. Do you have a breakdown on that?

Yes, we do, Nikos. On a dollar basis, all of the 10% customers were up sequentially. In percentage terms, SBC was 21%, Verizon was 11%, and Sprint was 14%.

Okay, thanks a lot.

Your next question comes from the line of George Notter of Jefferies.

Hi, thanks very much. Going back to when you reported Q2, I believe you had about three weeks of backlog, you were mentioning exiting Q2. Can you give us any update on where that backlog number might be right now? And any sense for the -- I know the Company's philosophy historically has been to really drive a book-and-ship model. Looking into Q4, are you anticipating any desire to work backlogs down to more of a book-and-ship model? Thanks.

I would say that, yes, there was no doubt that in Q2 we had a larger backlog than we were comfortable with. At this point in time, I would say that we're actually fairly comfortable with where we are with our backlog situation. We're back more closer to our normal, typical backlog cycle, which is book and ship.

Great. Thanks.

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

Good morning, guys.

Good morning.

Good morning.

I want to clarify a couple of things. If I remember correctly, we talked about how during 3Q you basically had strong shipments to pull down some backlog. And a lot of that was specifically in the optical product. Did I remember that correctly?

I don't know if we gave -- I don't recall giving any particular color on that. I mean, I think that the backlog situation in Q2 is probably across several product areas.

Okay.

Optical very well could -- in fact, I recall optical being one of those areas where it was -- that was definitely in one of the buckets.

All right, but it sounds like a more broader base than just any one?

Yes, it wasn't -- I don't think you could say it was one particular product. Although, I think optical was definitely in there.

Okay. And if I remember on SuperCom we talked about how the pipeline was really building for a lot of business activity for the NetVanta products. And I just want to check kind of -- we talked about there was some nice, meaningful deals that were coming up. Where are we in the valuation of a bunch of those deals, and how should we think about NetVanta? I mean, is this likely just to be lumpy back and forth, or are we kind of seeing more and more opportunity here in the near-term so we just need to kind of execute on those? And I had one other follow-up after that.

Marcus, I think that you should think about the NetVanta growth being more of a long-term linear ramp as opposed to maybe being as lumpy as our RBOC customer base is. And we do continue to get engaged in more and more end-user opportunities. We are winning a good percentage of those opportunities where our products are a good fit for the customer's application. So we have continued to invest in the product line, added new capabilities to the entire product set and added new products to the product set. So that the momentum there is still building.

Great. And then just the third question, what is ADTRAN's expectations for helping to rebuild some of the hurricane damage that occurred in the Southeast? And is that at all a factor in expectations for 4Q?

The answer is not really. I mean, we've gone through several hurricanes since I've been here. And the net effect of that over any length of time has basically been neutral. So you may see an uptick in one particular product area, but you would see a downtick in another product area. So we really haven't factored that into any kind of meaningful change true to fourth quarter.

And you don't think it would give any boost in 3Q?

It may. I would say the same thing may have happened where we probably saw an uptick in one product area, but we saw a downtick in another. So I would say the affect was basically neutral.

Great. Thanks for the information, Tom.

Okay.

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

Thanks. I wanted to see if we could drill down a little bit on gross margin. Another quarter with nice sequential move up. I guess two parts to a question. If you could give us a range of your gross margin assumptions implied in your fourth quarter guidance, as well as maybe some color on what's driving the gross margins in terms of how much of the improvement is coming from some more of the mature products, HDSL and Legacy systems? How much from volume? And how much simply from the mix with the new products contributing at a greater percentage of revenue? I'm assuming that the new products still are the higher gross margin elements. Thank you.

Hi, Simon, this is Jim, and I'll answer the question. In terms of guidance assumptions, I think the EPS guidance that we gave pretty much reflects gross margins, fairly consistent with the third quarter. Okay? In terms of the improving gross margin that we saw in the third quarter, yes. It was driven in part by continued growth in the new product areas, or in the primary growth product areas. Also volume, I'm sure has some positive impact to that, as well. And we continue to reduce costs across a number of our products. In terms of breaking those out individually as far as the contribution goes, I'm just not able to do that at this time.

Well, maybe just another way to skin the cat. Could you tell us are the gross margins on the new products holding stable or trending up as they're ramping? Or are the older products where you're getting increases?

I think we're seeing a bit of both, but again, on a percentage basis in terms of gross margin percentages, our new products outweigh the traditional.

Okay. Thank you very much.

Your next question comes from the line of Ehud Gelblum of JPMorgan.

Hi, good morning. Thank you very much. I just have a couple of questions that might have been asked already. I'm curious to dig a little deeper on the enterprise side and learn a little bit about the trends that you're seeing. As far as NetVanta goes, I understand that Q2 was a very strong quarter and therefore Q3 pulled back a little bit. On the other side with HDSL still continuing to go strong, it sounds like you're seeing a lot of enterprise strength there. It's one of the reasons that you said for enterprise connectivity.

In other parts of the networking world, we're hearing mixed to not great things about enterprise in general. What do you think you're seeing in terms of enterprise spending for networking; that is, keeping your HDSL as strong as it is? And how your salespeople and your funnels looking as far as enterprise spending going into the back half of the year? And how do you compare that to your HDSL and your NetVanta sells? Is there -- I'm trying to get sort of a macro view and how that -- on enterprise and how that's impacting your sales in those two categories?

Thanks for the question. I think, in general, first of all, the enterprise spending environment affects several product areas. And I think if you look in totality at those product areas -- that would include HDSL, that would include things like IADs, to some extent that includes M13s and, of course, that includes our NetVanta, which are all kind of connectivity things for a business environment. And the strength in all of those areas is what's really driving us to say that we think at least for our products that the enterprise spending environment seems to be a positive one. Dan, you got some additional color on that?

Yes, just in terms of what we have seen in the revenue performance of the enterprise division, we saw a broad-based growth across the product sets in enterprise division. And while Q3 was not a record quarter for NetVanta it was a very strong quarter for NetVanta. We also had the strongest quarter of the year for the traditional Legacy products. We had a strong quarter for enterprise products that are sold to wireless carriers. And we had a strong quarter for IADs. So it was broad-based across the different product sets that represent the enterprise division.

In terms of customer outlook, I think we would classify the demand that we see in the enterprise customer base as strong; maybe healthy. And certainly improved over the environment that we saw in 2004. I've seen customer surveys, particularly targeted to the size of the customer base into which ADTRAN sales that would suggest that the outlook for the last part of 2005 and for 2006 represents an optimistic improved spending environment among the customer base into which we sell.

Are you -- do you think you're gaining share in enterprise or do you think you are seeing that the market itself continues to be strong?

I think some of both. If you break that question down, you really have to look at the specific, individual product sets and ask the question, is the market growing? Or are you gaining share? Because I think it varies across the different product sets. Obviously, we're gaining share in the NetVanta product set because we've not been in that market in the past.

Okay. If you look -- am I correct to infer from the answer to an earlier question that IAD because of the transitions that CLECs are going to IP could be a little lumpy and that could be one of the reasons in Q4, you're unsure of where numbers could end up?

No. The IAD market is a little lumpy because it is a carrier-based market. And carriers often have lumpy purchase patterns. It's probably less of a degree in the CLEC marketplace than it is in the RBOC marketplace. The comments on Q4 for the IAD space were optimistic in that we have not been in the IP/IAD market until the product introduction we made in Q3. So we began shipping for revenue for the first time. IP/IADs that support SIP-based protocols. Revenues were essentially immaterial in Q3. But we expect that to grow going forward.

Okay. Last question. In Q4 -- your guidance for Q4 -- your new guidance for Q4 is up about 3 or 4 million from your implied guidance previously, just even a month or so ago. What has changed in your outlook? Is it still across-the-board everything strong? Or do you think certain product categories have surprised you, the upside that you think will continue?

I would characterize this pretty much across-the-board. And I think the change is just reflective of the fact that Q3 came in stronger. And what we're -- so, basically the environment that we're selling into is just stronger in Q3 than we had imagined maybe even two months ago. So I think that's just sort of a reflection on that.

And I apologize. One last thing. You gave an impression as to what your enterprise customers were seeing as their outlook. What about your RBOC and ILEC customers as you go into the back half of the year? There's some thought that perhaps spending may either be flattish or not have the same seasonal uptick in the fourth quarter -- out of RBOC's and ILEC's. Do you see spending patterns similar this year to previous years where spending goes up in Q4, or do you think it's a little bit more --?

It depends on the year that you're talking about as to whether or not there was an uptick or downtick in Q4. In general, we don't try to nor do we typically participate in any type of budget flush situation. I think that those situations are areas where you end up maybe seeing a particular uptick in a quarter, but then you ultimately you pay for it in the next quarter or the following two quarters. So it's something that we don't actively go out there and try to pursue. As far as the spending environment, in general, though, I would say it's as optimistic today as it has been all year.

Thanks so much.

All right.

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

Thank you and good morning. One of my questions has been asked. But I would like to ask you this if you would care to comment. Given current business trends, do you expect any factors to help to mitigate the kind of normal seasonal effects that you might be inclined to see in the first quarter of the new year, 2006?

I would really like to defer that to the fourth quarter conference call when we talk about our 2006 guidance. In the past I will say that we have been able to overcome that seasonality typically by gaining market share in other products to the extent that it overcame the normal seasonality in our traditional product areas. Although, the traditional product areas were still down. But other than that, I would invite let's say let's wait until fourth quarter.

Okay, thanks.

Your next question comes from the line of Paul Silverstein of CSFB.

Thank you. A couple of questions if I might. Just a clarification on the DSLAM, Optical Access, and NetVanta product lines, were each of those once again about 5%, notwithstanding, NetVanta having been down sequentially?

Well, we did talk about NetVanta exceeding 5% for the second quarter. But I think if we look at Q3 given the broad advance in total revenue that we probably didn't make it.

Okay --?

All of the others, obviously, absolutely were in excess of 5%, yes.

Okay, I assume that NetVanta wasn't much below 5%?

Correct.

Okay. Jim and Danny, Tom, can you guys give us -- historically you've given some insight with respect to NetVanta in terms of small enterprise versus -- if I'm not mistaken you had been gaining ground with larger enterprises with multiple small locations, retailers from multiple sites, etc. Can you give us some insight in terms of the progress in the customer base between small enterprise versus those retailers and other entities with multiple locations as a percentage of NetVanta revenues?

Yes, Paul. If you look at the NetVanta product set, the customers that we're attempting to go after with the NetVanta product set are really based upon the product set itself. So today the product is suitable for application in small and medium-sized networks. And the people who operate those networks are either true, small businesses or, in some cases, large enterprises that have lots of remote sites. And so that's where we have targeted our sales efforts.

Now in terms of interesting customers to talk about, small enterprises, any individual small enterprise is usually not noteworthy. And that market is reached through our two-tier distribution partners and today is one of the fastest growing segments of the NetVanta product line. The other one that is often interesting to talk about is our success in large enough enterprise names, household names, that they gain some attention. We have been able to penetrate more and more of those larger -- basically turned out to be retail-type environments over the last year. And I think we're increasing our brand recognition there. We're increasing our credibility as a supplier of internet-working products there. And I think we're gaining momentum in that market base.

Danny, at this point in time is the business still skewed to small enterprise or is it more balanced 50/50 between those two different market segments?

I believe that the market for ADTRAN is today small -- not predominant -- but is still small business-based and we are growing the numbers into the larger enterprise segment.

Okay. If I can ask you about international, it's been growing for the last several quarters. If I'm not mistaken, historically Telstra has been a decent piece of your international revenue. Can you give us some insight in terms of the concentration of the growth this quarter? Was that a function largely of one customer, or was it distributed? Do you continue to penetrate into new regions, etc.?

Telstra is our largest international customer and continues to be that and was definitely that in Q3. So at this point in time, tough to significantly grow that number without Telstra growing. So Telstra kind of remains a good mainstay for us. I would say we saw growth in the other areas outside of Telstra, but Telstra is a significant customer.

Okay.

While the numbers are smaller, we did see good growth across the rest of Asia/Pac and also Latin America in Q3.

And would you expect that business to be up again in Q4?

We don't have that type of granularity. I mean, we're expecting kind of broad-based support, but we really wouldn't want to comment on a specific customers.

And if you look at the international business, in general, it's essentially doubled in run rate this year. And continuing to double for the next quarter. It's probably not something we would plan for.

Okay. I'll pass it on, thank you.

Your next question comes from the line of Bill Choi. One moment, please.

Am I on?

Yes, Bill.

Can you guys hear me? Okay, great.

Bill Choi of Kaufman Brothers. Please go ahead.

Great, thank you. I just wanted to talk a little bit about HDSL, which the growth continues to, obviously, surprise given it's a fairly mature segment. You talked about declines in the past in the DSU/CSU segment. Can you talk about whether that segment specifically is coming back or not?

To the extent it did come back -- and Dean, I don't know if you have that number right in front of you? To the extent it did come back, it's something that we wouldn't plan for in the long-term. I mean that product segment has been in decline for the last few years. And it is a lesser piece of the HDSL/T1 number to where it's not -- if it is up, I don't think I would read anything into it.

Okay. Second half of last year, into early part of this year, there were some inventory adjustments in this segment. Did all of the inventory adjustment in your mind has that corrected, and are we at a normal run rate?

I would say at this point in time, we don't see any -- we're not aware of any inventory problems in any of our areas at this point.

And what kind of growth rate in this business would you expect into the future -- 2006, 2007, kind of time frame?

This business being --?

HDSL.

I mean HDSL, we have traditionally put in the same category as our traditional product areas which we have stated in the past has been kind of high single-digit, low double-digit-type growth. Of course, here recently we've exceeded that, albeit we had a depressed first half of this year; definitely in the first quarter. We'll look at the going forward numbers at the end of Q4.

Okay, high single, low double-digits?

Yes, that's what we've said.

All right. Just a little bit on the Optical Access products. You've made headways into both wireless customers there, as well as wireline. There were quite a bit of RFP that the beginning part of this year that you guys participated in. Can you talk about the mix of Optical Access revenue between those two major product segments, and is this at 10% or fairly close to it at this point?

We haven't set this new 10% measurement threshold yet. And so I really would hate to start doing that at this point in time. But, no. I mean our optical product line has done great this year. And you're right, it is fairly broad based. It's in the wireline and wireless piece of business. I would say the wireline piece of business is probably more RFP driven than the wirelines is more RFP driven than the wireless piece of business. I would say they were both very strong contributors in the third quarter and really have been this entire year. And we would expect to see continued growth in both of those segments going forward.

Are they about 50/50 in terms of contribution?

It's -- I think from a -- from a talking perspective, that's probably not a bad way to look at it. Although, it is very difficult for us to break that out into some of the larger carriers that have both wireline and wireless networks. Alltel would be an example of that where it's difficult to see one versus the other.

Okay, and some of those RFPs have been with long-distance carriers who have recently merged. So I'm wondering if you could give a little bit of an update on how your business with some of those long-distance customers have been trending, whether you've noticed any differences in purchasing patterns?

Well, the good thing and the bad thing is that we, the two long-distance carriers that are going through that process right now are AT&T and MCI. And neither one of those customers were really large customers for us in the past. We have done business with them, but they weren't that significant. And so we -- no, we haven't seen a trend in those buying patterns. Although, we do have some optimism towards our ability to sell into those two customer bases as the mergers complete and as they start building out their infrastructure. As far as the impact on any of the RFPs that have been talked about in the past, we really haven't seen any impact. I mean things still seem to be on track.

Okay, thanks.

[OPERATOR INSTRUCTIONS]. Your next question comes from Joe Chiasson of Susquehanna Financial.

Thanks, good morning, guys. Two questions if I might. Tom, can you comment to what extent the strength, the recent strength in HDSL might be indicative of growing interest in things like H.HDSL and Ethernet over copper?

I would say that the two aren't intertwined at this point in time. SHDSL or G.SHDSL or Ethernet over copper are technologies that the carriers have been talking about for maybe three, four years now and have kind of showed interest and then backed away and then showed interest again. And depending on the carrier you may see some moderate interest in trying to understand the technology better. But I'm not aware of any significant rollouts in North America using those technologies. So I would say that those are kind of two separate animals at this point in time.

Okay, thanks. And then, Jim, can you talk a little bit about the R&D number specifically? We've seen that come down now in absolute terms here by several million dollars over the past couple of quarters. And I'm just wondering, is there any guidance that you can give with respect to the sustainability of that number at those particular levels? In absolute terms.

Well, I did comment that -- and in terms of Telcordia expenses we had larger expenses in that particular category last year, and those expenses continued somewhat through the first quarter of this year and somewhat through the second quarter, as well. The vast majority of the Telcordia expense that we anticipate this year has already been incurred through the second quarter. So we're anticipating a very low spin so to speak in the fourth quarter this year in terms of Telcordia.

Okay, going forward even into FY '06, without getting too much into FY '06 guidance here. Are there any new products coming online that might, in fact, require Telcordia certification in the FY '06 period?

Yes, the answer to that is yes. There are always. And, in fact, even as our Telcordia expenses came down through this year, there is still an ongoing level of Telcordia that really varies from month to month depending on the particular product segment. We actually still do some Telcordia work even with our HDSL products. Going into next year we continue to plan on new product introductions, and those will have Telcordia expenses associated with them.

Okay. But perhaps not necessarily to the same magnitude that we saw coming off of the latter half of '04, is that a safe assessment?

Yes, some of that was driven by particular customer wins in a particular product segment. And that was really that uptick. So to be honest with you, I hope we do. I mean, because if we're driven by a particular customer to meet an aggressive timeline, for a meaningful piece of business, that's something we're going to do. But it's real tough to forecast, exactly when those would fall into.

Okay, great. Thank you.

Your next question comes from the line of Tim Daubenspeck of Pacific Crest Securities.

Thank you. Just to go back to the Telstra question, it sounds like they were probably close to -- were they close to a 10% customer in the quarter?

They were not a 10% customer, Tim.

Okay. What type of visibility do you have into Telstra? I mean they're going through kind of a messy privatization right now. Do you have concerns about disruption in spending kind of near-term from Telstra even the next couple of quarters?

Well, they've been going through kind of a privatization process in one form or another for quite sometime. And we have not seen that directly impact our business. In our business right now, it's very much end-user customer driven. They've rolled out an IP network and a large percentage of their serving area, and are putting customers on that network. So I wouldn't expect the merger or, excuse me the privatization activities to -- specifically to affect our business.

Okay. And then just a question as you go Alcatel is going to have their outside plant DSLAMed sometime in the first half of '06. Have you seen it in customer labs? Or have you had any discussions with customers about them maybe adopting the Alcatel product in the first half of '06?

I have, of course, heard about it. And I've heard about it now for about a year. And I would fully expect them to develop. In fact, anybody that I would think is going to be a long-term player in the DSLAM space I think is going to be required to develop something like this. And I think we've got a good two-year headstart on it. As far as customers showing interest in it for maybe in a competing application, I'm not aware of any large customers doing that. Most of the contracts that we've sign and we've won several RFPs over the last year and a half or so are fairly longer term arrangements. They're not something that I would expect them to stop come Q2.

Okay. And then I guess a question for Jim. Share count went up. It doesn't look like you guys executed any buybacks, is that true? And kind of where would you step back in with buybacks?

During the quarter we repurchased 133,000 shares, and it was right at $25 per share.

All right. Thank you very much.

Your next question comes from the line of Gina Sockolow of Buckingham Research.

Thank you. Could you discuss why the tax rate went up sequentially? Was this because of international revenue mix or other factors? And what the outlook is for the fourth quarter and if you can give it for '06?

Okay, Gina, I can answer the '05 part of your question. The tax rate did go up in Q3, and it was driven primarily by the significant increase in pretax income. Okay? Now that resulted in a year-to-date tax rate through the nine months of 35%. And that 35% rate is what we anticipate for the fourth quarter.

But what was it the pretax income that created this shift? If you --?

Sure, sure. Within our tax rate, we have certain fixed components. We have state incentive credits, and we also have R&D credits, which again, are relatively fixed as we go through the year. And as our pretax income increases, that would drive our actual rate up.

I see.

Okay?

Yes, thank you.

In terms of '06, that's more of a January conference call question.

Okay. Thank you.

Your next question comes from the line of Ken Muth of Robert Baird.

Quick follow-up on the NetVanta side. Can you tell us how many VARs you have in the network today for NetVanta and kind of where your goals are at?

Ken, I don't have the numbers that are -- VARs who are specifically selling NetVanta. I can give you the numbers associated with ADTRAN's VAR channel. And ADTRAN's VAR channel across varying degrees either embraces themselves in NetVanta or doesn't. Today there are roughly 3 to 400 resellers that are on [direct entering] contracts, and there are 4 to 5,000 resellers that have sold an ADTRAN product that sit behind our two-tiered distribution partners.

Okay, and then of that kind of the tier-two guys, Ingram Micro and Tech Data, would that be the vast majority of kind of NetVanta sales?

Today, the majority, even though it's not a large majority of our NetVanta sales are coming through that two-tier distribution channel.

Okay. Thank you.

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

Yes, I would like to go back to the Optical Access products, Tom. And, although, this isn't as relevant as the DSLAM products, how many of the top seven carriers irrespective of wireless or wireline are you shipping the product to?

Good question. I think the answer is somewhere around -- it's over 50% of them. To be honest with you I haven't broken that out.

Okay. Thank you.

Okay.

That's it.

Your next question comes from the line of Robert Sanders of Pacific Crest Securities. Mr. Sanders, your line is open. Your next question comes from the line of Rich Church of Unterberg.

Thanks for the follow-up. Tom, with regards to the new DSLAM projects at Verizon and SBC, can you comment on, was the DSLAM strength driven by those new projects, or was it more driven by the RLEC or the independence?

I would say the DSLAMs strength was across-the-board.

Okay. And --?

Definitely. I mean there's no doubt that having SBC and Verizon buying your outside plant, DSLAMs is a positive thing. But it was broader based than that.

Okay. Then you expect this Verizon and SBC projects, they're just in their early stages? I mean, do you expect them to continue to ramp in Q4? Or how is that progressing?

We're in the relative early stages of that. Somebody had brought up seasonality on outside plant DSLAMs and it's tough for us to try to forecast what that would actually be. But I would say characterizing that we're in the early stages, and we would expect it to go on for some quarters after Q3 is absolutely accurate.

Okay, thank you.

Your next question comes from the line of Scott Coleman of Morgan Stanley.

Great, thanks, guys. Just one follow-up on the inventory question. Last quarter your inventories grew about 6 million sequentially. And you indicated it was the anticipation of strong sales growth in the third quarter. This time it's up about 7 million sequentially and you're guiding down. Is it fair to assume that you're just giving yourself some slack on the inventory side in case you do see demand in the third -- in the fourth quarter? I'm just wondering what the difference last quarter to this quarter is.

Yes, I would say if you take in aggregate the adjustment that we made in our inventory level, it kind of coincides and it is driven by the adjustment that we've seen in our base revenue base. I mean, we were in the kind of teens. Somewhere around the teens or low 20s, and now we're kind of in the 140s, 150s. And I think that the inventory adjustment you saw is directly reflective of that.

Okay, that's helpful. And then, Tom, one other question if I might. Last quarter, you indicated some robust optical RFP activity out there. You alluded to it again on today's call, particularly in the wireline side. I'm wondering if you can give us an update of where your customers might be in the process. If you expect these RFPs to be awarded or the contracts to be awarded this year or if that's more of a 2006 event?

I would say that some of those RFPs will definitely be awarded this year. And I would say that some of them have probably been awarded. And once you win an RFP and then turn that in -- turning that into revenue is kind of a different timeline in and of itself. But I would say we're on track -- there's nothing that has changed really throughout this year on the RFPs that we're going after. Some of them very well may be awarded without an RFP being finalized.

Great. Thanks for the insight, guys.

Your next question comes from the line of John Anthony of SG Cowen.

Good morning, guys. A couple quick questions. Have you started shipping the 1100F yet in volumes?

No.

And what about the OC-48 mocks?

The OC-48 mocks is something that we'll probably start shipping in Q4 of this year. So coming up.

Okay.

That very well depending on how lab trials go very well could slip into Q1.

Okay, what has the take rate been on the line power NetVanta?

The line powered NetVanta?

Oh, the net switches?

Yes.

Four of the net switches have been well accepted. We're still very early in the adoption of those products. So they're just coming into production really in Q3. But those products have been well accepted.

Okay. Any plans on the headcount side?

We're fairly cautious about adding operating expense and you would think we would maintain that cautiousness although we will grow the business as the business grows.

Okay. And last question, given the 400 million cash balance, any plans what to do with it?

That's looked at every quarter by our Board. And we announced our dividend this quarter and we'll continue to look at that going forward.

Thanks, guys.

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

Thank you. I guess just a few questions. First of all, Jim, was book-to-bill below one? I'm just guessing because of the backlog reduction it might have been.

Jason, we don't give that number.

Okay. So let me ask it a different way. In terms of the guidance, how much is related to seasonality and how much is related to the backlog reduction in Q3? In other words, that the comp will be tougher as you reduce backlog in Q3?

We think the larger part of it really relates to potential seasonality.

Okay. And then on the outside plant DSLAMs, you had talked about some major RFP wins, I guess late last year, beginning of this year. Have you started shipping meaningful volumes? And I'm talking about two major RBOCs. Have you started shipping meaningful volumes into those customers?

Yes.

And would you expect it to be somewhat of a linear ramp? Or how can you help us think about --?

Yes. That's a good question. It's a tough question to ask because we're dealing with an RBOC. I mean, I would expect -- I don't think that the third quarter level of shipments to either of those RBOCs is the peak of their shipments. So I would expect some ramp at trying to put a curve on it would be difficult. These things typically ramp-up over six to nine months before they hit their run rate.

Okay.

I had no reason to think this would be different. But it's tough to forecast that.

So would you say that most of the sequential growth in the DSLAM was related to the RFPs, or is it more broad based than that?

It is more broad based than that, but there's no doubt those had an impact.

Okay. And then last question on the HDSL front, I guess I'm surprised at how much even year-over-year it grew. And I mean, do you have anything that you could -- do you have any color that you can add to help us understand what may be going on there? Is there any specific accounts where you might have gained share? Because it just doesn't seem like -- for instance, your competitor had anywhere near that kind of growth year-over-year. And just trying to think about that business going forward, it's just -- I don't know. I guess hard to understand exactly what's happening in that space.

I can understand the confusion there. Now, from a competitive perspective, I mean, I think the base that we're selling into is much, much broader than where our competitors is selling into. So it's probably tough to call the market on a relatively small piece of business there. From our perspective, I mean, I think there are a couple of things. One is we did have a relatively depressed first half. So I think some of that was getting back to normal levels. And there's no doubt that things going on in the wireless side of the business has probably had a positive impact on the HDSL business in general. So it's tough to say whether or not it's enterprise demand driving it more, capacity upgrades, or if it's wireline connectivity or wireless connectivity. But I would say it's, from our perspective it seems to be fairly broad based.

Do you think that there was a bit of a -- I know we had talked about Verizon in particular and the reuse program they had. But do you think there was a more broad-based kind of inventory soak-up in the first half of the year that --?

Maybe. But they typically don't carry a lot of inventory anyways. And the Verizon reuse is kind of a separate animal. I mean reuse is really different, although it kind of impacts you the same. It's different than a specific inventory buildup. But it's -- they typically don't carry a lot of inventory on this type of equipment.

Okay. Because I'm just thinking about the growth rate, I'm assuming that you're not -- I know you're not getting guidance for next year. But you grew 16% year-over-year in HDSL. And you've been talking about kind of -- I think I remember you talking about kind of a mid single-digit-type of growth rate, kind of slightly above GDP-type of growth rate. So that --?

I think we've been saying high single-digits, low double-digits.

Okay. All right. Thank you.

All right. Listen, Nicky, probably one more question. I think we're actually past our time here.

Yes, sir, we do have one follow-up question from Marcus Kupferschmidt of Lehman Brothers.

Just want one little question to ask. In terms of the DSLAM orders, or sorry, revenues for 3Q, is international at all a meaningful contributor to that, and does any of that go into Telstra at all at this point?

We do sell Telstra DSLAMs configured for SHDSL deployment. So it's really more of a business class environment they're selling into. And we do sell DSLAMs in a broader sense including ADSL DSLAMs internationally. So they are a meaningful piece of our revenue stream.

Is there any way of breaking down U.S. versus international for the DSLAM business?

No. For DSLAMs, we haven't -- we're not in a position to do that at this point.

All right. Thank you.

Okay.

At this time there are no further questions. Do you have any closing remarks?

Yes. I just want to say thank you to everybody out there for taking the time to participate in our conference call. And we look forward to seeing you next quarter.

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