ADTRAN Holdings Inc (ADTN) 2018 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to ADTRAN's second-quarter 2018 earnings release conference call. (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 10-K for the year ended December 31, 2017.

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 Tom Stanton, Chief Executive Officer of ADTRAN. Sir, please go ahead.

Thank you, Erica, and good morning, everyone. We appreciate you joining our second-quarter 2018 conference call. Our CFO, Roger Shannon, is here as well. Following my opening remarks on the quarter and what we expect to see going forward, Roger will go over the quarterly performance in greater detail and then we will take some of your questions.

The headline for this quarter, A Midyear Reflection Point, is steady progress towards a stronger second half of the year, as we advised last quarter. Overall the Company performed well with quarter-over-quarter improvements in revenue, gross margins and cost controls while we continue to make strategic investments in the development of future innovations.

From a top-line perspective, revenues were up 6% at $128 million from the first quarter. Network Solutions accounted for the bulk at $115 million while services and support revenues contributed $13 million or 10% of the total Company's revenue for the quarter. Total revenue in our domestic markets came in at $68.2 million or 53% of the total, and our international revenues continue to come and strong at $59.8 million or 47% of the total.

In general we are pleased with our level of engagement across domestic and international operators in the strategic areas of software defined access, including 10 gig EPON, NG-PON2, GFAST, our Mosaic Cloud platform and our new Mosaic subscriber experience applications including Insight, Device Manager and Activate.

In regards to the merger-related shift in spending with our Tier 1 domestic customers, I'm pleased to see further clarity and meaningful progress toward stability. We saw a modest increase in revenue over the previous quarter and we have been awarded net new business. We are also in other projects with this customer at various stages of development ranging from initial scoping to field trials. We continue to gain further clarity on their priorities as they emerge from this transition.

The cable/MSO broadband access market remains a strategic priority for us. Building upon our recent acquisition and organic developments, we are achieving meaningful revenue progress with Tier 1 cable/MSO operators with our 10 gig EPON remote optical line terminal and head end solutions, and our 10 gig EPON optical networking solutions. And as an adjacent market growth area, we are pleased with what we are seeing to date and expect this trend to continue.

Within the carrier space we continue to advance our 10 gig NG-PON2 solutions with a domestic Tier 1 operator and are approved for GFAST deployments out of region and have met the criteria and are continuing our first office application with a major Tier 1 carrier for in-region shipments.

Further, we are continuing to ship vectoring products to a large domestic Tier 2 operator, have just begun those this quarter, and it's something that we expect to continue on for the next few quarters.

Our International business is up 58% on a year-over-year basis with strong contributions from two European and Middle East operators as well, as additional vectoring shipments and super vectoring shipments with regional EMEA operators. We have successfully introduced super vectoring into a Middle East operator as they begin a nationwide rollout.

We have now shipped 17.5 million VDSL 2 vectoring or super vectoring ports globally to date as operators look to maximize existing infrastructure while delivering the services that our customers demand. Total gross margins on a quarter-over-quarter basis in both product and service segments is coming in at 39%. Our product gross margins improved both domestically and internationally with a stronger overall mix led by super vectoring solutions internationally.

As we head into the second half of the year, we expect strengthening in our domestic markets for ultra-broadband and fiber to the home solution. We anticipate a pickup in CAF spending in Tier 1, Tier 2 and regional service provider market segments. We also continue to see strong traction in our SD-Access and EPON solutions.

Additionally, we expect to see our GFAST solutions to begin ramping in the second half of the year domestically and in Australia. Our international GFAST revenue should help us offset seasonally lower spending with our Western European Tier 1 operator.

In closing, investments in creating open vendor agnostic software defined access solutions enable us to not only drive innovation with the largest carriers, it also allows us to help all communication providers prepare for transition -- to transition their networks to meet increasing subscriber expectations of faster, better and more intuitive connectivity.

The great common denominator of our time is the -- our unequivocal desire for fast, ever present access to the world with a real-time on-demand experience. We are moving forward with our long-term mission to identify strategic opportunities and partnering with those who share our mindset to grow a robust and healthy ecosystem through our Mosaic open network alliance.

ADTRAN's global leadership and software defined access ensures we are well positioned to help service providers who seek transformation to grow revenue, reduce cost and accelerate service delivery and deployment. With that I'll turn the call over to Roger and we'll be happy to answer any questions you may have afterwards. Roger?

Thank you, Tom, and good morning. I'll speak about our second-quarter results and discuss what we see for the next quarter. During my report I'll be referencing both GAAP and non-GAAP results.

As Tom stated, ADTRAN's second-quarter revenue came in at $128 million compared to $184.7 million for quarter two of last year and $120.8 million we reported last quarter. Our Network Solutions revenues for the second quarter were $115.1 million versus the $155.5 million for quarter two of last year and $105.3 million reported for quarter one of 2018.

Our Global Services and Support revenues in quarter two 2018 were $13 million compared to $29.1 million earned in quarter two of 2017 and $15.6 million reported for the first quarter of 2018.

Across our revenue categories access and aggregation revenues for Q2 2018 were $84.7 million compared to $138.6 million for quarter two of 2017 and $81.7 million last quarter. Customer devices revenues for the quarter were $34.6 million versus $33.8 million for quarter two of 2017 and $30.1 million for quarter one of 2018. Traditional and other products revenues for quarter two 2018 were $8.7 million compared to $12.2 million for quarter two of 2017 and $9 million last quarter.

Looking at revenues geographically, domestic revenues for quarter two of 2018 were $68.2 million versus the $146.7 million we reported in quarter two of last year, and $62.1 million in quarter one of 2018. Our International revenues for quarter two of 2018 were $59.8 million compared to $38 million in quarter two of last year and $58.7 million for quarter one of 2018. We've published the reporting of each of these categories in our Investor Relations webpage at ADTRAN.com.

For the quarter, we had two 10% of revenue customers. Margins for the second quarter of this year were 39% compared to 45.8% for second quarter of 2017 and 32.9% last quarter. The year-over-year decrease in our gross margins was driven primarily by the decreased volumes of our domestic business and higher weighting of International business. This was partially offset by improved gross margins in our International product and Domestic services portfolios in the current quarter.

Our quarter-over-quarter gross margin improvements were across the board in our Domestic and International mix and in our products and services segments.

Total operating expenses on a GAAP basis were $62.8 million for quarter two of 2018, a decrease of $5.5 million compared to $68.3 million for quarter two of 2017 and $3.6 million lower than the $66.4 million reported last quarter. On a non-GAAP basis our Q2 operating expenses were $59.8 million compared to $65.6 million in quarter two of last year and $60.6 million last quarter.

The year-over-year decrease in operating expenses is primarily attributable to lower compensation and labor expense in the quarter. The quarter-over-quarter decrease in operating expenses was primarily the result of lower restructuring expenses and lower compensation and labor expense in the quarter just ended.

The difference between GAAP versus non-GAAP operating expenses in Q2 is due to restructuring expenses, amortization expenses related to our acquisitions, and equity-based compensation.

Operating income on a GAAP basis for the quarter just ended was a loss of $12.8 million compared to operating income of $16.4 million reported in Q2 of last year and an operating loss of $26.6 million reported in quarter one of this year.

The decrease in Q2 GAAP operating income as compared to Q2 2017 is attributable to lower revenues from lower domestic volumes and increased International mix, partially offset by favorable foreign exchange movements and lower operating expenses. The quarter-over-quarter increase in operating income is primarily driven by higher revenues with favorable mix and lower operating expenses.

Non-GAAP operating income, or adjusted EBIT for Q2 2018, was a loss of $8.9 million compared to income of $19.2 million for quarter two of last year and an $18.3 million loss reported in quarter one of 2018.

As described in the supplemental information provided in our operating results disclosure, stock-based compensation expense net of tax was $1.4 million for quarter two of 2018 compared to $1.4 million reported in quarter two of last year and last quarter. Expenses related to amortization of acquired intangibles were $841,000 net of tax compared to $582,000 in quarter two last year and $427,000 last quarter.

Restructuring expense net of tax was $758,000 for the quarter just ended compared to zero recorded in quarter two of last year and $4.4 million last quarter. All other income net of interest expense for quarter two of 2018 was $1.6 million compared to $1.5 million for quarter two of 2017 and $11.9 million last quarter, which included an $11.3 million bargain purchase gain.

The Company's tax provision for quarter two of 2018 was a tax benefit of $3.6 million, or an effective tax rate of 31.9%, as compared to a tax expense of $5.5 million, or 30.6% in quarter two of 2017, and a $3.9 million tax benefit in first quarter 2018. The shift in tax from an expense of $5.5 million in quarter two 2017 to a benefit in the current quarter was primarily driven by current year net losses in our domestic business.

GAAP net income for quarter two of 2018 was a loss of $7.7 million compared to income of $12.4 million for the second quarter of 2017 and a loss of $10.8 million last quarter. Non-GAAP net income for the second quarter of 2018 was a loss of $4.6 million compared to earnings of $14.4 million in quarter two 2017 and a loss of $15.9 million last quarter.

Earnings per share on a GAAP basis, assuming dilution, was a loss of $0.16 per share compared to income of $0.26 per share for the second quarter of 2017 and a loss of $0.22 per share for quarter one of 2018. Non-GAAP earnings per share for the second quarter of this year were a loss of $0.10 compared to earnings of $0.30 per share for quarter two of last year and a loss of $0.33 per share last quarter.

Non-GAAP earnings per share exclude the effects of stock compensation expense, amortization of acquired intangibles, restructuring expense, and the bargain purchase gain related to the acquisition in the first quarter of 2018. We have provided a reconciliation between diluted GAAP earnings per share diluted non-GAAP earnings per share in our operating results disclosure.

Now turning to the balance sheet. Unrestricted cash and marketable securities net of debt totaled $203.2 million at quarter end after paying $4.3 million in dividends and repurchasing 184,000 shares of common stock for $2.6 million during the quarter. For the quarter we produced $6.7 million of cash from operations.

Net trade accounts receivable were $76.1 million at quarter end resulting in a DSO of 54 days compared to 39 days at the end of second quarter of 2017 and 60 days last quarter. The increase in DSO versus the same period last year is a result of the higher mix of International business in the current quarter while the decrease from last quarter is mainly attributable to customer mix and the timing of shipments within the quarter.

Inventories were $120.5 million at the end of the second quarter, flat to the $120 million from last quarter.

Looking ahead to the next quarter, the book and ship nature of our business, the timing of revenues associated with large projects, the visibility of order patterns to the customer base into which we sell, and the fluctuation in currency exchange rates in our international markets we sell into may cause material differences between our expectations and actual results.

However, taking into account the previously disclosed merger-related review and slowdown in the spending of a Tier 1 customer, our current expectations are that third-quarter 2018 revenues will be in the range of $146 million.

Also, taking into account the potential impact of currency exchange rates and anticipated mix, we expect that our third-quarter gross margins on a GAAP basis will be in the low 40% range. We expect that GAAP operating expenses for Q3 2018 will be approximately $62 million.

Finally, we expect volatility in the quarterly tax rate for the rest of the year due to the anticipated mix of US versus International income and the impact the new tax law is having on those earnings. While we had a tax benefit in the quarter just ended, we anticipate the consolidated tax rate for the third quarter to be an expense of approximately 40% due to international earnings.

We believe the significant factors impacting revenue and earnings realized in 2018 will be the following: the macro spending environments of the carriers and enterprises; currency exchange rate movements; the variability of mix and revenue associated with project rollouts; professional services activity levels, both domestic and international; the timing of revenue related to the Connect America Fund projects; the adoption rate of our broadband access platforms; and inventory fluctuations in our distribution channels.

You can see this information at ADTRAN's Investor Relations website by going to WWW.ADTRAN.com and following the Investor Relations link. With that I'll now turn the call back over to Tom.

Great, thanks, Roger. Erika, we are ready to open up for any questions people may have.

(Operator Instructions). Rod Hall, Goldman Sachs.

I wanted to open up with just a question on what is driving exactly the pause in the US. I know a lot of it has been merger-related. But wanted to ask whether you think people are also pausing because of the 5G fixed wireless programs that are being tested now and thinking about whether that might be a more efficient way to access homes. And then, if that's the case, what your participation level in those kinds of projects might be. And then I'll (technical difficulty).

Yes, so, the first answer to your question is I haven't heard anybody pausing because of 5G -- potential 5G rollout. So, without a doubt, and I covered this I think some last quarter, if I look at the math of the decrease in our domestic spending on a year-over-year basis it was 100% attributable to that slowdown in that one customer.

Having said that, we have -- the Tier 2 space has got some -- it's very much project-related. And we had on a comparable basis some strong projects in the previous year that are not yet starting. And having said that, I did mention we did have a Tier 2 customer in the US that's now actually starting to deploy our vectoring product.

So, there's pluses and minuses around the space, but I don't think there's any big movement that is negative. I definitely haven't heard anything about 5G. And then what was the second part of the question?

Well, let me follow-up on that first one, Tom, and then I've got a second one. But the follow would be when do you -- I mean the US revenues are obviously at historic lows. And I'm just wondering -- visibilities continue to be pretty poor. But I just wonder when you guys think you can get back in the ballpark of even $100 million of US revenues. Do you think that that's doable by the early part of next year? Or do you just have no idea of when you might be able to get back to something like that level or better?

So, I think a few things have to happen. One of course we have a couple of customers, one of which I mentioned were at the tail end of the FOA for GFAST that would clearly move that up. The other is, as you are aware, we have NG-PON2 -- and I now recall the second part of your question, which is the wireless piece on 5G. Which, as you are probably aware, has an impact on NG-PON2 deployments as well as they are looking -- I don't want to speak for that customer, but their plans for wireless rollouts include NG-PON2.

Either one of those coming on as strong as we're expecting them to come on would materially move this here. And of course one of them would actually -- the NG-PON2 piece has got very strong potential in and of itself.

And then other than that, there are project-related things that can come in at $15 million to $20 million a quarter even on the Tier 2 space that can move that number north of that. So, I think there are a lot of different pieces. I think one of them -- we have to get through this FOA project and get that product rolling en masse. And then the other big one, of course, is the one that you are aware of with NG-PON2.

Okay. And then my second question was just International. That's obviously been a really bright spot for you guys. Do you feel like the revenue levels we've seen the last couple quarters now are sustainable? And if they are, how long do you think you can sustain those or is that the new normal for International?

Yes, let me touch one other piece which I did miss. I mentioned it in my comments, but it -- may have not have emphasized that. The progress we are making in the MSO space is fairly material. It's coming off of what has historically been a lower number. But just the opportunity that we see in MSOs for next year as products start really rolling out -- and we're just really starting to roll out 10 gig -- could move that number to $100 million. So I think there are three different buckets that would actually impact that.

As far as the International number, we will see a downturn in the European number next quarter, but we will see an uptick that's fairly meaningful because of new rollouts of GFAST in Australia. So, it probably -- you think about it, I think about it as kind of flattish for International with the expectation that our vectoring rollouts in Europe will come down. Sometimes they surprise us and they are a little stronger than we expect. Does that answer your question?

Okay, great. Thank you very much. Appreciate it.

Paul Silverstein, Cowen.

Yes, hey, Tom and Roger, I'll apologize to you and to others on the call including Rod if you have already answered these questions or (inaudible) prepared remarks. I've been having some audio problems. I do apologize. Hopefully not the case.

But first off, the $100 million number you just cited, Tom, or I think you cited on with respect to MSOs, that number is relative to what? When you said the significant opportunity with respect to deep fiber in calendar 2019, moving that number up to $100 million, that's $100 million from -- or did I misunderstand your comment?

Yes, I think you -- well, the question was the domestic revenue rate now is sub $100 million. I think it's roughly in the, what was it, (multiple speakers).

Okay, so you're referring to moving US up to $100 million.

Right, yes, which it's $32 million. So if you look at the MSO adder, that in and of itself could be strong. I don't know if it would do it next year, but if you look at that plus NG-PON2 plus G.FAST. And then the real kind of wildcard is what happens in the Tier 2 space. CAF will pick up in the second half, but then we'll have the normal slow start next year.

All right, that makes a lot more sense because, correct me if I'm wrong, historically while you've done a little bit of revenue I think with cable MSOs, it hasn't been very much historically. Is that correct?

That's right, that's absolutely correct. As a matter of fact I would venture to guess, and this is a guess because I haven't really looked at it from a historical perspective. But I would bet this is the strongest quarter we've ever had in MSOs and I expect it to be materially stronger next quarter.

And Tom, again, I apologize if you already said this, but would you characterize cable/MSOs (inaudible) strongest? Was that material this quarter or is it still not even meaningful to revenue?

I am thinking it's right there on the verge.

I appreciate that. And Tom, I think you might have said this historically. But with respect to the two opportunities, (inaudible) and Comcast relative to deep fiber, as we look to 2019 and beyond, those opportunities measure in the tens of millions of dollars each?

I think it will be -- well, yes. Yes, I'm thinking about on an individual quarter -- you know how these things roll out, but yes.

But if we look over and annual period, smoothing out (multiple speakers)?

Oh, yes, without a doubt. Yes, yes, yes, I mean yes. Honestly I am thinking on a quarterly basis, so on a yearly basis absolutely.

So, on a quarterly basis you're thinking these could be in the tens of millions, on a yearly basis you are thinking of $50 million to $100 million each?

I didn't say each. I think $50 million to $100 million adder, right.

All right, I appreciate that. Let me move on. I think you answered this question in part if not in full relative to Rod's question. But, Tom, it seems with all these projects, whether NBN, AT&T, prospectively Verizon, Charter, Comcast, etc., the key question, or a key question has been timing/visibility.

Your confidence today in terms of the timing of those rollouts over the next 12 months or so relative to 90 days ago with the benefit of 90 days more information, how confident are you that these respective projects are going to hit over the course of the next 6 to 12 months?

There are certain ones I'm very confident on, there are certain ones I'm unless on. So, we will get out of the FOA of our G.FAST here in the US. The issue there is just when does that customer actually get to a point to where they're really moving in a big way? So I still expect that to be a longer-term rollout.

On the Australian NBN opportunity, I'm as confident as you can be when you have purchase orders in hand and you're starting to ship. For NG-PON2, I think that's, if I think about it from a six-month timeframe, I'm feeling pretty good from a six-month timeframe. I would expect us to see there's a likelihood of some movement even later this year.

But I think that that's also a -- I guess that puts us in that 6-month timeframe that I would say we'd see some initial things later this year. But you know how those things can slide by a quarter two. That one's probably the one that the timing is the least understood.

And the simple question of this quarter versus last quarter in terms of incremental pauses or incremental negatives, is it mostly around the visibility in terms of improvement or stability at CenturyLink and improvement in the US?

Yes, so I would think our visibility there is without a doubt better. We have a good understanding of the piece of business that we have with them today. A lot of it is CAF-related as well as vectoring. We are doing some vectoring projects with them. And our ability -- so, we know what those are and that's -- so we have got at a minimum stability there.

I mentioned that we are working on a couple of other projects with them that could be potential adders. Some of those are on the product side, some of those are on the services side. But if I look at it from a baseline perspective -- and needless to say we are not counting any of that in our projections at this point. If I look at it from a stability perspective I would say we are much better off.

All right. One last question if I may, Roger; I want to get you in here. Given all these projects and the perspective impact as we look out over the next 12 to 18 months in terms of margin recovery, do you think you'd get back to the mid to upper 40s or is it too early to say? You obviously just put up some pretty big improvement without the benefit of significant revenue progress. Any thoughts you could share with us?

Yes, that's certainly still our target, as we've discussed consistently. What -- you saw improvement from Q1 to Q2. The primary drag on our gross margins has been the decrease in product and the manufacturing expense related to that.

Now we have done quite a lot of work related to rightsizing that, but absolutely as the volumes pick up we'll see efficiencies in margin improvements across our gross margins. And as we consistently talk about, the US margins have a positive profile compared to the International. So that really nothing has changed in terms of our target and our expectation.

Appreciate it. Thanks, guys.

Rich Valera, Needham & Company.

Thank you. First, I guess, question for you, Roger, on the 3Q revenue guidance. That was an unusually granular guide for you guys. Typically you give a range, I would say, typically of at least around $5 million or so, but this is kind of a point number. So wondering if there's anything that gives you higher than typical visibility going into the third quarter relative to prior quarters.

And then -- and this may be for one or both of you, maybe Tom -- but I was wondering if you could kind of list out the projects that you see contributing the most incrementally from Q2 to Q3 kind of in size order. And I suspect they include things like NBN and the ramp of the MSO business but didn't want to put words in your mouth. Just to kind of give us a sense of what we should expect will be driving that revenue ramp from Q2 to Q3. Thank you.

So for starters, I did say --.

Sorry, you seemed to cut out there for a while. So whatever you just -- whatever you had said hopefully you can say that again.

Yes, my apologies. I did say in the range of 146 -- I think it goes back to what Tom just said about the projects and the visibility. So in our guide we -- you talk an approach of what we feel good about. Now there is some timing and some other things that we just have to see how it plays out.

We are in a little bit of an unusual case because of some of the International business that we have, and it's not really just with Australia where -- we are typically a book and ship business. And I would still characterize in general our business as being book and ship. But the International mix that we have today happens to be a little bit more concrete than that. So kind of lets us point more directly.

As far as the quarter-to-quarter comparison, it's directly related to that. So we do expect a downtick in our European vectoring customer. Maybe not as predominant as we've seen historically, so there may be -- it's a little bit stronger than if you take the average of the quarter-to-quarter declines from second to third over the last few years it's probably a little bit better than that. And then we have Australia starting to ship which is really on our -- it's truly a matter of us executing on the manufacturing side and those will both -- those in combination.

We also -- I talked about the super vectoring rollout in the Middle East. That will actually pick up in the quarter. And then we actually have some vectoring customers that are relatively new that were actually strong this quarter in Europe that are not the typical Tier 1 vectoring customer that we have that showed really good performance and we expect that to continue. So there are multiple points, but the two big ones are the Australia and the German Tier 1 carrier and their movements.

And how about NBN in terms of materiality Q2 to Q3?

Well, without specifically mentioning a customer, we expect material change in revenue between Q2 and Q3 for Australia.

Got it, that's quite helpful. And then I just wanted to make sure I understood the situation at CenturyLink with vectoring. So that was a huge revenue contributor for you guys up until Q3 of last year. And that obviously seems to have caused most of the shortfall of revenue recently. So, can you say what the status is of that program that you were doing, which was, as I understood it, deploying across their whole footprint?

I'm kind of -- I think the assumption is that program has been stopped or I'm not sure how you'd characterize it, but it sounds like you are doing some other vectoring revenue or vectoring business. I'm just trying to get a clearer understanding of what's going on there, because obviously a very big chunk of vectoring is gone. But what is this additional stuff you are doing?

I think you mentioned in your prepared remarks, Tom, you thought it would go on for, to quote you, I think a few more quarters. So I guess that would suggest that has a tail to it but will also go away. So just wanted to get some clarity on that. Thank you.

So, I kind of -- I could've been clearer in my notes there in the way I at least presented the notes. The notes were probably clear. There are a couple things going on in the US in relation to vectoring. One is we do have, and this is reflective of my notes.

One is we do have -- in the Tier 2 space we are starting to deploy vectoring. And that really doesn't have a finite period of around it. I mentioned it as going on for a couple of quarters, but really there is no end sight to that. So it is initially starting now. They're kind of getting their plans together on what they want to do with it long-term, but I don't see a particular end to that.

As far as our Tier 1 vectoring customers, of which there is one in the US, there is still some vectoring activity going on. But I think the way that we think about that customer is they are no longer proving it as a kind of footprint wide let's upgrade. They are doing it on a case-by-case basis. And there is vectoring activity going on. We actually expect -- I don't want to get myself in trouble here.

So, there are some use cases for vectoring that make an awful lot of economic sense. So, we expect as those use cases start surfacing, and they are surfacing now, that we're going to see actually a pickup in vectoring with that customer as they really accelerate the deployment in the areas that are very economically advantageous to them. Having said that, they are doing this on a case-by-case versus kind of a footprint wide expansion, which is really the big change that we saw.

That's helpful clarity. Yes, that's perfect. Thanks, gentlemen. Appreciate it.

Michael Genovese, MKM Partners.

Tom, it seems like your business is a much broader base than before. So for example, Deutsche Telekom seasonally down in the second half but still your overall International business hanging in there. Or still seems to be some merger review overhang at CenturyLink, but you have a lot of things coming back domestically in the second half.

So, can you just talk more about this broad base of customers and larger opportunities? I mean, is it different than anything you've seen in the history of the Company? Or does this feel like just another cycle or is there something fundamentally different going on here?

Well, I think from our perspective -- I think there are two things going on. One is we are seeing -- and this comes and goes as far as amplitude on a fairly regular basis, but if you step back the general trend towards, let's say 25 meg is not enough and we have to do something about this because we're losing our customer base, that has gotten louder.

And that's on any particular customer that may -- that can be project-related. So it comes and goes and we have seen that really kind of happen over the last couple years. But if you look at the mass of customers then I would say the trend is upward and in general that trend itself is accelerating. So that's a positive piece.

I think in our unique area the difference is we've had a drive and you could -- basically you could make a strong case as to the timing of that drive, but we've had a drive for diversification of our revenue. And that started when we -- really in earnest when we acquired the assets from NSN and really tried to grow our piece outside the US.

And historically our customer base has been driven by large Tier 1 customers. We kind of got into the Tier 2 and Tier 3 space. We saw benefit from that, but it was still dominated -- and to this day is still dominated by a very small handful of customers. So our movement over the last three years has been to continue to try to break out of that.

So the big change for us is now we have a stronger international footprint, so we have new customers finally coming online that aren't just the one we had that we had acquired. And we also now have a foothold that we're feeling good about in the MSO space which we never had before. And all of that has to do with diversification of our revenue base. And as we've seen, that's really important for us.

Great. And can you maybe talk about what needs to happen on the gross margins? I think the guidance here was low 40%s. To sort of get sustainably into the mid-40%s or even slightly above that, what sort of has to happen between there and here?

I think Roger touched on it and I'll ask him to ask any other things that -- but at this point in time, so we're always going to be hit by mix shifts, really international versus domestic. That's kind of the top-line thing that drives it the most. But if I look at the pricing today that I am giving to customers versus my bill of material, it hasn't materially changed from where we were before when we were in the 45%, 46% range.

Our key right now is going to be volume. We've got to get the volume back up and we've got to lower our overhead costs associated with what we are doing here. We took a big stab at that in the first half of this year, so we will see a benefit from that in the second half. But the easy fix of that is just the pickup in our domestic business. Roger, any other comments?

That's exactly right.

Great and then one last one for me. Just on the early look at the fourth quarter, sort of top line for the fourth quarter. Should we think about typical ADTRAN seasonality? We're having a much -- we had a weak second quarter, much better seasonal sequential third quarter. Fourth quarter seasonally normal or what?

I really need to not give guidance on the fourth quarter until we get through the third. At this point in time what we would typically say, and I have no reason other -- you know the projects and we have some timing things going on with the US business, so CAF should be good. But then again you get towards the winter months and they tend to slow down.

So, if I look at it from a macro level, there's nothing I can tell you at this point in time other than seasonality. We will know more as we get through this quarter, but right now I can't tell you anything different than that.

Thanks very much.

Tim Savageaux, Northland Capital.

I wanted to focus back on some of the dynamics around Q3 guidance and really what's driving that in a little more granularity. And assuming kind of a flattish to maybe slightly down profile internationally, that does imply a pretty good uptick in domestic revenues, actually not that far off that $100 million target.

But -- and I think given your comments on CenturyLink and that ongoing review, that our expectations should be flattish there as well. Assuming that's accurate we are looking at something on the order of a 40%, 45% sequential increase in domestic revenues ex that. And I think you -- so am I doing my math right, number one?

And I think you kind of hinted toward maybe a Tier 2 ramp in cable strength, but is there -- and maybe some seasonality I suppose. But is there anything else incremental there? You really haven't touched on Tier 3 spending trends. Anything to note there in terms of driving what appears to be some pretty extraordinary strength domestically in Q3?

I think -- and of course at the number that we're at right now, it only takes a couple million one or the other that can actually affect things. So first of all, on the Tier 1 customer -- on our vectoring Tier 1 customer in the US, if I look at the total sales of that, then I would expect that to be up. And there's a couple things.

One is we do expect a little pickup in some of the vectoring projects we are doing. We also expect a pickup in CAF spending with them, some of the CAF-related projects that we have with them. So to the extent I said just flat, I think that's not correct. And Tier 2 -- I think the way that you characterize it is correct, that we do expect stronger CAF spending and just stronger spending in general.

And then the MSO space you probably -- that may be stronger than what you are modeling. Tier 3s will also be up and that has to do with CAF spending as well as just general market dynamics of Q2 to Q3. Literally all of these pieces will be up.

Got it, thanks.

George Notter, Jefferies.

I guess I wanted to dig into this NG-PON2 project a little bit more. I'm trying to better understand your confidence in generating revenue out of that project going forward. If I look at that situation I think the initial trials were with competitor's products. I know they are doing trials and the success of that NG-PON2 effort will be predicated on penetration rates and economics of those initial trials.

And at the same time they are focused on enterprise applications, initially implies volumes that are lower than maybe if they were focused on residential. So, the bigger picture here is why do you believe that that really generates interesting amounts of revenue for ADTRAN at some point in the near or intermediate future?

That's a good question. So I think you are right. We are always -- once we get these products out then it is incumbent upon the carrier to do what it is that they are supposed to do with them. And I agree with you on the characterization of the initial rollout of the business, which is still, by the way, material business, right. It is not hundreds of millions but it is a material business even on the enterprise side.

Our understanding is that the plan of record goes deeper than that. And so, to the extent that it stops at enterprise it will be a nice adder, but it's not nearly if they were to go into the residential side in the wireless side, which is what our belief is, is that that's what they are doing, but if they don't they don't.

So, that is inherently a risk that we have with Tier 1s and we have been bitten before by that. At this point in time the -- our discussions with the NG-PON2 customer is that it's -- they are planning a fairly meaningful deployment next year.

Got it, okay. So does that then filter into your model, do you think, what, Q1 of next year or is it midyear? Or how do you think about it if all goes well?

Yes, so we haven't -- of course we don't forecast Q1 until next year and we'll give some color on the full year on the fourth quarter call. Our expectations will be that we will be shipping it next year. I think that we are liable to see some activity this year, but, like you just mentioned, it's the trial piece.

The key is getting out of that trial build out and getting to tens and tens of cities, which I'm sure you are aware of, which is what our expectation is for next year. That may slide a little bit. As to whether or not it explicitly starts in Q1, I don't know and I would not forecast that at this point.

Got it. Okay, thank you.

With that I think we are -- completed our call. So, I appreciate everybody for joining us on our call this quarter and we look forward to talking to you next quarter.

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