ADTRAN Holdings Inc (ADTN) 2011 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to ADTRAN's second-quarter 2011 earnings release. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there'll be a question and answer session. (Operator Instructions).

During the course of this 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 risk and uncertainties, including the successful development and marketing 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, 2010 and Form 10-Q for the quarter ended March 31, 2011.

These risks and uncertainties could cause actual results to differ materially from those in those forward-looking statements, which may be made during the call.

I would now like to turn the call over to Mr. Tom Stanton, Chief Executive Officer of ADTRAN. Sir, please go ahead.

Good morning everyone. Thank you for joining us for our second-quarter 2011 conference call. With me this morning is Jim Matthews, Senior Vice President and Chief Financial Officer.

I would like to begin this morning by discussing our second-quarter performance, along with some comments on what we expect for the third quarter. As stated in our press release, ADTRAN set a new revenue record of $184.2 million in the quarter. Our performance was driven by our growth areas, which grew 48% over the same period last year, as our Company continues to benefit from increasing demand for higher speed services in both business and residential markets.

In addition, broad-based strength for mobile infrastructure upgrades, the continued migration towards IP services, as well as an increase in demand outside of the US all combined to drive our growth area categories to achieve a record $132.1 million in revenue, which represent a record 72% of our Company total.

Looking at our businesses on a product line basis, Broadband Access achieved its sixth consecutive record revenue level by growing an impressive 71% over the same period last year to $77.1 million.

As expected, both the Total Access 5000 and Fiber-to-the-Node platforms contributed to this performance. Strength in the Total Access 5000 was driven by continuing broad carrier acceptance, with strong growth in both large and small carrier segments.

It is important to note that although we saw an increase in broadband stimulus shipments, as we expected, we would characterize this opportunity as still being in the early stages, with an expectation for continuing acceleration as we move through 2011 and into 2012.

We also saw meaningful growth with the Total Access 5000 in the CLEC segment of the market, as competitive carriers increasingly take advantage of the platform's unique abilities to deliver world-class Ethernet capabilities to both business and residential customers.

Our Broadband Access business was also positively impacted by our continuing success in the Fiber-to-the-Node product area. This area not only saw the typical seasonal increases, but also increase due to incremental marketshare gains and a meaningful increase in international revenue.

Moving onto Internetworking. This category achieved its fifth consecutive record revenue quarter, growing 18% over the prior year. As in recent quarters, we saw growth across all our distribution channels, including the various carrier segments and our growing dealer base, where we have continued to increase focus on reseller development.

Another area of note is that, as in recent quarters, Internetworking saw growth in every major product segment, although we saw particular strength in the Ethernet switching and EFM product areas.

Optical Access also performed well, as expected, growing 30% -- 36% over the prior year. This new record revenue level was a direct result of our market position with both large and small carriers as we continued to invest in mobile backhaul infrastructure upgrades.

Moving forward, we see new areas of opportunities as we continue to position our current product offerings and aggressively pursue development efforts to address the rising needs and what will prove to be a very long-term and increasing market opportunity.

HDSL was down over the prior year, with $34 million in revenues. This was below our previous expectations. Although this decline was partially offset by growth in our fiber products, we believe some of the decline was likely due to the traditional pattern pullback after multiple quarters of strong demand. For the third quarter we expect HDSL will perform in a range between Q1 and Q2 levels.

Moving on to a discussion about the rest of our products for third quarter. We expect to see continuing strong performances from our Broadband Access, Optical Access and Internetworking categories, as well as growth in Professional Services revenues as ongoing projects progress and new awards come online.

We believe strength in our Broadband Access category will continue to be driven by our Total Access 5000 family and Fiber-to-the-Node platform, as carriers continue to deliver higher speed services, migrate their networks to Ethernet, and as these product lines benefit from increasing activities with international carriers and as broadband stimulus builds accelerate. We believe Internetworking will continue to maintain its current positive momentum.

Although the enterprise spending environment can be characterized as cautious, increased scrutiny on performance, return on investment and total cost of ownership continue to increase opportunities for our value proposition.

We expect our Optical Access products to continue their strong performance driven by increasing demand for our fiber-based platforms for mobility service upgrades.

Accelerating broadband deployments driven by increasing competition and intensive upgrade for mobile infrastructure, channel expansion in our Enterprise segments, meaningful sales initiatives outside of the United States, government and regulatory initiatives, coupled with an innovative, diverse and expanding product portfolio lead us to believe we will benefit from meaningful growth through this year.

I would now like Jim Matthews to review our results for the second quarter of 2011 and our comments for the third quarter of 2011. We will then open the conference call up for questions.

Thank you, Tom, and good morning to everyone. Revenue for the second quarter increased 23% to a record level of $184.2 million compared to $150.4 million in Q2 of 2010. Broadband Access product revenues for Q2 of 2011 increased 71% to a record level of $77.1 million compared to $45.0 million for Q2 of 2011. This increase was primarily related to continued growth in deployments of our TA5000 and Fiber-to-the-Node platforms.

Internetworking products revenues for Q2 of 2011 increased 18% to a record level of $33 million compared to $27.9 million for Q2 of 2010. Optical Access products revenues for Q2 of 2011 increased 36% to a record level of $22 million compared to $16.1 million for Q2 of 2010.

Carrier Systems revenue for Q2 of 2011 increased 54% to a record level of $112.3 million compared to $73.1 million for Q2 of 2010. Business Networking revenues for Q2 of 2011 increased 11% to $35.7 million compared to $32.2 million for Q2 of 2010.

Loop Access revenues for Q2 of 2011 were $36.2 million compared to $45 million for Q2 of 2010. HDSL product revenues for Q2 of 2011 were $34 million compared to $42.2 million for Q2 of 2010.

As a result of the above, Carrier Networks division revenues for Q2 of 2011 increased 28% to a record level of $150.5 million compared to $117.6 million for Q2 of 2010. Enterprise Networks division revenues for Q2 of 2011 increased to $33.7 million compared to $32.8 million for Q2 of 2010.

International revenue for Q2 of 2011 increased 182% to a record level of $23.4 million compared to $8.3 million for Q2 of 2010. To provide the reporting of each of these categories we have published them on our Investor Relations page at ADTRAN.com.

Gross margin was 58% of revenue for Q2 of 2011 compared to 59.4% for Q2 of 2010. The lower gross margin in the quarter was largely attributable to significantly higher perpetual services revenue, a significant increase in cabinet shipments related to footprint expansion of high-speed applications, and expediting costs related to specific customer opportunities.

Research and development expenses were $24.6 million for Q2 of 2011 compared to $22.3 million for Q2 of 2010. This increase in expense was primarily related to an increase in staffing costs, customer-specific projects and Telcordia expenses related to customer developments in mobile backhaul.

Selling, general and administrative expenses were $30.9 million for Q2 of 2011 compared to $28.5 million for Q2 of 2010. This increase in expense was primarily related to an increase in staffing costs and selling activities in the US and abroad.

Stock-based compensation expense, net of tax, was $1.8 million for Q2 of 2011 compared to $1.6 million for Q2 of 2010. All other income net of interest expense for Q2 of 2011 was $4.7 million compared to $3.3 million for Q2 of 2010. The increase is related to an increase in realized investment gains and an increase in interest income due to higher investment balances.

The Company's income tax provision rate was 34.0% for the second quarter of 2011 compared to 33.9% for the second quarter of 2010. The tax provision rate for the second quarter of 2011 included the normal benefit from research tax credits, and also included an additional benefit of $130,000 related to new state tax legislation taking retroactive effect from January 1, 2011.

The tax provision rate for the second quarter of 2010 included a benefit of $643,000 related to closure of the IRS audits for years 2006 to 2007, but did not recognize benefits from research tax credit due to delays in legislation. Again, that last sentence relates to 2010.

Earnings-per-share, assuming dilution, for Q2 of 2011 increased 27% to $0.56 compared to $0.44 for Q2 of 2010. Inventories were $86.7 million at quarter end, up $7.7 million from Q1 of 2011. The increase was driven by an increase in anticipated sales volumes, and an increase in activities related to installation services contracts.

Net trade accounts receivable were $83.3 million at quarter end, resulting in DSOs of 41.

Unrestricted cash and marketable securities, net of debt, totaled $478 million at quarter end, after paying $5.8 million in dividends during the second quarter.

Due to the book and ship nature of our business and the timing of near-term revenues associated with large projects, it is our policy not to give specific guidance for the quarter or for the year. However, we would like to give color to help you formulate your views on our near-term business outlook.

For the third quarter of 2011 we anticipate revenues will be in a range of flat to up mid-single-digit percentage points on a sequential basis. We expect third-quarter operating expenses on a percent-to-revenue basis to be in a range similar to Q2.

We believe the larger factors impacting the revenue we realize for the third quarter and the year will be the following -- spending levels of our Tier 1 and Tier 2 carrier customers; the adoption rate of our Total Access 5000 platform; Professional Services activity levels, both domestic and international; upgrades for mobile broadband infrastructure; the macro enterprise spending environment; and the timing of revenue related to broadband stimulus projects. Tom?

Thank you, Jim. Debbie, at this point in time we would like to open it up to questions.

(Operator Instructions). Ehud Gelblum, Morgan Stanley.

Thanks for the question. If I could dig a little bit deeper into the gross margin that you talked about, Jim, you give three reasons for it. Can you start giving us a little more color in how much each of those reasons contributed to the decline in gross margin?

And give us a sense as to when you're looking at the guidance for next quarter, you are flat to up mid-single-digits, how do each one of those chassis services, how do each one of those play into what you expect the revenue mix to look like next quarter? So what direction should we be looking at on the gross margin line?

I will try to answer that question the best I can. I don't have the specific data in front of me in terms of those three drivers. However, in terms of a third-quarter expectation, we will continue to expect gross margins, again, to be in the high 50s range; however, specifically to the third quarter, something closer to what we actually saw in the second quarter. Again, because we don't see any sort of meaningful mix shift between those components that I talked about in terms of driving gross margins lower for the quarter Q2 versus Q3. Hopefully that is helpful.

Yes, but the chassis comment, usually what comes after chassis are blades. Should we be seeing more chassis? So is this kind of an effective broadband stimulus that we see more chassis or is it more -- are we starting to put the blades in?

I would agree with your comment that typically we do see blades after the cabinet shipments. So the timing of that I would estimate would be in the foreseeable future. But in terms of pinning that to a third quarter, revenue item, it is hard to say at this point.

You said broadband stimulus was definitely affected this quarter and will accelerate going into the back half of the year. Can you give us a sense as to how are large that was and how large you are assuming that will be in your Q3 guidance?

I would say -- we would say it is in the single-digit millions for this quarter and expect it to accelerate. There is definitely -- we could get into the double digits next quarter, but I would just say we are expecting it to be larger than we did in Q2.

Did you expect that -- is that what drove the outperformance in the topline this quarter, the broadband stimulus was larger and earlier than you thought or was it the other areas and your share gains you mentioned?

I would say it is pretty much in line with what we thought before. I think we had a couple of things that came in that were stronger. I need to say the 5000 were stronger, but it wasn't just in stimulus-specific bids, it was stronger in both large carriers and small carriers with stimulus and without stimulus. And then we did see some incremental pieces outside of the US that came in fairly strong.

Okay. And finally the unearned -- what should we -- on your balance sheet your unearned revenue number kind of bounced around. It went up last quarter and came back down again this quarter. If we look at that -- should we be looking at that as a deferred revenue number, and what can we read into that decline there?

Well, the decline in deferred revenue really relates only to timing issues. I think most people know that the fluctuation that we saw -- or the increase that we saw in Q1 was in large part related to an international opportunity. And, again, the fluctuation in deferred revenue from quarter to quarter will be based on timing of revenue recognition. And as it relates to that specific international opportunity for the third quarter, we expect to see another strong contribution from that individual customer in the third quarter.

Okay. And then, finally, what can you tell us about 10% customers? Last quarter you changed your tune there in terms of what you could say, so what -- can you tell us how many, anything about how large they were or anything?

Well, we can tell you that we had three 10% customers, and we cannot go beyond that at this point.

Okay, I appreciate it. Thanks, guys.

Jim Suva, Citi.

Thank you. And congratulations, gentlemen, to you and your team for good results. When we look at the details of the different segments, is it fair to say that HDSL was a little bit softer than expected? And then you mentioned it is going to increase and be somewhere between Q1 and Q2 levels. Are we still on track for being down mid- to high-single-digits for this year or has that declined because of this quarter taking that number to be not necessarily valid and maybe down a little bit more this year? How should we think about how that product line is trending since it has a bit of a long tail?

HDSL is, unfortunately, one of those products that we have probably the shortest leadtime. I would just remind everybody our typical leadtime between order and shipment is somewhere on the order of -- well, it is less than two weeks. And HDSL probably actually brings that average down to some degree. So it is difficult for us to forecast.

The comments that I made in my comments around HDSL were -- we think there were a couple of things. One, we did see a pickup in the Optical business, which we were expecting. And what we had seen historically is those two kind of play off of each other to some extent.

Then, if we look at the last two to three quarters we saw a lot of strength that we were unexpecting. And if you go back far enough we have seen these kind of dips in quarterly revenue following some period of strength. So trying to figure out what is what is a little difficult. So with that we had pulled back from our previous low to mid -- to high-single-digits. And at this point just trying to give your view of what we think next quarter will be.

And our sense right now is that we are early in the quarter and, as I said, very short lead times. But our sense right now is that we will see some strength off of Q2. And I just gave your range of where we think the upside may be. Jim, you still there?

Thank you, and congratulations to you and your team.

Greg Mesniaeff, Kaufman Brothers.

A question on breaking out some of your revenue segments by wireline versus wireless or backhaul. In the past I know you have had some difficulty in being able to obtain that breakdown from your customers. I was wondering if there is any granularity you can give us about both in the legacy product area, the HDSL product area, as well as in the growth products? What percentage or what proportion was going to wireless backhaul applications versus more traditional wireline? Thank you.

So Greg, Jim. I will take that. So if you look at our Optical Access category, substantially all of that, the vast majority of that would relate to wireless backhaul applications. So that number is fairly well defined.

As we look at HDSL, in our view we saw very little wireless backhaul spending in the quarter as it relates to HDSL.

So most of the HDSL at this point is pretty much confined to more traditional wireline applications.

I think that is true. We tend to see -- having said that, there are inventory things that happened within, so we will see a buildup and then a slowdown. But our sense is that there is very little wireless spend this quarter on HDSL, and you were really kind of seeing the underlying enterprise and business-to-business connectivity. And if we compare this quarter to, let's say, roughly five quarters ago or so where we thought we were seeing very little wireless spend, I think it is pretty comparable to that.

Thank you.

Joanna Makris, Mizuho Securities.

I am wondering if you could comment a little bit on enterprise trends on a sequential basis? It looks like the revenue in that segment was flat. But you also commented on improving VAR relationships, so anything you can say about demand trends during the quarter and your thoughts on that segment going forward.

We are bullish on the segment. I will tell you the general feedback we get from the customer base is that there is some cautiousness out there in being able to make sure that they get a return on the investments that they're making. That has probably actually boded well for us over the last couple of quarters and maybe even through the recovery, or coming out of the recession. But there is still that angst about making sure that there is a fairly short-term return on their investment.

The reseller channel grew, and it has grown now for what, Jim, maybe five quarters in a row or so?

Yes.

We continue to see growth in that channel. We do have still a small amount of legacy products in that channel which declined, but the Internetworking segment continued to grow, and that is exactly the outcome that we are looking for. So I would say cautious, but we are still optimistic, and we still believe that we will continue to see growth out of that channel.

Just really quickly on the international business, you commented on strength there. Wondering about the implications of Telmex' lack of video approval as you think about your international business. And then also some general comments on the success you are seeing with the [UPE] product.

On our Latin American customer base, the franchise, I think you are correct specifically about Telmex not getting the franchise, but our sense is that they are looking for broadband -- higher-speed broadband expansion. And the product line that we are selling into that area is very, very well-suited for that. It does give them the feature upgradability if they were to get a franchise at some point into the future.

But I think their head is definitely focused on trying to increase customer speeds and footprint. So I don't see any negatives associated with -- any negatives associated from our perspective anyways with the delay there.

As far as UPE, we are in trials now in Asia and several carriers in Asia, as well as in Western Europe, and those are just continuing to move forward.

Thank you.

Ari Bensinger, Standard & Poor's.

If you could just give us a sense of how to view stimulus spending. Should that be seen largely as incremental revenue opportunities? And if so, your guidance for flat to single digits up sequentially for Q3, would that imply that the base business, absent stimulus, has reached a peak for the year?

We don't mean to give that implication. I think what we are looking at is the fact that timing with large carriers and small carriers and various initiatives, whether they be large carrier initiatives or broadband stimulus, tend to have push and takes within a three-month period of time. So what we try to do is aggregate all of those and come out with a most likely scenario, assuming that all of them do not happen at the same time.

If they do all happen at the same time, we are very pleasantly surprised. If you look over the last few quarters, probably more of them have happened than we have experienced, which is the rationale between the guidance that we give and our overtick above that guidance. But it is just a matter of us looking at that.

So I would not say that the underlying business -- we do not expect the underlying business to decrease, but we are saying that there will probably be some give and takes.

Understood. Congrats on a good quarter.

Simon Leopold, Morgan Keegan.

This is [Victor Chiu] in for Simon Leopold. The Optical and Internetworking sales seem to have slowed in momentum of this quarter. Was the delta driven by a confirm of particularly strong Q1 or are there things that you are seeing in terms of spending patterns from your customers?

I don't think anything is worrying us. If you look at those two product lines, Broadband Access without a doubt was stronger than we had expected. I would say those two product lines, nothing underlying in the momentum. I think if I look specifically at Optical Access, I would say the activity around Optical Access has actually been increasing over the last few quarters and we saw more activity this quarter.

So I would say it probably has to do more with timing of shipments and when one customer specifically has projects in a particular region coming online or not online, but nothing underlying there.

Internetworking, we had continued to see strength across the channel. I think Internetworking has had several quarters of sequential pieces, and I would say it is more of what ships in Q1 versus Q2 versus Q3. Nothing underlying there, other than the fact I would say there is a significant amount of scrutiny on what customers are spending money on today.

Just a more general question. The decline in overall legacy business, was a bit more pronounced this quarter, so just kind what are your thoughts regarding the trajectory going forward?

That is a difficult one. That decline -- we saw the decline in both the enterprise legacy business and, of course, the HDSL. The HDSL is the one I think most people focus on because it is the largest portion of it. And we have been seeing the decline in our legacy enterprise business for some period of time, so I don't think that was really that big of a surprise.

The HDSL piece was not something we were expecting that marked of a decline. We were very positive -- very happy that the growth areas were able to more than offset that. We are very bullish on our growth areas, so to the extent that we see a decline in there, we are very bullish the growth areas continue to grow at a rate that will make that decline basically a nonfactor.

Now having said that, we don't have a whole lot of backlog. Customers do not give us any really type of forecast on HDSL, so we get it and ship it. And if we look back over history, there is some sense that we have bottomed in this area, and that you will probably see some uptick. And in trying to weigh the amount of that uptick, I would say we are probably being slightly conservative on that. But having said that, we have been surprised both on the upside and the downside in the past on HDSL.

So you wouldn't expect the decline to accelerate (multiple speakers)?

I would not expect the decline to accelerate.

That's helpful. Just one last question. Just clarifying on your comments on Telmex and their plans, should we take that to mean that they weren't a very significant contribution to international revenue this quarter or are you (multiple speakers)?

No, I would not say that. Telmex was definitely a significant contributor to our international revenue in the quarter. I think the only underlying comment there that maybe Jim was talking about was the fact that we expect that strength to continue on. That was not a one quarter phenomenon.

Great, thanks very much.

Nikos Theodosopoulos, UBS.

If I look at the US business this quarter I believe it grew about 13% year-over-year. It decelerated from the prior quarters, and that makes sense given that HDSL is predominantly US. Do you think that that is a trough now in your year-over-year growth in the US, if HDSL doesn't decline any faster, and you've got broadband stimulus picking up, or do you see this as a new steady-state kind of growth and most of incremental growth going forward will be international for the Company?

That is a good question. I need to answer that over the long term, because quarter to quarter variations, as you know, in our business can skew things for the short period of time.

If I look at the different growth segments that we are looking at over the next few quarters or the next couple of years, there are several things that have not come online that we feel are very meaningful. We had talked a little bit about broadband stimulus. Without a doubt, I would expect broadband stimulus to continue to grow and add incrementally to our base.

If I look at the international revenue that -- we had already touched on that. If I look at the OEM opportunities that we have those have not meaningfully contributed in any way and those are yet in front of us.

If I look at the Optical, both from an Optical Access and a broader product segment, we are seeing things today and are working on things today that will benefit us several quarters from now that will be incremental to the baseline revenue.

So if you look at the baseline revenue on our growth product areas, are those declining? I would say no. So we do see a lot of incremental opportunities to us, and basically a solid base on the type of business we are doing today with our growth product. So I would say the answer over the long-term is no.

All right. Second question, I guess the next two just for Jim, or actually both of you on this one. Cash continues to build. Is the Company considering buying back more shares? I mean, it is just piling and piling quarter after quarter. The Company doesn't have a track record of being acquisitive, so I am just curious what -- does it make sense to just keep it on the balance sheet, especially with the stock pulling back after this quarter. Would the Company consider either increasing dividend or buybacks?

I am going to let Jim answer more specifically, but the answer is as it has been historically, option buyback or share buyback are absolutely a key part of our -- kind of a shareholder value and what we think is a good use of our cash. It is something we look at every quarter.

As you know, we are opportunistic about that. We also have a limited trading window by which we can do things, so that kind of puts a little caveat on what we can do. But, no, that it still is very much an active part of the way we look at things. And, Jim, anything specifically you want to --?

Yes, we have just over 1.9 million shares remaining on the current program -- on the current program, so we do have the ability to engage on an opportunistic basis.

Okay, but it doesn't sound as of now there is any plan to raise that authorization.

Well, historically we have raised that once we get to a level that, let's say in the 1 million share range. And it is something that we, of course -- is something that can be acted upon fairly quickly if the Board decides to do so.

Okay. Tom, on carrier spending, last quarter there was questions on just the overall environment, and there were some that were a little tight. My sense is that probably continued again this quarter. What do you think it is going to take to change that or is that just the ongoing for the rest of the year?

That tightness is very specific, so I would not at all call it across-the-board tightness. There are some large carriers that are doing very specific things that they are anything but tight about. We have seen the benefit of that, and we saw the benefit of that in Q2.

I made a comment after several questions on the last conference call about a specific customer. I would say that customer actually increased too, so we are seeing some.

But having said that, you have to be in the right area. If you are outside of that kind of target scope then it is a very difficult time right now. And I would say most of our products are in the right area for a large percentage of the carriers. So there is tightness, but I would say it has been no tighter in the product areas we are in now than it was 12 months ago. I would say we are still -- we still seem to be in an area where carriers are focused on.

Okay, great. Thank you.

Rich Valera, Needham & Company.

I have a question on gross margin, if I could. You mentioned three things specifically pressuring gross margin now. And it seems like at least two them -- that is the higher mix of cabinets right now versus blades and the expediting costs should mitigate in let's say quarters beyond Q3. So is it fair to assume that gross margin maybe trends up a bit towards more historical levels as we move into Q4 and beyond?

I think that is premature to say at this point. We did say in our comments that we are pursuing new installation services opportunities, which would be incremental to operating returns to revenue. So I think it is a bit premature to make any comment in that direction yet.

Let me just make sure that I maybe break that down to one final level, which is we have cabinet shipments where we are in effect taking somebody else's cabinet or our cabinet and we are buying additional material and we are shipping that out to the customer. As you would expect, the gross margin profile, if I am reselling in effect a battery or something is going to be different.

In aggregate that is a very positive thing for us. We don't have the same type of operating expenses associated with that as we may have with something that we develop ourselves.

The second piece of that is we are actively pursuing services revenue where we would actually go out and do installations. And we have seen a pickup in that business, which again has a different gross margin profile, although it has an accretive operating margin profile.

So those are the pieces that are coming in that weigh on gross margins, but in aggregate we believe that they're very beneficial to the bottom line.

How about the incremental expediting costs, should those mitigate at some point?

They should mitigate. Those come in when we see a shift in the business, for instance, where Broadband Access picks up in a very aggressive fashion. And there is a tight timeline associated with it. Those hit us historically from time to time, but they are not something that we would say would be every quarter.

Great, and one final one, if I could. It looks like looking back over the last several years you have seen about a 5% average sequential improvement in revenue Q2 to Q3, and you are guiding for sort of the flat to, I guess, roughly that range.

Is there anything specific that is holding you back from guiding towards historical levels? Is it maybe the Internetworking, maybe a little bit of a slowdown there or is it just -- that is just the way things are shaking out given all the puts and takes?

I would say that is the way things are shaking up, but I would probably say the -- if you go back far enough and you really see that type of that growth that wasn't specifically project related, then a lot of that was HDSL. So HDSL typically saw a seasonal pattern that you could pretty much bank on, starting in Q1 and going all the way through Q3. And then Q4 is the wildcard. With our sense right now of being cautious on HDSL that is probably some of what you are seeing.

Okay, that is it for me. Thank you.

Michael Genovese, MKM Partners.

I just wanted to revisit some of the comments on the interplay between HDSL and Optical Access. It sounded like you said Optical Access was pretty much 100% in the broadband -- sorry, backhaul area, and HDSL these days is -- there is only a small piece of that in backhaul, but yet there is a trade-off there.

And if you are guiding HDSL to be up sequentially in the current quarter does that suggest that Optical Access could be down a little bit in the current quarter?

I will tell you we are not expecting a significant shift in either one of those product areas. So could Optical Access be down? It could be, because we are a book and ship business, but I really don't think so. We are seeing an awful lot of activity in Optical Access.

HDSL, from what we see today from the ordering activity that we have, albeit it is a short period of time, and the fact that we were at a base that we think was very much non-wireless in Q2, we don't expect it to be down.

But the question of could either one of those things happen, with our backlog being as short as it is or our current -- or our ship times being as short as it is, it could, although that is not what we were expecting.

Fair enough. Then just a second question on the inventory levels, which continue to increase. And this quarter the inventory level increase certainly is above your revenue guidance for the next quarter. Can you give us any indication of how much of that inventory roughly is in the field installed in carrier networks awaiting revenue recognition and how much would be raw materials or finished goods that you hold or that your manufacturers hold?

Jim, you want to speak to [that]?

I don't have those details before me, but there is certainly a meaningful amount that does. I don't want to confuse people when I say this, but we do believe that inventories have reached potentially a peak. We are seeing some loosening up in certain parts of our supply chains in terms of certain components, although I did say we did see expediting cost in the second quarter related to certain customer opportunities.

So we are anticipating that inventories have seen a peak, and Q3 levels should be in the same range and potentially slightly less than what we saw in Q2.

And I think that that change is probably going to be more reflected in the inventory that we have here actually in our warehouse facility versus what may be in the field. We are continuing to sell services and we are continuing to sell kind of longer-term contracts where they may be positioned with a customer.

With broadband stimulus coming online, and with the things we have going with our international carriers, you may see that continue to go up. But at this point in time we feel that the supply chain is in such an area that we can probably start drawing down some of our internal material and more reflect what our historical basis of internal raw material and internal WIP has been historically. So I hope that answers that for you.

Okay, great. Congratulations on the solid execution.

Amir Rozwadowski, Barclays Capital.

I just wanted to just, Tom, if I may touch base again on the international opportunities. Obviously if we look at the revenue contribution this quarter it picked up pretty significantly from the prior quarters. If we think about the international opportunity going forward, this is -- how sustainable is this sort of revenue level at these levels over the next several quarters, given your visibility into the build of what is going on in Latin America?

Well, Latin America is one piece, and it was without a doubt a significant piece. But I will say we had won several opportunities outside of Latin America that have yet to start shipping. And trying to add those into these pieces as things aggregate themselves is maybe not as clear as you would think.

If we talk about specifically the Latin American piece, it is a multi-quarter piece of which we really started initial shipments of any meaningful size, I would guess, in Q1. We would expect them to continue on through this year. And there are activities that will be going on through next year, so it is a multi-quarter phenomenon.

Then our mission is to make sure that we bring these other pieces online in shipping within a period of time that makes sense. And hopefully these things dovetail in such a way that we see really positive results.

Do you expect to see then based on timing fluctuations off of the levels that you experienced in the second quarter?

We will absolutely see fluctuations. I expect that with our best forecasting US customers, of which there are not many, but we will see fluctuations from quarter to quarter.

Then, if I may, on -- you had spoken a bit about some of your larger customers and what is going on with purchasing there. I was wondering how should we characterize the Tier 2 and Tier 3 operating environment right now? It seems as though based on their CapEx trends at least for the year they expect fairly significant buildouts of their networks. I wanted to see how you guys are seeing purchasing from those types of operators.

I would say in certain areas it is strong. And I would agree with you on say that the Tier 2s and the more meaningful sized Tier 3s have specific objectives, whether or not they are for wireless backhaul or for IPTV or just broadband spend. And I would say that is a very good environment for us right now.

The Tier 3s, I would say some of that increased activity is centered around broadband stimulus. If I look at the last report, 50% of the broadband stimulus awardees have not yet even picked their vendors yet. So there is still an awful lot of activity there that I think is yet to come. So I would say that in the Tier 3s it is starting to happen, but I would not call it the same level activity as what we are seeing at some of the larger carriers.

Okay, that is very helpful. Thank you very much.

Simona Jankowski, Goldman Sachs.

I just wanted to follow up on your international customer. Obviously, international was up quite a bit this quarter. Did that customer now rise to the level of a 10% customer, and if not, do you think they might later this year?

Well, to answer your question, the 10% customers that we had in the second quarter were all domestic.

Okay, and do you think that the international customer might become a 10% customer, say, in the course of this year or next?

There is absolutely that potential.

Then relative to some of the other international wins that you commented on that you haven't yet started shipping to, would those have the potential to become 10% customers at some point as well?

Oh, would those. If you let me reach far enough into things like what we are doing on UB, the answer is yes. If you were to say the projects that right now we are planning on that we have won and are planning on shipping, I don't see any right now that really stick out by themselves. In aggregate the answer is yes. I don't see any one that really sticks out by itself as being at this point in time that large.

Okay, and then back on the quarter it seems that most of the revenue upside, if not all of it, came from Broadband Access. And, also, margins -- gross margins were a little bit lower than expected, and it seemed like those two are related.

So can you just, again, specifically try to pinpoint for us if the upside in the Broadband Access business was driven by the services piece or the international piece or some of the TA5000 and expediting that you saw in that area? So maybe if you can just rank order or quantify those three drivers or if there is another one in there as well.

The Broadband Access upside in revenue, is that what --?

Right.

I mean, all of those in aggregate -- so if you say upside -- if I can just say Broadband Access, what kind of the growth drivers in Broadband Access would be easier for me to maybe quantify.

I think this will help you, if you understand also that a lot of our international product today is fiber-to-the-node. The largest growth that we saw in Broadband Access this quarter on a dollar basis was Total Access 5000.

And that is where the expediting occurred as well?

Yes, that -- we saw some expediting in that, cabinets and things associated with the 5000.

Okay. And that is all domestic, right? Was that expediting activity, was that related to the broadband stimulus or just some of your existing other customers?

By and large existing other customers.

Okay, terrific. Thank you very much.

Todd Koffman, Raymond James.

Back to the gross margins. When you look at your international businesses does the international deployment generally have -- the products have similar gross margins to the domestic products that you have built out over many years?

Let me add the one caveat, which is that a large percentage of our international business today does have services associated with it. So we will actually do the installation, some of the engineering work of things. So that these will actually be, of course, less gross margin, but the product specifically itself has very similar profile.

Then just to follow-up on the gross margins. The footprint expansion associated with the success and popularity of the Total Access 5000 has been going on for quite a few years, and yet you have called this out as your margins are starting to maybe tick down a little bit.

I was wondering it is there anything else as it relates to the success and popularity and buildout of that that may be a factor, meaning have you lower the price, or is there any other factor on the gross margins maybe coming down a little bit?

All we can say about the cabinet piece -- and you're right that they do vary from time to time. Sometimes we don't -- we have better visibility to what is going to be ordered so that we don't have the same level of expedite charges.

As far as the pricing environment, it has been very competitive in pricing environment for some period time. So do we lower prices? Yes, we lower prices for a specific opportunities in order to win the deals. That really hasn't changed and that is just kind of our normal course.

But I would say that the difference that you saw on the expedite pieces was really due to the performance of a specific [RT Fed] or RT cabinet type expedite charges, which sometimes you have a better handle than on what that forecast would be than we did this quarter.

One last quick follow-up, totally unrelated, back to HDSL. You said HDSL today is now still being used overwhelmingly today for just business connectivity, not wireless backhaul. Is that likely to be the case that the application of HDSL wireless backhaul is largely behind you, and now it is just the people who are still using it for business connectivity going forward?

That is a multi-million-dollar question. If I talk to carriers, carriers are still using it in areas, both Tier 2 carriers for what they are offering as services to the large wireless carriers. And if I talk to Tier 1 carriers, they are still using it in areas for wireless buildout.

So I would say we would still see that, but I think that activity is going to be sporadic, which is what we are seeing actually in Q2. So the answer to your question is -- will it go down over time? Yes. Do we expect incremental wireless spend on HDSL periodically through the next few quarters, if not the next few years? The answer to that is also yes.

Thank you very much. Good luck.

Larry Harris, CL King.

I was intrigued by the percentage of sales that is in the gross products category -- 72% right now. I was wondering how high could this go? I guess maybe it could be affected by the HDSL increase in the third quarter. But is this a category that can go to 75%, 80% or more of your total revenues? What sort of target do you have?

We would like 100% to be in growth categories at some point in time. We may not get there, but we've could definitely get in the 90s. The whole thought behind our growth product categories are these are areas where we see incremental opportunities or expansion and capabilities either in marketshare or in capabilities that we add from a feature set perspective.

And over time that transition from the legacy product area to these growth product areas will happen. So we want that number to be as high as possible, because we see more upside potential in these areas than we do in our legacy areas, which are capped just by the nature of the type products that are in there.

Are the gross margins on average higher in the growth categories than the legacy area?

They're basically in line with -- you may see plus or minus several basis points, but in general they have been in line with what we have seen in our historical product areas. Where you'll see the difference is that the growth product areas, especially on the carriers side, have many times services associated with them which will have a different gross margin profile.

Understood. Then on the expediting costs in the quarter, was there any impact, say, from component shortages from Japan or weather conditions in the US during the quarter that led to higher than expected expediting, and it might be relieved in future quarters?

I think very little from Japan. I think we were fortunate enough to be able to procure what we needed to procure in a short period of time. I think we may have even touched on that from some of the inventory build that we have had that was associated with building -- making sure that we had supply until the suppliers were able to come back online. So I would say very little there.

As some of you may know, we had a fairly dramatic incident during the quarter with tornadoes coming through this area. Trying to quantify that exact cost is difficult. I will tell you we were -- our manufacturing operation and our purchasing operation and many other facets of the Company were basically shut down for six days, and we had to bring things back up.

I would love to take this opportunity, by the way, to comment our employees on the way that they reacted during that situation, and being able to keep our customers happy and really keep the lifeline operations of the Company running. There is an impact on that, but trying to quantify that is very difficult.

I understand. All right, thank you.

[Mark Singer], [Besmeister].

You got to my call already. Thank you.

Paul Silverstein, Credit Suisse.

I know you don't want to give too much detail on the 10%, but can you tell us what the 10% customers were collectively as a total percent of revenue and total dollars?

I don't have those numbers in front of me at this point.

Jim, could you even say whether it was in line with historical? It had been writing about 45% of total revenue with fluctuation. Would you know that offhand or --?

I don't see any material change off of that range that you mentioned.

On to Telmex, I know you addressed this before, Tom, but I just want to confirm. So your expectation is that this particular project runs strong until through the end of the year with some incremental revenue next year. Is that a fair characterization?

It does run -- it runs through the end of this year. Actually, the project in totality runs until several quarters into next year. So, yes -- the answer to your question is yes.

On the other international business you referenced those new wins. No one win is the equivalent to Telmex, but collectively they could substitute for Telmex? Is that a fair way to look at it?

I think that is a fair way to look at it. I would say incrementally, actually, they're larger than Telmex.

On the comment you made on service on your international service, the fact that your international business has a higher tax rate on services and those gross margins run lower, I don't know that you have ever given us much, if any, insight on your services gross margin. Can you share with us what the gross margin profile on the services piece of the international business, what that looks like compared to your current corporate average gross margin?

This is Jim. So what we have said on services is that although services revenues have a gross margin less than our normal equivalent gross margins, they are accretive to our operating margin. So, obviously, that will put them somewhere in between our operating margins and our gross margins.

So that is to the extent that we have broken it out at this point. We are not at the level where we break out those revenues and margins on our disclosure yet. We don't anticipate to be to that level this year. So that is a level of color that we have given thus far on that.

So [it already attracts] gross margin, but it doesn't adversely impact operating margin?

Well, it is actually accretive to operating margin.

It is accretive (multiple speakers).

All right. Finally for me, Jim, I appreciate the level of disclosure you gave us, but could you -- given how big the businesses are and how important they are, can you tell us what fiber-to-the-node was versus what TA5000 was in terms of the Broadband Access business?

That is not something that we do disclose, but I can tell you that -- and again your question is TA5000 versus fiber-to-the-node, is that (multiple speakers)?

Well, to the extent those are the two key growth drivers of broadband access, which in turn, is the first and foremost growth driver of your overall revenues, I'm hoping you could share with us some insight in terms of to what degree it is one versus the other.

We made a decision several quarters ago to not get to that level of detail, particularly in regards to the TA5000, because, again, it is a very competitive situation.

We did say earlier in the call that the sequential growth in Broadband Access -- we had a higher dollar contribution in that growth from the TA5000 as opposed to fiber-to-the-node.

All right, one more question if I may. In the fiber-to-the-node business that international customer, Telmex, it is that still 50%, 50% plus of that fiber-to-the-node business?

The majority of that is [5%] of our business, yes.

No, the majority of your fiber-to-the-node is Telmex?

We have never said that the majority of the fiber-to-the-node was Telmex.

No, but it is certainly a meaningful portion.

It is a meaningful portion of it, but I wouldn't characterize it as 50%.

We certainly have meaningful domestic customers on fiber-to-the-node.

And we started shipping to incrementally new customers in the US fiber-to-the-node in the second quarter.

Tom, any of those incremental new customers would you consider to be sizable Tier 1, Tier 2 type customers?

Yes. I am trying to think of what that list was, but yes.

I will pass it on. Thank you.

I think we are out of time here. So, Debbie, we are going to close up here. Thank you very much everybody for showing up on our conference call, and we look forward to seeing you three months from now.

Thank you. This concludes today's conference. You may now disconnect.