ADTRAN Holdings Inc (ADTN) 2013 Q2 法說會逐字稿

Ladies and Gentlemen, thank you for standing by, and welcome to ADTRAN's second-quarter 2013 earnings release conference call. All lines have been placed on mute to prevent any background noise, but 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 Management's best judgment based on factors currently known; however, these statements involve risks 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 cost, manufacturing efficiencies, and other risks detailed in our annual report on Form 10K for the year ended December 31, 2013 and Form 10-Q for the quarter ended March 31, 2013. These risks and uncertainties could cause actual results to differ materially from those in the forward-looking statements which may be made during the call. It is now my pleasure to turn the call over to Mr. Tom Stanton, Chief Executive Officer of ADTRAN. Sir, please go ahead.

Good morning, everyone. Sorry about the disconnect there. Thank you, Josh. Thank you for joining us for our second-quarter 2013 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 the details behind our Q2 results, and I'll end with some comments on what we see for the future. We will then open the call up for questions.

As stated in our press release revenues for the quarter were $162.2 million, exceeding our initial estimates. Highlights for the quarter included a greater-than-expected rebound in our Enterprise business, increasing strengthen our EMEA business, market share gains with Tier 2 carriers, and a slightly stronger Tier 3 spending environment. Our Carrier Networks Division revenues came in at $123.3 million, up 12% sequentially, lead by our Broadband Access category. The increase was driven by market share gains in our domestic Broadband Access business as well as an increase in shipments to Europe and the Middle East. Our Enterprise division Q2 sales totaled $38.9 million, a strong 17% sequential increase and a 24% year over year increase, driven by Internetworking category, which on a combined product basis, including both Enterprise and Carrier products, grew 19% sequentially and 26% year over year to a record $43.9 million.

Total Company domestic revenues came in at $127.5 million with international revenues coming in at $34.7 million. On a product basis, as I mentioned before, Broadband Access had a solid quarter as we saw the benefits of our market share expansion into Tier 2 and Tier 3 US Markets and the benefits of our recent Broadband Access acquisition. The strongest product areas were the TA5000 platform followed closely by the hiX 5600 platform. The TA5000 performance was positively impacted by Tier 2 market share gains as well as slowly improving spending environment in the Tier 3 space as Carriers began to acclimate to the new CAF regulations. Likewise, the highest platform benefited from improvements in Europe and the Middle East.

Our Internetworking product category also performed well with solid sequential growth in all major product areas. Our Router product area lead this growth followed by Carrier Ethernet and IP Gateways. From a channel perspective, we saw an increase in sales in both Carrier distribution and our value-added resellers. During the quarter, we added approximately 100 new value-added resellers to our programs. Other activity of note in the quarter for the Enterprise Division included our NetVanta products being selected by a major European Tier 1 carrier for wide scale delivery of managed ethernet services. And during the quarter, the Enterprise Division secured primary vendor status for wireless LAN services at a domestic Tier 1 carrier and a domestic Tier 2 carrier.

I had mentioned on our last call the RFP activity surrounding two major infrastructure upgrades, and I view these two opportunities as progressing well from our last call. We will commence shipping our vectoring technology to one of these carriers based in Europe this quarter. The other carrier, a US carrier, remains a 2014 revenue opportunity.

Looking forward into the next several quarters, we believe our business will be positively impacted by several factors. First, we have begun to see signs of spending environment improvement, most notably in our Enterprise business. The broad-based nature of this improvement gives us some confidence that it is a sustainable macro improvement. Secondly, as I mentioned above, we are starting to see the effects of improved clarity relating to the USF to CAF transition, and although we would not characterize the environment as back to normal, we are seeing improvements nonetheless. Finally, our market share (inaudible) and global expansion is timed well with carrier cycles associated with the rollout of ultra high speed access, as carriers around the world embrace next-generation access technologies to strengthen their competitive positions and meet their customers' growing demands. As most of you are aware there are several major carriers who have already laid out their plans for this cycle, and we believe we are in the very early stages of this major infrastructure upgrade.

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

Thank you, Tom, and good morning, everyone. Revenue for the second quarter increased to $162.2 million, compared to $143 million for Q1 of 2013 and $184 million for Q2 of 2012. Broadband Access product revenues for Q2 of 2013 were $81.6 million compared to $72.2 million for Q2(Sic)of 2013 and $106 million for Q2 of 2012. Internetworking product revenues for Q2 of 2013 were $43.9 million compared to $36.9 million for Q1 of 2013 and $34.9 million for Q2 of 2012. Optical product revenues for Q2 of 2013 were $16 million compared to $8.9 million for Q1 of 2013 and $14 million for Q2 of 2012. Carrier Systems revenues for Q2 of 2013 were $105.5 million compared to $92.8 million for Q1 of 2013 and $126.8 million for Q2 of 2012.

Business Networking revenues for Q2 of 2013 were $45.4 million compared to $38.1 million for Q1 of 2013 and $36.6 million for Q2 of 2012. Access revenues for Q2 of 2013 were $11.3 million compared to $12.1 million for Q1 of 2013 and $20.7 million for Q2 of 2012. HDSL product revenues for Q2 of 2013 were $10.3 million compared to $11.4 million for Q1 of 2013 and $19.5 million for Q2 of 2012. As a result of the above, Carrier Networks Division revenues for Q2 of 2013 were $123.3 million compared to $109.9 million for Q1 of 2013 and $152.7 million for Q2 of 2012. Enterprise Networks Division revenues for Q2 of 2013 were $38.9 million compared to $33.1 million for Q1 of 2013 and $31.3 million for Q2 of 2012. International revenues for Q2 of 2013 were $34.7 million compared to $34.9 million for Q1 of 2013 and $53.6 million for Q2 of 2012. To provide the reporting of each of these categories, we have published them in our Investor Relations web page at ADTRAN.com.

Gross margin was 49.2% of revenue for Q2 of 2013 compared to 48.7% for Q1 of 2013 and 51.7% for Q2 of 2012. The higher gross margin compared to Q1 of 2013 was primarily attributable to a more favorable customer mix in North America. The lower gross margin compared to Q2 of 2012 was primarily attributable to less favorable customer mix in North America and a higher mix of revenue from the EMEA region in Q2 this year. Total operating expenses were $65.7 million for Q2 of 2013 compared to $63.1 million for Q1 of 2013 and $68.4 million from Q2 of 2012. The increase in operating expenses from Q1 of 2013 to Q2 of 2013 was primarily attributable to higher sales volumes. The decline in operating expenses from Q2 of 2012 to Q2 of 2013 was primarily attributable to a reduction in R&D, Sales, Marketing, and G&A expenses in our organic business, partially offset by the addition of a third month for a full quarter of operating expenses for our recently acquired Broadband Access business.

Acquisition related to amortizations totaled $0.9 million for the quarter. Stock based compensation expense, net of tax, was $1.8 million for Q2 of 2013 compared to $1.9 million for Q1 of 2013 and $1.9 million for Q2 of 2012. Supplemental information for acquisition related expenses, amortizations and adjustments in connection with the recent acquisitions are provided in our operating results disclosure. All other income, net of interest expense, for Q2 of 2013 was $2.8 million compared to $3.2 million in Q1 of 2013 and $5.9 million for Q2 of 2012. Q2 of last year included a bargain purchase gain of $1.8 million related to the acquisition of the Broadband Access business. The Company's income tax rate was 41.4% for the second quarter of 2013 compared to 35.7% for the second quarter of 2012. The higher tax rate for the second quarter of 2013 relates to adjustments in the deferred tax asset valuation allowance for the acquired Broadband Access business, partially offset by a benefit related to research tax credits this year.

Earnings per share on a GAAP basis, assuming dilution, for Q2 of 2013 were $0.17 compared to $0.13 for Q1 of 2013 and $0.33 for Q2 of 2012. Non-GAAP earnings per share for the quarter were $0.21 compared to $0.17 for Q1 of 2013 and $0.38 for Q2 of 2012. Non-GAAP earnings per share exclude the effect of acquisition related expenses, amortizations and adjustments related to acquisitions, and stock compensation expense. The reconciliation between GAAP earnings per share diluted and non-GAAP earnings per share is provided in the operating results disclosure. Inventories declined to $87.8 million at quarter end compared to $95.8 million at the end of Q1 2013 and $103.8 million at the end of Q2 2012.

Net trade accounts receivable were $103.5 million at quarter end, resulting in DSOs of 58 compared to 52 DSOs at the end of Q1 2013 and 59 DSOs at the end of Q2 2012. Unrestricted cash and marketable securities net of debt totaled $419.9 million at quarter end after paying $5.4 million in dividends and after repurchasing 3.2 million common shares for $67.4 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 of 2013, we expect total Company revenues will increase sequentially in the range of mid to high single-digit percentage points. Although gross margins have continued to improve this year, our European business continues to be at lower gross margins as compared to our organic business and large fluctuations in volume between those two businesses can drive variations in our consolidated gross margin.

For the third quarter, we expect consolidated gross margins to decline due to increased volumes in our European business as a result of newly-awarded business from a large carrier. We expect GAAP gross margins for the third quarter will be in the mid to high-40s percentage-point range. We do expect gross margins will begin to improve in Q4 of this year as we begin to see some benefit from product cost reductions. We expect GAAP operating expenses for the third quarter will increase slightly on a sequential basis. We anticipate a lower tax rate in the third quarter due to improved profitability of the recently acquired Broadband Access business because of higher sales volumes.

We expect the consolidated tax rate for Q3 to be in the mid-20s percentage-point range to pretax income. We believe the larger factors impacting the total revenue we realized for the third quarter in 2013 will be (inaudible). The macro spending environment for the carriers in Enterprises, professional services activity levels, both domestic and international, the timing of revenue related to Broadband stimulus projects, and the adoption rate of Broadband Access platforms. Tom, back to you.

Thank you. Josh, at this point we would like to open it up to questions.

Absolutely.

(Operator Instructions)

We will first go to the site of Rod Hall with JPMorgan. Please go ahead; your line is open.

Yes, hi, good morning guys. Can you hear me okay?

Yes, we can hear you.

Tom, I just wanted to get you to comment a little bit more. You said that you'd see the spending environment continue to improve. Could you give us a little bit more detail on regionally where you see things improving from a macro point of view, and also talk to us a little bit about the split between Enterprise and Carrier on that? Are you seeing improvement on both sides of the equation, or do you think it's mostly Carrier? Is that mostly what you're referring to? And then I have one follow-up to that.

Sure, so I would say the biggest improvement we saw was actually in our Enterprise Division, but that improvement included CLECs, so we saw a good pick up in our CLEC business as well as our standard Enterprise business selling to end users. Secondly, the Tier 3 space actually did fairly well for us this quarter, and it had been dragged down for a year or so, so that was the first time we saw some pickup there, which we do think has to do with the CAF regulation, the changes in those regulations that happened earlier this year and people just starting to understand more how to work within the new environment. And then lastly, without a doubt, we saw Europe starting to pick up, especially towards the tail end of the quarter, the order flow from Europe was fairly strong.

Okay, thank you, and then I also wanted to -- you said you commenced vectoring shipments this quarter. I assume that made you've actually recorded revenue for that vectoring equipment?

When I say (multiple speakers) -- Excuse me, when I say this quarter, I mean third quarter.

Right, okay. So you would expect some revenue in the third quarter from that vectoring equipment. And then I wonder, can you just confirm that that's the case and then also talk to us a little bit about the ramp of those shipments, how you expect that to go over in the next few quarters?

Yes, so I think there will be seasonality in this customer just like there typically is, so I would expect a lower fourth quarter. I will say that the shipments this quarter are going to be meaningful in the third quarter, which is one of the things that Jim touched on, and then we would expect them to pick back up some time similar to what we saw -- see here in the US, which is some time in the first quarter, you'd see them pick back up, and then you'd see them accelerate. Without a doubt, our view is, at this point, that the business that we'll see next year will be substantially larger than the business we will get this year.

Okay. And then you said on the TA5000, you said it was strong and you had share gains in Tier 2 carriers.

Right.

Was that share gains in existing footprints? Do you expect those share gains to continue, or could you give us a little more color on that? And I think that's my last question.

Sure, so in two of the Tier 2 carriers, it was just flat out new applications that have gotten approved, so you can consider that to be new footprint. In the other two of the Tier 2 carriers, one of them was a ongoing continuation, so really no share gain there, but in the fourth one, which is the largest one, we are really just starting to monetize the 90% market share award that we actually achieved last year.

Okay, great. Thank you very much.

Okay, sure.

Our next question comes from the site of Amitabh Passi with UBS. Please go ahead, your line is open.

Hi. This is Jim Hillier for Amitabh. I was hoping you could maybe give a sense for directionally how the NSN BBA business trended in the quarter.

Really, from a -- I will tell you that that customer is, or those customers, some of them have longer forecasting periods and place orders with more lead time than we would typically see here in the US, so we have greater visibility and because of that greater backlog visibility to some of those customers, but I would say that the order trend was up, just accelerated from the beginning of the quarter.

Okay, got it. And then also looked like you saw some quarterly improvement in Optical Access. Could you discuss some of the trends you're seeing there?

Yes, probably the -- I would say the biggest thing that happened there is we had talked about last year about the fact that we were finally getting approval at a very large Tier 1 carrier here in the US, and that actually started shipping, so -- and that's for sell-side backhaul, so that was a pick up. But then in general, we just saw just a general pick up from really a low base in Q1, though, so I don't want to over play that, but the most notable thing was actually that Tier 1 carrier starting to deploy.

And then finally, were there any 10% customers in the quarter, and could you tell us if they were domestic, international?

Yes, there were two 10% customers, and both of those were domestic.

Got it, thank you.

Okay.

Our next question comes from the site of Michael Genovese with MKM Partners. Please go ahead. Your line is open.

Great, thanks for taking the questions. First of all I think you guys have said in the past that both AT&T and Deutsche Telekom are nine-figure opportunities, so I'm wondering, can you help us, is it closer to -- are you closer to the $100 million or the $900 million numbers? And what is the timing of this? Are these things going to happen in four to six quarters, or are these going to be spread out over three to four years?

Okay, so I don't think we've ever mentioned any customer specifically by name because that would get us into issues with those customers. The large opportunities we're talking about are, in our view, are multi-hundred million dollar customers, and that's probably about as much color as we want to give on that because there is some variability in what they will do. This is over approximately roughly three years, and maybe go a little bit longer than that, so that's the way that we think about them. One, of course, one has a greater potential to be meaningfully higher than the other one, but both of them are multi-hundred million dollar opportunities for us.

As far as the timing, one of them, as I mentioned previously, is starting to ship this quarter, and we don't see any real lull in that other than what we would see in normal seasonal, things tend to slowdown in the fourth quarter, and then you'll see it pick back up next quarter. So that one is very, needless to say, very four wall. Products approved and being deployed as we speak. The second one is a 2014 event, and that's with a large US carrier who -- the schedules tend to fluctuate some with rollouts with that carrier, at least for us. So that one, we're just a little more cautious about. So I tend to think about it more middle of next year. I think current plans that have it accelerated from that, but I'm always cautious about trying to give a specific quarter on that just because of our history there.

That's helpful color. Now, when you talk about multi-hundred million opportunity, is that purely for equipment? Is that the overall project that would include carrier spending on labor, or is that also -- is that purely on your equipment and services?

That's ADTRAN equipment and services. And when I say, if you just give me the latitude of multi-hundred million is ADTRAN equipment and services, there are some upside service opportunities at one of the carriers, but it would still keep us in that range.

Should we think about these as being a fairly normal split between products and services as your typical business?

Yes, I would think so. That's the right way to think about it. There are longer-term maintenance agreements with both of these customers, so if can you think about what our split has been over the last three years or so, I think that's the right way to think about it.

And then just finally, could you just, what happened with the DSOs? Why did those go up so much and what was behind that? And then just if you could talk about your thinking about buying back so much stock in the quarter, why -- what you're thinking there?

Sure. On DSOs, Michael, they did go up sequentially to 58, but below last year's second quarter of 59, driven in large part by, really, the increased activity that we've seen from the acquired business, which those customers have traditionally, many of them, longer payment terms. There's a mix of payment terms amongst them all, but this quarter, or Q2, the mix was higher towards the longer payment terms. So we do expect it to moderate -- DSOs to moderate as we go through this year as that mix, we expect, will shift a bit as we go through Q3 and Q4.

And the buybacks?

Oh, the buybacks, so yes, we certainly had healthy activity in buybacks in Q2. We do continue to consider the best use of excess cash, so it would be buybacks going forward. We would continue to do that on an opportunistic basis.

Yes, and I'll tell you, because there have been questions about this before. One of the things that -- from our view, the environment last year was very -- was a challenging environment for a lot of people in our space, and we were hurt by that too, and one of the things that -- it's good to have cash on the balance sheet when you're going through an environment like that. But we continue to think that's the best use of cash, and as things clear up and you get better visibility, we tend to get a little more aggressive.

Thanks a lot for the detail and color, helpful, thanks.

Thank you.

Our next question comes from the site of Simona Jankowski with Goldman Sachs. Please go ahead. Your line is open.

Hi, thank you very much. You talked a little bit about improving activity in terms of orders from Europe toward quarter end. Was that specific to that one large customer that is beginning to ramp this quarter, or was it broader than that?

It was broader than that, but that one customer definitely contributed in a meaningful way towards that, but it was more than one customer.

Okay. And can you just paint the picture a little bit -- you also commented on seeing a multi-year access infrastructure upgrade opportunity ahead of you that is only just beginning, and there's two sizeable opportunities you've been engaged in. But can you just give us a little bit more detail of do you think there might be other carriers right behind that that might have similar opportunities that currently in the process of bidding for?

Yes, there are actually several, and the way I'd characterize it is, up until, really, very recently, carriers were somewhat frozen in their ability to really compete with DOCSIS 3.0 and definitely DOCSIS 3.1, so there really weren't good alternatives. And two things have happened. One is fiber deployment has gotten substantially cheaper, so we have some carriers that are looking at increasing fiber deployments in order to get to a more competitive network. And the other one that's probably impacting us more near term is vectoring technology, which really, for the first time, allows carriers to deploy an 80 to100-megabit service and truly be competitive, and actually, in many cases, be a step ahead of where their competition is. The economics of deploying vectoring completely changed the landscape of how they view that business, and I think most of them are very much aware of it, and they are just basically at different levels of engagement at this point in time as to when they will actually deploy it, so we really do view it as a third phase of DSL deployment for vectoring, and then I think GPON, the economics just continue to get better.

Got it. Do you see any discernible impact on the spending environment in response to Google Fiber's actions?

I would say there's activity that's generated by Google Fiber's actions, and I do think that it does help drive this whole sense that a 15-megabit service is going to be challenging to sell into the future, so I think it does actually help carriers focus on what their plans are with the residential network. So I would say yes, but I wouldn't say that there's a lot of direct -- I think it is helping shape the architectures of the future, but I don't know if I would say that there's direct movement yet. In spot cases there is, but in general, I think that it's more architectural and longer-term planning.

Yes. And then just lastly, the two opportunities you've been highlighting at the multi-hundred dollar opportunities, can you just give us a sense, roughly, of what your share is of the total award? My understanding is, in each of those cases, there's about typically two vendors in that buildout, so are you the majority or the minority share vendor?

Well, there are different applications within these awards, and for instance, in one of the awards, we will be a -- there's already an incumbent, and we will be brought in as a second vendor. We think our share there will be very meaningful. But in that exact same customer, there's a portion of the network which is very large which we will be primary, and in fact, single source. So in general, if I take a look at the aggregate spend, I would say we're the majority in both of those carriers.

Great, thank you very much.

Our next question comes from the site of Ehud Gelblum with Morgan Stanley. Please go ahead; your line is open.

Hi guys, thanks, good morning.

Good morning.

Just quickly on your two 10% customers. One of them, I would imagine, is your traditional 10% customer that you had for some time. The second one, because you didn't have two last quarter, just want to see, was that second one pushed over the 10% hurdle by the Optical Access build that you were talking about to a Tier 1?

No. No it was not.

Was not. Okay. And was that 10% customer someone you've had in the past, recent past over the last couple years, or is it a brand new one?

I think they pop-up from time to time.

Yes.

Okay, that's actually helpful. If we look -- if we try and parse your international business, can you give us a sense as to what the -- because we know that Telmex was particularly strong last quarter. Can you give us a sense as to what your legacy or core ADTRAN ex the BBA, how that performed this quarter versus last quarter, give us a sense of if it was flat or up?

The core BBA -- the core ADTRAN business was actually down quarter to quarter, and then it was made up by the BBA business, but that down was driven -- if I look at it on a regional basis, it was really driven by one customer, and that has to do with just the fluctuations within that customer.

Right. Do you expect that customer to come back next quarter, or is it more like they've finished for now and come back in Q4?

There's ongoing projects going on, so it has to do as much as anything with that customer's ability to deploy. So the products, many of the products are there and just waiting, and it's just a matter of that carrier actually getting the deployment out of the door, so that -- the fluctuations that you see with that customer, which we've talked about in the past, have to do with more of the deployment of and how quickly they can actually get the equipment out in the field and up and running.

So they have equipment, and they have to still -- this is still part of the same phase of their buildout? I know they had a multi-phase buildout?

It is part of the same phase of the buildout, and a lot of what we do, and we had talked before about that customer, we having services and TA5000 equipment, all of that is actually being sold as they deploy. That make sense to you?

Yes, so -- but I'm trying to understand. Did they finish a phase here, or are they still in the mid phase and so there's still more shipments that you have?

They are still in the mid phase, and we're still shipping equipment. It's just different types of equipment in many cases, but we're still shipping equipment.

Okay, so we should expect them, if not next quarter, in Q4 or Q1, although maybe Q4 not because of seasonality. Maybe Q1 we should start seeing that come back again?

Yes, there's just variability in how quickly they do it, so the answer to your question is yes, though. There are absolutely plans to go out there and get this equipment installed, and there's a need to get the equipment installed, so, yes, there's just variability in that customer.

Okay. And then as far as the BBA business, it sounds like that's just going to keep going up now that you have one of your two Tier 1s -- your Tier 1 projects starting real shipments in Q3, one of them flowing through your BBA business. That sounds like that BBA business just goes up.

With the exception of the seasonal factor that we talked about, we feel very strong about that customer. I will tell you, the BBA business itself, that's not the only customer that is doing well and that we really think will accelerate, but without a doubt, that customer should accelerate through next year.

Okay. So we should be modeling a down seasonal Q4 for that business as well, and then back up again next year?

Even though we really don't want to give Q4 guidance, I don't see any reason -- we came into the last Q4 not really sure because it was a very new situation to us, but the reaction that we saw pretty much around the world with the BBA business was what we saw here in the US, which is, we definitely saw a pullback.

That makes sense. Now, digging a little bit deeper into the gross margin guidance that you gave, two questions. One about the gross margin guidance and then second about the gross margin for this quarter. I'd imagine that the Q3 gross margin dip is entirely related to the shipments, so is revenue going to ramp that much that it brings gross margin down by 200, 300, 400 basis points?

It is directly related to the shipments. So -- but now, there are several factors to that shipments which Jim didn't go into. One is, is so you will see a shift, just the European business is going to be strong in the third quarter. The other is, is the volume has come at us in a fairly quick manner, and so we are expediting quite a lot to keep up with an accelerated schedule. And then the third piece is, is on the new projects, as you would expect, there's more chassis shipments, and in fact, it's heavily chassis based, and as we talked about before, chassis shipments tend to have a lower gross margin profile.

Absolutely, and you get it back on the back end. But how long does this chassis phase last is what I'm trying to just understand, with the pace of gross margin over the next year and a half.

The chassis phase will actually last through next year, but I will tell you that we have cost improvements that are continuing to come on line, so I think you'll see -- Jim had talked about an improving fourth quarter, and I would expect to see improvement through next year as well.

Okay, but you do expect -- sorry for taking so much time, but you do expect that this dip in gross margin to only be one quarter long even though we're still doing chassis after that?

I would expect our gross margins -- so two things I think will happen. You'll see an acceleration there, but as we talked about before, next year you'll also see an acceleration in some other pieces of our US business, so you'll see an offset there just in the mix.

Correct.

And we have cost improvements that are continuing to come on line through this year and through next year, so I think both of those will mitigate that.

Okay. I'll save -- my other question is about gross margin this quarter, but I'll save them to follow up. I appreciate it.

Thanks very much.

Thanks.

The next question comes from the site of Rich Valera with Needham & Company. Please go ahead; your line is open.

Thank you, yes, another question on gross margin. Can you give us an update on where the gross margins are on the BBA -- the NSN BBA business and where you see them going over the next year?

Well the margins have improved. We do expect that the gross margins, as Tom said, as we go through next year and see further cost reductions, improve from what we saw in Q2 and even from what we expect to see in Q3. The gross margin levels for the acquired business is not something that we disclose other than saying that they are lower than what we experienced in our organic business. But again, over time, we expect that those gross margins will continue to improve.

I think you've recently talked about them as being in the high 30% range. Just wanted to see if that was accurate and wondered where you were because I know when you acquired that business, you had a pretty specific road map in terms of the margin improvement, the first phase being to outsource the supply chain to a lower cost, I think Asian, supply chain, and then the next phase being cost reduction, so just wondering how you are relative to that road map and where you see that getting those margins to?

You're right, and Jim can kick me here if I say something I shouldn't say, but we did start in the 30-ish percentage range, and we had talked about getting it into the mid-40-ish percentage range, and to be honest with you, we were right on track with that. But the thing that we talked about on previous calls is the thing that when we say that, you have to look at it over a broader window because chassis shipments, if we have a strong quarter in chassis shipments, then we're below that number. If we have a strong quarter in line card shipments, to be honest with you, we're substantially above that number. So you have to look at it over a bigger window, so we have seen some improvements from quarter to quarter depending on what that mix shift ends up being.

And one of the things that's hurting us right now in the third quarter is the fact that there is a higher chassis shipment piece, and because of the quick nature by which this business has come on line, we are not using all of the low cost things that we would typically use. For instance, chassis, you can -- there are higher-cost areas where you can get chassis and there's lower-cost, and if volume comes up quickly, then you tend to have to resort to the higher-cost areas, and that's one of the things hitting us also in the third quarter. As from as your road map is concerned, on a normalized business, I would say we're still close to where we want to be and pretty much on track.

Great, and now I'll ask this one. I'm not sure if you'll be willing to go here, but when you look at the business medium to longer term, can you say how you think about the gross margin? Do you see it being a 50%-plus gross margin type of business, or do you think it structurally ends up below that because of this mix shift towards the European business? Any color there would be helpful.

I think some of that is going to be -- there are several variables in that. Do I see it in the 50%s? I really do, but there are a lot of variables that are very difficult to forecast. Our Enterprise business is well above that. Our US Carrier business tends to be above that. We had talked about some aggressive pricing we did for the Broadband stimulus piece, and we have caught up, or are catching up, on the cost reductions associated with that Broadband stimulus piece, so I would fully expect that to be above that. So it's going to depend on what's the Enterprise mix, what's the US mix, and how aggressive we can roll out additional cost reductions. I had mentioned before that -- or I believe I'd mentioned before that -- we have a major cost reduction, for instance, in our European business that centered around the middle of next year, and that will help boost the overall corporate average too, especially when we expect that customer to be taking a significant amount of volume. And then we have this second carrier in the US, the Tier 1 carrier in the US that will come on line some time in 2014 as well, which, when compared to the overall European business, will be a positive margin contributor.

Just one final one for me. Will that -- the Tier 1 coming on mid next year, will that have margins comparable to your current domestic BBA business?

Domestic?

Growth and access business?

I probably don't want to get much more into that. I would say it reflects more the US business than the European business, but I don't want to -- for probably obvious reasons, I don't want to touch too much more on that, but we think in aggregate it will be a contributor. There's also, of course, within that customer, there are multiple applications, fiber to the prem versus vectored VDSL, fiber to the node, fiber to the curb, and the mix of that will affect what that gross margin profile will end up being as well.

Great, thanks for taking my questions.

Okay.

The next question comes from the site of Simon Leopold with Raymond James. Please go ahead; your line is open.

Hi guys, this is Victor Chiu in for Simon. I just wanted to ask you about your Internetworking business a little bit. You mentioned a major Tier 1 carrier customer for your Internetworking products this quarter. Was this new business, and was this an incremental driver for the Internetworking strength this quarter?

It wasn't a driver for the strength this quarter because really, what I'd said is we were awarded the business, which means we haven't started shipping it yet. We would expect, really, that to start shipping probably in the first half of next year. And it is a significant piece of business, especially for the Enterprise division. It is -- if I take a look at what we believe the volumes would be, they will ramp up fairly substantially over the next three years, and really be able to help move the needle there, but it is not in our numbers today.

Okay, so how should we think about the strength going forward? Should we expect it to continue at this rate given that you've got this new business coming?

Yes, the good thing about what we have seen, and we really started seeing a little bit of a pick up, really, even as early as Q1, is that it's really broad, so it's not like I have one customer that's driving the Enterprise number up. It's really pretty much across the board, which makes us feel good that it's something that's really sustainable. So I don't know if there was somewhat of a -- well, I'd characterize it as a rebound, so I don't know if we saw a little bit of a rebound effect and that you'd see the same type of growth that we saw from Q1 to Q2, but we fully expect it to continue to grow.

Okay, so it's fair to say that the macro trends are --

Yes, that's really how it feels right now.

Okay. And relating -- just regarding the Optical business this quarter, with the exception of this quarter, it seems that the transition from SONET to WDM systems has impacted the Optical results over the last several quarters, and it's actually been declining for two quarters now, so what is your strategy to address this? And were the results this quarter exceptional because I think you mentioned earlier that you didn't have a specific driver for that this quarter?

Yes, well, I said we had a pick up a Tier 1 carrier, and they started deploying a little bit broader, but I will tell you that some of the uptick that you're seeing, and to be honest with you, I don't have that quantification in front of me, but some of the uptick you're seeing is the fact that we have another platform, the 5000, which is also used in Optical deployment with the ONE and Optical network edge. So without a doubt, we saw a broader-based pick up and although I don't have it in front of me, I would venture to say that that was probably driven more by the 5000 than by the SONET gear.

Okay. And looking forward, how do we look at it going forward?

I think that you'll see -- continue to see the 5000 portion of Optical go up, and that will be a positive piece. I think the only -- the mitigating piece is, as you had mentioned, SONET is in decline, so there is a drag on the Optical piece that is driven by the 6100 SONET piece. So even though Verizon is at a positive note towards that, I would still expect, overall, for that to be much more challenging than what we would see in the 5000.

Okay, thank you.

Okay.

The next question comes from the site of George Notter with Jefferies. Please go ahead. Your line is open.

Hi, thanks very much guys. I just wanted to ask about the unearned revenue on the balance sheet. It was down a bit sequentially. I assume it was related to the NSN BBA business, but I just want clarification there.

So George, this is Jim. It actually relates to the acquired business and organic activity as well, okay, as it relates to our services business.

So a little color on that, so there's two pieces. One is we have customer service contracts predominantly in our BBA business that there's just timing associated to when those contracts get signed, so I don't think that business is going down. And I just think that we happen to be at a period of time where we have contract negotiations going on at several customers at the same time, and we have not yet re-upped that. Those will get re-upped though. One other piece that's happening I think is impacting that number is the BBS business, the Broadband stimulus business, was very much a RUS contract-type scenario where we would ship equipment and we would have to wait for customer acceptance before we would recognize that revenue, and as those systems get accepted, you'll see that number go down. But I will tell you, as I mentioned in my comments, that the order flow from that area has actually picked up, so it is actually being replaced by things that just aren't reserved because our normal terms with almost all of our customers is, we req it, we ship it, they receive it, they get tied on, and we recognize it. So the RUS contract BBS portion actually shifted that some.

Got it, okay, that's helpful. And then the other question I had was just on the position you guys have in Dialog Semiconductor, can you remind me how many shares you still own there, and at what pace have you guys been peeling out of that position, and how much longer do you think you can continue selling those shares?

George, that's a fact that I don't have before me at this point in terms of the number of shares of that particular security, but --

We typically don't, to honest with you, break down securities that we own anyway.

Got it. Okay, great. Thanks very much guys.

Next we will go to the site of Sanjiv Wadhwani with Stifel. Please go ahead. Your line is open.

Thanks so much. Tom, I was wondering if you could give us an update on Tier 1 carrier spending in the US. How do you think it trended in Q2, and what do you think is going to happen for the rest of the year? Thanks.

Well, the Tier 1 carrier spend we have in the US is, with the three Tier 1s we have one that's predominantly Broadband, and that customer did well. It is one of our 10% customers. And then we have two that as of today are HDSL, SONET, and a little bit of Broadband. I would say the portion -- the Broadband portion of those customers was stable and we're really waiting for this next phase that I'd talked about for that really to meaningfully pick up, and we do think it'll meaningfully pick up. The HDSL portion was down again. I think it's now down to about 8% of the Company's revenue, so it's relatively immaterial at this point. And then the Optical piece we already spoke about. Oh, but (multiple speakers) --

Do you think the trends continue has this Broadband being stable to doing better and Optical being volatile with HDSL going down for the rest of the year?

HDSL is -- if you look at the HDSL number, it's on a -- I hate to call it a floor, but I'm sure I'll get hurt if I do call it a floor. I would say -- but it's 8% of the number, so it just bounces around there. Broadband will probably continue to pick up a little bit, and then the real driver will be next year, and then it will substantially pick up.

Got it. That's helpful, thanks.

The next question comes from the site of Bill Dezellem with Tieton Capital. Please go ahead; your line is open.

Thank you. Two questions. Would you please remind us when you anticipate the cost reduction plan for the NSN acquisition to be complete? And then secondarily, we actually just missed your comments as to why the margins were going to rebound in the fourth quarter from Q3. Would you please go over that, and if you could have additional details and you add --versus what you added before, that would be great, too.

Well first of all, the cost reduction plan for BBA, the stated plan that we had for BBA is pretty well done with the caveat that when we are expediting to the extent that we're expediting right now, we are not using, necessarily, the lowest cost providers, but that has also happened in the US business. I think the delta is probably larger in our European business, so you're seeing that impact that happens in the -- that happened in the third quarter. In the fourth quarter, with that much visibility and that much time, I think you'll see that mitigate some, and you'll see that's why we're talking about a margin improvement. I also think that, due to the seasonal factor, that we'll probably see a more favorable mix of US to international.

But having said all that, the next big leg of cost reduction is about middle of next year, and that has to do with introduction of new products, and I don't -- that is a stated very much focus of ours, but I will also say that cost reduction is something that we continually do, so we'll continue to try to improve gross margins on there. Typically, as we bring on a new customer of this size, what you'll see is a gross margin impact up front, and then you'll see us as we continue to cost improve things that over time, that area will get substantially better, and we think that's exactly what will happen here. Did that answer your question?

I believe so, but it does raise another. You've mentioned the mid 2014 or mid next year when that's the next big leg of cost reduction. That also happens to tie in with the time frame you mentioned for the large US opportunity to begin to ramp. Is that pure coincidence or does that all tie together?

No, that's absolutely pure coincidence. They are completely different product sets.

Great.

Now to be honest with you, we will benefit from the volume associated because the components are similar, so there's no doubt it puts us in a much better negotiating position from a component perspective, but they are really just different products.

Great. Thank you for the color.

Okay.

The next question comes from the site of Michael Genovese with MKM Partners. Please go ahead. Your line is open.

Thanks for taking yet another one. I just wanted to get more color on these Tier 2 market share gains that you're talking about. I believe you said earlier in the call that the organic Broadband Access business -- or the US Broadband Access business was down sequentially, so I'm trying to square that with market share gains, like what gives you the confidence that you are making these market share gains?

Well, it really has to do with the fact that we're getting approvals for applications that other people were approved for before. So in two of the Tier 2s, we know for a fact that we weren't selling into these applications a year ago, and we're selling into them now, and so that's an easy thing to figure out. The other piece is, on the largest one, we have a stated agreement with them, and as they started to pick up their sales this year coming out of Q1, they're living up to the agreement that we have, and that's a substantial increase in market share. To be honest with you, it's probably 40% or 50% increase in market share than what we were guaranteed last year, what we were getting last year.

Okay. Can you make any comments on the competitive -- I know you don't like to talk specifically about customers too much, but the Tier 1 we haven't talked so much about, that's traditionally your largest customer where there's been some market share questions. Any market share comments in that account?

I would say that we're -- I mentioned before that that account did well for us. The area -- rollout of IPT services in that customer I think is very positive for us, so we're doing a good job of keeping up. And then that is one customer that is right now looking at longer-term plans and how fiber will play into their network and how vectoring will play into their network, and so in general, I feel good about that. I think we're doing well. We had talked before about the fact that the west portion of that customer was predominantly us. We feel very strong in there. We still have a very good install base, and we're still growing our footprint there as they continue to add the IPTV service, and I think we're eating in on these, so really no big change.

Thanks, Tom.

Okay, and our next question comes from the site of Paul Silverstein with Cowen & Co.

Josh, I think this would be the last one because I think we're just about out of time. Go ahead. Paul?

Thanks, Tom. So Jim, can you all remind us, the TA5000, the ramp, if I remember correctly, was what? It was in the 2008-2009 when it really ramped big time? There's a question attached to this.

It was probably more -- it was really more '9, '10.

All right. So here is the question. This is what I'm trying to understand. When I look back at your ramp on the TA5000, when I look at the gross margin numbers, there doesn't appear to have been an adverse impact that was chassis and line card related. And I assume the platform is not far different from the hiX with respect to the VDSL vectoring rollout and the other stuff you're doing with that European carrier, so I'm trying to understand what's different?

Literally, the difference is the mentality and the price points of that business and that region are just different than the mentality and the price points in this region. So we have in the US, at least to my knowledge in any significant way, we have not really played one off for the other. We haven't given chassis away in any big way in order to secure line card business, and when I say give them away, you sell them at a substantially reduced price. That is just not the case in the acquired business. There is a history there of doing that for some number of years, and that is just -- and the competitive environment does the same thing, so it's just that it's got more to do with what the customer expects in those particular regions.

So the chassis line card concept in terms of differential, put aside dramatic difference in margins, but you're telling me within North America, there really is a negligible impact in terms of chassis to line card ratios?

Yes, I would say yes. And that's why you just didn't see the impact on our gross margins. You just -- it just historically has never been that way.

One other quick question if I may, and I apologize because I know you were all asked this before, but in terms of the split right now between ethernet in legacy SONET within Optical Access, I heard you say you didn't have the number in terms of the growth rate, but do you have the split between the two where you're at?

No, and to be honest with you, that growth rate would be on that same sheet of paper, and I don't really want to venture a guess. It's not 90%/10%. It's probably closer to 50%/50% or something like that, which -- here it is -- I'm venturing a guess, but I don't know that for a fact.

Okay, I appreciate it. Thanks.

Okay, thank you very much. Thank you, Josh, for hosting us here, and we look forward to talking to everybody next quarter.

This does conclude today's conference. Thank you for your participation. You may now disconnect.