ADTRAN Holdings Inc (ADTN) 2012 Q2 法說會逐字稿

Ladies and gentlemen, thank you for stand by, and welcome to the ADTRAN second quarter 2012 earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer period.

(Operator Instructions).

During the course of the conference call, ADTRAN representatives expect to make forward-looking statements, which reflect the management's best judgment based on factors currently known. However, these statements involve risk and uncertainty, including the successful development of market acceptance of core 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, 2011, and Form 10-Q for the quarter ended March 31, 2012. These risks and uncertainties could cause actual results to differ materially from those in forward-looking statements which may be made during the call. It is now my pleasure to turn the conference over to Mr. Tom Stanton, Chief Executive Officer of ADTRAN. Please go ahead, sir.

Thank you for joining us for our second quarter 2012 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 some details on our Q2 results, including our thoughts on the spending environment, and it's impact on our near term outlook. As you can derive from our press release issued last night, the spending environment and the markets we address deteriorated in the second quarter, with the most significant changes affecting our domestic Tier 1 carrier customers, and several areas served by our enterprise products division.

During the quarter, we achieved revenues of $184 million, and if we exclude our recently acquired NSN BBA business, revenues were $161.4 million. The $161.4 million represents a sequential increase of 19.8% for our organic business, but a year over year decrease of 12.4%. Our acquired business came in at $22.6 million, in range with our expectations. In total, our CN division had organic revenues of $130.1 million, again in line with our expectation.

During the quarter, we saw the expected acceleration of our Tier 1 fiber-to-the-node build-out, and the resumption of planned activities in the Tier 2 and Tier 3 markets. However, we experienced a heightened sense of cautiousness and budget uncertainty, with both large and small carriers, which resulted in project delays and an uneven order flow. We are confident that our market position remains strong with no meaningful market share loss where we have incumbency, and we continue to add new customers at a rate consistent with our performance over the last two years. The macro environment impacted our enterprise division, and more importantly our Internetworking products which grew 6% year over year, the smallest increase since the first quarter of 2009. The impact was felt across nearly all product areas, with the exception of our virtual wireless LAN segment, which continued to build strength with both resellers and carriers.

From a channel perspective, only our reseller base showed growth, a likely result of our increasing focus in this area. Looking at our business from a product segment perspective, our organic Broadband Access segment was up both sequentially and year over year, driven by our fiber-to-the-node platforms as we saw meaningful increases in shipments to a domestic Tier 1 carrier, coupled with a strong performance in Latin America. This area also helped by strong performance by the Total Access 5000 platform in the Tier 2 and Tier 3 markets, where we continue to add in excess of 20 new carrier customers per quarter. Our Optical business was impacted by the slower Tier 1 sales, although it was partially offset by an increase of our newly released ONE product line. Also during the quarter, we received approvals from two additional tier 2 carriers for our ONE products, and began initial shipments to one of those two.

Looking at our business from a geographic perspective, US sales were down 19% year over year for the quarter, driven predominantly by HDSL and other legacy products to Tier 1 carrier customers. As most of you know who follow the Company, the decline in these products areas has been expected, and we continue to drive the focus of the Company towards packet-based technologies. Conversely, it is important to note that total international revenues represented nearly 30% of the total Company revenue, and our organic international revenues grew 32% year over year, as we continued our global -- our goal of geographic and customer diversification.

We closed on the NSN Broadband Access business on May 4 this year, and I am pleased to report we remain on track with our integration activities. During the quarter, we successfully onboarded the required personnel, negotiated terms of supply agreements with all major vendors, and began production of selected products using ADTRAN's supply chain. It is our belief that in the years to come, ADTRAN's growth will be influenced by our ability to expand our geographic presence, and our relevance with Tier 1 carriers around the world. This business, with it's entrenched incumbency at large carriers outside of North America, will without a doubt substantially accelerate our initiatives and increase our odds for long-term success.

Finally, during the quarter it has become apparent that customer sentiment in the current environment, from both an economic and regulatory perspective has deteriorated. This was reflected in the second quarter results by slowing enterprise demand, accompanied with increased -- increasing uncertainty in purchasing decisions. Although we remain confident in our ability to grow market share in the future, the environment has impacted our visibility to near-term business trends. I would now like Jim Matthews to review our results for the second quarter of 2012, and our comments on the third quarter 2012. We will then open the conference for any questions. Jim?

Thank you, Tom. Good morning, everyone. Revenue for the first quarter(sic-see press release "second quarter" ) was $184 million, compared to $184.2 million for Q2 of 2011. Broadband Access product revenues for Q2 of 2012 were $106 million, compared to $77.1 million for Q2 of 2011. Internetworking product revenues for Q2 of 2012 were $35 million, compared to $33 million for Q2 of 2011. Optical product revenues for Q2 of 2012 were $14 million, compared to $22 million for Q2 of 2011. Carrier Systems revenues for Q2 of 2012 were $126.8 million, compared to $112.3 million for Q2 of 2011. Business Networking revenues for Q2 of 2012 were $36.6 million, compared to $35.7 million for Q2 of 2011. Loop Access revenues for Q2 of 2012 were $20.6 million, compared to $36.2 million for Q2 of 2011. HDSL products revenues for Q2 of 2012 were $19.5 million, compared to $34 million for Q2 of 2011.

As a result of the above, Carrier Network division revenues for Q2 of 2012 were $152.7 million, compared to $150.5 million for Q2 of 2011. Enterprise networks division revenues for Q2 of 2012 were $31.3 million, compared to $33.7 million for Q2 of 2011. International revenues for Q2 of 2012 were $53.6 million, compared to $23.4 million for Q2 of 2011. To provide the reporting of each of these categories, we have published them on our Investor Relations web page at ADTRAN.com.

Gross margin was 51.7% of revenue for Q2 of 2012, compared to 55% of Q1 of 2012. The lower gross margin compared to Q1 of 2012 was largely attributable to lower gross margins of the recently acquired NSN Broadband Access business. Gross profit for the quarter was negatively impacted by $1.2 million attributable to amortization of purchase price adjustments to revenues, and to cost of goods sold. Total operating expenses were $68.3 million for the second quarter of 2012, compared to $55.5 million for the second quarter of 2011.

The increase in operating expenses for Q2 of 2011 -- from Q2 of 2011 to Q2 of 2012 was primarily attributable to two months of operating expenses related to the acquired Broadband Access business and Bluesocket, including amortizations, integration and other expenses in connection with these acquisitions, and increased staffing costs. Amortization costs included in operating expenses totaled $0.4 million for the quarter. Integration and other acquisition-related expenses included in operating expenses were $2.7 million for the quarter. Stock-based compensation expense, net of tax was $1.9 million for Q2 of 2012, compared to $1.8 million for Q2 of 2011.

In the quarter, we recorded a bargain purchase gain of $1.8 million net of tax, related to the acquisition of the NSN Broadband Access business. This amount represents an estimate of the excess fair value of net assets acquired, as compared to the consideration exchanged. Supplemental information for acquisition-related expenses, amortizations, and adjustments in connection with the Broadband Access business and Bluesocket acquisitions are provided in our operating results disclosure. All other income net of interest expense, excluding the bargain purchase gain for Q2, was $4.2 million compared to $4.7 million for Q2 of 2011.

The Company's income tax rate provision was 35.7% for the second quarter of 2012, compared to 34% for the second quarter of 2011. Removing the effect of the bargain purchase gain previously mentioned, our income tax provision rate would have been 37.7% for the second quarter. The tax provision rate for the second quarter of 2012 does not include benefits from research tax credits due to delays in legislation. The tax provision rate for the second quarter of 2011 included benefits from research tax credits, and increased benefits for employee stock option exercises.

Earnings per share on a GAAP basis assuming dilution for Q2 2012 were $0.33, compared to $0.56 for Q2 of 2011. Non-GAAP earnings per share for the quarter were $0.38, compared to $0.59 for the second quarter of 2011. Non-GAAP earnings per share exclude the effect of acquisition-related expenses, amortizations, and adjustments related to the acquisitions of the NSN Broadband Access business and Bluesocket and stock compensation expense. The reconciliation between GAAP earnings per share diluted, and non-GAAP earnings per share is provided in our operating results disclosure.

Inventories were $103.8 million at quarter-end, compared to $95.8 million at the end of Q1 of 2012. The increase in inventory levels for the quarter relates to inventories acquired as part of the Broadband Access acquisition, partially offset by a reduction in organic inventory levels. Net trade accounts receivable were $118.5 million at quarter-end resulting in DSOs of 59. The higher DSO level was primarily the result of trade receivables incurred during the months of May and June, and the acquired Broadband Access business, and the timing of shipments in the organic business during the quarter. Unrestricted cash and marketable securities net of debt totaled $494 million at quarter-end, after paying $5.7 million in dividends, and after repurchasing 455,000 common shares for $13.4 million.

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 2012, we expect the sluggish economic environment will negatively impact our revenues, and therefore we are cautious going into the third quarter. With that in mind, we are planning for total Company revenues to be flat to slightly up on a sequential basis. We expect GAAP gross margins for the third quarter to be roughly flat from second quarter levels.

Our expected GAAP gross margins will be net of purchase price adjustments to revenues and the cost of goods sold, in the range of $1.1 million to $1.5 million. We expect GAAP operating expenses for the third quarter to be in the range of $71 million to $73 million, as they will include a full three months of the acquired Broadband Access business. GAAP operating expenses for the quarter, we expect will include acquisition-related amortizations of $500,000, and integration and other acquisition-related expenses of $600,000 to $800,000.

As a result of delays to extend legislation for research tax credits for the 2012 year, we anticipate our tax rate for the second quarter(sic) will be in the range of approximately 37%. This tax rate provision is in range, with the tax rate it occurred in the second quarter, excluding the bargain purchase gain. We believe the larger factors impacting the organic revenue we realized, or the total revenue that we realized for the second quarter of 2012 will be the following, the macro spending environment for Carriers and Enterprise, the adoption rate of our Total Access 5000 platform, professional services activity levels both domestic and international, upgrades for mobile, broadband, infrastructure, and the timing of revenue related to Broadband service projects. Tom, back to you.

All right, Jim, thank you. Blake, at this time, we are ready to open it up for questions.

Certainly.

(Operator Instructions).

It looks like our first comes from the site of Sanjiv Wadwani from Stifel Nicolaus. Please go ahead.

Thanks so much. Tom, just a broad level question on Tier 1 budgets. Are you getting the sense that given sort of weakness in the first half, that budgets are still unchanged in -- for the full year? Or essentially have been sort of ratcheted down for the full year?

Well, I'd hate to speak for the customer base. And my sense is, that there's still this sense that there will be some accelerated spending in the second half, I think is what the verbiage is, but that is something that we're not planning on ourselves. So we're assuming that the environment is kind of what the environment is, and that the spending levels at most of the carriers will stay consistent to what we saw in the first half.

Got it. And sort of -- did you see normal sort of sequential uptick in the second quarter? Or was it way below normal seasonality, just in terms of given that first quarter was weak? I'm just trying to gauge as to where the second quarter essentially came out in terms of spending.

It was actually somewhat lumpy. I mean it was actually came out. We came out of the quarter -- of the previous quarter and we saw pretty good order flow. And that stayed consistent for some part of the first month, and then we saw a slowdown, and then we saw it pick back up in the end of the quarter. So it definitely was not a normal seasonal quarter for us. And I can look at different market segments and talk about different pieces. I have touched on some of those in my notes. Definitely, the Tier 1s, other than the fiber-to-the-node buildout that I mentioned, was slower than what we normally see. And we saw some project delays in the Tier 2 accounts. Now, those project delays right now are scheduled for just later in the year, including the third quarter. But our take on that is, they have been fluid enough for us at this point in time just to discount that potential start, and just see kind of how things roll out through the third quarter and the fourth quarter.

Got it. That's helpful. Just one quick question, Jim. As far as NSN is concerned, if you look at the two months that you had in the June quarter, are we still looking at about a run rate of about $36 million or so for the September quarter?

Well, Sanjiv, we do expect a sequential increase in revenues from Q2 to Q3 for BBA. Just by the fact of a three month period. But in terms of giving specific guidance on the revenue level for Q3 for BBA, at this point I don't think we're prepared to do that, other than saying that we do expect to give -- to see sequential increase.

I think maybe a better way to look at it, and there is pressure that we're seeing in Europe, but to be honest with you, nothing like what we're seeing here. So I think the uncertainty around BBA has to do with the fact that we're three months into it, two-and-a-half months into it, I guess. So the way that we're looking at that, and trying to be as cautious as we can, is basically say, let's take two months, and add another month to it. And that's kind of the range that we're looking at it.

Got it. Fair enough. Thanks so much.

Thank you.

Next we'll go to the site of Jim Suva from Citi. Please go ahead.

Thank you. First, a clarification question, and then my main question. The clarification one, I want to make sure, did I hear correctly you're expecting kind of Q3 guidance in total Company to be flat? And that even includes I believe an additional full month of the NSN -- the NSN acquisition? And my actual question after that clarification is, for the gross margins, it looked like core ADTRAN before the acquisition continued to deteriorate here for the gross margins, when you don't include acquisition integration. Can you talk to us a little bit about that and why margins should be flat going forward, when one would expect you'd start to see some synergies improvements from NSN? And is this kind of a new permanent reset to the ADTRAN model for margins?

Let me cover the first one. I'll touch on the second one, and turn it over to Jim. The answer to your question is the total Company, including the acquired NSN BBA business, we're expecting flat to slightly up in the Q3 period. So that would include all of the revenues for the three months of Q3 with NSN. On the second piece, we have two months now of NSN margins. And the margins on the NSN business came in basically in line with what we had projected, and what we had talked about. And if you blend those two margins, we're within the range of what it is, that we thought was going to happen for the total Company. We had some one-off expenses, mainly a warranty expense that was in excess of a $1 million that we occurred in Q2, which is not something that's typical for us and did impact slightly. Jim, do you want to add some?

Right. And as we look at Q3, in terms of the BBA business, we do expect to see some cost improvements, in the -- and the cost of sales area or some gross margin improvements. However, the flip side of that is that we will see a full three months of BBA at lower than our organic business. So there's that to consider as well, in our view of the Q3 gross margins.

So if you look at Q2 to Q3 organic, I would say there were no surprises there. And I would say Q2 gross margins were in line with what we would say. And Jim if you would mind restating what our gross margin outlook was for BBA -- that market?

Well, as we have said on prior calls, we expect that BBA gross margins to start out in the low 30s. And then as we progress through the quarters, we expect to see improvements. And actually, we said on the last call that we expect to see the full savings of our supply chain transition in Q1 of next year. So that has not changed, and we expect that gross margins on BBA will improve between now and then to reach that point. That answer your question, Jim?

Yes, thank you very much, gentlemen.

Thank you.

Next we'll go to the site of Michael Genovese from MKM Partners. Please go ahead.

Great. Thanks a lot. It sounds like in the second quarter there was one US Tier 1 that was strong in Broadband Access, and then there were two weaker customers. And my question is that a function of the products that you sell, which are mostly legacy products, and kind of a lack of getting newer products into those customers? Or do you think that this is an overall CapEx issue? And you may have been asked this earlier, but I guess I would just ask again, because I might have missed it. Do you think that CapEx in the second half of the year in the US will be flat to lower, than it was in the first half of the year?

I would tell you what we're forecasting is a challenging CapEx environment, which would say flat to lower. I think we are probably thinking more flat than lower. To answer your question on the Tier 1s, and give you a flavor on the rest of the pieces, I mean, it is very rare that every customer on our customer list comes in exactly as we expect coming into the quarter. But what you typically have, and what has been consistent with us over the last few years up until last quarter was, enough upside on the other customers, where they spend past what they initially had projected to you, or we had projected ourselves, where it covers any downside. And I think that's typical with most businesses.

What we saw this quarter was very little upside spending. We had a lot of customers that met their plans. In fact, the majority of them, customers met their plans, but we had very, very few customers that exceeded their plans. And then we had a handful of customers that did not. The largest customer actual impact was a Tier 1 carrier, and that carrier buys a significant amount or had bought a significant amount of legacy products, predominantly HDSL. And we saw especially on a year-over-year basis, a significant decrease in HDSL sales to that customer, which accounts for 100% of the shortfall that we saw in the quarter. And it does make us cautious about going forward, as to what the revenue levels with that customer are going to be. That, in combination with seeing very little upside, or being nervous about very little upside potential with the rest of the customer base kind of places us where we are.

Okay, great. And then just one follow-up. On the Tier 2 business, can you tell us where we stand, with kind of the regulatory up, mandated access line upgrades? I mean, it seems like last year or the year before, there was Tier 2 carriers buying Tier 1 access lines, which they had to upgrade. And are we done with that now, or are we towards the end of it, or still in the middle?

I would say we're definitely, more towards the middle, and maybe the front half of the middle than done. I do think that, that customer base is being as cautious as any. So they're planning their builds very carefully, and sometimes we see movement in the timing of those builds. And that's some of the uneasiness that you're hearing from our tone today.

Great. Thanks for the candor.

Okay.

Next we'll go to the site of Mark McKechnie from ThinkEquity. Please go ahead.

Great, thanks. So a couple questions. Do you break out, or can you break out your 10% customers, and how big they were in the quarter?

Well, Mark, what we can do is, is talk to the fact that we had two 10% customers in the quarter, but we've refrained from naming those at their request.

Okay. And can you tell me how big they were, or just that they were bigger than 10%?

Yes. Both of those were bigger than 10%. But in terms of providing more data than that, again we have been requested not to do that.

Okay, got you. And then on the NSN acquisition price -- I looked at your cash flow statement. And am I right, I saw a $7.5 million number in there on that cash flow statement. Is that what -- the net, what you paid for NSN?

Well, if an amount was paid, it would have been bracketed. And as you can see, that amount was not bracketed.

Okay. So it was either that or less, is what you paid? Or what else would have been in that $7.5 million number?

Well, Mark, I mean, what that means is, that we actually received consideration of that amount, rather than paying it out.

Oh, okay. Okay, got -- actually, that was a positive number, so the acquisition came with the check to you?

Right. That's one way to look at it.

Yes. Got you, okay. And then just on your guidance the -- I know you just guided for September, and it's flat which is obviously different than normal seasonality, especially with NSN kicking up. Again, you're not giving guidance beyond that, but strange seasonality out there. Would you think about December being up sequential versus the normal down. Or is the -- would you still make sense to expect a down sequential December?

At this -- first of all, it's very difficult for us to forecast that in the environment. We typically wouldn't forecast two quarters out. I would say normal seasonality is not normal for us at this point in time. And I think there are multiple things for it. I think the environment itself, is one where we're seeing delays in projects that we typically wouldn't see. I also think that HDSL was a big driver of some of that seasonality in the past, and HDSL number is becoming more and more inconsequential. So we don't expect to see that kind of pick up that you would typically see. And potentially that following in Q4, but having said that, I don't want to set any expectations at all in Q4 until we get closer to that period of time, just because of the uncertainty. And I think at this point, right now it would be, it just would be inappropriate.

Okay, great. Thank you.

Okay.

Next we'll go to Simon Leopold from Raymond James. Please go ahead.

Great. Thank you. Just a couple of quick clarifications. Understand your issues on the 10% customer details, but could you just clarify if one was domestic, and one was international?

I think that would be accurate, Simon.

Okay, I thought that was pretty easy. And then in terms of this revenue forecast for the third quarter, obviously you're talking about the acquired business contributing more, given that you've got it for a full quarter. Clearly it implies something else is contributing less sequentially. Is that in a particular business element, business segment, broad brush? I guess, what I'm trying to get at is, what will be down sequentially in September, offsetting the full quarter of the NSN acquisition?

Well, I can tell you the way we are doing it, and it may not be as scientific as you would like us to be. But when we roll up all of the numbers, the enterprise environment is somewhat challenging. If I take a look at what our people say things are going to do, to be honest with you, they are thinking more flattish than anything. If I look at the domestic carrier spending -- and really let's say the organic carrier spending, things look more flattish than down. And then there are the projects that I had talked about that had been delayed. So there's potential there, but -- and then we lay in BBA which we had talked about basically taking the three months versus two months. But we are taking aggregate those numbers -- and to be honest with you, doing a hair cut on those because of the uncertainty in the environment. And we've seen in the past, we would haircut less --

Yes.

And still be able to exceed those numbers. But we have seen very little upside movement, and there are always carriers that will disappoint. So it's really that thought process.

Okay. And then just in terms of the Internetworking business, that was the degree of the sequential decline was what was most surprising to me. I'm just wondering, from your expectations going into the quarter and your original forecast for June, what were the biggest surprises to you? And in terms of Internetworking, I guess what I'm trying to think about here, is this really a reflection of the macro versus maybe some inventory in the channel? And if it's inventory in the channel, how long do you think it takes to work that to a level where you get back to normal patterns?

I think it's the macro. And I think the macro leads to inventory in the channel, but I think at the end of the day, it's the macro. I don't think that we saw an increased drive towards increasing inventories in the channel. But I do think when you see a slowdown that you then, depending on the timing of things can build up a little. I don't think it's a predominant factor. I do think that it's a more macro piece. And I will say it hit pretty much most segments. We saw a slowdown in switching. We saw a slowdown in routing. We saw a slowdown in IP gateways. And we saw a slowdown in most of the distribution channels and the reseller distribution channels. The two pieces that were different than that, would be the reseller distribution channel, which now also has Bluesocket products, and then Bluesocket itself which was up. But other than that, it's kind of hard to find anything that really stood out.

Okay. Thank you very much.

All right.

Our next question comes from Ehud Gelblum from Morgan Stanley. Please go ahead.

Thanks. Good morning. A couple things. First of all, I just wanted a little clarity on something you had said earlier. Originally, I think one of the questions was, do you think you have -- you are seeing a fall off in the types of products you're selling, in the sense of do you have the right products that your Tier 1 carrier customers are buying? Or is the problem a more overall CapEx issue? And I think you answered it, that you thought it was a more overall CapEx issue. But then you said one of your large Tier 1 customers that predominantly bought HDSL, a fall off area in your basis was primarily the fall off in HDSL. And so that would sort of indicate to me that perhaps they are not buying HDSL anymore, they are buying more packet-based products. So perhaps they are buying other types of products instead? I'm still trying to get to the sort of the more global picture is -- have they moved from the products you've been selling for some time, to other types of products? Or have they just stopped spending entirely? Did I miss --?

Let me just give you what I can talk about, because I'm not going to try to forecast as to whether or not they stop spending entirely. I would say that they, if you look at the -- not all of the Tier 1s as you're aware. But if you look at a subset of the Tier 1s, they have predominantly bought our legacy products. Now, we have got many products approved at those Tier 1s that have not rolled out. We talked about our pivot project. We have talked about IP aggregation projects. We have talked about ethernet-over-copper and they have not rolled out en masse. As you know, we have also an OEM arrangement with Ericsson, that has not rolled out en masse. So there are things that are sitting there that have not rolled out, that have been either approved or going through the process, most of them have been approved, that have not turned on. So I look at that subset of Tier 1s, and see that we have a large portion of our revenue to them being legacy product sales, predominantly HDSL as you're aware. And HDSL has definitely turned off, without those other ones turning on.

Now that is not a new thing. That is actually we have seen that decline over the last at least year or so. And I think we've been very open about that. But what we have had in the past is enough of the other customer base to kick into really overcome whatever that was, and still post solid growth. What we've seen at this point in time is that those other carriers have really turned cautious. And those other carriers as I think you're aware, we have very strong new product momentum but we have hit a slower portion in time right now, with what their spending level is. But with that, with the Tier 1 subset that I'm talking about, there is a shift that needs to occur with their spending with us that has not happened yet. Does that answer your question?

When you push back on them, what do they say? Do they say, we just aren't sure if we have the budget right now?

I think in general, yes. And it's not, well -- no, no, no, I'm not speaking to their total budget for this year. When I talk about our particular projects, it is we do not have the budget for those projects at this point in time, we're focused on 4G or something else. And we do want to do those, our plans are to do those, but they aren't at this point in time.

Okay. You have always, you never had great visibility on how your products were being used at the end of the day, how much was for backhaul, how much was for other types of things. Do you have a sense as to -- do any of your projects do you think, the projects you're working on, besides HDSL dovetail into 4G builds and other types of backhaul builds? Or do you think right now you're more exposed to just rural Broadband Access?

Yes, I think there's some products that we have that are still sitting in the queue, that do that. Maybe, for instance, some of them, the approvals that we previously received that may have an impact on that are our Optical business has traditionally played in different areas of the network. But I would still say it was predominantly HDSL, and HDSL is just not being used for 4G. There is another exacerbating factor. I hesitate to bring it up, because I think it can be confusing. But we had talked about the fact that 4G was not, HDSL was not a big part of 4G that, that's actually probably more fiber-based than anything else and we had seen that down tick.

There is still a very good demand for HDSL in the business market. But we have seen a increase in reuse, that is reusing plugs that are being decommissioned, that is higher than anything we had ever seen before. And that has impacted the number -- there's not a lot we can do about that at this point in time. If I look at the demand of HDSL itself, it is down. But the decrease in HDSL is significantly lower than what that demand decrease has been, or actually significantly steeper and it has to do with reuse. In other words it's something we're not going to spend a lot of time talking about, because it is kind of what it is. And HDSL has gotten to a level, that it's just less of an issue for us.

Right. Optical Access, however does play into backhaul, and perhaps 4G. Were you surprised that's still weak?

I was surprised at the weakness in Optical, because it does -- like you said, it does play in several of those areas. And how that reflects the overall capital environment I won't try to guess.

Okay. Another quick one. Your organic large international customer, that obviously was very large this quarter. Does that drop off next quarter, and is that the offset to the increase in NSN that you're thinking about?

No, I mean -- I think if you think of our business, as generally the way that we are forecasting our business is generally flattish. And I think that that's kind of the general sense of almost every segment.

But NSN is up?

NSN is up, because there's an additional month.

Right. So something has to be down, as someone else mentioned before --

Oh, yes, yes, yes.

And does that end up being that you are planning the international customer to -- (Multiple Speakers).

And I have tried to explain that earlier. I would think, I would say, flattish with a hair cut on most of the segments.

Okay.

But to that particular customer, flattish is the right way to be thinking about it.

Okay. I'll get the rest offline. I appreciate it.

Okay.

Next we'll go to the site of Rich Valera from Needham. Please go ahead.

Thank you. Earlier in the year, you had been pretty optimistic about Broadband stimulus contributing incrementally in the back half of the year. Wondering what the current status is or your thoughts on that?

Broadband stimulus was -- there's some positives a and some negatives. From a shipments perspective it was kind of flat to what we saw in Q1. We were really looking more for a sequential uptick. From a booking perspective, it was a very strong quarter. Of course, those shipments will occur or we will recognize revenue of those shipments in the quarters to come. So I would say from a bookings perspective, is right where we are, from a shipments perspective, it was slightly disappointing.

But you would expect sequentially better revenue in Q3 and Q4, from Broadband stimulus off the bookings you were seeing in Q2?

There is the potential for that. But those -- there are a lot of different approvals and things and rollout variations. So there's definitely the potential for that, but I don't want to say that's a big uptick that we're expecting in Q3.

Great. And can you give us an update on a Tier 1 Opti opportunity, which you mentioned I think was in lab trials last quarter, how that's progressing? And do you think that will result in revenue in either Q3 or Q4?

That is a customer that we (inaudible) always have the forecast on. But yes, that is still progressing and we're at the very tail ends of that, and hopefully we'll monetize that this year. But we haven't, but that's about all I can say about it. There is that is still alive and active, and we're still working with that customer on getting the final things wrapped up.

So it's fair to say nothing baked into Q3 for revenue from that opportunity?

That would be fair to say.

Okay, thank you.

Our next question comes from Jonathan Kees from Capstone Investments. Please go ahead.

Great. Thanks. I just wanted to get a clarification. In Q1, there was one reason for the shortfall, there was an IT system coming online. Did that resolve itself? Was that not a factor in Q2?

That was not a factor in Q2.

Okay.

And it has resolved itself. And we had talked about Tier 1s spending being sluggish, mainly with legacy products in HDSL. That was not the case with our fiber-to-the-node products, which is where we saw that slowdown.

Okay. And I guess I'm a little surprised, because HDSL has been decreased in terms of percentage of revenues. It's about 10% for this quarter. I guess it still has enough of an impact on revenue, there for you to be concerned, and for it to bring down Tier 1 sales as a whole. But isn't the expectation for HDSL to just continue to decrease, and that should become less and less of a factor?

That's exactly the case. If you look at the year-over-year period, which is where you really notice the start difference in HDSL, there was a very big decrease in HDSL on a year-over-year basis. On a sequential basis, it was basically flat. So I do think that reuse though, continues to be pressure on that and could continue to grow. But in general we're just expecting that to continue to decline over the next few quarters or probably the next few years.

Okay, all right. So it will be less and less of a factor then. All right. So it's just mainly the Tier 1s have not been ordering applications they've approved. And the -- I guess not to bring up something that's already been asked before, but just to make sure I've got it right here, it's you're forecasting for challenging CapEx in the second half, so in your conversations with the carriers, I guess I'm asking this way, you're hearing more of a slowdown or a delay, rather than a cancellation. Is that the correct way of looking at it?

That is definitely the right way to look at it. I have not heard of any significant cancellations. And there were some that are probably more optimistic on second half CapEx than others. But I would tell you -- plans change, so in general we think it will be a sluggish capital environment for our equipment. I'm not trying at all to forecast the entire capital universe out there.

Okay. And for Tier 2s, that's a new development. Is that just more of a short-term hiccup, or is that now in the same bucket as Tier 1s, in terms of slowdown possibly for the second half?

Yes. I am trying -- I want to be as factual as I can, as far as what we're hearing and kind of what we're planning, which may be slightly different because of the fact that everything that people plan on doesn't come into play or doesn't actually happen. I would expect a stronger -- I will tell you the feedback that we're getting is a stronger capital spend in second half than in first half. To the extent that we discount that, it is because we have multiple businesses. And to the extent that, that one is up, and the we are giving ourselves some leeway for some other piece to be down. But if you talk to me specifically about Tier 2s, I will say that the current sentiment is that there will be stronger -- much more, well I shouldn't say much more, more activity in the second half than we saw in the first half.

Okay. And it sounds like also for the Tier 3s, especially with the stimulus, it should be picking up in the second half or there is potential?

Yes. And I would say there is a very similar sentiment to the Tier 3s, that I just mentioned on the Tier 2s. I'm hoping I'm not confusing the issue here.

Yes.

But the answer to your questions is yes.

Okay. And then with enterprise, that is -- you are looking for that to be flattish in the September quarter. Is that just short-term, or are we talking about something for the second half, something more pronounced, more elongated than just the third quarter?

I hate to say it, but I think that has more to do with the macro environment than anything else. And whether or not end-users and businesses are actually in the mood to upgrade their infrastructure with our type of equipment or not. And so I would say that environment will turn when we see a turn. I'm not going to try to forecast, in terms of that environment.

Okay.

The way that we're forecasting it at this point in time gives us some comfort, in -- we are being able to meet or hopefully exceed numbers.

Okay. And if I may have, one last question. DSOs were up pretty dramatically in the quarter. Just some elaboration in there.

Which sales, I'm sorry?

DSOs.

Oh, DSOs were up.

Oh, yes. So good question, Jonathan. So as you know, we acquired the NSN BBA business. Now in that acquisition it did not include bringing over an accounts receivable balance. So therefore in the months of May and June, we built receivables in that business as we shipped product. So we ended the quarter with about $22 million in receivables for that business. And again, that occurred over only 57 days. Right? So the way you compute DSOs, you actually, I have to divide it by 91 days, rather than 57, right? So that certainly drove our DSOs up -- a substantial part of the increase in DSOs for the quarter. Okay? So as we go through Q2, we think that we will see some level of normalization if you will, for that.

Okay, great. Thanks a lot. Good luck.

Thank you.

Next we'll go to Eric Ghernati from Banc of America. Please go ahead.

Just a few questions. Can you actually, just clarify is your order flow right now, for the month of July like flattish for June or down versus June?

We don't typically talk about that granularity, but I will give you the color. I would say it's more flattish, from where we exited the previous quarter.

Okay. The -- just want to look back at the Internetworking business. I mean -- the performance was in stark contrast with what one of your distributors, [SELEX], discussed back in their results, like a few weeks ago. Can you just describe what happened exactly? Like which areas, like which not products, but which customer base, is it non-distributors that saw the biggest -- (inaudible) was weaker than the channel business or?

Well, we have three major areas that we sell the products to. The reseller base, which is through the distribution channel that you're talking about. And then we also sell it to large carriers, and then we sell to [SELEX] and the smaller carriers, and that's where we tend to categorize them, and actually run them internally. I would say we saw pressure in the reseller base, but the resellers were actually up, and that maybe what you're talking about. But I would still say we saw pressure there and kind of elongated order times or deal times. And then in the other two bases, we actually saw a tick down.

I see. And then can you just remind us again, like about the -- because it seems like the flattish gross margin on a sequential basis for the December quarter, does not take into account the fact that you have like a one-timer from Q2 that should go away in Q3. It seems like you're implying that, even with the, I mean if you do the math, even with the additional one month you should still see some improvement in gross margins for the organic business. Just walk us through why that's not happening?

We have the turn around on the warranty issue, and we have the incremental one month on the NSN BBA.

Right.

And I'll let Jim --

So Eric, I mean, the range -- we attempt to give a range of gross margin outcomes, in terms of our view for Q3. Might we be spot on to Q2? I doubt it. There may be some differences there, in terms of 30 basis points. We may come out better. But again, I'm just trying to set a area of expectation, really more than an exact expectation for gross margins. So we do have a number of things that are playing. Yes, we have benefits from the fact that certain things are not reoccurring in Q3 as we expect. But on the other hand, we have a full three months of BBA gross margins, which are lower than our organic margins. We do expect some level of improvement on BBA gross margins. But we think that we will see gross margins somewhere in the range of what we experienced in Q1.

Can you, as you look for the year, can you just discuss what your market share would be at your largest customer? Your direct competitor, of course, is banking on some share gains in the back half of this year and starting next year. Can you just discuss what your expectations are?

Our expectations are no share shift this year at all. So we are expecting -- I think we're meeting all of the requirements. And I think we're doing a good job. And I think the communication lines with us and that customer are very open, and I don't expect any share shift.

And is there a function of you, just being more aggressive, or is it them not performing? What do you think it's attributed to, because it would seem like your largest customer, if anything like -- has committed to them being part of their network.

Well, they are part of the network. I think --

Yes, I understand.

Yes. I think the way at least my interpretation of what the customer has told us, is that they want two vendors. And that they have two vendors, and they want the two vendors approved in multiple areas. So you can imagine, we have done a lot of work on getting approved on the legacy Century link piece. And from that point on, that they will allow vendors to sell into the network. And it's really up to the regions as to what they actually choose, and we feel like we're in a very good position.

Thank you.

I think the way to think about that more is of a hunting license, than any particular regional award. And that's the way we look.

Thanks.

Okay.

Next we'll go to the site of Jeff Kvaal from Barclays. Please go ahead.

Yes, thanks very much. Tom, I think (inaudible). Could you -- would you categorize the (inaudible) nature of CapEx spending in the US, is that kind of a new-new situation? Or are the carriers saying well, we're waiting for the macro to get better, but we really do need to do things. And then I think what's interesting to me is that, where we hear a lot about the macro weakness is in the international markets. For you, those seem to be going well. Why are those markets going well, and relative to US when those markets are actually the ones, where the macro if anything is worse than it is here?

So I would, first of all, I'm really hesitant on trying to project that we are forecasting the overall capital spend. We're talking about the capital spend that's in relation to the particular product sets that we sell. So I'm not at all trying to say that all CapEx in the US is going to be this or that. And as far as our customers, is this a new piece? I would say definitely, I mean there has been I would say uneasiness, and maybe slow capital spend starting into the year. I would say people were, at that point in time thinking that the budgets will be approved, and things will roll on. And I would say, we just continue to see the same sluggishness in Q2 that we saw in Q1. Except in Q1, there was this general belief that things would turn back on, and they didn't turn on to the extent that I think we had planned. So in general, you could say that it's not a new animal. But I would say it has increased, that conservatism increased for us in Q2. And we're expecting similar conservatism in Q3.

As far as the international market versus capital versus where our performance has been, I -- there are -- first of all most of that business if we talk about the NSN BBA business is new. And I think they have gone through probably some capital constraint or tightness for some period of time. And what we are doing is picking up the ball at a point in time where the capital is already tight. It doesn't mean that it couldn't become tighter. But I think that a lot of the down tic that you would have expected in the capital constrained environment has already happened in this business. And so that's where we feel better about the relative place that they are, versus if it had been at a peak and we were actually catching it on its way down. And then we have other customers, one that's more predominant than the others, that have very specific things, very targeted things that they're trying to get done. And we happen to be right square in the sweet spot of that.

The growth that you've posted there suggests a decent amount of share gain. Is that a fair assessment? And then could you talk little about why those are happening, and perhaps who you think you're able to take the share from?

Sure. The share gains have been happening over some period of time. The incumbent in that particular customer is Ericsson and Alcatel Lucent, and Huawei is also in there. And I think it has to do with a unique design of our architecture which fits very, very well into their network architecture. And I think it makes us incredibly competitive, and meets the overall speed and performance requirements that they're looking for. And I think we're somewhat unique in being able to do that. But that share shift has happened over the last two years, and we continue to benefit from that and be able to sell more equipment into that.

Does that premise, supply outside of that 10% international customer that you have?

That premise, do you mean the thought itself?

Well, it seems like you're able to do well outside of that one --

Yes. Yes.

Customer itself. Is it the same general premise?

It's the same general -- yes and no. I mean, that product that we're selling the majority of is our 1100 Series product, which is a very unique product did in the market. The 5000 is -- if you look outside of that customer, I would say we have a mix of both 5000 customers who buy for different reasons than the 1100 Series products. But in every case we have to be able to differentiate ourselves. We do not have the same in-country presence as most of our big competitors. So we really do have to differentiate ourselves.

Okay, I'll pass it on. Thanks.

And text we'll go to Blair King from Avondale partners. Please go ahead. Great. Thanks for taking me. I just have a couple quick questions, a couple maybe a little bit of a rehash here too. But just first, Jim, what -- can you give us a sense as to what percentage of the sales were services this quarter?

Blair, I don't have that number, but even with the BBA acquisition, it still remains at something less than 10% of total Company revenue.

All right. And I just wanted to go back to the margin, a margin question. I know it has come up a couple of times. But maybe a more generic way of asking the same question as -- I mean just kind of looking at the ADTRAN core gross margin in the second quarter, at least the implied margin versus just say, the margin from the first quarter of 2011 or the second quarter of 2011, there's a pretty dramatic down tick. And I guess I just haven't heard a good explanation for that, outside of -- I understand the service mix. I understand the transportation costs, I understand all that. But even, and even last quarter there was lower volume associated with the gross margin. But then this quarter, the volume goes up, and the gross margin appears to actually be down sequentially. And so I'm just curious -- I think a lot of people are confused. And if there's any way to just give a little bit of background as to what's going on in the business to drive that, would be really helpful, Jim.

Yes, so there's one increment, that we did bring up. We did have a warranty cost run through in the quarter that doesn't typically happen. But that was, as Tom said, just in excess of a $1 million which is certainly a negative, an incremental negative as it relates to the prior quarter and year-over-year. Okay? And there's some other things -- I'm not quite sure how people were picking this up in their view for gross margins. But in terms of the purchase price accounting or adjustments that are happening on the revenue line, and also on the cost of sales line, related to the purchase of NSN. And that was just over a $1 million in Q2. And we expect it to be just a bit more than that, in a range just a bit more than that in Q3, because of the full three months that we have into it. So those are some of the other things that I can offer there, Blair, in terms of reconciling what's happened.

All right. And then is there any way to kind of give a little bit of color on the BBA manufacturing runs? And you mentioned some products had been moved, and others hadn't. Has it been high run rate products, or low run rate products, or what has moved so far?

I think the big key to us, was actually starting to build itself, which means that we actually have a new facility up and running. And I'm sure I know that the schedule includes initially the higher running rate products of -- but to be honest with you, I don't have the exact product in front of me, and what the actual run rate of that -- of those particular products are. Let me reflect back to you exactly, what the moves are, and so kind of tell you where we are within the process. We are in the midst of moving products from manufacturing in Germany, to manufacturing at locations, at a new location for us in Hungary. We have started that process, and have very good momentum. And we'll work through I think the majority of that process, Jim, through Q3. And then we also have -- and that's at a new facility for us, which is an ADTRAN Supply Chain facility with one of our existing subcontractors that are located in other parts of the world.

We also have another phase which we are in the midst of, and will accelerate in Q3. Which is moving some pieces from even Hungary, and then moving those or from Germany at the same time, and moving those to Asian manufacturers under the existing umbrella that we have. So there's two steps there, and a large percentage of those, if not most of those would be accomplished this year. I don't know if I added confusion there, or if I actually --

No, no, that's clear. And then the last question is, Jim, no one has asked yet about the deferred revenue build. I suspect that has something to do with the NSN acquisition as well. But if you could talk about what that is, or if that's more stimulus related?

Absolutely, Blair. The bulk of those deferred revenue increases both in short-term and long term relate to the BBA acquisition. We acquired a substantial number of contracts. And those contracts are multi-element agreements, that include customer care revenues that had built up that deferred. There are a level of Broadband stimulus deferred revenues as well in that number. But I've got to tell you, the larger piece would be BBA-related.

Okay.

Okay. All right.

Thank you very much.

Okay. Blake, at this point I see we're past our time. So I appreciate everybody calling in today, and hopefully we'll have a positive call in Q3. Thank you very much.

Thank you.