ADTRAN Holdings Inc (ADTN) 2008 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the second-quarter 2008 earnings release conference call.

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 10-K for the year ended December 31, 2007 and Form 10-Q for the quarter ended March 31, 2008. These risks and uncertainties could cause actual results to differ materially from those in the forward-looking statements which may be made during the call.

After today's presentation, we will conduct a question and answer session. (OPERATOR INSTRUCTIONS). Thank you. I would now like to turn the conference over to Mr. Tom Stanton, CEO. Sir, you may begin.

Thank you, Vanessa. Good morning, everyone. Thank you for joining us on our second-quarter 2008 conference call. With me this morning again is Jim Matthews, our Senior Vice President and Chief Financial Officer.

This quarter's performance was driven again by continued acceptance of our growth products, including Broadband Access, Optical Access and Internetworking. Combined our growth businesses again achieved a new record level for the Company led by 55% growth in our Broadband Access category. Optical Access came in with a strong 36% year-over-year growth, followed by Internetworking, which also reached record revenue levels.

In our traditional product areas, HDSL continued to show resiliency despite a soft SMB environment. HDSL revenues of $45.5 million were essentially flat to the same period last year. Traditional enterprise products were essentially flat to the first quarter and now equate to approximately 8% of the Company's total revenue.

As mentioned before, Broadband Access had a tremendous quarter, due largely to the Fiber to the Node products. Our 1100 series products continue to gain acceptance, and we are excited about the long-term growth potential of this category as we introduce new generations to meet growing customer demand.

Moving on to our 5000 series products, we remain on track with our major Tier 1 awards. As some of you will recall, we shipped our first Tier 1 carrier late last year, and that customer remains active as they continue to predeploy infrastructure and begin marketing their new service. We received initial orders from our second Tier 1 carrier at the end of the second quarter. Although these are very positive steps for our Company, we would like to remind you that we are still early in the deployment cycle of these two carriers.

Similarly our Tier 1, Tier2 and international accounts continue to move forward, and our optimism remains very high for the long-term positive impact this series of products will have on our Company.

Although we're very pleased with the number of awards to date in our Broadband Access product families, we should remind you that carriers require significant time to operationalize complex products like the Total Access 5000 and Fiber to the Node series products, and the timing of these opportunities can vary significantly from anticipated date.

Optical Access had a strong quarter with 36% year-over-year growth. Again, this quarter was driven primarily by Tier 1 carriers as we continue to gain traction with new awards in that market segment.

Our Internetworking business saw its seventh record revenue quarter within the last [days], despite a sluggish spending in the SMB sector. This growth, although muted by economic conditions, continues to reflect the broad-based support we're seeing as we work to leverage our carrier distribution channels and our growing VAR dealer base.

The support we're seeing confirms that our SMB solutions are meeting the needs of businesses that require integrated solutions for voice, data and Internet connectivity.

The economic environment experienced during the quarter was similar to what we experienced during the previous six-month period with general weakness in our SMB markets and constrained spending by midtier carriers. However, clearly we continue to make good progress transitioning our Company to a global systems level provider of IP-centric solutions for both copper and fiber. This achievement makes us very excited about our global growth potential. We believe our growth business will continue to see strength based on market share gains related to both current and future product introductions and customer spending trends. Our traditional business will continue to track on a macrolevel with enterprise demand, wireless network expansions, wireline capacity upgrades and general economic conditions.

I would like Jim Matthews to review our results for the second-quarter 2008 and our comments on the third quarter of 2008. We will then open the conference call up for questions. Jim?

Thank you, Tom. Good morning, everyone. Revenue for the second quarter was $131.2 million compared to $123.7 million in Q2 of '07. Broadband Access product revenues for Q2 of '08 increased 55% to a record $31.3 million compared to $20.2 million in Q2 of '07. Comparing Q2 of '08 to Q2 of '07, this significant in price increase in Broadband Access product revenues is primarily attributable to 1100 series Fiber to the Node upgrades and 5000 series rollout of Ethernet over Copper services, broadband digital loop carrier and other applications.

Optical Access revenues increased 36% to $13.4 million over the second quarter of '08 compared to $9.8 million in Q2 of '07. Comparing Q2 of '08 to Q2 of '07, the increase in Optical Access revenues was the result of continuing market share gains across numerous customers, including Tier 1 carriers.

Internetworking product revenues increased to a record $16 million in the second quarter of '08 compared to $13.6 million in Q2 of '07. Internetworking products continued to experience increasing momentum as a result of continuing efforts to improve traditional enterprise channel focus and leverage carrier distribution.

In total, our growth products grew 39% in the second quarter of '08 compared to the same period the prior year.

Carrier Systems revenues were a record $57.7 million for Q2 of '08 compared to $46.5 million for Q2 of '07. Comparing Q2 of '08 to Q2 of '07, the increase in Carrier Systems revenues was primarily attributable to revenue increases in Broadband Access and Optical Access product categories.

Business Networking revenues for Q2 of '08 were $21.8 million compared to $22.2 million in Q2 of '07. Comparing Q2 of '08 to Q2 of '07, the decrease in Business Networking revenues was primarily attributable to a decrease in traditional integrated access device revenues, partially offset by an increase in Internetworking product revenues.

Loop Access revenues were $51.7 million for the second quarter of '08 compared to $55 million for Q2 of '07. Comparing Q2 of '08 to Q2 of '07, the decline in digital access -- the decline in Loop Access revenues was attributable to a decline in enterprise T1 and HDSL revenues. HDSL product revenues were $45.3 million in Q2 of '08 compared to $46.3 million in Q2 of '07.

As a result of the above, carrier network division revenues were $104.6 million, and enterprise network division revenues were $26.6 million in Q2 of '08.

International revenue was $7.8 million for the second quarter of '08 compared to $8.3 million in the second quarter of '07. To provide the reporting of each of these categories, we have published them on our Investor Relations page at www.ADTRAN.com.

Gross margin was 60.5% revenue for the second quarter of '08 compared to 59.5% for the second quarter of '07. Comparing Q2 of '08 to Q2 of '07, the increasing gross margin percentage was primarily attributable to more favorable product mix and lower manufacturing costs for the quarter. Research and development expenses were $20.2 million in Q2 of '08 compared to $19.5 million in Q2 of '07. The increase in research and development expenses was primarily attributable to an increase in activities related to customer-specific development efforts and (inaudible) costs related to Tier 1 carrier product approvals. Selling, general and administrative expenses were $25.7 million for Q2 of '08 compared to $26.2 million in Q2 of '07.

Stock-based compensation expense net of tax was $1.8 million in the second quarter of '08 compared to $2.1 million for the second quarter of '07. Other income net of interest expense was $1.9 million in Q2 of '08 compared to $2.8 million in Q2 of '07. The decrease in other income net of interest expense would for Q2 of '08 is primarily attributable to lower investment balances as a result of our share repurchase program on lower interest rates.

The Company's income tax provision rate was 36.6% for the second quarter of '08 compared to 35.2% for the second quarter of '07. The tax provision rate for the second quarter of '08 was unusually high, primarily as a result of delays in thorough legislation required to extend research tax credits for the 2008 year.

Earnings per share or assuming dilution for Q2 of '08 were $0.34 compared to $0.28 for Q2 of '07. Inventories were $49.8 million at quarter-end. Net trade accounts receivable were $62.7 million at quarter-end, resulting in DSOs of 43 days for the second quarter of '08 compared to 49 days for the second quarter of '07. Net cash provided by operating activities for the second quarter of '08 was a strong $30.7 million compared to $28.7 million for the same period in the prior year.

Unrestricted cash and marketable securities totaled $248 million at quarter-end, after paying $5.8 million in dividends during the second quarter.

As you are aware, ADTRAN has traditionally seen sequential revenue increases from the second quarter to the third quarter. The third quarter of 2008 we believe that revenue will grow sequentially and, therefore, year-over-year. Although our second-quarter results reflected good momentum, we want to remind you that timing of near-term revenue associated with large projects we are engaged in, combined with a possible impact of the slope enterprise spending environment, make it difficult to predict the amount of sequential and year-over-year growth we expect to see in the third quarter.

We believe the larger factors impacting the revenue we realized in the third quarter will be the following -- stability of our traditional product revenues; spending levels at our Tier 1 and Tier 2 carrier customers; order trends and traction into our international customers; the adoption rate of our Total Access 5000 and 1100 series platforms; the adoption rate of our OPTI 6100 with Tier 1 carriers; continued growth in Internetworking revenues and general economic conditions. We believe we will execute in a range consistent to our historic operating model at the achieved revenue level in the third quarter.

Tom?

Thanks, Jim. Okay. Vanessa, we're ready to open it up for any questions we may have.

(OPERATOR INSTRUCTIONS). Scott Coleman, Morgan Stanley.

Maybe I could start with a housekeeping question in terms of what the customer percentages were this quarter, Jim?

Sure, Scott. AT&T came in at 24% of revenue, Verizon 11% and Qwest at 20%.

Okay. And one of the things that stood out from the numbers was the lack of a buyback during the quarter. You had been pretty consistent over the last eight quarters. What was it that caused you to hold back in Q2?

Well, Scott, first of all, I would like to say that we really have not changed our view at all in terms of our buyback and the approach that we are using in terms of it being an opportunistic approach.

At times we do miss an opportunity within a quarter if we look back to the earlier part of the window that we would typically buy back in. We have an opportunity there, but in hindsight we should've taken advantage of it but did not. But again, going forward our view again has not changed in terms of taking an opportunistic approach on this.

Okay. And then one last one if I could. Just to make sure I understand your comment about Q3, it sounds like you expect to grow as you traditionally have in Q3. The question is what level. So if you grow from here, it sounds like you would expect to keep operating margins somewhere around the 25% level at least in Q3. Is that the right way to interpret your commentary?

Well, let's take this approach perhaps. If we look at gross margin, we continue to anticipate gross margins will be in the high fifties range going forward. If we look at OpEx, SG&A we anticipate will be flattish somewhat in the third quarter versus the second. And we anticipate that R&D will probably move up a little in the third quarter. Tax rate at a rate somewhat consistent to what we saw in the second quarter.

Okay. Very helpful. And then I guess maybe one last one from me, which is when you talked about the stability of your traditional products and spending levels at Tier 1 and Tier 2 carriers as the first two things that you mentioned in what the factors that could affect revenue in Q3. Now the traditional products obviously had a very good quarter in Q2, maybe better than most were expecting. Is there any reason right now to think that that falls off? Are you seeing anything that gives additional concern?

And then a similar question on spending at Tier 1 and Tier 2 carriers. Have you noticed any change -- DSOs were down a lot. Did the quarter start to trend a little worse as you went through it? I'm talking about Q2. So what is it that gives you incremental pause here?

Well, the quarter did not trend worse. In fact, the order flow for the quarter was very, very consistent, which obviously contributed to an improved DSO. It also contributed, while we're talking about order flow through the quarter, it also contributed positively to our gross margin. A consistent order flow allows us to more efficiently and effectively plan for shipments and meeting customer dates. We incurred significantly less if not zero expediting costs in the third quarter. Our freight costs were lower. No reason to believe that that will not happen in Q3.

Now, Scott, does that answer all your questions?

It does. Thanks a lot, guys.

Vivek Arya, Merrill Lynch.

A couple of questions. First is just sort of a macro question, Tom. I know you sort of addressed it in your opening remarks. The question really is, what is your view of carrier and enterprise spending trends as you look out in the second half? Are you seeing deals sort of remain on track or get pushed out? What is the general mood of your customers versus the first half of this year?

We are expecting a mood that is very similar. Let me speak to the carrier piece first. It is very similar to what we have seen over the last six to nine months, which is it is going to be very, very targeted on what they spend then or spend on. That Q2 carriers have kind of lowered their spending levels, and they are being just very careful on how they spend, and we kind of expect that same mentality going forward.

Tier 1 carriers have specific projects that they want to move forward that help them long-term, and I think that they are spending on those projects. And we really have not seen any change in the appetite. I think our positive feeling going through the rest of this year and into the future is that we believe we are positioned well in a lot of those target areas both for Tier 1 and Tier 2 carriers. So we believe as we continue to introduce new features and new products that we will be able to garner market share in areas that we really have not played in before.

On the enterprise side, I would say it has been a slow environment definitely through this year. Our traditional enterprise products have taken the brunt of that. HDSL has held up very well, and we are expecting it to continue to hold up well. But it has more pieces than just the enterprise or SMB customer base that kind of helped drive that momentum one way or another. But the rest of the enterprise products will continue to get market share in our Internetworking products, but the traditional enterprise products that we would not -- I would not be surprised to see them continue to trail down.

And then specifically regarding some of your customers, especially Qwest, which I think you have seen very strong deployments at I assume with the 1100. Is that just a one or two or three-quarter type cycle and then it again trends down? Or do you see a longer-term three to five-quarter type growth prospects ahead at Qwest? So it is just really the magnitude and the growth prospects going forward.

Sure. Qwest has been a growing customer of ours both on the carrier side and on the enterprise side really for quite a number of quarters actually, and we expect that there is still an awful lot of potential in that account. They buy multiple products. We, as you are probably aware, have received awards on additional products that have yet to be operationalized. I think that we will continue to seek mixes in what they buy from quarter to quarter, but we are definitely optimistic about the multi-quarter outlook on Qwest.

And just last question, the TA 5000, you have awards with the number of Tier 1 carriers. Now I'm reminded of a similar situation. I think a year or two years ago when there was a lot of promise, a lot of optimism around the remote outside plan, DSLAMs, and I think the market for that turned out to be perhaps smaller or perhaps not as big as expected. How would you -- first of all, is that a fair characterization? But how would you really compare the addressable opportunity that you saw with that kind of product versus now that you're seeing with the TA 5000?

Yes, so I will quibble a little bit with the characterization in that. I think that the outside plant product a couple of years ago actually we did see a very large uptake, and there was a period of time -- now we are going back literally two years or so -- where, and if I look back three years, the majority of our sales were central office DSLAMs. We really started pushing our outside plant and remote terminal products. We saw a significant shift in the market towards those products, and those products did very well. And those products, the outside plant DSLAM, is exactly the product -- now it's a matured since then in that we have added features and things, but it is exactly the product that we are now selling to every carrier in the US, including -- or every major carrier in the US -- including Qwest for their Fiber to the Node deployment and including Telmex for their Fiber to the Node deployment. So those products have been doing fantastic. And we expect those products actually to continue to grow even from this point.

Now does the TI 5000 have more potential than the 1100 series, the Fiber to the Node products? It plays in a lot more markets, and those markets in and of themselves any one of those markets where some of those markets are just as big. So I think it is dependent upon us and how we execute and how much marketshare we can garner going forward. But I would say we're just as optimistic if not more on the 5000.

Simon Leopold, Morgan Keegan.

I wanted to see if we could drill down a little bit on gross margin in the discussion. Jim had forecast a gross margin in the high fifties range, which is consistent, and this quarter you broke through that 60% barrier. I know we are sort of discussing tentative basis point perhaps. But if you could give us a little bit of sense of what were the key factors this quarter to take you over the 60% mark?

Sure. You know, there are a few things. A portion of it was more of a favorable product mix. A portion of it again was attributable to the very consistent order flow that we had across the quarter, which enabled us to plan our orders in terms of manufacturing and shipments very efficiently, thereby avoiding much of the expediting costs that we have incurred in the past due to a more irregular quarter in terms of orders.

We incurred less expediting costs. We also incurred lower labor costs as well, and also our inbound freight cost was down meaningfully as well in the quarter. So all of those things would contribute to a gross margin that we saw.

And I will add, if you remember in the last couple of quarters, and let's say if we go back at least three quarters, there were periods of time there where we had incentives in trying to grab marketshare in one place or another. In one case we had kind of undue expedite costs as we had one carrier come in and buy a significant amount in a quarter and one that shipped in that same quarter. It kind of happened late in that quarter, and we did not have those type of expenses happen this quarter.

And I have had the impression, and I'm wondering if this is still the case, that your newer products within broadband, optical and Internetworking tended to have a better than average gross margin, whereas the more mature products in the HDSL and carrier segment had a slightly worse than average gross margin.

First of all, is that the case, and that is part of the reason why I was a little bit surprised about the gross margin this quarter given the mix.

Actually my opinion is that they have really trended towards the same poll, and we may get efficiencies, for instance, in HDSL if we have a very level loaded order rate in HDSL, and that efficiency would play through an improved gross margin, the same way we can with our broadband product.

But I would say if you look at them on a major product set, by a major product set basis, they are right in there with each other.

Appreciate that. One last one is, I think during the last call you had talked about the 5000 revenue or contribution being on the order of, if I recall, correctly I think you said 5%-ish of revenues, a number that I interpreted in the neighborhood of $6 million. Could you give us some more commentary of where we were in the June quarter for that product?

Yes, I hate to keep breaking that out in such a granular level, so let me just give you from a high point. I mean I would characterize our order flow within the 5000 as being basically consistent with what we saw in Q1. If you think about it, the reasons are straight forward. We have the new wins. We just started -- we just received orders. We did not start shipping for that second Tier 1 carrier, so that impact has not happened yet. The third Tier 1 carrier is still expected towards the end of this year to receive orders. So that has not happened yet. We have won some approvals in some of these Tier 2 carriers more than what we had had, let's say, exiting last year, and we're expecting those to come on in the second half. And, in general, I would say that the spelling space was very similar to what we were in in the first quarter. And that the Ethernet over Copper customer, the very large Tier 1 that we did start shipping to is very early in their phases of marketing the service.

Okay. And just one last follow-up on that one. I assume in terms of the outlook for the progression for the TA 5000, particularly with those Tier 1 customers, I assume you are forecasting what I would call a normal progression, a normal ramp for that kind of carrier as opposed to something expedited or slow?

Yes -- you know, we have -- the answer to your -- the high-level answer to your question is yes. You are correct. There are some more project-oriented type wins that may swing us from quarter to quarter, but in general over the long-term the answer is yes.

Nikos Theodosopoulos, UBS.

A couple of questions. Your 10% customer historically you have had Embarq in there fairly consistently, and I noticed it dropped off this quarter. Was that both across the operating company and the distribution part, or was it on one side? Can you give some color on that?

You know, I would say that we saw a slowness in Embarq in general if I can answer your question. (multiple speakers) -- talk about their specific businesses. But let me just say in general we saw a slowdown. I would not attribute it to one particular segment.

Okay. Okay. Can you give on the TA 5000, you mentioned that the Tier 2 orders came in towards the end of the quarter or the second Tier 2 customer. Are those orders you think are targeted to ship in the third quarter, or would you say it is after the third quarter?

The second Tier 1 and yet we expect to receive additional orders through this quarter, and we will start shipping this quarter.

Okay. And just last question. Can you give an update on the trials for the 5000 overseas? You had talked about those. I think you said there were about a dozen or so. I know that BT announced today that they are going to do a Fiber to the Node deployment in the future. I'm just wondering is that an account that you think you could penetrate, or is that kind of a long shot given the lack of a historical relationship?

Well, the lack of historical relationship absolutely hurts your odds of being able to penetrate any of these accounts, and that is just one of the issues that we have got to deal with in that we have got to have some presence there for some period of time. Do I think BT is a potential customer that is a realistic potential customer? Absolutely.

As far as the rest of the trials going on in our international space, they are still ongoing. Of course, they are further along. We are hopeful that we will secure awards, maybe not shipments but awards on some of those 5000s this year. And, to be honest with you, I would not be surprised -- I did not check on that exact number -- I would not be surprised if we had already done so. But they are all moving forward, and we're still optimistic about the long-term prospects.

George Notter, Jefferies.

I guess I was just thinking about your Q2 guidance for sequential and year-on-year growth, sorry, Q3 guidance for sequential and year-on-year growth. Any impacts that you expect there front Verizon? Obviously the labor contract there expires on August 2?

We're not forecasting that. In the past when those things have happened, they haven't the duration or just because of the preparation did not affect things for us in any meaningful way. And that is kind of what we're expecting here. If Verizon shuts down for an extended period of time, then we would have to rethink that. But we're not expecting that at this point.

Got it. Just coming back to the TA 5000, certainly in some of the Tier 2 opportunities, Calix would be an incumbent vendor in many of those accounts. How do you see the competitive environment vis-a-vis Calix? Are you winning primary sources vis-a-vis Calix or secondary sources vis-a-vis Calix? What is your thought there?

I would say at this point it is all of the above. Calix is a good competitor. They have been in that market, serving that market for some period of time. We think that there's absolutely space for us in every one of those accounts, and many of those accounts and in all of the Tier 2s, we have been able to show that value enough to be able to create that space.

You know, George, long-term we drive for market share. And we are confident in our position right now, but I will not ever say that -- Calix is a good company. So they will continue to fight with us along the way.

Greg Mesniaeff, Needham & Co.

I was hoping to drill down a little into the AT&T customer, 24% of revenues in the quarter. More specifically if you can give us some color on to what extent is AT&T deploying your products in its wireless back haul infrastructure now that 3G -- the 3G ramp is fully underway? And I was wondering if you could maybe give us similar color on Verizon as well? Thanks.

Yes, sure. I think to the extent that all of these carriers upgrade their network capacity for 3G or for any reason for that matter, that it is predominantly and I mean very near 100% if not 100% using the products that we are all familiar with. So HDSL and SONET-based optical assets for the most part.

Are you noticing a transition towards moving away from traditional HDSL or T1-based backhaul to pseudo wire-based?

No, not at this point. There has been talk about that. We have participated in many conversations about that with different carriers, and to my knowledge it is just not happening in any meaningful way at this point.

So is it fair to say that the relatively nice resilient HDSL business tone was due in part to the backhaul business?

I think that would be fair to say.

Paul Silverstein, Credit Suisse.

It may be more appropriate for Jim, but Tom, feel free. A question, if you go back in time, I think it was the second half of '05 when you all were generating 32, 33% operating margin. I recognize it has not exactly been the norm, but Jim, what would it take to get back there? Is that a possibility, or is that just too far a stretch? You're doing 60% plus gross margin now. I understand that may not be sustainable either, but is 30% plus doable?

Well, Paul, I think it is all dependent on the revenue level. If we look back to the third quarter of '05, that was at a record revenue level. And could it happen again? Sure, it could, okay? But again, over the longer-term, we don't think that that would be sustained as we would again increase investment in R&D and sales and marketing again to grow the business, to continue to feed the business.

Jim, if you just isolated volume in terms of the impact on operating margins, can you quantify for us above a certain dollar amount for every blank dollars of revenue, it is an additional blank percentage points of operating margin?

Well, not at this point. I think analysts are pretty much aware of our operating history and leverage on the revenue line. I think I need to leave it at that.

Okay. One other question if I may and I apologize. I know you guys have explained this a number of times, as well as on this call. But Tom, can you go back over the visibility on rollouts with the Tier 1s on both the optical and the TA 5000 platform?

I guess I'm still a little confused in terms of you're talking about -- it sounds like you're talking about a hunting license and a lot of it is dependent upon their ability to sell the service in terms of what quantity of product that they are taking. Can you just give us a little bit more insight there?

Yes, I think maybe the confusion is because we're talking about multiple products; that has been also multiple customers and within that multiple application. And within that big sphere of things, the potential is different.

So let me start with the OPTI product line and just kind of step you through where we are on that.

With the OPTI product line, I think the big -- they were a couple of things that we were looking forward to continue to drive that business to where we think it can be. The first one was a Phase II deployment at the largest Tier 1 carrier in the US, which happened towards the tail end of last year. And since that point in time, we have seen that optical product really do well in that carrier, and it has grown meaningfully. It continues to see very strong growth quarter-to-quarter, and we're expecting that to continue on.

So I would say we are still early. We're really two quarters now after the initial approval, and we are -- it is where we thought it should be.

And the other Tier 1 where we have widescale approvals, that business also is growing. It really started here again at the tail end of last year, and it has been growing meaningful, although smaller in size because the carrier is smaller.

The third RBOC, our approvals are not for the entire application set. It is really for the business side of -- I think it is very well known, it is Verizon business, it is not Verizon telco. We continue to work toward getting approval on Verizon telco, but right now we're in Verizon business, which is more customer-oriented. We do have approvals going through to continue to add features, and we expect actually that account to continue to grow for some period of time, and it has done pretty well this year.

The other piece in the OPTI line that we were looking for were we introduced OC48 products towards the end of last year, and we're looking to get approvals within the Tier 2s of those OC48 products, and that has started happening early this year. We saw some uptick, customers like Embarq and like Windstream, and we think there's a lot of potential there. If you look at the optical line across those accounts, I think that we have a lot of growth potential. And in those accounts, the hunting license I thought that you brought up is true. In the largest Tier 1, they do not have to buy our product, but our product has significant advantages in my opinion compared to the competitive products. And we have seen the momentum behind it so that we really believe we're not just believing our own press releases or whatever.

In the 5000, the first approval, Tier 1 approval, happened end of last year. You are aware of that, Ethernet over Copper. That is one that will be success-based. There is no hunting license from our perspective. That market is a market that there is no competitor selling against us in that network. The hunting license may be that what has to happen is that customer has to go out and sell services, and they are just really in the early phases of marketing and starting to sell those services. I believe they are very, very optimistic about the potential of the marketplace, and they believe that business customers are going to go towards ethernet connectivity, and this is going to be a main avenue towards growing ethernet connectivity.

In the other Tier 1 that we just received orders for, we are -- it is here again not a hunting license. It is if they are going to do this type of switchover, they are going to use our equipment. It is project-oriented, so it will be region by region as they decide to go and upgrade these pieces, and we have seen just the first pieces of that, the tail end of last quarter.

The third carrier on the 5000 and I believe in every win and we have won multiple wins in all of these, but in that third carrier we have won three or four different application sets, and in every one of those application sets I believe we are sole-source. So it will be -- (multiple speakers) as they move into it.

I appreciate it.

A long answer but I hope we covered what you're looking for.

Blair King, Avondale Partners.

My questions have been asked. Just maybe one question would be, if you could outline any progress with Telmex? I know they have been a little lumpy, but if you could give us some insight into what their pipeline might look like for the balance of the year?

That is a good question. They are a customer that is, as you know, was new to us, and we have been -- we believe that there is -- first of all, we believe there is potential for orders this year. They are going through the still operationalizing of the equipment that they bought. They also have initiatives on their on part on what they want to do with IPTV and rolling out video, utilizing our products. And I think that may affect the magnitude of what they do over the long-term, but I don't think it necessarily -- that approval or nonapproval does not necessarily affect whether or not they will continue to buy equipment.

So to sum that up, we expect at this point in time still to receive additional purchase orders this year. We think they will be meaningful purchase orders, but like I said, it is a new customer, and we're still trying to learn the ropes there.

Rai Archibold, Kaufman Brothers.

Thank you. Most of my questions have also been asked. I just wanted to follow-up, though, on the Internetworking product where we did see some very strong growth. But you did reference headwind I guess related to some what you felt was softness in spending. Can you just sort walk us through what is driving the share gains, if you will, there? And are you seeing that in specific type of applications, specific type of geographies?

Yes, I think what is driving Internetworking at this point, if I had to pick the one biggest positive mover, it has been the RBOC accounts or the Tier 1 carriers really driving in the product into the customer base. And we have won towards the tail end of last year and maybe towards the middle of last year some awards at two of the Tier 1s. Those awards basically have since grown to where we have more approvals now. And as we get more approvals, we're just gaining more market share, and I think that is what has affected those numbers the most.

We think that will continue to be a positive. If I look at the VAR base, the dealer base, I would say that that is not as robust as you would typically see in a normalized economy.

Okay. And in the carrier that you have for the Ethernet over Copper application for the TA 5000, are you seeing that also driving more of the Internetworking business, or have you not seen that connection take place yet?

There is a connection there in that one of the things that is positive about our Ethernet over Copper product line is that with every Ethernet over Copper central office or remote terminal point I ship, I also ship a NetVanta termination router on the other end. So there's basically a one-for-one correlation there, and that will drive it over time.

Ehud Gelblum, JPMorgan.

I want to look at Q4. I know you don't like looking more than two weeks beyond the end of all of our noses. But looking historically and I am looking at your HDSL business separate from your growth product, your Q4 has traditionally been weak because of weak HDSL.

Now last year your Q4 you actually had up growth and down HDSL, and you ended up in total being down slightly but not as much as in prior years. Your growth products now are increasing percentage obviously of your revenue, and it sounds from what you're saying that growth products will continue to grow both in Q3 and in Q4.

Last quarter you gave us guidance that revenue would grow sequentially in both Q2 and Q3. Now I notice you would not go so far as to say that revenue would grow sequentially two quarters out in Q4. But when you look at your growth products, can you feel confident that they should grow at least in Q4, and so that if you were to have a down Q4 for total revenue, it would again be because of the unknown in HDSL and not because of your growth products?

Well, let me give you -- start by giving you kind of my take on the legacy products and what they do in Q4. I would say traditionally what we have seen is every product has the decline in Q4, and that is including growth products. The only thing that offsets that is, if we end up winning particular market share in a particular region that is strong enough to offset it or if an approval comes online that we have been waiting on and then we have that initial buildup for a product set. Other than that, we typically see weakness across the board. And I think we probably explained on the first quarter that -- excuse me, on the fourth-quarter conference call --

The Telmex in Q4.

Yes, that we had some projects that got approved which really drove some products. But in general we would still say we saw the typical seasonality in the fourth quarter across the board, and what that did is maybe mute the growth that we could have seen if we did not have that seasonality. So I would still expect seasonality across the board and not really just in HDSL in the fourth quarter. And because of that, we are going to be reluctant on trying to tell you where the fourth quarter sits. The fourth quarter could be impacted by some of these approvals and some of these rollouts where the timing is around that same timeframe. But we just don't know that yet right now. And forecasting RBOC deployment is a very difficult -- I don't even know if I would call it a science.

Okay. Do you think in October when you have your third-quarter conference call, you would have visibility on whether Q4 will be up or down, or do you think it would still be --?

I would fully expect that on the third-quarter conference call to give you some color on fourth quarter the way we traditionally do and give you the visibility that we have at that point in time.

Would it at least be true that because of the growth products being a larger portion of your revenues that you have a little bit more of a deterministic ability to understand what your growth rate is versus before when HDSL was a larger piece?

Well, maybe as we look forward a few quarters out, that may be true. But right now we still have the problem of new products getting approved and getting them through that approval cycle, which can swing things. So I would not call it more deterministic at this point in time. I mean I dream of the time when that will be the case, and that we will be shipping an awful lot of system level products that require longer leadtimes. But I would not say that is the case today.

Okay. Your DSOs being as low as they were, it sounds like it is related to the high gross margins from what Jim said, in that your linearity was very linear for the quarter, and therefore, you could plan things a little bit better.

I guess in general your linearity is a lot more back-end loaded into the last quarter. What were the reasons for that, for the better linearity, and do you expect that to continue into Q3, or would you expect it to go back to a much more back-end loaded quarter bringing your DSOs up and your gross margin down?

This is Jim. I would not say that every quarter is back-end loaded. I mean it varies quarter to quarter as you go through the year. However, the first quarter is typically back-end loaded. The fourth quarter is typically front-end loaded.

The second quarter was -- again, it was a very consistent almost to an unusual consistency across the entire quarter, to enable us to realize some -- a meaningfully business season. So whether or not that will happen in the third quarter in the same way, we don't know yet.

I would say traditionally, though, there is no one real standout month in those middle quarters that takes -- that 50% of the revenues fall in that middle quarter or something like that. Traditionally they are smooth. This one was smoother than most.

Can you give us some numbers around that because DSOs fell an awful lot.

They did fall a lot. I mean it was --

Can you quantify the linearity this quarter versus other quarters?

(multiple speakers) very, very, very linear. More linear than -- it was probably one of our most linear quarters.

But not front-end loaded? Actually just completely linear?

Correct.

Okay. Finally, FairPoint, is at any update on trying to get back in there, or was that kind of a [dormant] situation?

With FairPoint?

Right.

Well, we do sell to FairPoint some of our products. I think you are probably specific to that particular rollout in the Verizon (multiple speakers) territories, and I would say there is no change. At least from my visibility, there is no change in the (inaudible).

Okay. Thanks so much.

Brian Coyne, FBR Capital Markets.

Just a couple of them. First of all, Jim, you talked about your OpEx outlook being flat to slightly up on a sequential basis. I assume you're talking on a dollar basis. I guess just on that, if you could just maybe drill down a bit on the cost structure. I mean this quarter both R&D and SG&A both declined as a percentage of sales. Can you say if that involves any roll-off of the Total Access 5000 startup cost?

No, no, the startup cost on the 5000 in terms of initial performance would be have been more of a contract in the first quarter. So now we did see some (inaudible) costs and the R&D line in the second quarter related to some 5000 application approvals.

Okay, yes, I guess that is what I was thinking about.

And we will probably continue to see those, be it in the 5000 or OPTI as we add new features going forward, so those will always be there.

Okay. And then over the past couple of years, your OpEx in the third and fourth quarters generally followed that sequential trend of declining and then again rebounding as a percentage of sales I guess largely on the seasonality of the sales. And I guess going back to a couple of other questions that have been asked previously, any reason to think that pattern really changes in 2008, and maybe does the slower enterprise demand trend influence that?

I don't think so. I mean we're not expecting any discontinuities in the expense line for the rest of this year. So I don't see anything that should affect that.

Okay. Then I guess the last one, at AT&T revenues again flat roughly I guess quarter over quarter. But I was wondering again if there is perhaps a little bit of a mix shift. I think Greg referenced this a little bit earlier. Again, it sounded like HDSL had a big snapback in the first quarter at that carrier. If you could just comment perhaps on what happened in the June quarter?

Well, first of all, it was not flat. It was actually -- (multiple speakers)?

Yes, AT&T was 24%. And now on a dollar basis, AT&T was up slightly.

Right, right.

On a mix I would say the biggest, probably the single biggest contributor, and correct me, if I'm wrong here, Jim, was probably the growth in Optical Access.

Growth in Optical Access and some sequential growth in HDSL as well.

Jack Monti, Lehman Brothers.

Just a quick question on inventories. It seems like they grew modestly in the quarter. I was thinking is it fair to assume that they will grow more as you meet demand for new products and perhaps maybe you build additional inventory as a cushion to make sure there's no mistakes with those product launches?

I would not expect a significant increase in inventories. We shoot for turns around 4.5 or so, and we have been pretty consistent with that plus or minus 0.2. And I would expect us to be able to manage. I think from an inventory perspective, we are at a manageable level. We are able to meet our customer requirements right now, and I don't see a big shift in that.

The only thing that may change that is, if we do have at least one if not more, but mainly one customer that will come in and buy an awful lot of stuff, and we will have to increase inventories at that time. And if it does not ship in that quarter, you may see a shift, but that would be a short-term phenomenon.

Todd Koffman, Raymond James.

Just a clarification on the TA 5000. With regard to the second Tier 1 that you said you received initial orders for, is there any opportunity at that carrier to deploy the TA 5000 in an Ethernet over Copper deployment, or has that vendor already made its decisions regarding its deployment for that service?

Yes, it can be confusing depending on which Tier 1 we're talking about, so let me give you a little bit more color. The application for that Tier 1 is ATM to ethernet aggregation. So it is putting 5000 in the central offices. They will terminate existing DSLAMs and then convert those -- aggregate that traffic and convert that traffic overtaking it. That carrier has not made a decision on Ethernet over Copper.

The other Tier 1 carriers have made decisions on Ethernet over Copper, and the other Tier 1 carriers for mass deployment I think we're in -- of course, one of we have already announced that we have won. But I think we're in very, very good position with both of the carriers that have made decisions or are deciding to roll forward with Ethernet over Copper. Did that answer your question?

Yes, just very helpful. Just a quick follow-up. For that second Tier 1 where you are deploying the TA 5000 for ATM for ethernet aggregation, what is the timing for them to maybe decide as it relates to Ethernet over Copper, or is that still completely up in the air?

That is still completely up in the air. I think that when we talk about Ethernet over Copper, it is real easy to get confused with that and ethernet over TDM, and there are some other things going on in that arena of trying to convert services over to an ethernet backbone. Ethernet over Copper is kind of native ethernet, so that is kind of fresh stuff you can think of. But that carrier has not made that decision yet.

To the best to my knowledge, that carrier has not made the decision to even move forward with that product set at this point in time.

Then there is the how do I convert my existing legacy network over to an ethernet core, which the 5000 does a tremendous job of. And we are in discussions with all the carriers about different phases of that.

Vanessa, I think this will be our last question. I think we're about out of time.

Ari Bensinger, Standard & Poor's.

I just was hoping you could provide more color on your statement of constrained spending by some of, you mentioned the lower tier customers. Is it because of the housing slowdown or just consumers are being more cautious with their -- with what they are spending on access technologies?

Sure. I think the note was mid-tier carriers, and as to the rationale, I would really like to leave it to them to explain. But I do think that most of the midtier carriers have been really cautious in their CapEx spending at this point in time probably for a year. In fact, we even saw periods of that prior to a year ago. And I would say that environment has not gotten worse. I would say it is just the same and that they are still being very, very cautious in how they spend money and even maybe the approval cycles of how they spend it and things.

So I don't know if I would attribute it specifically to the economic environment more so than just the methodology under which they are running their company today.

Alright. Thank you.

Okay. Well, thank you very much, Vanessa, and thank you very much for joining us on our conference call. We will look forward to seeing you a quarter from now. Have a good day, everyone.

This concludes today's ADTRAN conference call. You may now disconnect.