ADTRAN Holdings Inc (ADTN) 2013 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to ADTRAN's first quarter 2013 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 session.

(Operator Instructions)

During the course of the conference call, ADTRAN representatives expect to make forward-looking statements which reflect management's best judgment based on factors currently known. However, these statements involve risk and uncertainties including the successful development and 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, 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 call over to Mr. Tom Stanton, Chief Executive Officer of ADTRAN. Sir, please go ahead.

Thank you, Zach. Good morning everyone. Thank you for joining us for our first quarter 2013 conference call. With me this morning is Jim Matthews, Senior Vice President and Chief Financial Officer. I'd like to begin this morning by discussing the details behind our Q1 results and I'll end with some comments on this year. We will then open the call up for questions.

As stated in our press release, revenues for the quarter were $143 million, slightly beating our expectations. The first quarter confirmed that our base business continued to solidify, both here in the US and abroad, as we started seeing signs of improvement in both our Carrier and Enterprise businesses. Our Carrier Networks Division revenues came in at $110 million, flat with Q4, but up from the same period last year. On a sequential basis, sales to US Carriers came in essentially as expected, with sales of HDSL continuing to decline and sales of other Carrier products flat to their Q4 levels. The decrease in HDSL sales were offset by sales increases in Europe, Middle East and Latin America.

On a product basis, the Carrier Division revenues were led by Broadband Access which came in at $72.2 million, slightly up from the $70.1 million in Q4 of last year and meeting our expectations. Of course, revenues on a year over year basis were up significantly due to incremental sales from the acquired Broadband Access Business, but were also positively affected by an increase in sales to Tier 1 carriers here in the US. Of more importance was the continued activity level we saw in the first quarter around our fiber to the premise and vectoring solutions which I will touch on in a moment. As I previously mentioned, HDSL sales were down, both on a sequential and year over year basis, coming in at $11.4 million. I do think it's important to note, however, that for the quarter HDSL represented less than 8% of total company revenues. On a going forward basis, we believe that a decline in sales in this legacy product area will be relatively immaterial to the Company's overall performance.

From a customer perspective, we continue to make good progress in our market share initiatives with Tier 2 and Tier 3 accounts. Within the Tier 2 accounts, we continued our drive towards broadband share expansion and we were able to secure either market share awards or new application awards spanning all four Tier 2 customers. These applications range from ethernet aggregation and ethernet over fiber for mobile back haul to class five switch replacement. In addition, we continued to receive very positive feedback on our ONE product series, with various trials and deployments in both Tier 1 and Tier 2 accounts here in the US. And although I will still characterize the Tier 2 and 3 market as having severe regulatory driven constraints, we are making progress nonetheless.

As I mentioned in our last call, we continue to see an increase in activity in our international markets, driven largely by the acquisition we completed last May. These activities are generally revolving around expansion and upgrading of access infrastructure to integrate new features such as vectoring and GPON. These movements, driven by the competitive landscape, the introduction of significant technological innovation, and positive regulatory changes, continue to gain momentum. Total company international revenues came in at $34.9 million, up 20% sequentially and up 91% from the same period a year ago. On a sequential basis, we saw strength in Europe, Middle East, and Latin America.

Moving on to our Enterprise Division. Q1 sales totaled $33.1 million, a strong 14% sequential increase driven by strength in our Carrier channels. On a product basis, the increase was driven predominantly by an increase in sales of our Internetworking products which grew 17% for the Company sequentially. The strongest areas of growth were in the IP Gateway and switch product categories. During the quarter we continued to add strength to our dealer channel, adding approximately 80 new VARs to our program. Also during the quarter, we continued to add to our product capabilities in Enterprise with the introduction of our active chassis switch capability and the introduction of several new Wi-Fi products. We continue to progress with our field trials with our Carrier Wi-Fi offload and hosted solutions as well.

Finally, I realize there's been some speculation about two significant requests for proposals by two major carriers, one in the US and the other in Europe. Both of these projects involve significant upgrade and expansion to their existing networks. As you know, it is our policy to refrain from commenting on specific customer activity. However, we can say that we feel positive about the outcome of these negotiations and furthermore can state that we have begun seeing initial orders from one of these carriers for a multi-year project.

We came into this year optimistic that we were entering a period where many carriers around the world would embrace next generation access technologies to strengthen their competitive positions and meet their customers' growing demands and although we are still early in the adoption cycle, the activities that occurred in the first quarter of this year reinforce that optimism. We are confident in our ability to capitalize on recent Tier 1 carrier initiatives, as well as having confidence in our ability to expand our market share in the Tier 2 and Tier 3 carrier space. And we are hopeful that as the year progresses we will see additional clarity in cap associated regulation and the corresponding return to spending in the Tier 3 markets. We also believe Internetworking will continue to see growth from market share gains and new product offerings.

I would now like Jim Matthews to review our results for the first quarter 2013 and our comments on the second quarter of 2013. We will then open the conference call up for questions. Jim?

Thank you, Tom and good morning everyone. Revenue for the first quarter increased $143 million, compared to $139.8 million for Q4 of 2012 and $134.7 million for Q1 of 2012. Broadband Access product revenues for Q1 of 2013 were $72.2 million, compared to $70.1 million for Q4 of 2012 and $49.5 million for Q1 of 2012. Internetworking product revenues for Q1 of 2013 were $36.9 million, compared to $31.6 million for Q4 of 2012 and $41 million for Q1 of 2012. Optical product revenues for Q1 of 2013 were $8.9 million, compared to $12.3 million for Q4 of 2012 and $14.3 million for Q1 of 2012. Carrier system revenues for Q1 of 2013 were $92.8 million, compared to $90.1 million for Q4 of 2012 and $71.3 million for Q1 of 2012.

Business Networking revenues for Q1 of 2013 were $38.1 million, compared to $33 million for Q4 of 2012 and $43.1 million for Q1 of 2012. Loop Access revenues for Q1 of 2013 were $12.1 million, compared to $16.7 million for Q4 of 2012 and $20.3 million for Q1 of 2012. HDSL product revenues for Q1 of 2013 were $11.4 million, compared to $15.6 million for Q4 of 2012 and $19 million for Q1 of 2012. As a result of the above, Carrier Networks Division revenues for Q1 of 2013 were $109.9 million, compared to $110.8 million for Q4 of 2012 and $96.7 million for Q1 of 2012. Enterprise Networks Division revenues for Q1 of 2013 were $33.1 million, compared to $29 million for Q4 of 2012 and $38.1 million for Q1 of 2012. International revenues for Q1 of 2013 were $34.9 million, compared to $29.2 million for Q4 of 2012 and $18.3 million for Q1 of 2012. 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 48.7% of revenue for Q1 of 2013, compared to 48.2% for Q4 2012 and 55% for Q1 of 2012. The lower gross margin compared to Q1 of 2012 was attributable to lower gross margin related to the recently acquired Broadband Access Business and a change in customer mix. Total operating expenses were $63.1 million for Q1 of 2013, compared to $64.5 million for Q4 of 2012 and $57.9 million for Q1 of 2013. The increase in operating expenses from Q1 of 2012 to Q1 of 2013 was primarily attributable to research and development and sales and marketing expenses related to the acquired Broadband Access Business, partially offset by a decrease in SG&A expenses in our organic business. Amortization costs included in operating expenses totaled $1 million for the quarter.

Stock based compensation expense net of tax was $1.9 million for Q1 of 2013, compared to $2.2 million for Q4 of 2012 and $1.9 million for Q1 of 2012. Supplemental information for acquisition related expenses, amortizations and adjustments in connection with recent acquisitions are provided in our operating results disclosure. All other income net of interest expense for Q1 of 2013 was $3.2 million, compared to $3.5 million for Q4 of 2012 and $3.9 million for Q1 of 2012. The Company's income tax provision rate was 18.9% for the first quarter of 2013, compared to 35.4% for the first quarter of 2012. The lower tax rate for the first quarter of 2013 relates to a benefit related to legislation to extend research tax credits, partially offset by adjustments in the deferred tax asset valuation allowance for the acquired BBA business.

Earnings per share on a GAAP basis assuming dilution for Q1 of 2013 were $0.13, compared to $0.06 for Q4 of 2012 and $0.20 for Q1 of 2012. Non-GAAP earnings per share for the quarter were $0.17, compared to $0.11 for Q4 of 2012 and $0.25 for Q1 of 2012. Non-GAAP earnings per share exclude the effect of acquisition related expenses, amortizations and adjustments related to the acquisitions and stock compensation expense. Reconciliation between GAAP earnings per share diluted to non-GAAP earnings per share is provided in our operating results disclosure.

Inventories declined to $95.8 million at quarter end, compared to $102.6 million at the end of Q4 2012. Net trade accounts receivable were $82.1 million at quarter end, resulting in DSOs of 52, compared to 53 DSOs at the end of Q4. Unrestricted cash and marketable securities net of debt totaled $495.9 million at quarter end after paying $5.6 million in dividends and after repurchasing approximately 1 million common shares for $22.5 million.

Due to the book and ship nature of our business and the timing of near term revenue 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 second quarter of 2013, we expect company revenues will increase sequentially in the range of mid to high single digit percentage points. We expect GAAP gross margins for the second quarter will be in the range of what we saw in Q1. We expect GAAP operating expenses for the second quarter will range between OpEx levels experienced in Q1 of this year and Q4 of 2012. GAAP operating expenses for the quarter we expect will include acquisition related amortizations of about $1 million.

We believe the larger factors impacting the total revenue we realized for the second quarter of 2013 will be as follows. The macro spending environment for Carriers and Enterprises; regulatory uncertainty in the domestic carrier market; professional services activity levels, both domestic and international; the timing of revenue related to broadband stimulus projects; and the adoption rate of our Broadband Access platforms.

Tom?

Thank you, Jim. Zach, at this point we'd like to go ahead and open it up to questions.

(Operator Instructions). Amitabh Passi, UBS.

Hi. Thank you guys. Just a couple from me. First, was hoping you could touch maybe on -- the deferred revenue balance declined slightly sequentially, just wanted to get a sense of what might have driven that. Tom, very intrigued by your commentary around order activity related to one of your two large, well talked about Tier 1 operators. Just wanted to get some sense of how do you see developments progressing through the rest of the year, either with both accounts or one of them, whatever you could shed light on would be highly appreciated.

Amitabh, the question on deferred revenue, the change there is a result of normal revenue recognition as we recognize those deferred revenues. I don't think there's any sort of significant sort of issue around that change other than that.

Jim, was that related to international or domestic? Can you clarify that?

Relates more to international.

Okay.

On the second piece, I think the good thing for us was the fact that we actually had gotten past the award stage down to where we were actually able to move forward with receiving orders. So on the carrier, on the one carrier that I mentioned, we are receiving orders. We would expect to be shipping those orders in the second half of this year. I would say the real ramp-up for that customer though is still going to occur -- I think we'll see that ramp from the second half of this year through the next couple of years.

On the other carrier, we're not in a position to really talk much about that, but other than to say I would expect that to be a -- more a 2014 event than a 2013 event. We may see orders this year to the extent things continue the way they're going, we would see orders this year but I'm not sure we would ship a lot this year.

Tom, can I just ask one clarification? On these new Tier 1 operators, can you give us some sense of the pricing environment, the margin profile, is it consistent with your corporate average, accretive to your corporate average, just any rough sense of how we should think about the pricing action and the margin profile?

I would say that they're pretty much in line but I'll caution you on one thing and that one is using -- one is a European carrier and it is using the BBA product line. So that one inherently has lower gross margin at this point in time than the US product line for various different reasons. So are they at the average, I would say they're around the point that we would expect them to be for the type of products that they are. I don't know if I confused you or not, but those are two different product lines.

Got it. I appreciate it. Thank you. I'll jump back in queue.

Rod Hall, JPMorgan.

Can you hear me?

Yes.

I just wanted to ask a couple quick questions. First of all, just to follow up on the European commentary, [Utob at DNET] came out with route vectoring in Germany and some existing street financing won't be updated until 2016. Wonder if you could comment on whether that has any impact to the size of the revenue that you would expect to potentially receive in 2014, does it increase it? Decrease it? Any other commentary or color around that ruling would be interesting as well in terms of you how it affects the size of the potential deal you would have over there.

And then also just wanted to come back on Enterprise. Those numbers were better than we expected. Do you think that, that strength in Enterprise continues? Do you expect that to continue to get better for you as the year progresses or is it a particularly abnormally good quarter? Can you just give us a little bit more color around what's going on there? Thanks.

So first, on the European activity, first, anything that will help carriers to be able to deploy in a quicker fashion broadband, of course, is positive for us. So we see those moves as positive. I do think that in the near term a lot of the roll-out that we're hoping to do in Europe is premised around those rules coming into fruition. It was going to be rolled out in some form or fashion, in my opinion, betting on those rules or regardless of those rules. I think that there is a requirement for bandwidth and that these things have to be worked out. So I don't think they really affected us for the near term. For the longer term, without a doubt, the fact there's more clarity on how they're going to do on bundling and how vectoring will work will be beneficial in both the adoption rate and the speed of deployment.

As far as Enterprise is concerned, it was -- there was nothing that stuck out as far as -- there were no very large things that came in that affected the number. It was a general increase. As I mentioned on my notes, it was definitely more Carrier than VAR but it was a fairly broad-based increase. So we're hopeful and as you and everybody on this call knows, one quarter is just one quarter, but we're hopeful that we at least got past the bottom and seem to be moving upwards. So we would expect growth at this point in time. Having said the fact that we're one quarter into it.

Okay. Thank you.

Michael Genovese, MKM Partners.

Thanks a lot. Can you give us any 10% customer detail? And then secondly, maybe walk us through, from your perspective, what has to happen, what the guideposts are, what the milestones would be for dealing with the severe regulatory constraint in the Tier 2, Tier 3 market? What do you think is going to happen there and what would the timing be for that to get better?

Sure, Michael. On the 10% customer, the details that we can provide at this point is we had one 10% customer and that customer was domestic.

Okay.

As far as the regulatory hurdles, there are still some work that the SEC is doing in relation to the I would say mainly Tier 2 carriers, there is one Tier 1 carrier in there for the CAF phase one funding that was actually allocated last year, had very little uptick. There's some movement going on there. That would be beneficial.

In the overall Tier 3 space, I think the real problem has to do with the funding models and the way that they actually calculate whether or not you're an overly expensive carrier or not an overly expensive carrier. There was some relief on that in that they are now being able to allow CapEx and OpEx to be bundled together. There's now a floor, I think it's 15%. Jim, if you remember. I think it's 15% that gives some at least assurances as to how low your budget may be cut.

I think at this point in time, I don't really see on the Tier 3 piece a significant amount of additional rule change. I may be surprised there. But I think these things are just rolling out at this point in time and what we really need is some time. We really need people to start operating under these rules, realizing where the pit falls are and where the positive pieces are and it will just start picking up. So that's the way I view it.

Okay. Can I just ask on the Tier 2, you mentioned four Tier 2s where there was all some new business, some new awards at all four Tier 2 carriers. Is any of that CAF related or were those all separate commercial projects?

Those are separate commercial projects. And in some carriers, in some areas, in quite a few we actually brought in just the new applications that we weren't into for -- I will tell you, I don't think any of those are shipping yet. Those are all things that were able to just kind of secure in Q1. In some areas we're into market spaces that we weren't into before. We may have had an incumbent in that space. I think the CAF piece, we're waiting for those funds to release. I think we're in a good position on those CAF funds if that money is released.

Finally, on this Tier 1 opportunity where you started to see orders and expecting initial revenues in the second half of '13, is the eventual timing and scope of this eventual revenue opportunity and timing, is that going to become clearer to you over, say, the next 3 to 4 quarters or is that something that you feel like you know today how it's going to play out over the next 6 to 10 quarters what those revenues are going to look like? Or, is this stuff that's still being negotiated, still up in the air and you couldn't really call it today?

I think we have some boundaries, kind of an upper and lower range. But as far as how we fall within those boundaries, I think without a doubt that will be clearer as time goes through.

Great. Thanks for the questions.

Rich Valera, Needham & Company.

Thank you. Was wondering if you could comment on the Optical Access segment, that was pretty light this quarter relative to recent levels. I know you had some product development going on there and some sort of qualification going on. So could you give us any sense of how you think that might trend for the balance of the year? Thanks.

Our Optical Access activity, so it was low and that's even taking into account that we had an approval with one large Tier 1 carrier last year towards the tail end of last year that we started seeing shipments from but it really didn't overcome just the overall decline. Our focus on Optical Access right now was more centered around our total access system which has the ONE. I'd also mention we just secured some new ethernet over fiber deployment, I think one of the Tier 2s last quarter, so we'll see that pick up. You'll see some of it in the broadband line because some of it is based off of Total Access chassis and our ONE products which are really -- the customer acceptance of the ONE product has been very good. It has been very slow to get through the approval process. I really do think that will have a very positive impact for us. It's when those two pieces, the ethernet over fiber piece out of the 5,000 and the ONE out of the 5,000, really start getting broad deployment. We're through -- we've got I think two of the Tier 2s right now that are using the ONE product but it's very early, and you'll start seeing that pick up as we start picking up more wins and start being able to capitalize on the wins that we have.

Do you think that's kind of a second half of '13 to start seeing some of that revenue traction?

We're seeing some of it now. The question is when will it overcome the 6100, which is a SONET-based product, when will it be able to overcome that point. To be honest with you, I think to be able to overcome that the second half of '13 is early. I think it will probably be sometime next year.

That's helpful. One more if I could on the international front. I know you don't want to specifically break out the contribution from the NSN, BBA business, but can you give us a sense directionally how that business fared from Q4 to Q1, was that up as well with the overall international business?

Yes it was.

And can you give us any sense of your expectation for that business for this year? I'm guessing it has maybe a fair bit to do with one of your Tier 1s over there, but I think the perception was it was quite light in 4Q. Do you see that business kind of generally being stronger than those 4Q levels this year and kind of ramping from those levels?

Rich, yes we do, yes.

Okay. That's helpful. Thank you.

Simon Leopold, Raymond James.

A couple things I was hoping to clarify. In terms of the new Tier 1 opportunities, can you provide some framework to help us think about the size of these opportunities in terms of what you're thinking total revenue and then the competitive aspect of whether these are sole source opportunities or whether you are really looking at a share of a larger project? If you could talk about the two of them independently.

Sure. So the European opportunity is -- well, both of them I would characterize in total opportunity as hundreds of millions over three to four years. And the one in Europe is -- there is a competitor that is approved as well. The one in the US is multifaceted and then some portions of -- let me call it multi-project. So there are a couple projects, one in the US, one of them there would be a competitor, an incumbent competitor and the other one would not.

Great. When you first acquired the business from Nokia Siemens, I think you talked about the plan to really migrate customers from the former Nokia products to your own organically developed platforms. Can you give us some perspective or sense of how that transition is either happening or how you see it happening?

Yes, so I don't believe we've ever said that. I think -- in fact, I'm pretty confident that we said from the very beginning we were going to continue on with the NSN platform, they're a customer where that is entrenched. That platform actually has no -- it's not a platform that's handicapped from where it can go. In fact, there's some very positive attributes to that platform and we were not going to try to force some type of upgrade or some type of replacement and that is still the plan.

You're investing in those products to essentially evolve them to new generations and build out essentially a second portfolio based on that? Is that a fair way to think about it?

That is. I will tell you where we're planning and still in fact are working on to this day on driving more and more value out of -- which is if you look at the development of these two kind of fundamental platforms that we have, the hiX system and the 5000, about 80% of that work is kind of higher level software development where we can absolutely be able to build one and use it in both. We're really trying to maximize that. To the extent we're not as far along as we would like to be it's because we have some very large customer opportunities that are driving a greater share of our R&D development than I would have guessed a year ago. But both of them are still working towards that end result.

And then just one last one. Sometime ago you had acquired Bluesocket for the wireless LAN market. It was not part of your commentary behind the strength of the Internetworking. Just wonder if we could just kind of check back on the status of that business?

Bluesocket had actually a very good fourth quarter and the first quarter I would say was probably affected by that. It wasn't dramatically down but it wasn't up. That's why we really didn't mention it. We just mentioned the two pieces that drove the majority of it. It is still -- it actually had a very good year last year and we're seeing actually no decline in activity around Bluesocket. So I didn't mean not speaking about it didn't necessarily point the fact that we saw poor performance there.

Great. Thank you for the clarification. That's all I had.

Thank you.

Simona Jankowski, Goldman Sachs.

Hi. Thanks very much. Just a couple of questions and a follow-up. So your guidance for mid to high single digit revenue increase in the second quarter compares to your historical seasonality in the second quarter that's typically been more in the double digits. And when I couple that with your commentary on improved activity levels, it just seems like it might be conservative or perhaps can you just kind of point us to what are some of the offsets that are holding back your guidance?

Well, Simona, I think we certainly want to be very careful on the view that we give to the Street. That is a number or target or range that we think that we can very reasonably achieve and there are a number of moving parts. We continue to be a book and ship business and there's some level of uncertainty related to that aspect. But all in all, that's how we feel about the business.

I will tell you also that, that goes back, depends on how many years you go back as to what the typical seasonality would be. So that's a variable number. And the business has shifted. We saw the business really shifting maybe two years ago as HDSL became less the driver which had a very specific seasonal nature to it and things like broadband became more important, which may be more project related. So I think it's harder and harder to relate just -- to rely just on let's say five years of historical seasonality because I think within those five years you'll see some fairly dramatic swings.

Okay. That's fair enough. Also wanted to follow up on the comment you made about having won some new business including [personnel] obligations in the Tier 2 space specifically. Didn't sound like any of those revenues showed up in the first quarter. Can you just comment on when you expect those Tier 2 wins to translate into revenues?

They're translate throughout this year. Some of them will start in this quarter and some of them -- be honest with you, I think most of them will start this quarter and then they'll ramp up or they'll complete. Just going forward we'll see them this year.

Okay. Just the last one I had is on the international market where you talked about increased activity and that business was actually up 20% for you sequentially. Do you view that as the beginning of sustained improvement for your international business this year or do you think it's likely to remain lumpy?

Jim, you want to take a stab at that?

We do see it improving. There is potential it could be lumpy, though, as with various parts of our business.

If you had to ask me -- which you are asking me today -- do we expect it to increase through the year, the answer to that would be yes. I think to be honest with you, the farther out we get, if you were to try to tell me, ask me what was the international goods business going to do in Q4, I think that would be a difficult question to answer. But going forward, in the near term do we expect it to increase? The answer is yes.

Okay. Thank you very much.

Sanjiv Wadhwani, Stifel.

Thanks so much. Tom, there's been some mixed signals about Tier 1 US carrier spending. I was wondering if you could sort of give us some comments about how you saw that trending through Q1 and sort of what do you think is going to happen in Q2 with sort of overall Tier 1 spending. Thanks.

I know there has been and that's one of the reasons that I commented with a little bit more granularity on the US Carrier spend. To us, the Carrier spend was basically flat in the US, with the exception of we saw a decline in HDSL which we think is just a secular decline in that particular product area. And then that -- of course, that decline was made up for on the international market. So we really didn't see a significant change the spending pattern. Activity levels typically pick up in Q1. They absolutely picked up this quarter compared to fourth quarter where people are typically winding down. But the environment itself felt very similar. The US environment or the US spending patterns was similar to what we saw in Q4, which is why we ended up with kind of a flat US Carrier spend level.

The question is that's typically better than normal seasonality, isn't Q1 sort of a slower start and things kind of start ramping maybe towards the end of the quarter into Q2?

It depends on how quickly they ramp down in Q4 and I think it's a 50/50. I think it's tough to say that they were typically down. If they are, they're down probably less than 5%. If they're up, they're typically up less than 5%, unless there's a big market share shift.

Got it. Thanks, that's helpful.

It's pretty much what we would have expected actually.

Sounds good. Thanks so much.

Ehud Gelblum, Morgan Stanley.

Good morning. Appreciate it. Thank you. Couple questions. First of all, sounds like BBA grew sequentially. If we were to exclude that from the Broadband Access group, would broadband have grown sequentially as well? What I'm saying, was the growth in BBA sequentially more than the $2 million increase we saw in Broadband Access? That's one.

Second, you used to talk a lot about services, Jim, and the growth in services especially as your Tier 1 in Latin America that business grew. Where is services? Can you give us a sense has that continued to grow and is that having an impact on margins and where do you think that goes forward, especially in your two big Tier 1 wins that you'll be rolling out over the next couple years? Looking at gross margin, give us the puts and takes this quarter versus last quarter, the 40, 50 bps that gross margin expanded and where do you expect that to go going forward with all the puts and takes you were talking about?

Let me try to answer your first question, Ehud. The sequential growth in the international business was actually -- was in excess of the $2 million that you mentioned. Okay? Did I cover the entire question on the first one, Ehud? I want to make sure I caught it.

Basically what you're saying is that the growth in Broadband Access was due to growth in BBA and then some and so ex-BBA, Broadband Access core ADTRAN Broadband Access actually declined sequentially. Is that right?

It was basically flat.

It was basically flat.

It was basically flat, Ehud.

Okay. The growth in BBA was $2 million. Okay.

In terms of your services question, Ehud, the relationship to total revenue over the last couple quarters really hasn't changed that much, if that helps, okay? Now, in terms of on a go-forward basis, I think it's going to depend on how newly awarded business will grow in relation to total services, okay? And that's going to be hard to say at this point. All right? So we had the hardware side of things at play with the new award. I know that doesn't answer your question but that's kind of --

On the puts and takes on gross margin going forward given that it sounds as though when this European Tier 1 comes in the second half in terms of revenue, it sounds like the margin's a little bit less. I also wonder as you get into the US Tier 1, is that going through -- is that going directly or is that going through your partner Ericsson that you've done some of that business in the past and how does that impact gross margin? How should we be modeling gross margin throughout the rest of this year and into next year?

Well, the question in terms of how to model gross margins for the rest of this year and next year, all we have at this point, Ehud, is a quarter outlook for the current quarter. We certainly have opportunities at play that are not finalized yet which may or may not have an impact on gross margins, so it's really too early to say at this point. That's really all I can say.

Okay.

Not being helpful, I know. But at this point that's all I can say.

Let me try a couple other things, then. International was very strong, up around $6 million sequentially. It sounds as though the BBA business was up only a couple million. So the rest should we assume the other $4 million of international strength came from your traditional customers like your friends in Latin America?

Right. That's right.

Okay. What inning are we in their build? I know they've had several phases of that build out. There was a period of time when there was a pause in their build out. Now it seems like they're back. Is this a late stage build out or is it still early or in the middle?

This is a multi-phase. The way that we look at this build out is we complete phase one, then we go to phase two, then we add a phase two plus. We're kind of in the middle of that. We fully expect there to be a phase three and a phase four and probably a phase five. So if you look at it from the number of phases that we are, I'd say we're very early. If you look at the penetration rate with the type of speeds they're trying to get to I have no doubt we're very early in the build out there. The problem that we have that makes it difficult to forecast is that those phases kind of get dropped in periodically and then have you to react to them and there's not a lot of forecasting of that up front. But I would say we're very early in the build out.

Phase two plus is almost complete or phase two plus is just started?

I mentioned, I think last quarter, that we expected the current activity level with Telmex to be meaningful at least through this year and I would expect it to be longer than that at this point.

Okay. I appreciate. One last thing if I could. Internetworking was strong again in Q1. It was strong in Q1 of last year and then fell off as the year went on. The previous year, in 2011, it was the opposite. Started low in Q1, got stronger as the year went on. This year we're starting off strong again. What's the seasonality that you're looking at in Enterprise and what makes that thing tick as we go throughout the year?

I think last year we had some strength, that strength actually was being carried over from Q4. We were -- as we got into Q2, but there's no doubt towards the tail end of Q1 we saw some softness. It wasn't clear at that point in time what the driver was but then we saw that continued softness through Q2 and I would say that's not the way it feels today. The actual order rate actually increased through the quarter and we're early into this quarter but we're still feeling pretty positive that we're in the right direction.

Okay. Very helpful. I appreciate it.

Okay.

Barry McCarver, Stephens, Inc.

Good morning, guys. Just a couple things you've already touched on that I wanted some clarity on. In terms of the progress in Tier 2 and Tier 3 spending you mentioned in your prepared comments, despite continued difficulty in the regulatory environment, do you feel like that spending is coming from these carriers really loosening up and starting to take a look at their budgets or was it more product enhancements on your part or spending they think they have to do regardless of the regulatory environment? Trying to get an idea there.

I don't get the sense that there's a lot of loosening. I kind of characterized the environment on the previous question as being similar to Q4 and Q4 was not a loose environment for Tier 2 and Tier 3 spending. I would say in the majority, if not -- I would say the majority of the carriers we deal with it's still a tight environment and we're -- really the way that we're going to be able to grow that business, at least until that regulatory clarity comes in, is through market share gains.

Okay. And then secondly, if I can, back on margins, understand your guidance for the next quarter but looking specifically at BBA and your outlook there, you mentioned those are still running below your typical margin. Any expectations this year that's going to improve significantly or longer term?

Longer term, without a doubt. This year, we'll see some improvement as we go through the year. On a cost basis we'll see improvement. We're already seeing some improvement. We actually saw improvement through most of last year and into this year. And we have some fairly dramatic cost decreases which will be coming in but some of those are not scheduled until next year. Those have to be actually scheduled with customers. So do we see it getting better in totality? Absolutely. We think our cost base is going to go down. What our gross margin is going to be on any particular quarter is also going to be dependent on the customer that we actually sell to.

Okay. Fair enough. Thanks a lot, guys.

Eric Ghernati, Bank of America.

Hi. Thanks for taking my question. Jim, as far as your core BBA business excluding NSN, what's -- how should we think about the expectations for that going into the second quarter? Clearly, it does sound like the NSN business is going to have a bigger ramp into Q2 as opposed to the core BBA business. Just wanted to see if that assumption is correct.

I think that's a reasonable assumption. We are seeing an increase in activity in both areas, but I think BBA, in terms of the acquired BBA, would be sequentially up probably to a larger extent.

Let me add one comment which makes that a little bit -- you would think that would be a fairly clear question to ask. Of course, we're still a book and ship business. Some of the revenue associated with the -- I'll call it the organic international business, the non-BBA business, is just depending on installations. Some of that is now service oriented business or even the recognition of the revenue is dependent upon service installation completion, which to some extent is in our control but not to the majority, not the majority of that is in our control. So it's difficult. We needed to leave ourselves some wiggle room in the way we think about that international business. So it's tough to say that specifically where it will be in Q2 at this point in time.

Okay. Another question is with respect to the gross margin. Sounds like the NSN business is -- doing some quick math here -- actually saw some pretty sizable improvements in gross margins. Just curious as to why you're guiding for flattish overall gross margins, despite the fact that we've -- sounds like you still have some cost reductions to be had in the business which will improve on a sequential basis into Q2.

Well, you also -- we mentioned a couple of times on the call that the gross margins on the BBA business is much more volatile than the gross margins on the non-BBA, the 5000 business, and the reason for that has to do with the chassis sales versus line card sales which can impact us. Actually have a meaningful impact on our gross margin. So even if we have cost reductions coming in depending on what our current view of chassis sales versus line card sales, that would still have an impact on what those gross margins would be.

And just as a follow-up on the Internetworking business, it's been under quite some pressure throughout last year. This year, it's off to a very strong start in Q1. It does sound like counterintuitive from what we're hearing from the carriers in the US where they say small to medium size business which is target market for your Internetworking business is still under some pressure. Do you think there was just like a little bit of a -- you said there was like a broad-based improvement but don't you think that some of that maybe just like inventory replenishment related or something like that? Can you just clarify what's happening there?

To be honest, there could be some of that, that's inventory related. Our sense of the strength -- let me take the two pieces and take them apart. One is, my comment was that there was no one customer that actually was way above other customers, that in general was a broad-based improvement, which leads you to believe unless the whole customer base had the same inventory adjustment problem, then that wouldn't be the case.

And then the other piece that I could just comment on is that if we look at the order flow and how the order flow appeared in the quarter versus last year. Last year we had a fairly strong Q1 and then it disappeared on us through the rest of the year, and if I look at the order flow of last year, I would say this year has a different order flow, that it's actually stronger as we exited the quarter and continued to have some strength. That gives us some sense that it -- I won't say that there wasn't inventory adjustment in there. I'm not aware of any. It actually could be true. The sense is right now we're seeing a better strength there. We'll know at the end of next quarter. That's our feeling at this point.

Okay. And just one last question. If you were to look at your US Carrier business and you strip out the portion that goes into Internetworking and also the portion that goes into HDSL, is it fair to say that going into Q2 the environment as you look at it hasn't really changed much and that you're more positive on your international business rather than your US based Carrier business that is non-Enterprise?

Okay. When you say less -- maybe less positive, we saw basically for the non-HDSL business flat is basically what we saw.

Correct.

In the US Carrier business from Q4 to Q1. We typically -- and we still expected to see some seasonal uptick from Q1 to Q2. Whether or not that's muted seasonality, whether or not you go two years back or five years back to figure out what that seasonality is, it's really up to you. We would expect to see some level of uptick in the US business. I wouldn't characterize that level of uptick being driven by any change in environment. I would say environment, right now my guess would be that the environment would be the same for this quarter as it was last quarter, which was the same as it was in Q4.

Thank you. Very helpful.

Okay.

Mark McKechnie, Evercore Partners.

Thanks much for taking the call. Mine's kind of a bigger picture question. In your commentary you talked about a Carrier Wi-Fi offload project and wanted to dig in a little bit. I'm assuming a lot of that's related to Bluesocket but like to know do you think this could be a material contributor this year, next, and what are some of the products that you'd be shipping into the Carrier Wi-Fi offload area? Thanks.

My comment was really -- so I will say on Carrier, when I talk about mobile Carrier, we did pick up some wins in ethernet over fiber from our Total Access product line which I just want to make sure there's a distinction between that. The other comments that I made about Wi-Fi and Carrier offload were specifically about our Bluesocket products where we are in trials at several, meaning more than two carriers, to either do Carrier Wi-Fi offload or in some cases they're looking at it for multi-premise Wi-Fi solutions that are hosted. And we view both of those as very legitimate and potentially large opportunities for the Bluesocket piece. Of course, the amount of development that you have to do in order to fine-tune these for each of the individual carriers can be somewhat burdensome, so we are going through an awful lot of prioritization on those developments but it has -- but I would say the Carrier space in general is one that I feel we are relatively untapped and is untapped for us and we see good promise there. The only other piece is that we are using also carriers as a resale agent and they've already started doing that. They started doing that I think towards the tail end of last year, Jim, and we'll see a pick up in activity where they're actually just reselling this product as in effect a channel to market for the product.

Great. Okay. That's it. Thank you very much.

Okay.

Bill Dezellem, Tieton Capital.

Thank you. A couple of different questions. First of all, relative to gross margin in the first quarter, relative to the fourth quarter, it was lower and yet revenues were slightly higher and hoping that you can give us some clarity on that. And then secondarily, in Latin America what are your thoughts there relative to all of the chatter about breaking up some of the larger carriers and the potential delays or negative possibilities it could lead to for ADTRAN in terms of spending?

You want to cover the first one?

I want to make sure I understand your first question. You're talking about the gross margin variance from Q4 to Q1? Is that correct?

That's correct.

Okay. And we did increase 50 basis points, okay, so I want to make sure I understand your question. I think you talked about a decline.

Jim, the implication is that I didn't do my math right. Let's just skip the question and I'll come back later.

Okay. As far as the second part of the question, which is the -- what's going on in Latin America, so our products -- when we initially started our first phase of product sales of our fiber-to-the-node products there, they were initially driven for the potential of IPTV and offering a television service. That has been that initial drive somewhat fell through, in fact it did fall through as far as the carrier being able to secure that franchise and we saw a lull in business that was kind of the first phase, we saw a lull in business and then the drive started being towards higher speed ethernet. And what has driven us from that point forward to this point in time has been high speed ethernet. I think a lot of the chatter around what's going on in Latin America in regards to break up of services has as much to do with television franchise capability and what's going to ultimately be allowed there as much as anything else.

There is -- I don't think there's any doubt that if a carrier is using our equipment and they are able to offer IPTV services or franchise for video, that would be a great bolster to our sales potential within that particular carrier and it would also, in some instances, force an upgrade of the existing infrastructure into higher speed infrastructure which of course is positive and we've experienced in different areas. So, yes, does it curtail what our growth potential could be if these things don't come to fruition? It does. Does it actually stop our business? I would still go back to say that the majority of our business today into Latin America is driven by simple Internet access at a higher speed and we don't see that really changing.

That's helpful. Thank you.

George Notter, Jefferies.

Hi, guys. Thanks very much. I wanted to ask about the HDSL business. I think you said earlier that any decline in that business going forward would be immaterial with financials and I think you also said HDSL was around 8% of sales this quarter. Is it fair to assume that HDSL is disproportionately smaller as a percentage of operating profit relative to sales or how would that stack up? Thanks.

So HDSL was $11 million, and I think I will just put a little caveat. I said relatively immaterial. If HDSL sales, it's $11 million on whatever the number is, I think everybody's in agreement that it won't go to zero any time in the near future. We just think that the movements from here, we just have less of an impact. HDSL from a gross margin perspective, we've always said has been in the corporate average.

I will tell you, there's no R&D to speak of associated with HDSL. So from an operating income perspective, I would say it probably is positive. But to be honest with you, I don't know if that will -- it's been -- there's been very little R&D in that product area for quite some time and those engineers have been moved over to the broadband area. So gross margin-wise, of course that's a -- when our gross margins were in the high 50s, it was basically in line with what our gross margins are at this point in time, although to be honest with you I haven't looked at it specifically. At this point in time, I would say it is above our corporate average, it would have to be above our corporate average at this point.

The other question I had just had to do with the NSN broadband business. You guys had talked about some warranty expense filtering through that product line this year. Can you just remind us when that warranty expense would run off and I presume that would help on gross margins at some point?

Jim, you want to --

Last quarter, I think we talked about it lasting to some extent through the second quarter.

Got it. Okay. Great. Is that a big driver of gross margin in that business or is it small relative to mix? I think you talked about chassis line cards, et cetera.

Chassis line cards are a much bigger mover than that expense.

Right.

For the size of that business, it was a material piece that happened that we're working through but in the overall aggregate, without a doubt the chassis line card piece is a bigger piece.

Thank you.

Thank you. I think we're out of time. So I would like to thank everyone for joining us on the call and we look forward to talking to you this time next quarter.

This does conclude today's conference. You may now disconnect and have a wonderful day.