ADTRAN Holdings Inc (ADTN) 2013 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to ADTRAN's third-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 answers period. During the course of the conference call, ADTRAN's 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 10-K for the year ended December 31, 2012, and Form 10-Q for the quarter ended June 30, 2013. These risks and uncertainties could cause actual results to differ materially from those on 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.

Thank you, Steve. Good morning, everyone. Thank you for joining us for our third-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 Q3 results, and I'll end with some comments on what we see for the future. As stated in our press release, revenues for the quarter were $177.4 million, exceeding our initial estimates.

Highlights in this quarter included a significant increase in our European business and continued strength in our enterprise business. Our carrier networks division revenues came in at $141.3 million, showing an increase on both a sequential and year-over-year basis. The broadband access category led this increase as we realized initial shipments to a large European carrier of our newly introduced vectoring products.

Our enterprise division Q3 sales totaled $36.1 million, a strong 20% year-over-year increase driven by our internetworking category, which on a combined product basis, including both enterprise and carrier products, grew 22% year-over-year. Total Company domestic revenues came in at $113.2 million, with international revenue coming in at a record $64.2 million.

On a product basis, our core product areas -- which include broadband access, internetworking, and optical -- reached an all-time record of $158.1 million, representing a record 89% of total Company revenues. More specifically, broadband access achieved $98.1 million in revenue, bolstered by increasing shipments in GPON and initial vectoring technology shipments to Europe.

US shipments of our IP DSLAM and fiber-to-the-node products remained stable on a year-over-year basis, but were down sequentially due to timing associated with Tier 2 and Tier 3 broadband stimulus project completion and the associated revenue recognition, as well as an overall tepid environment. The strongest product areas where the hiX 5600 platform, followed by the Total Access 5000 platform and our 1100 Series fiber-to-the-node products.

Moving on, our internetworking product category came in at $43.3 million, showing solid year-over-year growth in all major product areas. Highlights for the enterprise division included the initial launch of our hosted voice over IP service at a Tier 1 carrier and the selection of our Bluesocket virtual Wi-Fi solution at another Tier 2 carrier for hotspot deployment.

Finally, during the quarter, we launched our ProCloud hosted Wi-Fi service to the broader market here in the US.

From a channel perspective, we continue to see strong demand for new dealers joining our team. During the quarter, we yet again added approximately 100 new ADTRAN VARs, continuing our effort of making ADTRAN products easily available to the enterprise market. The division experienced an increase in sales through both its US VAR channel as well as its carrier distribution network on both a year-over-year and sequential basis.

Finally, our optical revenue saw improvement on both a year-over-year and sequential basis, coming in at $16.6 million, helped by increasing broadband-related shipments and increasing market acceptance of our Optical Network Edge product line. During the quarter, we received our first major Tier 2 transport award for our O&E product line.

From an overall perspective, the customer environment in the third quarter was very similar to what we saw on the second, with enterprise activity improving and the carrier business, on a macro level, stable, with some areas of strength. In the Tier 1 space, our major projects remain on track, with significant shipments of our vectoring technology having begun in the third quarter.

As I previously mentioned, we do expect seasonality to affect our quarter-to-quarter performance. However, we expect the project to grow meaningfully next year and to continue to contribute materially over the next several years.

In the US, the major Tier 1 award we have previously spoken about remains on track, with shipments expected to begin around the middle of next year. In the US Tier 2 and Tier 3 markets, we believe the USF to CAF transition continues to hold promise as more carriers have embraced the revised FCC funding regulations.

The oversubscription of CAF Phase 1 is a solid proof point that carriers are developing business cases to move forward with broadband deployment, and we expect this market to accelerate in the quarters ahead.

Finally, we believe our market share and geographic expansion is timed well with the carrier cycle associated with the rollout of ultra-high-speed access. We continue to see accelerating activities as carriers around the world embrace next-generation access technologies to strengthen their competitive positions and meet their customers' growing demand.

I'd now like to turn the call over to Jim Matthews to review our results for the third quarter of 2013, and some comments on the fourth quarter of 2013. We'll then open the call up for questions.

Jim?

Thank you, Tom. Good morning, everyone. Revenue for the third quarter increased to $177.4 million compared to $162.2 million for Q2 of 2013, and $162.1 million for Q3 of 2012. Broadband access product revenues for Q3 of 2013 were $98.1 million compared to $81.6 million for Q2 of 2013, and $94.5 million for Q3 of 2012. Internetworking product revenues for Q3 of 2013 were $43.3 million compared to $43.9 million for Q2 of 2013, and $35.4 million for Q3 of 2012.

Optical product revenues for Q3 of 2013 were $16.6 million compared to $16 million for Q2 of 2013, and $11.2 million for Q3 of 2012. Carrier systems revenues for Q3 of 2013 were $120.8 million compared to $105.5 million for Q2 of 2013, and $111.6 million for Q3 of 2012. Business networking revenues for Q3 of 2013 were $44.2 million compared to $45.4 million for Q2 of 2013, and $36.6 million for Q3 of 2012.

Loop Access revenues for Q3 of 2013 were $12.4 million compared to $11.3 million for Q2 of 2013, and $13.9 million for Q3 of 2012. HDSL product revenues for Q3 of 2013 were $11.5 million compared to $10.3 million for Q2 of 2013, and $12.9 million for Q3 of 2012.

As a result of the above, carrier networks division revenues for Q3 of 2013 were $141.3 million compared to $123.3 million for Q2 of 2013, and $131.9 million for Q3 of 2012. Enterprise networks division revenues for Q3 of 2013 were $36.1 million compared to $38.9 million for Q2 of 2013, and $30.2 million for Q3 of 2012. International revenues for Q3 of 2013 were $64.2 million compared to $34.7 million for Q2 of 2013, and $49.2 million for Q3 of 2012.

To provide the reporting of each of these categories, we have published them in our investor relations webpage at ADTRAN.com.

Gross margin was 46.5% of revenue for Q3 of 2013 compared to 49.2% for Q2 of 2013, and 49.3% for Q3 of 2012. The lower gross margin for the quarter was primarily attributable to a substantially higher mix of revenue from Europe. The European revenue levels were positively impacted by initial deployments of a recent award from a Tier 1 carrier.

Total operating expenses were $65.3 million for Q3 of 2013 compared to $65.7 million for Q2 of 2013, and $69.7 million for Q3 of 2012. The decline in operating expenses from Q3 of 2012 to Q3 of 2013 was primarily attributable to a reduction in R&D expenses in both the acquired and organic businesses, and a reduction in sales and marketing expenses in the organic business. Acquisition-related amortizations totaled $800,000 for the quarter.

Stock-based compensation expense, net of tax, was $1.9 million for Q3 of 2013 compared to $1.8 million for Q2 of 2013, and $2 million for Q3 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 Q3 of 2013 was $2.8 million compared to $2.8 million for Q2 of 2013, and $3.4 million for Q3 of 2012.

The Company's income tax provision rate was 18.9% for the third quarter of 2013 compared to 32.4% for the third quarter of 2012. The lower tax rate for the third quarter of 2013 largely relates to significantly improved profitability of the acquired broadband access business.

Earnings per share on a GAAP basis, assuming dilution for Q3 2013, were $0.28 compared to $0.17 for Q2 of 2013, and $0.15 for Q3 of 2012. Non-GAAP earnings per share for the quarter were $0.32 compared to $0.21 for Q2 of 2013, and $0.20 for Q3 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 our operating results disclosure.

Inventories were $93 million at quarter end compared to $87.8 million at the end of Q2 of 2013, and $102.6 million at the end of Q4 of 2012. Net trade accounts receivable were $108 million at quarter end, resulting in DSOs of 56 compared to 58 DSOs at the end of Q2 of 2013, and 58 DSOs at the end of Q3 of 2012.

Unrestricted cash and marketable securities, net of debt, totaled $425.3 million at quarter end, after paying $5.2 million in dividends and after repurchasing 0.6 million common shares for $14.2 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 formulate your views on our near-term business outlook.

We typically experience seasonal declines in revenues in the fourth quarter of the fiscal year. For the fourth quarter of 2013, we expect total Company revenues will decrease sequentially in the range of high-single-digit to low-teens percentage points. We expect GAAP gross margins for the fourth quarter will be in the mid- to high-40s percentage point range, but higher than gross margins of 56.5% experienced in the third quarter. We expect GAAP operating expenses for the fourth quarter will increase slightly on a sequential basis.

We anticipate a higher tax rate in the third quarter due to an expected sequential decline in revenues of the recently acquired broadband access business, which will result in reduced profitability. We expect the consolidated tax rate for Q4 to be in the mid- to high-30s percentage point range to pre-tax income.

We believe the larger factors impacting the total revenue we realized for the fourth quarter of 2013 will be the following -- the macro spending environment for carriers and enterprises; 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?

Yes. Thanks, Jim.

Steve, at this point, we'd like to open it up for questions.

(Operator Instructions). Rod Hall, JPMorgan.

Yes, hello, guys. I guess I want to focus in on the revenue guidance, which is weaker than we had anticipated a little bit -- just to get you guys to comment on what is happening there. It feels like Germany is actually -- or Europe, let's say -- is actually going a little bit better, maybe, than we had anticipated. So I'm wondering if you guys can juxtapose what's going on there with the overall revenue trajectory into Q4. I know you flagged that this would be an issue last quarter as well.

And then my second question would just be on OpEx. Can you comment on whether you think you've got further downward flexibility in OpEx? You came in a little bit lighter that you had anticipated in this quarter. Is that something that you think you can continue to do as we look forward? It doesn't feel like it, necessarily, for next quarter. But just generally, what's your flexibility on OpEx? Thank you.

Sure. Let me talk a little about the revenue. I'll let -- Jim, if you'll cover the OpEx piece. On the revenue piece, we did talk about a decline in the fourth quarter. We've been talking about seasonality. The definition of seasonality depends on how far back you go, and we try to give a range to cover what we've seen over the last few years. The reality is, we still are very much a book-and-ship business, so we don't know what happens until it happens.

Without a doubt, we had a strong Q3 with our European customer, and it's not yet fully known what their order patterns are going to be for Q4. They are a relatively new customer. Last quarter -- or last year, our first year we actually did see pretty significant pullback in Q4. And this year we're expecting the same type of pullback. So, that plus the fact that it's a new project and we've shipped an awful lot leaves us kind of cautious about the fourth quarter there.

The only other big variable is we do have -- and I mentioned a little bit in my notes -- we had broadband stimulus projects that are hanging out there for completion, and the actual completion date on those always varies. So I think you're seeing is give a broader range than normal because of those two variables.

Jim, do want to cover the --?

Sure, Tom. So, Rod, on your OpEx question, we did comment in our notes that we expect a sequential increase in OpEx -- a slight increase in OpEx from Q3 to Q4. A portion of that increase relates to certain Telcordia projects. Your question in regards to the flexibility that we might have on the OpEx line, our OpEx forecast for the quarter relates to the range of revenue that we gave. However, we don't expect, at this point, to fall below that range. In the event that we might, we do have some flexibility there. But at this point, again, we don't expect to need to do that.

Does that answer your question?

It does. I just wanted to follow-up on what Tom said on Europe. It sounds like what you're saying, Tom, is that you guys are being cautious because you've seen volatility in order volumes from this particular customer before. But it doesn't feel like you know for sure what's going to happen in Q4. So I'm just trying to understand -- is the risk on the upside here that they come in with better orders than you are currently anticipating? Or are you (multiple speakers)?

We're trying to cover the range there. So I want to make sure that we don't try to say that we are expecting meaningfully higher than what it is that we put out there. But without a doubt, this customer is new. And without a doubt, we've seen some pretty dramatic volatility in the ordering pattern. So, the answer to that part of the question is yes.

And is there any external driver we could all be looking at, to kind of understand how that customer might behave? Is there anything from a regulatory point of view or anything else? Or is this just random behavior inside the customer?

No. Some of this has to do with where the budget situation moves. And, of course, that actually moves around quite a lot this time of year for many large carriers. I'm not aware of anything that is regulatory, or anything external that's driving their demand profile. They are full guns on deployment of vectoring technology and re-habbing their existing footprint, and that's all -- none of that has anything to do with what our cautiousness is in the fourth quarter.

Great. Okay. Thank you, guys.

Amitabh Passi, UBS.

Hello, guys. Thank you. Tom, I guess first question for you. I was hoping -- can you shed some light in terms, or specifics just in terms of your broadband access business in the US? Looks like, overall, US revenues were down 11% sequentially. Just trying to understand some of the dynamics you might've seen in the quarter. And then update on Telmex?

And then, Jim, just one quick one for you. Deferred revenues, can you just give us a sense of what's going on there?

Okay, so first on the US piece -- I also talked a little bit about the revenue recognition piece on the broadband stimulus piece. And that was probably the biggest -- in fact, I'm sure that was the biggest declining piece, where we have revenue out there and projects are out there, and it has to do with the customer completion on that. We have targets for that, and they do vary from quarter to quarter. As far as the overall demand, I will tell you we haven't -- if you look at the Tier 2 and Tier 3 space, it's pretty much the way it has been throughout the year.

We saw little bit of a pickup in second quarter, and it kind of has just been meandering, is maybe the best word for that. The Tier 1 space, the real big pickup that we expect is when we actually start shipping the Tier 1 carrier that we have spoken about in the past. All of that is still moving forward at a very fast pace, and we feel good about that. At some point in time, with the CAF piece and with what's going on in general, and kind of the general starvation of the network, we think the Tier 2s and the Tier 3s will pick up. But we definitely didn't see that in the second quarter -- excuse me, third quarter.

Amitabh, in terms of your deferred revenue question, we have two pieces of deferred revenue, basically -- the short-term portion, which declined; and the non-current portion, which I think was slightly up. But, in net, it was down. In total, deferred revenues were down about $5 million from Q2. Those relate obviously to contracts globally, both domestic and internationally, contracts that require us to set up deferred revenues. And then those deferred revenues waterfall, so to speak, based on revenue recognition.

There's nothing particularly unusual happening there. As we go forward over the longer term, as we enter contracts that require us to establish deferred revenue balances, that balance will continue to fluctuate. But certainly, this quarter, it was down as we recognized levels of revenue from those deferred revenue balances. So that's really the long and the short of it.

Got it. Thank you both.

Michael Genovese, MKM Partners.

Thanks very much. I have two questions. The first is, do we think that this quarter will be -- or the third quarter I should say -- should be bottom for gross margins? Or is there a risk that as the European Tier 1 comes back next year, and the US Tier 1 starts in the middle of next year, that we could see gross margins down at this level, or below again?

And then, secondly, there was a bigger sequential increase in enterprise revenues than in internetworking revenues. If you could just kind of explain what, outside of internetworking, what other products drove the enterprise increase, that would be helpful. Thank you.

Yes, let me cover the first.

And, Jim, I don't know if you have that in front of you, on the enterprise piece.

Yes, I'll address his question on enterprise.

So, sorry, Michael, your first question again. Could you --?

Yes, the first question is, do we think 3Q 2013 was the bottom for gross margin?

So let me take a stab at that, Jim, and you can modify it.

Okay.

The shift that we saw -- we've been talking about third quarter being the bottom of gross margins for time now. And that had to do with the fact that we knew vectoring was going to start shipping in a big way, and that the balance between the US business and the European business would be tilted more heavily for the European business than it typically is. And that is still our thought. You'll see improvement in fourth quarter. You'll see improvement over this quarter. We don't expect it to be at that same imbalance in first quarter either; and then you'll see DT start picking up again in the second quarter.

At that point in time, we have other pieces of revenue that are coming in, as well as we have a cost reduction that is scheduled for sometime about middle of next year with the European business. So our current vision is is that we're looking at the bottom right now.

Jim?

Michael, in terms of your question on revenue trends, I just want to reconfirm something. Now, in terms of revenue recognition for EN, we are actually sequentially down, when internetworking was sequentially down just a little. So, internetworking category was not down as much sequentially as EN, because our carrier networks division has a certain amount of their revenues that relate to internetworking products for their division -- that for certain solutions that are deployed.

Okay. Those were both very helpful answers. Thanks very much.

Eric Ghernati, Bank of America Merrill Lynch.

Hello. Thanks for taking my question. Just a few clarifications here. So, I want to focus on what's happened on the US broadband portion piece, because that's always -- it seems to have been much weaker than expected, and you're attributing this to Tier 2 and Tier 3. But I wasn't clear whether this is just a revenue recognition issue or is this a demand issue? Because back in the Q2 conference call, you had talked about share gains; you had been relatively bullish on the trajectory going into the second half. And I want to reconcile that with the fact that your deferred revenue is down on a sequential basis and a year-over-year basis as well. Thank you.

So, there's no doubt that the deferred revenue piece -- or let's say the project-oriented revenue on equipment and projects that we have closed and, in many cases, have already shipped, was the single biggest piece. But in general -- so, I'll say that was a large percentage of the environmental change between Q2 and Q3. But we did not see a snap-back. We did not see the normal sequential increase that we would see from Q2 to Q3 in demand for broadband in general in the Tier 2 space. Tier 3s were about the same. I would say they were probably slightly up, and I don't have that number right in front of me. I'd say they were probably slightly up. But Tier 2s just did not see any type of increase, pretty much across the board.

All of the projects of -- we talked about market share gains that we had had -- all of those remain in place, but they just did not ship.

Okay. And I had one more question -- two more questions, please. I thought I heard you say DT should pick up in Q2. But, initially, I believe the expectations were for a sequential decline in Q4, and then a ramp back up in Q1. Is that not the case anymore, or has something changed?

If I spoke to DT, then I should have caught myself, because I really should be talking about the large European carrier instead of specific customers. Where that large -- the vectoring project goes, we would expect it to start picking up in Q1, but as to -- as you know, the first part of Q1 is typically very slow, and then it picks up from that point on. So we're not really going to give sequential guidance or guidance for Q1, other than to say, typically it's about flattish and then you see it start picking up in a very meaningful way in Q2. And if we've intimated something different than that, then that was a mistake.

That's okay. And then finally just, if you don't mind, with respect to your Tier 1 broadband access domestic piece, can you just give us a sense of what's going on there? Because it certainly seems like, at least by our estimate, that that piece has declined quite a bit on a year-over-year basis, and also on a sequential basis.

No, I would say it's basically in line for domestic Tier 1 (multiple speakers) broadband. I would say it's basically, both on a sequential and year-over-year basis, in the same ballpark.

Okay, thank you.

Simona Jankowski, Goldman Sachs.

Hello. Just wanted to follow up on some of the earlier questions. So do you have any visibility at this point on when some of the share gains in the Tier 2 segment are likely to start playing out? And also, similarly, any visibility on the timing of the revenue recognition for the broadband stimulus projects that seemed to slip out of this quarter?

On the project piece, my sense is that those projects -- some of them will get finalized. We really don't know the answer to that. That has to do with the budgeting and the workflow associated with the carriers. Some of them will be cleaned up this quarter. But I wouldn't say that we would be on the normal run rate that we experienced, for instance, in the second quarter until probably towards the tail end of first quarter. That's just my guess right now based off of what we're hearing.

On the market share pieces, we will pick some up. We did ship a little bit. We saw a little shift in third quarter. We'll pick some more up in fourth quarter. But I would expect those also to be kind of more towards next year. And that is kind of what we are forecasting right now, if you look at our fourth-quarter number.

Got it. So the first answer there was on broadband stimulus, on those projects specifically, your best guess was around the end of Q1?

Yes.

Okay. And with those, would you first see any impact at all from the government shutdown, just in terms of the rural utilities commission service being shut down? And is that influencing anything at all?

That's a really good question. We do know that there are -- that has the potential to hurt probably more of the CAF funding than on the broadband stimulus piece, and it can definitely slow down paperwork. I'm not aware, because the slowdown that we saw on that was earlier in the third quarter. I'm not aware of any specific things, but I wouldn't tell you that that's out of bounds. But I will also tell you that where our project completion timelines are right now, assuming they get this funding piece closed in the next six months, I think we're okay.

Got it. So the project completion pieces, those are irrespective of what may happen with any future funding to be administered?

Exactly.

By the RUS?

These are already approved, already allocated. It's a matter of just closing out the projects.

Got it. So it's really -- the thing to watch for is the administration of any funding on the CAF. And that's more of a forward-looking comment depending on how long this drags out.

Right. And one thing to note that happened is we did see Tier 2s and a Tier 1 carrier step up for CAF Phase 1 in a meaningful way, where they were actually matching funds. All of those have to be done in the three-year period of time, and most of those people are in the planning stages right now.

Yes, okay. And then just a margin question. So you talked about a cost down for the European business for you guys around the middle of next year. In the meantime, is there any margin improvement there, relative to at the point when you acquired those NSN BBA assets? Or are margins still at that depressed level, and you won't get an opportunity to see an improvement until that cost down middle of next year?

Most of the margins improvements -- we had picked up about 10 points since the acquisition of the business, and most of those margin improvements are baked in. We see incremental margin improvements pretty much every month, on one piece or another piece. But the real, meaningful stuff is going to be middle of next year.

Yes. And just a quick clarification -- other than the European customer, did you have any other 10% customers in the quarter?

We had one domestic one, Simona.

Got it. All right. Think you very much.

Tim Quillin, Stephens Incorporated.

Good morning. Would you be able to say what percent of revenue the two 10% customers represented?

Tim, not at this point.

Okay. So that will come out in the Q?

Typically not. Typically, that level of information comes out in the 10-K.

Okay.

For the total year.

Let me ask you this -- of the international revenues' sequential increase, is that largely or fully attributable to your large European customer?

It's definitely largely attributable to our large European customer.

Okay, okay. And following up on operating expense control, I think R&D especially went up quite a bit last year around the NSN BBA acquisition. It looks like you've started to rationalize those expenditures a little bit. So is there room to take out additional cost there in absolute dollar terms, or with the plan B of perhaps to hold R&D at roughly current levels for an extended period?

I think the thing that -- you're right. We have been pulling out expenses out of the R&D side. Actually, it's been an ongoing process that we've been on. I don't see, at this direct point in time, a meaningful decrease because of the R&D projects that we have going on with those two large carriers. So we have very stringent deliverables on the US carrier, and it's a very broad product set that's looking at being deployed. So it affects multiple product areas, and we have very tight timelines around that.

And the same thing with the European carrier; we have the initial phase of deployment, but there are additional technologies -- things like system-level vectoring. And I had mentioned before that we had won some more enterprise-related business with that same very large carriers. And those right now are project-related R&D efforts. I don't see a big step down from here.

And would you expect to be able to hold operating expenses roughly at the same levels for a year or two? So I understand not being able to bring those back, but maybe as you grow revenue be able to leverage those.

Yes, we see no reason, at this point, with the headcount that we have and the expense level that we have, to have to meaningfully increase our expense level from the current level.

Okay. And just lastly, could you give any of additional details on the margin enhancement initiatives that you have at NSN BBA mid-year, next year? Is it mostly around supply chain initiatives and lowering the bill of materials? But any detail would be great. Thanks.

No, we literally have a redesign of several modules that are very high-running modules, and represent a large percentage of the total bill of material of the system. So they are actually new products that will be introduced into that network around the middle of next year.

Thank you.

Rich Valera, Needham & Company.

Thank you. I wanted to follow up on some of the earlier gross margin questions. As I understand it, the NSN business was supposed to be around a mid-40% gross margin level at this point. I know you've highlighted unusually low margin in this 3Q due to, I believe, primarily two factors -- one is the mix of heavily chassis-oriented; and the other is expediting costs. And I'm wondering if you can give any sense of the relative pressure from those two factors. Because doing some simple math, it seems like the margins on that business are probably closer to 30% than 45%. And just trying to understand how much of that is really one-time in nature or very short-lived, in terms of expediting costs and how much might be -- take a longer time to recover. Thanks.

Well, let me -- and Jim may take issue with me on this -- but let me give you my view on it. So we were -- if you think about the business, and the US business being kind of in the, let's say, 50s, low- to mid-50s type number; and our BBA business, we had talked about getting into the low 40s. That is kind of the baseline that I think you should work from.

First of all, I think we are not [done]. If you think about the low 40s, I think we're closer to that number than the 30s on the BBA business, and we expect it to go up from there. So, there was no doubt there was a, let's say, a few point -- not 5 -- but a few point impact because of the chassis shipment and the expedite charges. But I'd still say we're closer to the 40s than the low 30s, or 30%.

Yes, we're certainly not 30% that you indicated.

Okay. Yes, I guess I'll have to take that up off-line. And so, just to follow up on that question, how much -- I guess as you continue shipping beyond the third quarter, do you expect the expediting costs which you cited pressuring margins to continue? Or are you beyond that now? Have you gotten the supply chain sufficiently bolstered that you won't be incurring these higher costs as you ship -- start reaccelerating shipments, say, in the first quarter of next year?

I think we've got a good handle on the supply chain at this point. I think we opened up alternative supply chains to make sure that we have the capacity that we need. And we've been able to, through that process, secure longer-term pricing commitments. So I think that big, initial hump, that we're past that.

And then with respect to the mix, can you say what your expectations are on mix as you move into next year? Do expect it to remain a very chassis-heavy mix into next year? Or do you think you might start seeing the mix shift to a little more balance between chassis and line card as you move into next year?

The initial piece is still going to be chassis-heavy. They are absolutely building out footprint for probably the most of next year. Now, as they build out footprint, the positive piece to that is they build out footprint; but all of the ones that they've built out, for instance with these shipments that we've just made, start driving line card sales. So there's a positive piece to the fact that for the footprint you've already built, but there's no doubt that they are building out footprint through next year.

Right. And just one more, if I could. With respect to just your pipeline of global broadband access opportunities, you sounded pretty optimistic about that, Tom, in your prepared remarks. Any other color you could give us on that? And I know you don't want to try to predict wins, but do you think in the next, say, 12 months, that you have the potential to secure one or more additional really large deals? And I'd also say, do you have the capacity to handle them, given it sounds like there's very significant custom R&D associated with each one of these deals? Could you even handle another one or two DT/AT&T type deals, without mentioning names?

The answer to that question is yes. And I will tell you, the custom deals -- we have two big projects, but there are many customers -- and the size gets much smaller -- where they still need particular variations on feature sets. So the custom feature sets in the carrier business typically to be not just for the larger ones but also for the smaller ones. The difference with the large Tier 1 carrier we're talking about is that it affects -- because the rollout is, and the award is, very broad in the products set, it affects many different products.

But we make those priority calls on a day-to-day basis, not just for those two customers, but for the additional customers. So the answer to your question is yes. And in the next 12 months can we -- do we think we can secure another one? Those are two very, very large ones. I can tell you, if you let me step down one level from those two -- because those are probably the two biggest going on in the world -- then the answer to your question to that is yes.

That's helpful. Thank you very much, gentlemen.

Simon Leopold, Raymond James.

Hello, guys. This is Victor Chiu in for Simon Leopold. I just have a couple quick questions. Can you just speak a little bit about your competitive positioning at the international customer? And if the business you saw this quarter was in line with what you were expecting for your share of the contract?

It's in line with what we were hoping to see for the contract. And we'd expect that to continue on.

Do you see any opportunities for you to expand it outside that? Or just kind of in-line with what you guys (multiple speakers)?

There are definitely opportunities. As I mentioned, there are additional deliveries we have to have from a technology perspective. We think we are ahead of the game on delivering those additional feature sets. And we're doing a very good job of keeping up with the demand, so there's definitely potential for that. I would say it's not an immediate thing. That happens on a quarter-by-quarter and, really, an order-by-order basis, almost.

And just following up the question that was asked previously, does the outcome of this project -- how you deliver on this particular contract -- impact other opportunities down the road for you internationally with other carriers? What are you thinking about your opportunities going forward outside of the completion of this contract? How does that open up other avenues for you?

Well, there are very few carriers in that part of the world that aren't looking at vectoring technologies, and what they can do for vectoring -- how they deploy vectoring; how do they get higher-speed services, 100 megabit services. So, it definitely has an impact. And so I would say that we have, right now, secured a position with the leading vendor -- or, excuse me, the leading carrier in Europe, leading the charge on ultra high-speed broadband deployment, and I think other carriers differently look at that.

Great, thank you.

Bill Dezellem, Tieton Capital Management.

Thank you. A couple of different questions. First of all, relative to the tax rate, are we to understand correctly that there's really a swing factor that's going to take place? So the more successful that you are in Europe, the lower the tax rate, and so that's why we saw it down this quarter; but next quarter it will jump, and essentially that's something we should expect. And so as long as you do have the high sales in Europe, the lower tax rate is, in fact, sustainable?

Well, Bill, first of all, to give of brief overview of the rules, with a newly acquired business, the rules say that we're not in a position to take a, call it, a tax benefit on losses that we have accumulated thus far. However, when it flips to a profit in a particular quarter, we're assuming that profit is not yet in excess of the accumulated loss -- we don't take a tax charge or a tax provision. Now, as we develop a longer history in that business of profitability, the rate should normalize. But we're not quite outside that period yet.

So, the tax rate for that business, once you get into a normalized profit run, is a little bit lower than statutory rates here in the US, to kind of give you a feel for it. But, again, we're not in a position now to where we can recognize a normal provision or a normal benefit from a quarterly loss until we are outside of that initial period of the situation that we're in now.

Does that answer your question?

I think so. So, let me make sure that I'm clear. Since you're anticipating the European business to increase again in Q1 and Q2, it would -- it sounds like it would be reasonable to think that the tax rate for ADTRAN as reported would be lower in each of those quarters. But maybe about the time that the Tier 1 US customer starts to ramp, you've also had enough history, coincidentally in Europe, and so you see higher profits from the US; and you have your history in Europe, which means you go from that zero tax rate on your profits to a normalized tax rate.

Well, I think you're in the right direction, and your comments in regards to Q1 and Q2 I think are correct. As we expect to see revenues increase, we are hopefully in a position to where we actually realize a profit in that acquired business; and therefore, particularly in Q1 and Q2, I don't think we'll be in a position yet that we would actually charge a normalized tax rate. So we'll continue to see the benefit of no tax on the acquired business, assuming that business is profitable in Q1 and Q2.

Great, that is helpful. And then the second area I'd like to go down is the Tier 2, Tier 3 competitors. I believe that there were some comments that in terms of their spending, they're really starving their networks -- you didn't say it quite that strongly, but to some degree. And that also seems to tie with some delays with the broadband stimulus.

I guess there are two questions inherent here. Are those two comments tied together and related? And then, secondarily, doesn't that imply that there is a pent-up demand that then is beginning to develop?

Well, I think they are. I think for some carriers they are tried together, and maybe for other carriers they are not. What we have typically seen is that when people significantly reduce their spendings in the network, as they have over let's say the last two years or so, that they have to play catch-up. They play catch-up not only because competition has moved on, but because they've got to have competitive speeds. And it affects not only the access portion of the network, but all the way through, including the transport piece. So I think the answer to your question is yes.

And that starving that they have done, is it a result of waiting for the broadband stimulus projects? Or are there two different things going on here?

I think there are two different things going on. I think in general we just saw a capital pullback in that space, and I think it affected much of the carrier space. And then, secondarily, for certain carriers the broadband stimulus piece has maybe exacerbated -- or let's say the CAF piece has maybe exacerbated the issue.

Thank you both.

Paul Silverstein, Cowen and Company.

Tom and Jim, I hate to ask you guys to revisit this question; I know there have been a number of questions already on gross margin. But I just want to make sure I understand -- it sounds like the NSN piece of your business is up towards 40%, if I understood your previous response. And you expect to get -- and broadband access right now is in the low 40s, and you still expected to get it to the mid-40s. That's the first question. Is that accurate?

Jim?

Yes, I think that's the right range. So when you say broadband access, Paul, you are referring to the acquired business, is that right?

Well, actually thought -- and maybe I misunderstood. I thought the acquired business you said was approaching 40%, with overall broadband access being in the low 40s now, hoping to get it to the mid-40s. But maybe I misunderstood.

No, no, no.

No, no, no.

No, no.

The broadband access business, outside of the acquired business, has gross margin certainly well above the acquired business.

Understood. But --

(Multiple speakers) it's in the 50s.

It's in the 50s, yes.

Okay. But the NSN business is approaching 40%, but you haven't broken 40% yet?

We have, from quarter -- if you had asked me that last quarter, the answer would've been yes. If you had asked me this quarter, because of the increased chassis shipments, the answer would be no.

All right. And one other on gross margin -- again, I apologize. I know you addressed it, but I didn't understand the response. So, the low 40s you referenced earlier in the conversation, in response to a previous question, that low 40s number was what?

Was for the acquired broadband access business, the European business.

And so, Tom, going back to what you just said, it's above 40%, or it's fluctuating in that range, below 40% and above 40%?

It's fluctuating in that range, depending on the particular product ordered on any period of time. If you remember, we talked early on, after the acquisition of the business, that we saw greater-than-normal fluctuations because of chassis versus line card sales, and the fact that chassis sales were, because of historical reasons, sold at very low gross margins. So that continues to be the nature of that business.

So there are quarters where we're below 40%; there are quarters we're above 40%. And what we have said is if you take it on a normalized basis over a large enough period of time, over just a meaningfully large period of time, that we're in the above-40s portion. And that's still the same.

Okay. And the mid-40s number you all cited earlier, that's the near-term goal to get the NSN broadband access business to, or is that --?

No, I think that's -- here again, giving us the lead way of what I just said about chassis versus line card sales, that's what we'd be expecting after we do the product upgrade, middle of next year.

And that's post-middle of next year, you hope to get it to the mid-40s? Between now and then, we should expect it to continue to be roughly where it is today?

Right around the 40-ish range. Yes, that's the right way to think about it.

All right. One final question. I know you haven't had the business all that long, and so maybe you don't have this information. But when you look at pricing -- when you look at pricing abroad, relative to the NSN business versus your historical pricing in the US in broadband access, is there any insight you can share with us? I assume pricing is always coming down. The question being, what does the rate of decline look like abroad versus over here?

At this point in time, I would say it's very -- it's similar. I would say it starts at a lower base, but if I look at the price degradation associated with that business, I would say it's no worse than what we see in the US.

All right. And I apologize, just one final question, if I may. On the other potential pieces of business out there in VSO vectoring, I assume -- and specifically in Europe -- is financing a factor in any of those deals, to the best of your knowledge?

No, it hasn't been. There are customers that will come and ask for certain things, but it has not been a decision point.

So the deal that Telefonica did in Spain that was a one-off, that $500 million deal where ZTE financed it --?

I don't know. I will tell you that we are not involved in anything where financing is, at this point in time, a big driver. The financing that you're talking about with some of the Eastern vendors has been around for a long time.

Okay.

It just hasn't been the decision point, at least in the deals that we are actively pursuing.

I appreciate it. I'll pass it on. Thank you.

And we have no further questions at this time.

Okay. Well, thank you, everyone, for joining us on our conference call. And we look forward to talking to you next quarter at this time.

And this does conclude today's program. You may now hang up any time.