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Executives

Thomas R. Stanton – Chairman and Chief Executive Officer

James E. Matthews – Vice President and Chief Financial Officer

Analysts

Nikos Theodosopoulos - UBS

Ehud Gelblum - J.P. Morgan

Paul Silverstein - Credit Suisse

Amir Rozwadowski - Barclays Capital

Vivek Arya - BAS-ML

Jim Suva - Citigroup

Colby Synesael - Kaufman Brothers

George C. Notter - Jefferies & Co.

Simon Leopold - Morgan, Keegan & Company, Inc.

Greg Mesniaeff - Needham & Company

Todd Koffman - Raymond James

Blair King - Avondale Partners

ADTRAN, Inc. (ADTN) Q1 2009 Earnings Call April 15, 2009 10:30 AM ET

Operator

Good morning. My name is [Cassandra] and I will be your conference operator today. At this time I would like to welcome everyone to the first quarter 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 new products; the degree of competition in the market for such products; the product and channel mix; component costs; manufacturing efficiencies; and other risks detailed in our annual report on Form 10-K for the year ended December 31, 2008. 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.

And now I would like to turn the call over to Mr. Tom Stanton, Chairman and CEO and Mr. Jim Matthews, Vice President and CFO. Sir, you may begin.

Thomas R. Stanton

Thank you Cassandra, and good morning everyone. Thank you for joining us for our first quarter 2009 conference call. With me this morning is Jim Matthews as Cassandra mentioned, Senior Vice President and Chief Financial Officer.

As in the last couple of quarters, I’d like to start by discussing the environment in the first quarter. I will first remind you that ADTRAN has a book and ship business and any short term data is suspect in its ability to predict longer term results. But given the current economic environment, we feel compelled to add as much color as possible in regards to current customer activity. As we mentioned last quarter, order flow in the early part of the period was good. This strength moderated during the second month and resumed during the latter part of the quarter.

The carrier segment acted much as anticipated with cautious spending in targeted areas of focus. Tier 1 carriers came in slightly above expectations, with Tier 2 and T3 carriers being incrementally more cautious as they contemplate utilization of the recently enacted broadband stimulus package.

Enterprise came in as expected, with strength in our networking sales through carrier channels as we continue to gain market share. Traditional Enterprise products weakened as expected. From a product perspective, there were no major surprises in the quarter.

I will start with HDSL, which was up both sequentially and year-over-year. We attribute this strength to normal quarterly variations and the continued pressure on increasing wireless backhaul capacity.

Broadband access was up sequentially, driven by expected increases in Fiber-to-the-Node shipments. Operational activities of our TA 5000 continued to progress well through the quarter, and we expect increasing strength through the year. However, we did see some spending delays in the quarter attributable to regulatory uncertainty in some of our Tier 2 and Tier 3 accounts, as I mentioned previously.

Recent order activity suggests that some of the regulatory uncertainty is beginning to resolve itself, and we expect this uncertainty to resolve itself further as we move through the year. Sales of Optical Access gear to Tier 1 carriers remained relatively flat to the fourth quarter, although we did see a sequential decline in the category overall.

Given the current economic environment, our inter-networking category had a solid quarter with revenues up from the prior year. A stronger than expected performance in our carrier channel was offset by seasonally soft traditional channel as that channel continued to feel the brunt of the current economic environment.

As expected, our legacy traditional products, which of course do not include HDSL, were down on both a sequential and year-over-year basis. Historically, Q1 typically represents the lowest revenue point in a given year for the company, and we expect this year to follow that same pattern.

The activity around our Fiber-to-Node and Total Access 5000 products, both from a bidding and lab perspective, continued to be strong as we progressed through the quarter. We began receiving orders for new features including VDSL2, and as you may expect we are seeing significant interest in footprint and bandwidth expansion around the U.S. We continue to anticipate that expanded deployments and addition of new applications will contribute meaningfully to the growth of these platforms well into the future.

For Optical Access we continue to believe, despite our gains to date, that we are in the early phases of Optical Access conversion and that the increasing demand for bandwidth, both wireline and wireless, holds great promise for this product area.

Internet working revenues, although muted by economic conditions, continue to reflect the broad based support we are seeing as we continue to focus on carrier distribution channels and grow our dealer base. As I mentioned last time, the economic situation has heightened our focus on improving operational efficiencies across the board. That will lead to a company with greater flexibility and increased capacity. I believe that our results today reflect the impact of that focus.

In addition, we continue to believe this environment is one where companies with strong operating models can aggressively pursue market share and continue to fund R&D efforts to open up future opportunities. Although in the near term we will continue to be impacted by macroeconomic headwinds and regulatory uncertainty, we are positioned well to weather this environment, and over the long term prevail as a preeminent access supplier.

I would now like Jim Matthews to review our results for the first quarter 2009 and our comments on 2009’s second quarter. We will then open up the conference call for questions.

James E. Matthews

Thank you Tom and good morning everyone. Revenue for the first quarter was $110.4 million compared to $119.9 million in Q1 of ’08. Drop in accent part of revenues for Q1 of ’09 were $22.2 million compared to $28.6 million in Q1 of ’08. Optical Access product revenues were $10.7 million for Q1 of ’09 compared to $11.2 million for Q1 of ’08. Internetworking revenues were $15.3 million for Q1 of ’09 compared to $14.9 million for Q1 of ’08.

Carrier systems revenues were $42.7 million for Q1 of ’09 compared to $51.2 million for Q1 of ’08. Business networking revenues for Q1 of ’09 were $20 million compared to $21 million for Q1 of ’08. Loop access revenues were $47.6 million for Q1 of ’09 compared to $47.7 million for Q1 of ’08. HDSL product revenues were $42.9 million for Q1 of ’09 compared to $42 million for Q1 of ’08.

As a result of the above, carrier networks division revenues were $87.1 million and Enterprise networks division revenues were $23.3 million for Q1 of ’09. International revenue was $6.9 million for Q1 of ’09 compared to $6.4 million for Q1 of ’08. To provide the reporting of each of these categories, we have published seminar investor relations webpage at ADTRAN.com.

Gross margin was 61.1% of revenue for Q1 of ’09 compared to 58.6 for Q1 of ’08. The increase in gross margin is primarily attributable to lower transportation, expediting and unit costs per sales dollar. Research and development expenses were $20.9 million for Q1 of ’09 compared to $19.6 million for Q1 of ’08. The increase in research and development expenses was primarily attributable to an increase in activities related to customer specific development efforts.

Selling, general and administrative expenses were $23.7 million for Q1 of ’09 compared to $25.5 million in Q1 of ’08. Stock-based compensation expense net of tax was $1.6 million for Q1 of ’09 compared to $1.8 million for Q1 of ’08.

Interest income was $1.6 million for Q1 of ’09 compared to $2.3 million for Q1 of ’08. The decline in interest income was attributable to lower interest rates.

During the quarter of 2009 the company recorded net realized investment losses of $3.2 million in its investment portfolio, primarily related to other than temporary impairments of marketable securities as a result of significant declines in the equity securities markets that continued in the first quarter. Tax affected this reduced diluted earnings per share by $0.03 for the quarter.

The company’s income tax provision rate was 26.3% for the first quarter of ’09 compared to 36.5% for the first quarter of ’08. During the first quarter, the company completed a review of its estimated tax deductions for the years 2005, 2006 and 2007, related to Section 199 of the Internal Revenue Code. This review resulted in a $1.7 million benefit being recorded in the first quarter of ’09, reducing the company’s income tax provision for the quarter. The increase in tax deductions was attributable to an increase in the calculated dollar value of domestic content of products we manufactured for those years.

Also in the first quarter the company recognized their usual benefit from research tax credits. Legislation providing this benefit was not in effect during this same period the prior year, causing tax provisions to be unusually high for that period.

Earning per share or assumed dilution for Q1 of ’09 was $0.24 compared to $0.26 for Q1 of ’08. Inventories were $49.7 million at quarter end. Nets rated accounts receivable were $56.8 million at quarter end, resulting in DSO’s of 46 days for the first quarter of ’09 compared to 54 days for the first quarter of ’08. Net cash provided by operating activities for the first quarter of ’09 were $24.5 million. Unrestricted cash and marketable securities totaled $241 million at quarter end.

We’d like to remind you that we typically do not give specific guidance on revenues. However, given the environment, we feel compelled to assist you in developing your opinions on future revenues. We want to remind you that we are a book and ship business, and timing of near term revenues is associated with large projects we are engaged in, combined with the impact of the economic environment on carrier and S&B spending make it difficult to predict revenue levels. Assuming economic activity levels remain constant with the current environment, for the second quarter of ’09 we anticipate that revenues will increase sequentially in the mid to high single digit range. For the second quarter we believe we will execute in a range consistent with our historic operating model at the achieved revenue level. For the total year 2009, we anticipate profitability will be in a range consistent with our historic operating model as well.

We believe the larger factors impacting the revenue we realize in the second quarter and the full year of ’09 will be the following; spending levels at our Tier 1 and Tier 2 carrier customers, the adoption rate of our Total Access 5000 and 1100 Series platforms, the adoption rate of the OPTI-6100 with Tier 1 carriers, continued growth of Internetworking revenues, the continued negative impact of the economy on [inaudible] for product revenues, timing of implementation of the broadband stimulus package, and order trends and traction at newer international customers.

Tom, back to you.

Thomas R. Stanton

Okay. Thank you Jim. Okay, Cassandra, at this point we’d like to open it up for a question.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Nikos Theodosopoulos – UBS.

Nikos Theodosopoulos – UBS

I had a couple questions. First of all, if you could give the 10% customer levels and then on the gross margin, I wanted to get a feel for how much of that was – was there any product mix related to that and how sustainable is it going forward?

James E. Matthews

I’ll take those questions. In terms of the 10% customers AT&T came in at 29% for the quarter, Verizon at 11%, EMBARQ at 10% and Qwest at 18%.

Now in terms of our view on gross margin expectations as we go forward, we’re still anticipating gross margins in the high 50s. The reason for that is that as we bring new projects on, new customer projects on from an initial revenue standpoint there will be start up costs. And again we anticipate that, you know, potentially those will bring margins back to the high 50s level for the longer term.

Nikos Theodosopoulos – UBS

So in this particular quarter then what got you way above your target? I mean, I know you mentioned lower transportation costs and so forth, but can that have such a material move? Was there more of a product mix or?

James E. Matthews

In terms of product mix, Nikos, the gross margins for each of our product areas are fairly consistent. What we saw again in the first quarter was a very linear quarter. You probably picked that up from the lower DSO’s than we typically have in the first quarter. That enabled us to again avoid significant expediting costs and, you know, in terms of material expediting and shipment costs, air freight costs. You know, those costs again were very, very minimal in the first quarter. Okay? So again it’s all back to efficiencies and a very linear quarter which enabled us to plan very effectively, production flows as it related to order.

Thomas R. Stanton

Nikos, if I could add one other point that I do – you know, we have had a heightened focus on efficiencies both from a transportation and from a manufacturing perspective. And you knew we manufacture some percentage of our goods here in Huntsville, Alabama. So I think the caution that we see in trying to raise that target at this point is fairly early into those efficiencies taking hold and trying to understand which ones will prove out over time and to what level is a little difficult. So I think we’re just more comfortable in the high 50s until we have some quarters behind us.

Nikos Theodosopoulos – UBS

Okay. And Tom, you know the guidance for the next quarter up sequentially? I mean, given that you’ve seen towards the end of the quarter better bookings trend and so forth, is it fair to say that, you know, and you maintain the view that the first quarter will be the bottom for the year that the carriers are sounding more willing to spend after a tough fourth quarter and early first quarter? Is that a fair assessment?

Thomas R. Stanton

You know, I hesitate to say that the carriers are less cautious, because I think that they’re still very targeted. I think what we’ve seen is some of the activities that have been planned for some time are continuing to move forward, really as we expected. So maybe a good piece there is nobody’s pulling back any more. I’d say the one area where, you know, we’ve seen a change in tone is probably with those Tier 2 and Tier 3 carriers, and I do think the broadband stimulus package is, you know, directly relevant to that. And so the amount of activity that we’re seeing in that space has gone up dramatically. And when I say activity I’m not necessarily saying orders. The activity would be in a lot more planning and a lot more discussions about what they want to do than we’ve seen any time in the near past.

Operator

Your next question comes from Ehud Gelblum - J.P. Morgan.

Ehud Gelblum - J.P. Morgan

A couple of questions, first of all you can see that the effect of the Tier 2 and Tier 3 spending when you take your 10% customers and subtract them from your total and you look at that over the last year. In September it was $55 million for the 9, 10%. In December, $60 million and now it seems to have dropped to $35 million, and I’m guessing that’s the effect of your Tier 2 and Tier 3s. Can you just explain a little bit as to why? I see there’s regulatory uncertainty but the uncertainty seems to just be around if they’re going to get lots of free cash from the government or not. Why would that affect their spending now? And I think if anything it would just delay their thoughts about how much extra they would spend. I’m just not quite understanding why it would impact their ability to spend, you know, right now in the near term on what they need to normally spend.

And then when you look at the FTTN business that seems to have pushed up a lot, obviously and Qwest popped up as an 18% customer now, what stage of the process? Was this a one quarter build? Is this to be a two, three, four quarter build? How long will [CapQwest] be able to stay there at 18%? And how long will the FTTN – what are the legs behind the FTTN build-out as we look at the rest of the year?

Thomas R. Stanton

Okay. First on the Tier 2 and Tier 3, and I’ll try not to speak for them, I’ll give you my summation of general feelings that occurred. It is true that it will enable a significant amount of increase in spending in that space to the extent that people qualify and move forward with those projects. And I would say that the uncertainty is easing. I would say it’s not where anybody would like it to be, but we did see it easing as people started to understand the rules better. Not all the rules are set in place yet. There’s a notice for rule making and I believe sometime in June those will actually come out. So there’s still some uncertainty as to what will qualify and what won’t qualify.

And I think pre-planning on jobs is a particular area of concern, because to the extent these are jobs that were going to happen anyways, they would not qualify. So I think you see more scrutiny about what it is that they would say they were going to do versus what it is that the stimulus package enables them to do. And, you know, initially when those rules first came out, I think there was just kind of a freeze, a “let’s not do anything and let’s see what will qualify. Let’s not shoot ourselves as we try to work through this package.” That is easing to some extent. It’s still not where we would like it to be. I think every month it gets better. But you know the sooner the rules get out and people are submitting for the money and it starts flowing, I think you will see a change in activity.

As far as Fiber-to-the-Node, we – I don’t want to talk about any particular customer. I would say that Fiber-to-the-Node in general in the U.S., we would expect that the increase in sales that we saw in the first quarter is not a one quarter phenomena. So we would expect to see increasing sales and my guess would be at this point that you would see from a kind of slope perspective, similar activity to what we probably saw last year in the overall market.

Ehud Gelblum - J.P. Morgan

So that’s probably a better, if the year goes on even from where it is right now?

Thomas R. Stanton

At this point in time I would expect it to, yes.

Ehud Gelblum - J.P. Morgan

Optical Access seems to be sort of kind of stuckish in the $8, $9, $10, $11 million range. Do you expect a lot of optimism?

Thomas R. Stanton

Well, you know, in the Tier 1s it did okay. Especially we do see some seasonality in the first quarter in the Tier 1s and we saw it do okay. Where we saw a slowdown was actually the same thing that hit us in the general marketplace with the Tier 2s and Tier 3s. I think there was just really a “let’s stop and see what we’re going to do for the year” kind of attitude in Q1. And so it was in the Tier 2 and Tier 3s where we saw some slowness in the –

Ehud Gelblum - J.P. Morgan

Tier 2s and Tier 3s had actually been flat sequentially from where they were in Q4, the total Optical Access was $10.8 million then and you’re $10.7 now, but if your Tier 2 and Tier 3 had been actually flat instead of this regulatory uncertainty where would your Optical Access have been?

Thomas R. Stanton

Well, you would have seen an increase. I wouldn’t try to forecast what that number is, but you would have seen an increase no doubt from where we are because the Tier 1s were essentially flat and, you know, we would expect an increase from the level – from the first quarter level in the Tier 1s going forward. So, you know, I think some of it is going to be getting these, you know, to what extent the Tier 2s and the Tier 3s come back and at what level.

Ehud Gelblum - J.P. Morgan

Okay.

Thomas R. Stanton

I do think that it really does revolve itself, though, around the current regulatory uncertainty.

Operator

Your next question comes from Paul Silverstein - Credit Suisse.

Paul Silverstein - Credit Suisse

Tom, Jim, can you all give us an idea of what the TA 5000 contribution was? If you gave that before, I apologize, maybe I missed it. And also can you address Qwest, how much – I know you don’t want to give too much information about a particular customer, but what do you say to the legs on that FTTN deployment? It obviously had a big impact on your quarter. I think it was less than 10% last quarter, so it looks like it was up $10 million sequentially. If you could give us some insight there that would be appreciated.

Thomas R. Stanton

Okay. As far as the 5000 it was less than 10%. We did, as I mentioned before, I think see it slow down in the Tier 2s and Tier 3s that kind of brought to that. We did see the activity by the way pick up towards the end of the quarter in the 5000 and there’s no doubt that we will see the sequential increases in the 5000 from just where we are, looking at the first part of this quarter and the tail end of last quarter. And that real slowdown kind of happened towards the tail end of January and through February, and we saw it start picking back up.

As far as Fiber-to-the-Node, here again I will not talk about any specific customer. I get in trouble when I talk about specific customers and their plan. As I mentioned to the previous question, we do expect though Fiber-to-the-Node to carry on through past Q1 and accelerate and have a similar profile, albeit the total numbers may be different, but a similar profile to what our Fiber-to-the-Node business did in last year.

Paul Silverstein - Credit Suisse

Tom, on the 5000 is it now somewhere between 5 and 10%? Is it getting close to that 10% mark?

Thomas R. Stanton

Well, it actually has and in previous quarters passed the 10%. So it’s, you know, you would expect, you know, we’re kind of in that broad range.

Operator

Your next question comes from Amir Rozwadowski - Barclays Capital.

Amir Rozwadowski - Barclays Capital

One of the areas I wanted to discuss with you folks or get a little bit more color on is the potential impact from strikes at AT&T and how you folks are looking at that in the current quarter.

Thomas R. Stanton

Well, you know, historically we’ve gone through situations like this and we don’t really see if your horizon is broad enough, which means spanning a couple of quarters, we typically don’t see an impact that’s really meaningful to us. And, you know, there have been times in the past where you’ll see a run up before a potential strike, and then a moderation or a slowdown afterwards, or sometimes you’ll just actually see the slowdown and then the pick up after the strike has remedied itself. But it usually happens to be if it falls on a particular month boundary or something, and the nature of our business is so book and ship that it typically doesn’t have a big impact to us. So, you know, we’re really not expecting any major changes at this point.

Amir Rozwadowski - Barclays Capital

Okay. That’s helpful.

Thomas R. Stanton

You know, if the strike were to go on for a few months that would be a different animal. But that just hasn’t been the case.

Amir Rozwadowski - Barclays Capital

So have you seen that sort of order pick up here in this situation, or no?

Thomas R. Stanton

You know, I don’t believe so. The general sense is the answer is no.

Amir Rozwadowski - Barclays Capital

And then you know just a little bit more color on sort of the order patterns or sort of your outlook for the year. You know, it seems as though, Tom, you had mentioned that another material downtick in spending is probably unlikely at this stage of the game. Is that a fair way to think about things?

Thomas R. Stanton

Yes. I don’t know if I’ve said that. I mean, you know, right now, I mean at this moment in time, it feels unlikely, but you know it’s a very volatile market. We’ve seen huge swings from month to month. I’ll take you back to a bad period in our time which was, you know, end of the third quarter last year when we saw a fairly substantial decrease out of the blue. And so I wouldn’t say that it couldn’t happen.

Amir Rozwadowski - Barclays Capital

Okay. You’re not ruling out the possibility, but it seems as though things have somewhat stabilized from your current visibility levels.

Thomas R. Stanton

Current, yes, I would say so.

Amir Rozwadowski - Barclays Capital

And then, you know, in terms of your share repurchase plan, obviously you folks have been very supportive of that plan in the past and, you know, given sort of the near term volatility of the market, probably have not been as aggressive. When should we think about you folks probably stepping on the pedal a little bit more in the future? What factors, you know, need to come into play for you folks to get a little bit more aggressive once again?

Thomas R. Stanton

Well, you know, we’re going to continue to be cautious, although we’re at the same time going to be optimistic. Obviously I can’t say whether or not we’re going to go in as aggressively in the second quarter as we did in the third. But again I think the only thing I can say at this point is we will continue to be opportunistic but still with a level of cautiousness, given the volatility of the market. Okay? And, Amir, I think we just would be better to leave it at that at this point because we really can’t anticipate. Okay?

Operator

Your next question comes from Vivek Arya - BAS-ML.

Vivek Arya - BAS-Michael Look

First, Tom, in broadband access you mentioned that we could see improvement throughout the year. If I look at 2008, broadband access sales I think were roughly down 29, 30% in the second half versus the first half. Why would this year be different?

Thomas R. Stanton

You know, what I was specifically talking about was the profile of Fiber-to-the-Node products, and that the market in general we see to follow a pattern that is similar. And I would say to your point that last year, Fiber-to-the-Node products were a major driver at our overall broadband access product category. So you could absolutely conclude that. And, you know, I haven’t checked the numbers and I don’t know if Jim has in determining as to whether or not that’s – but I’ll take it as that’s roughly kind of where we came in at.

The difference this year may be, although the profile will be the same quarter-to-quarter, boundaries may fall slightly different, and probably the big unknown is there’s a I think a market for the 5000 that is absolutely maturing from where we were last year. And we’ll see, you know, we’re very hopeful to see incremental pick ups from last year versus this year. So whether or not it’ll follow the same profile, I’m not going to try to give you third and fourth quarter guidance on broadband today. But I do think there are different buyers in the mix this year than there were last year.

Vivek Arya - BAS-ML

Secondly, on the business networking segment sales have been down sequentially for the last two quarters, presumably because of the macro weakness and lower Enterprise spending. When do you think we’ll start to see a pick up in that segment?

Thomas R. Stanton

If I was trying to look at a company and look at the drivers, I would not put the business networking segment as necessarily a driver. There are components to that. One of them are some of our legacy gear TSUs, some of our TDM IDs that we don’t expect to rebound. There’s no doubt that or our belief is that they probably have slowed down in a faster fashion because of the current environment. But we would expect those in general to be declining over time, anyway.

So the real drivers in our Enterprise segment have been and continue to do be in our networking where we’re still seeing, I characterize it as solid, which means it didn’t grow but in the environment with the additional pressures, we were okay with the results. And we would expect those to be the drivers which include the 900E product line as well as our net Banter product line, and some additional products that we’ve brought to market here over the last six months or so with new switches and some new IP gateway products. Those are the items that we would expect to grow.

Vivek Arya - BAS-ML

And in selling and marketing expenses, Jim, there was quite a bit of a drop in the first quarter. Were there any one time events there or is it just generally the lower volume of sales?

James E. Matthews

Oh, no. I mean, we’ve had a and I think we first mentioned this perhaps in the fourth quarter call, that we have a particular focus on OpEx and improving efficiencies in OpEx. And you saw some of that in the fourth quarter and a large part of it again happening in the first quarter. So again a continual focus on OpEx because of the economic environment we’re in, and we will continue to focus on OpEx to keep them at consistent levels, if you will.

Thomas R. Stanton

And I’ll add this one point, and it speaks to one of the very first questions which is, you know, from a gross margin perspective there’s no doubt that that focus on OpEx helped us increase gross margins, too. That focus remains today because although, you know, any particular space may be good or you’re seeing some light in some particular space, I think the overall economic environment really hasn’t substantially changed.

Vivek Arya - BAS-ML

One last question, Tom, if I may. How do you expect HDSL to trend through the year? Because what you have often seen, you know, at different company that first half there’s a lot of wireless backhaul [bid] and then second half that capacity is absorbed. So just in general how do you see your HDSL segment trending through the year? Thank you.

Thomas R. Stanton

Well, in general, you know, trying to equate our numbers to a different company’s numbers sometimes hasn’t worked. [Dax ports] in relation to HDSL, whenever we’ve tried to do that math we’ve never been able to quite get the numbers to jive. But in general what we see is HDSL accelerating through the year to the third quarter and then you see it drop off in the fourth quarter. There are times where, because of a particular order we may see the quarter differentials skewed, but in general that’s been the case and that’s what we would expect to see at this point in time through this year. Really no major difference. There is no doubt a heightened focus on wireless backhaul, but that focus has been there for some time. Particular projects may move the numbers around a little bit, but I would expect you to see a similar trend to what we’ve seen over the last, you know, probably eight years or so.

Operator

Your next question comes from Jim Suva – Citigroup.

Jim Suva – Citigroup

A question on the gross margins. You talked about returning to your historical operating model and kind of the high 59 gross margin. If I look at the sales forecast of, you know, an outlook of high to mid single digits, typically one would reasonably assume that you’ll have higher efficiencies than yield and operating efficiencies due to higher sales rate, and historically higher sales have resulted in higher gross margins for you. So I guess coming back to the question about returning to high 59% gross margins, and you appear at 61% now, last year gross margins went up 190 basis points from Q1 to Q2. Why shouldn’t we expect gross margins to go from 61% to maybe even an increase of even 100 basis points? Yet you’re kind of talking about the high 50%.

James E. Matthews

Jim Matthews. I’ll try to address your question there. You know, it comes back to the fact that we outsource about two-thirds of our manufacturing, which has a highly variable cost content. Okay? So, you know, as revenues go down we reap the benefit of that. Okay? Now, as revenues go up again the variable cost component will go up as well. Okay? So because of that, because of revenue fluctuations or when we have revenue fluctuations we haven’t seen as much of a change in gross margin as it relates to volume. Okay? Now, you might recall in ’07 and coming into ’08, gross margins down ticked a little bit and that was because of new customer start ups in terms of shipments. And we expect that that will not be unusual going forward. Again, when we incur start up costs for initial shipments of awards or new technologies. Okay? So that’s why we continue to be cautious on gross margins and still call it at the high 50s going forward.

Jim Suva – Citigroup

And as a quick follow up, when you say high 50s going forward you mean including Q2 in the longer term, because it seems like Q2 would still be –

James E. Matthews

Yes. We’re talking about the longer term, but and that being the target range. And as more quarters get behind us and we can see where that stabilizes up, we may actually take a look at whether or not that makes sense. It hasn’t been that long ago at least in [Telco] years anyway, it hasn’t been that long ago when we had to revise up from mid-50s. But, you know, we’ve got a couple of above 60 quarters behind us in the history of the company, so we’re just going to be cautious in saying that everything is in here and said at this point. And even having said that, there will be times as we have seen in the relatively recent past where we can be rolling along and see a point or a point-and-a-half downtick, with no fundamental change in the business and, you know, we just want to make sure people understand that.

Jim Suva – Citigroup

Right. But it’s not unreasonable to expect, you know, still 60% of the prior point-and-a-half would still give you a 6 handle on the front.

James E. Matthews

Yes. That’s true. And you know, I guess I would be very cautious. You know, you start off with would we actually see an improvement from Q1 and I would be very nervous about saying that we’ve seen improvement from 61%.

Jim Suva – Citigroup

And then my last question. On inventories there was some build there. Can you walk us through that and what’s going on there? Traditionally you haven’t had a build in Q1, even though sales have been going up Q2.

Thomas R. Stanton

Yes, well, I mentioned in my comments that we did introduce some new products. And one of the ones that we’ve introduced and I think it’s to a point now where there’s actual real market acceptance is VDSL2. Whenever we have a transition like that, which is kind of a fundamental transition from ADSL2 plus the VDSL2 with some level of volume behind that, you may actually see our inventory pick up. In this case it’s the majority of that pick up is in the 1100 Series Fiber-to-the-Node products. And you’ll actually see that pick up. Truly we’re not concerned about that. I can understand it being different than what we do on average, but I mean this is something that we think will work itself out, probably this quarter and if not within two quarters. But more than likely this quarter.

Operator

Your next question comes from Colby Synesael - Kaufman Brothers.

Colby Synesael - Kaufman Brothers

If you could just give us an update on your international strategy as it relates to, you know, some of the relationships you might be building with some potential resellers as well as what types of [inaudible] products you think [inaudible] as well as what areas?

Thomas R. Stanton

Sure. Our focus has been over the last year-and-a-half to two years really trying to drive Total Access 5000 and our 1100 Series Fiber-to-the-Node products into areas where their network evolution mimics our development profile. In that area, you know, we had had some success in Latin America. That project still remains active and we still have hope for continuing involvement as that project moves forward.

The other area where we have seen some success, we have seen some success in Asia. If we factor in Q1 we’ve actually won some EFM business. We’ve now got the 5000 and 1100 Series in a relatively small number of carriers. We’re in trials or working through things, labs, and in several I think we’ve probably won six or seven different carriers where we’re actually now selling the 5000 or the 1100 Series products. It’s still early in the cycle, but you’re going to see us focus in Asia, Western Europe has a profile very similar to the U.S. in regards to their network evolution so the same type of requirements and the same type of benefits that play through in the U.S. will also play in Western Europe. So you’re seeing us focus on those accounts also.

Now, having said that, trying to sell to some of these larger western carriers is very similar to trying to sell to some of the large U.S. carriers in that it’s a very long gestation period. But we’re in there without a doubt with our products in labs and working on it, but I don’t see near term changes that would affect the overall numbers at this point.

Colby Synesael - Kaufman Brothers

And have you given a long term percentage of what you think international should be for the company and whether it’s maybe a year or two or three years out?

Thomas R. Stanton

We haven’t given a percentage. There’s no doubt it should be a meaningful portion, and by that I mean in excess of 25% over the long term. But, you know, we haven’t tried to bring that granularity in. We have a hard enough time to be honest with you forecasting the U.S. market where we have an awful lot of history and trying to forecast when jobs will get awarded and when jobs will actually get integrated in these large networks and actually roll out. And that can easily be a couple of years, so that’s really why we haven’t put more granularity on it is because really at this point in time, there’s no good sense to be able to do that.

Colby Synesael - Kaufman Brothers

And I assume for practically all those sales you’ll be using a channel?

Thomas R. Stanton

Not necessarily. In some of the larger carriers in Western Europe we would. Sometimes we will have partners. In many cases, we’re in there – in most cases I would say with the larger carriers, anyways, we’re in there direct.

Operator

Your next question comes from George C. Notter - Jefferies & Co.

George C. Notter - Jefferies & Co.

Your Tier 2 and Tier 3 operators I guess I was trying to figure out what percentage of sales for the company do those accounts represent normally in a typical quarter? Thanks.

James E. Matthews

George, this is Jim. We haven’t disclosed that number, but I think that overall I think people can infer that the number was down in the first quarter because of the reasons stated.

George C. Notter - Jefferies & Co.

I guess historically I’ve been thinking it’s anywhere from 10 to 20%. Is that a good range to use?

James E. Matthews

George, I’m not sure at this point. Okay? Again, I’m not sure what the range would be at this point.

Operator

Your next question comes from Simon Leopold - Morgan, Keegan & Company, Inc.

Simon Leopold - Morgan, Keegan & Company, Inc.

I wasn’t quite sure if I missed it, so I apologize. First quick housekeeping. What did you say or what do you expect in terms of tax rate for the year and the coming quarter?

James E. Matthews

Sure Simon. This is Jim. So on a normalized basis we’re expecting something around the range of about 34.5% on a GAAP basis.

Simon Leopold - Morgan, Keegan & Company, Inc.

And more of a trending question, getting back to sort of the TA 5000 product cycle, it seems to have been I guess bouncing around this 5 to 10% range and you’ve I think sounded pretty upbeat about the pipeline, and you’ve talked about the opportunities. And if you could give us an update and revisit the applications in terms of rank order where you see the best opportunities, where you see the earliest opportunities, and refresh us in terms of how we might think about this product contribution let’s say out six months, or out a year, in terms of the evolution you’re anticipating. Thanks.

Thomas R. Stanton

That’s a good question. Let me try to first maybe tackle it from a customer base perspective. In the Tier 1s our focus has been to get the 5000 established within those networks and within the management systems that those Tier 1 carriers have. And that’s been an ongoing effort for the last two years. And at this point in time I would say we were successful in getting those established and integrated into their networks. So at this point in time through Q1 I think which is maybe at the tail end of Q4, but definitely through Q1, we’re at this point in time shipping to all three Tier 1 carriers in the U.S.

Now within those carriers and every one of those carriers we have multiple applications that we’re working through. So we’re shipping the first application to all three, albeit they’re very early in the stages of shipment, definitely the last two. It’s not a – AT&T was the first one that we started shipping to with [inaudible] copper. So that was the goal. We’ve met that goal. At this point in time we’re operationalizing additional applications in all three of those carriers, and [inaudible] the gamut from broadband DOC applications in one of them to IP DSLAM implementations to Ethernet over copper and we have Ethernet over copper awards in more than one Tier 1 carrier. But they have not all been implemented yet.

Simon Leopold - Morgan, Keegan & Company, Inc.

And in terms of the Ethernet over copper applications, I think there are two variants on that. One is [sell site]backhaul and the other is Enterprise. Can you maybe drill down?

Thomas R. Stanton

That’s true. And initially I would not have characterized them as distinct variants. At this point in time I would say at least in some of the Tier 1s they are distinct variants. I am pleased to say that we have won those distinct variants so that those will be ADTRAN gear moving forward in the ones where we’re the most active. The sell site variant of that I think is something, well I know is not yet in deployment. You know, there are internal goals that we and our customers have on getting those deployed, but they’re not imminent. And by that it very well could be this year, but they’re not going to be in the second quarter or probably even in the third quarter. So we’ll see those come on line.

And the focus at this point would be Ethernet over copper to the extent it’s being deployed is own business. Now there are variants yet again or different phases of that business deployment, and we’ll see additional phases of that business deployment come on line and right now they’re scheduled for, you know, towards the tail end of the third quarter. So in general we would see Ethernet over copper being more robust definitely in the second half than we’ll see in the first half.

If you’ll allow me then I’ll go down to the Tier 2s, and the Tier 2s you know their focus is broadband access and broadband DLCs. We’ve got all the Tier 2s deploying some level of the 5000. There are still some approvals, some of which will actually happen as early as this week, with some of the Tier 2s. That will continue to broaden the appeal of that product. And I think the thing for us there, the trigger for us there will be for them to kind of get their spending plans where they want them in relation to the broadband stimulus package and then move forward. And I think there’s a very good chance that they will move forward in a more aggressive manner with this package in play than they would have moved forward before that.

Simon Leopold - Morgan, Keegan & Company, Inc.

So if I kind of connect the dots of all these opportunities, it sounds like Q4 could be the first quarter where we could sustainably get above 10% of sales. Am I leaping to too broad a conclusion?

Thomas R. Stanton

Yes. The thing is there are enough variables and one of the things that I’d mention, and I don’t want to put too much optimism into the general feeling about that, but you know as of right now the top 1000 is doing well in the second quarter. We’re very much early into it, but you know some of those orders actually received towards the tail end of last quarter. So I wouldn’t go as far as to say that, but we would expect more activity in the second half than in the first half, and probably more activity in the first half of next year than the second half of this year. The real kind of swing thing that may move things more aggressively or less aggressively will be to the extent that the administration can implement on the broadband stimulus and give people some level of certainty as to what’s going to qualify and what’s not going to qualify and kind of unleash that angst that’s right now in the market around it.

Operator

Your next question comes from Greg Mesniaeff - Needham & Company.

Greg Mesniaeff - Needham & Company

If I could just return to the gross margin discussion earlier, you know the commentary centered around improvements due to better transportation costs and logistics costs. I was wondering if you can comment on the current environment you’re seeing for silicon pricing and also pricing for outsourced manufacturing as well, and whether that was a contributor to any positive trends.

Thomas R. Stanton

Yes. I would say the environment is kind of use the word we talk about, you know, business in general. I would say the environment is relatively stable and there’s probably some ability to remove costs, but that wasn’t a first quarter ability. That’s probably been true over the last three quarters or so. I wouldn’t say that that was the biggest driver, though. I think transportation costs – I do think in general we managed the operation a little bit better and it was more linear. And not just be the shipment flow but in also the way that we actually built products internally here in Huntsville. So I would say it was just a more efficient operation. I wouldn’t – I think there probably is still some price elasticity or ability there to see additional building material costs drops, but I wouldn’t say that’s been the driver or probably necessarily forecast that to be the driver.

Greg Mesniaeff - Needham & Company

And then the sort of the second part of that question was are you seeing your Tier 1, particularly your Tier 1 customers, as they, you know, face the challenging economic environment and the slowdown in spending, is it fair to say that you haven’t really experienced any additional pricing pressure from them to extract better pricing? Or put it a different way, has pricing been fairly stable for your products?

Thomas R. Stanton

I would first say the Tier 1s do a fantastic job of trying to get as much as they can out of us, and that pressure, that ongoing pressure hasn’t changed. But I would say in general it’s been consistent for some period of time and really no change in that environment. I think they do a very good job of trying to make sure their dollars go as far as possible.

Greg Mesniaeff - Needham & Company

So it’s fair to say that you’ve maintained a fairly acceptable to you pricing environment, acceptable to you clearly?

Thomas R. Stanton

Yes. I would think so, and I think our gross margins kind of reflect that.

Greg Mesniaeff - Needham & Company

And then just a final follow up. In the area of HDSL, I mean clearly you’ve referenced the strength in wireless backhaul which continues, any comment on the non-wireless backhaul aspect of HDSL? Are you seeing higher percentage of disconnects with small, medium sized business customers? In other words, is the ratio of Enterprise related to wireless backhaul continues to shift into the wireless backhaul significantly?

Thomas R. Stanton

That’s a good question and I’m sure it’s one that many people have. And all we can do is infer the answer to that, because we do shift to fairly large warehouses where these go out and we never get to touch the end user. And the inferences that we would draw upon would be what’s happened to our kind of traditional SMB Enterprise business which is without a doubt seen a fairly significant decrease over time. So I would say that that shift has to be happening, that we have to be seeing more of an impact on wireless. But I can’t give you much more granularity than that.

Operator

Your next question comes from Todd Koffman - Raymond James.

Todd Koffman - Raymond James

Yes. One more quick question on gross margin. You said that it was going to tick down a little bit because of the new products. What new products are you talking about that the [inaudible] going forward that haven’t already been shipping for quite some time?

Thomas R. Stanton

You know, Jim’s right here. I’ll let him finish it. I think, Todd, he was talking about things in general. There are no things that we see in the near term that would be like that, but in general we do have project oriented things. We sometimes will go in there and initially push on that. And then when we do introduce a new product. And probably, you know, one piece that is new and I just spoke about it would be something like VDSL2 changeover, where depending on the customer you may see that. I don’t really foresee any of that in the near term, but that’s the type of transition that from time to time will actually kick gross margins down.

Todd Koffman - Raymond James

Thank you.

Thomas R. Stanton

Jim, do you have anything else to add to that?

James E. Matthews

Well, yes, I was referring primarily to the VDSL as well.

Operator

Your next question comes from Blair King - Avondale Partners.

Blair King - Avondale Partners

Just a couple quick questions. In terms of the activity that you guys have been seeing in the Tier 2 and Tier 3 carrier market, is there any way to prioritize kind of what the level of activity is with regard to the projects that they’ve been working on? Is there one or two types of sort of applications or services if you will that seem to be running at the top of the list there for those guys?

Thomas R. Stanton

Yes, and you can characterize it in general is better coverage. You know, there is this – for instance in the seamless package the focus is under served and not served for broadband. So in the not served that’s a fairly easy thing to understand. You either have broadband capability or you don’t and in those cases I would characterize it as footprint expansion, where the ability to deliver that service is going to be there. It wasn’t there prior to that.

In the under served, although the actual definition is yet to be defined and the FCC is working on that, under served is where the speed is not high enough. So you know if you’re delivering a 500k service or a 700k service, you need to upgrade that speed or you may need to upgrade that speed. And so its broadband footprint expansion, as well as capacity or broadband capability upgrades. And those are predominantly what the talk is now. There’s an awful lot of talk also, we introduced some [G-pronged] products here recently including some new [L&T] products and there’s a lot of talk about G-pronged as well as traditional DSL broadband.

Blair King - Avondale Partners

That’s interesting. So the application’s really more sort of high speed data. You’re not seeing a lot of activity on sort of more interesting projects along the lines of IPTV or anything like that being utilized out of the –

Thomas R. Stanton

In the Tier 2s and Tier 3s I would say at this point, you know, the way I think about it is IPTV as a service that rides on top of a bigger broadband pipe. You are correct in that more Tier 2s and definitely more Tier 3s are interested in delivering IPTV service today than there were six months ago. So yes, that as an application that rides on top of it that would be correct.

Blair King - Avondale Partners

From a competitive standpoint, do you guys feel like you’re pretty well positioned to benefit from the broadband stimulus? I think – aren’t there some rules associated with which vendors can participate in that program?

Thomas R. Stanton

There are rules. I would say at this point that the rules and they’re not fully defined, so we’ve got that kind of caveat, but at this point in time I would say we are well positioned. It is a customer base that we have been working with for years now, and I think they know us pretty well and we know them pretty well. And I think our products fit the right space. But in a general sense, I would say there aren’t many people that I can’t think of any strong restrictions that would keep many other players from playing in this same market.

Blair King - Avondale Partners

Okay. Interesting. All right. Thank you very much.

Thomas R. Stanton

Okay. Cassandra, I think that pretty much wraps up our time here, so I would like to thank everybody for participating today on our conference call and we look forward to talking to you next quarter.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: ADTRAN, Inc. Q1 2009 Earnings Call Transcript
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