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ADTRAN, Inc. (NASDAQ:ADTN)

Q3 2009 Earnings Call

October 14, 2009 10:30 am ET

Executives

Thomas R. Stanton – Chairman and Chief Executive Officer

James E. Matthews – Senior Vice President and Chief Financial Officer

Analysts

George Notter - Jefferies & Co.

Michael Genovese - Soleil Securities

Jim Suva - Citigroup

Paul Silverstein - Credit Suisse

[Steve Salkoff] for Kenneth Muth - Robert W. Baird & Co., Inc.

Sanjiv Wadhwani - Stifel Nicolaus & Company, Inc.

Nikos Theodosopoulos - UBS

Vivek Arya - BAS-ML

Greg Mesniaeff - Needham & Company

Chandan Sarkar - Auriga USA

[Ari Benzinker] – Standard and Poor

Lawrence Harris - C. L. King & Associates, Inc.

[Paul Valentine] for Simon Leopold - Morgan, Keegan & Company, Inc.

Ehud Gelblum - Morgan Stanley

Bill Dezellem - Tieton Capital Management

Andrew Schopick - Nutmeg Securities

Brian Coyne - Wedge Partners

Operator

Good morning. My name is Vanessa, and I will be your conference operator today. At this time I would like to welcome everyone to the ADTRAN third quarter earnings release conference call. (Operator Instructions) As a reminder, ladies and gentlemen, this conference is being recorded today, Wednesday, October 14, 2009.

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, and Form 10-Q for the quarter ended June 30, 2009. 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.

At this time I would like to turn the call over to Mr. Tom Stanton, CEO. Mr. Stanton, you may begin your conference.

Thomas R. Stanton

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

During the quarter we benefited from increasing customer investment in Carrier Ethernet and Broadband service deployments and their migration towards packet based technologies. We also benefited from carriers’ increasing focus on wireless infrastructure upgrades as a result of growing mobile bandwidth demand. Although spending delays with our IOC customers persisted, we saw continual activity around stimulus planning. Also during the quarter the SMB environment remained relatively stable. However, we continued to see the positive effects of share gains.

From a product perspective, our growth areas delivered a solid revenue performance for the quarter. Combined these areas grew an impressive 20% year-over-year. Specifically, Broadband access revenue grew 29% over the prior year as a result of continuing deployments of Fiber-to- the-X products and the record revenue achieved by our Total Access 5000 service platforms. Revenues for these areas grew across all customer categories.

Optical access revenue was up, coming in at a record $20 million, and growing at a rate of 49% sequentially and 20% year-over-year. This strength was due to continued market share gains and increasing shipments to all major market segments as carrier’s invested to increase bandwidth for wireless infrastructure.

Internetworking revenue was up both sequentially and year-over-year, setting another record at $21.3 million. We continued to see growth in both our carrier distribution channels and our broad dealer base. HDSL revenues increased sequentially in the quarter. However, it followed an exceptionally weak second quarter. We believe HDSL revenues will continue to see fluctuations quarter-to-quarter as a result of the sluggish economic environment, the sporadic nature of wireless infrastructure upgrades and the longer term migration to Ethernet based technologies.

Moving on to items that will affect our future, activity for our Fiber-to-the-X and Total Access 5000 products remain very strong, driven by GPON, Carrier Ethernet and high speed DSL. We expect our Fiber-to-the-Node and GPON products will benefit from a reemerging interest in bandwidth expansion to deliver new services, as well as a reemerging interest in footprint expansion resulting from the broadband stimulus package and service provider consolidation. Our Carrier Ethernet products should continue to benefit from expanding Ethernet conversion initiatives spanning across all carrier customer segments. We anticipate these expanding deployments and the addition of new applications will contribute meaningfully to the growth of these platforms well into the future.

For Optical Access, we believe that we are in the early phases of conversion to fiber access technologies and that the increasing demand for bandwidth, both wireline and wireless, will provide meaningful growth opportunities. As mentioned before, previous market share gains in Optical Access have translated to revenue growth as carriers have increased their focus on adding bandwidth to urban cell sites. It is our belief this type of incremental bandwidth expansion will continue for some time, although we expect quarter-to-quarter revenue fluctuations and typical seasonal variations will occur.

We expect Internetworking revenues will continue to grow over the long term as we benefit from continuing market share gains and focus on new product offerings to expand our product portfolio. Looking forward, although we continue to participate in a large number of opportunities related to the broadband stimulus plan, we do not anticipate revenue contributions from these opportunities in the fourth quarter.

Also, our plans do not anticipate a change in the fourth quarter spending environment due to our customers’ management of year end capital expense budgets. Therefore, we expect to see a seasonal revenue decline in our Fiber-to-the-Node, enterprise and traditional product categories.

For Optical Access we expect to see a retreat from the historical third quarter level, but anticipate seeing momentum continuing for the longer term.

For our Total Access 5000 platform, we witnessed increasing activities as we exited the third quarter and we expect to see a sequential increase in this category into the fourth.

I would now like Jim Matthews to review our results for the third quarter 2009 and our comments on the fourth quarter. We will then open the conference call up for questions. Jim?

James E. Matthews

Thank you, Tom. Revenue for the third quarter was $128.1 million compared to $137.2 million in Q3 of ’08. Broadband access product revenues for Q3 of ’09 increased 29% to $29.5 million compared to $23 million for Q3 of ’08. Optical Access product revenues for Q3 of ’09 increased 20% to a record $20.1 million compared to $16.7 million in Q3 of ’08. Internetworking product revenues for Q3 of ’09 increased to a record $21.3 million compared to a $19.2 million for Q3 of ’08.

Carrier systems revenues for Q3 of ’09 increased to $59.9 million compared to $53.9 million for Q3 of ’08. Business networking revenues for Q3 of ’09 increased to $26.1 million compared to $25.4 million for Q3 of ’08.

Loop access revenues were $42.1 million for Q3 of ’09 compared to $57.9 million for Q3 of ’08. HDSL product revenues were $37.6 million for Q3 of ’09 compared to $50.8 million for Q3 of ’08. The decline in HDSL revenues is primarily the result of variations in demand as a customer continued to balance their wireless backhaul focus between urban and non-urban areas. As a result of the above, Carrier Networks division revenues were $96.8 million and Enterprise Networks division revenues were $29.4 million for Q3 of ’09.

International revenue was $6.7 million for Q3 of ’09 compared to $7.8 million for Q3 of ’08. To provide the reporting of each of these categories, we have published them on our Investor Relations page at ADTRAN.com.

Gross margin was 58.1% of revenue for Q3 of ’09 compared to 59.5% for Q3 of ’08. The decrease in gross margin is primarily attributable to an increase in demand of certain products as we progressed through the quarter.

Research and development expenses were $20.5 million for Q3 of ’09 compared to $21.7 million for Q3 of ’08. Selling, general and administrative expenses were $25 million for Q3 of ’09 compared to $26.3 million for Q3 of ’08.

Stock-based compensation expense net of tax was $1.4 million for Q3 of ’09 compared to $1.8 million for Q3 of ’08. Other income net of interest expense for Q3 of ’09 was $2.1 million compared to $1.8 million for Q3 of ’08.

The company’s income tax rate provision was 30.4% for the third quarter of 2009 compared to 36.8% for the third quarter of 2008. During the third quarter of 2009 the company recognized FIN 48 and R&D tax credit adjustments netting to approximately $1 million. These adjustments reduced the tax provision rate for the quarter by 3.2%. During this same period the prior year, legislation providing the benefit for research tax credits was not in effect, causing the tax provision to be unusually high for that period.

Earnings per share assuming dilution for Q3 of ’09 were $0.34 compared to $0.35 for Q3 of ’08. Inventories were $44.7 million at quarter end. Net trade accounts receivable were $65.3 million at quarter end resulting in DSO’s of 47 days for the third quarter of 2009 compared to 40 days for the third quarter of 2008. As you will recall, in the third quarter last year revenues declined as we progressed through that quarter due to a slowing economy causing our DSO’s to decline.

Unrestricted cash and marketable securities totaled $299 million at quarter end. Due to the book-and-ship nature of our business and the timing of near term revenues associated with large projects, it is our policy not to give specific guidance. We would like to give color to help you formulate your views on our near term business outlook. As is typical, we expect to see a seasonal decrease in activity in the fourth quarter. We expect revenues for the fourth quarter will decrease in the range of mid to high single digit percentage points. For the fourth quarter we believe we will execute in a range consistent with our historic operating model at the achieved revenue level. We believe the larger factors impacting the revenue we realize in the fourth quarter will be the following, spending levels at our Tier One and Tier Two Carrier customers, the adoption rate of our Total Access 5000 platform, the rate of fiber and copper upgrades for wireless infrastructure, the continuing negative impact of the economy on our traditional product revenues.

Tom, back to you.

Thomas R. Stanton

All right. Thanks Jim. Vanessa, at this point we’re ready to open it up to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from George Notter - Jefferies & Co.

George Notter - Jefferies & Co.

I guess I wanted to ask about the timing of the broadband stimulus plan and I guess I’m trying to get a better sense for when you think that might start to benefit your business next year.

Thomas R. Stanton

Thanks George. Well, I hate to say, but the timing of the broadband stimulus plan is still a little uncertain. Where we are as far as the first phase is concerned is the notices to actually who actually achieved or was going to receive the funds is supposed to be early November, I think November 7. I think that’s still the official date but I think there’s a chance that that actually may move out. And the extent of that move out we don’t know.

We’re still very hopeful that it would happen this year. Now after that notice of the receipt of being awarded funds, it’s up to another 30 days or so for those funds to actually make it into the customer’s hands. And then you would see the turnaround you know making it into orders and then shipments. So as of right now it’s still kind of a December-ish potential, but I think as I mentioned there’s a likelihood that that would actually move out, which is why in my comments I mentioned we really weren’t planning for that in the fourth quarter although we would expect to start seeing some benefit in the first quarter.

The other two phases, as directed right now there are three phases, it looks like there’s a good chance that Phase Two and Phase Three will be collapsed into a single phase which would be awarded sometime mid next year with the real finish date which is at this point in time set in stone of September 30 for being when all the money has to be used up, the $7.2 billion. So it’s definitely a 2010 event, you know potentially early 2010. We’re not expecting anything in the fourth quarter.

George Notter - Jefferies & Co.

So if I were to try to you know pin you down a little bit more precisely, I mean do you think then Q1 is when you really start to see you know the bulk of the money kind of flowing through to your customers and you’ll start seeing that spend? Or do you think it would be maybe more like Q2? And when do you really start to see the ramp?

Thomas R. Stanton

Well, we tend to be a little cautious on trying to time Carrier and definitely Carrier plus government funding. But as of right now it looks like we would start seeing the funds at least to the customers either at the end of this year or early next year and so potentially we would see something kind of towards the calendar first quarter. We’ll know more of course as we get through the fourth quarter and we will be glad to give color on that. Right now my guess would be late first quarter for the first phase and then the second and third phase will probably be third quarter.

George Notter - Jefferies & Co.

And then one separate question on gross margins, the 58.1% this quarter. I think I heard you say that it had to do with the timing of products shipped, certain product shipments to customers during the quarter. Did that mean you incurred expedite fees as you were shipping product? Or what exactly was that?

Thomas R. Stanton

Jim, do you want to?

James E. Matthews

Yes. And the demand did pick up as we went through the quarter and it did cost a little margin to [pull] certain of the components for our optical products for example.

George Notter - Jefferies & Co.

How much margin impact was that then?

Thomas R. Stanton

George, we haven’t quantified that. But it did [wham] margins a little bit. But we haven’t quantified that at this point.

Operator

Your next question comes from Michael Genovese - Soleil Securities.

Michael Genovese - Soleil Securities

So the guidance for the fourth quarter of down mid to high single digits, that seems like pretty typical seasonal pattern for you guys. So is there really no budget flush at all this year or you know any reason why we think the business should be slightly better than seasonal, maybe with some stimulus money coming at the end of the quarter?

Thomas R. Stanton

Well, there are things that we have pointed out that would affect the fourth quarter both positively and negatively from what we are today looking at. And yes, I guess what we wanted to get across to you is we’re not planning on a budget flush. And if we had some certainty that one of those, that something meaningful would occur, then we would project that to you. But we have no certainty around that and our guess would be at this point in time there has historically more times than not been talk this year of a budget flush. And we do see customers that do that, but they’re typically small amounts and they don’t really move the needle one way or the other. We also see sometimes contractions where people have kind of got themselves ahead of where they planned on being, and that event has been negligible to us. And that’s kind of the environment we’re expecting this year. I know there’s a lot of talk about that but it seems to me there typically is a lot of talk about that at this time of year.

As far as the broadband stimulus yes, if that comes in and everything works itself out then we would see potentially an impact as to whether or not it would move the number meaningfully. That would be question number one. And number two, we’re pointing at the fact that it seems to us the timing is actually starting to move out a little from what we were projecting last quarter. And even last quarter we would saying it would be tough for that to come in to the fourth quarter.

Michael Genovese - Soleil Securities

You know we’re starting to hear about maybe a new distribution agreement with Ericsson forming around the AT&T account. Wondering if you could comment on that in general and maybe talk about the possibility of taking that outside of just AT&T and also the international accounts as well.

Thomas R. Stanton

Sure. You know I’m limited as to what I can say about that because there are two other parties involved. But what I can say is yes there is an agreement in place to sell equipment to AT&T for an award that they had just previously made to Ericsson. We’re of course at this point in time focused on delivering on what it is that we’ve agreed to deliver and finishing up any R&D that’s required for that, and then going through the normal unfortunately extended integration process that’s typical of this type of award. There are areas where we believe and I don’t want to speak for Ericsson but there are definitely areas where we believe that our products would add value outside of the AT&T footprint and probably outside of North America, but there’s nothing to really talk about at this point in those type of areas.

Operator

Your next question comes from Jim Suva – Citigroup.

Jim Suva – Citigroup

I have a quick question about the new agreement with Ericsson and the vendor domain with AT&T. Can you comment and confirm is the DSLAM product incremental in addition to the typical work that you’re doing for AT&T? Is that an additional layer or is that already included? And if so can you help us maybe quantify so people don’t get you know numbers too aggressive about what that type of opportunity is?

Thomas R. Stanton

And so it’s much easier for me to answer the first question than the second, but let me give it a stab. First of all the relationship with Ericsson for the AT&T award is incremental to everything that we have talked about prior to this conference call. So all of the TA 5000 awards, some of which I’ll just remind people don’t deliver until at this point in time, and you know how dates are with big projects like that, but at this point in time they don’t deliver until, some of them don’t start delivering until middle of 2010, those are all in a separate bucket between us and AT&T.

This new piece is a different product set. There’s a lot of potential there. We went after it aggressively early on. We’ve been working with AT&T for quite some time on what the potential of our other products could be into their network, so there’s a lot of potential there but I really can’t give you much more granularity on that at this point in time. Especially with the fact there’s still an awful lot of IT work to be done. And the scope of projects can change during the course of that IT work.

Jim Suva – Citigroup

And then maybe just a quick housekeeping follow up question. With revenues seasonally being down, which is pretty typical you know the range that you gave, can you comment a little bit on what we should expect for the margins because of your product mix you know can really change margins a little bit as well as expediting shipping costs? And then finally on tax rate, should we expect a kind of more normalized tax rate into the you know 34 to 35% range or does the R&D credit continue to play out for the foreseeable future?

James E. Matthews

Hi, Jim. This is Jim Matthews. In terms of the tax rate, I’ll hit that one first. So we anticipate Q4 will be a more normalized tax rate, something closer to 34%. Okay? In terms of the gross margin we’re anticipating high 50’s but we do at this point believe that gross margins will be slightly up from Q3 levels.

Jim Suva – Citigroup

Great.

James E. Matthews

That is what we anticipate at this point.

Operator

Your next question comes from Paul Silverstein - Credit Suisse.

Paul Silverstein - Credit Suisse

Jim, can you give us the 10% customer breakdown?

James E. Matthews

Sure Paul. AT&T 24%, Verizon 10% and Qwest 20%.

Paul Silverstein - Credit Suisse

And a lot of the Qwest is the fiber roll out?

James E. Matthews

Yes.

Paul Silverstein - Credit Suisse

Secondly, going back to Ericsson for a second, Tom is the Ericsson one project or is it multiple projects? And I understand the revenue won’t hit for a while but when it does, because you’re selling through Ericsson does it change the margin structure?

Thomas R. Stanton

I wouldn’t say it was one project. It was one RFP which covers a need which you know it’s broadband related, so I’m not sure how you characterize it any different than that.

Paul Silverstein - Credit Suisse

I understand it’s for in the Hurricane Katrina type situation but I was just wondering if under that RFP if there were other projects beyond the hermetically sealed platform you have?

Thomas R. Stanton

Yes. It’s not a Hurricane Katrina type situation. It’s actually for specific allowing towns for BDSL broadband deployment. So the hermetically sealed really doesn’t play into what it’s for, although it does change the cost profile of deployments in those in particular line accounts. As far as the margins question we’re expecting to be able to ship that kind of corporate average type margins by the time all is said and done.

Operator

Your next question comes from [Steve Salkoff] for Kenneth Muth - Robert W. Baird & Co., Inc.

[Steve Salkoff] for Kenneth Muth - Robert W. Baird & Co., Inc.

Just observing the strength in Optical and the softness in HDSL I wanted to dig into the comments, Jim you made on customer balancing urban versus non-urban areas for backhaul, and I guess I want to get a sense are you indicating it would be incorrect to kind of infer from the product mix that there is any sort of accelerated transition away from HDSL and towards next gen backhaul? Maybe it’s more a function of which markets are being targeted or how should we think about that?

James E. Matthews

Well, we do think it’s a part of what markets are being targeted. But you know we certainly do acknowledge that over the longer term HDSL will be replaced by different technologies.

[Steve Salkoff] for Kenneth Muth - Robert W. Baird & Co., Inc.

But I guess have you seen is there an accelerated shift or was there anything that changed?

James E. Matthews

I don’t think so at this point.

[Steve Salkoff] for Kenneth Muth - Robert W. Baird & Co., Inc.

Okay. Great. Thanks.

James E. Matthews

Well, let me add my color to that if you don’t mind. We saw them actually build out HDSL pretty aggressively, whatever customer we’re talking about, pretty aggressively in the third quarter of last year really kind of carrying into the first quarter of this year. And those sale sites were specific line numbers and they were trying to increase the bandwidth to those. We then have subsequently seen them shift to higher line sale sites or higher line count sale sites and you saw pickup in our Optical Access business due to that. I do think that they are still looking at trying to add more bandwidth and that means as they add more bandwidth some sale sites that were traditionally HDSL will flip that switch, you know that bandwidth switch over to fiber. So to the extent that they accelerate the bandwidth demand that does accelerate that flip of the switch but we don’t see a change in overall fundamental deployment on what they’re trying to accomplish.

Operator

Your next question comes from Sanjiv Wadhwani - Stifel Nicolaus & Company, Inc.

Sanjiv Wadhwani - Stifel Nicolaus & Company, Inc.

A quick question on Qwest. The sequential decline from June to September was actually fairly minimal, in fact it was almost flat sequentially. What are sort of expectations in Q4? I’m expecting it would be down but just any magnitude would be helpful.

Thomas R. Stanton

At this point in time and they can change but at this point in time I would say if you look at the profile of last year that may not be a bad profile to look at.

Sanjiv Wadhwani - Stifel Nicolaus & Company, Inc.

Was the Qwest strength a little bit better than you had expected in September?

Thomas R. Stanton

No, it was about what we expected.

Sanjiv Wadhwani - Stifel Nicolaus & Company, Inc.

And then HDSL, what are you expecting that to be in Q4?

Thomas R. Stanton

Well we had you know two mild quarters in the last two quarters and at this point in time we’re kind of expecting to be about that same. So you know we may be surprised to the upside, and I think we’d be really surprised to see any significant downside to the last two quarters, so we’re kind of thinking flattish.

Operator

Your next question comes from Nikos Theodosopoulos – UBS.

Nikos Theodosopoulos – UBS

So I might have missed it but did you give any sense of what operating expenses will do next quarter as revenues decline? Do you expect to manage them or keep them flat or expanding them?

James E. Matthews

Nikos, this is Jim. We’re actually expecting OpEx to be slightly up for the fourth quarter as we begin new customer projects.

Nikos Theodosopoulos – UBS

And a question on the comments regarding Ericsson and international, you know I think historically I think the company has tended to shy away from you know deals with larger equipment companies and expanding its international business. You know its been more of a direct approach and you know probably with limited success. Do you view this as a change in strategy now, where you will look to do more of these type of deals internationally? Or do you see this as a one off and you’re just going to look for Ericsson to drive it? Or how should we look at this?

Thomas R. Stanton

First of all, we have although its not maybe been as public as you know normal information, we have historically done business with OEMs. If you name the top five OEMs in our space they either all have or do OEM products from us today. And some of our early international success, some of our early entries into [Telstro] were with Lucent back when it was just a Siemens, we used to sell gear to Siemens. So we have but we never really have had a product fit that wasn’t a relatively small niche. So we never really saw a big impact from that.

We do think that the products that we’re talking about today have a broader appeal than what we’ve done in the past. And we’re just as open as we ever have been to just trying to find the right channels to market, whether they’re direct or indirect. So I think the products are different. I think our openness really hasn’t changed and I do believe we have been open to that and the potential here is different though.

Nikos Theodosopoulos – UBS

I know historically you’ve found it difficult to give a percentage but as time goes on here and it seems like you have a better feel for what’s happening in these sell site deployments, do you have a rough estimate if we look at your entire revenue base what percentage of your business is actually tied to these wireless deployments?

Thomas R. Stanton

Unfortunately not, although traditionally we have said kind of mid to high 20’s in HDSL, and that was going back maybe two to three years ago. No doubt that when we saw the uptick in the back half of last year and early this year that that percentage went up but I can’t tell you how much because we don’t have access to that information ourselves. I will tell you that a lot of the upside, probably a majority of the upside that we saw in Optical Access without a doubt was going to sell side. So I can tell you that percentage has grown substantially over the last three years, but I would just be guessing if I tried to put a real figure on it.

Operator

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

Vivek Arya - BAS-ML

A couple of questions, first Qwest has been a very important customer for you in the past two years. How much life do you see left in that project? You know maybe if you can give us a sense for how much of the project is completed. Are you halfway done? Are you three-quarters done or is it still very early in that project?

Thomas R. Stanton

I think that’s a tough question for me to answer without me getting in trouble with my customer. If I step back a little bit if you’ll allow me and say Fiber-to-the-X products, so the 1100 Series products in North America, say that we are you know we’re less than a quarter through. So you know we’re definitely not to the halfway point from where we think those products will be built out in North America.

Vivek Arya - BAS-ML

But do you see the same pace of build out as you saw in 2009 for instance? Qwest this year I think was over 20% of sales, and I think last year it was more like 15%, the year before it was more like 10%. So do you this growth from this point or do you see some sort of stability at these levels?

Thomas R. Stanton

We see growth at this point. Try not to gravitate towards a specific what’s going to happen at Qwest, but we see growth at this point not just from our current customer base but we also see growth because other customers are intrigued with the way that Qwest has been able to build out an incredibly cost effective network that has an awful lot of capabilities. So the net answer is we expect the 100 Series products to continue to grow, not just in the customer base that it has today but also in the customer base that we have maybe some penetration but they really haven’t you know put the gas on on really trying to upgrade their networks yet.

Vivek Arya - BAS-ML

One question on operating expenses, some of your competitors I think CNM, ABC, etc., have spoken about freezing operating expenses as they start looking at growing top line next year. I’m curious what your plans are as you look at a lot of new activity heading into next year.

Thomas R. Stanton

Well first of all we were able to manage our expense lines going through this downturn without doing any headcount reductions, so our R&D staff remained intact and in fact if I look year-over-year we were actually able to grow our R&D staff in a meaningful manner through this downturn and be able to maintain our expenses. So we may not be in the same position as everybody else out there in the space.

If I look at Q4, in the near term you know we’re still making sure that the ground is solid. I think that we feel much better this quarter than we did last and if you’ll recall we felt better last quarter than the previous quarter. The slight uptick that Jim was talking about is more in relation to project oriented things like Telcordia where we’ve got some work to do for some customer wins that you’ll see you know an uptick in expense on that particular line. And to the extent the other pieces may offset that we’ll just see. So not a big increase at this point in R&D. You know continually adding on as we need to add on and then as we move into next year we’ll talk about it then.

Vivek Arya - BAS-ML

Your pretax margins are around 24% and I think in the past you have signaled the target of around 25% if I’m not mistaken. I’m just wondering if those are still the right assumptions to make as I look at the business model. Thank you.

James E. Matthews

Sure, Vivek. This is Jim. The mid-20’s remains our target, our long term target.

Operator

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

Greg Mesniaeff - Needham & Company

Looking at your large customers, they totaled I guess 54% of revenues, the Tier Ones. You’ve obviously made a significant attempt to move into the Tier Two and Three markets. Can you talk about how assuming that continues how that should alter your sales and marketing strategy and organization?

Thomas R. Stanton

Sure. Some of it is going to be a little bit historical because we actually made that move some time ago. We geared up our Tier Two and Three sales force my guess is probably three to four years ago and really started seeing some incremental wins. Now you know in a recessionary period you know with revenues still being down it’s hard to kind of just highlight those but we really made a good splash into that space over a long period of time. And a lot of the 5000 noise that you’re hearing about is because of that. So we have a separate sales force now that calls on them. We’ve substantially increased our marketing efforts, geared specifically toward that Tier Two and Tier Three market. If you go on our website for instance you’ll see an awful lot of information there, probably the best website available on the stimulus package and what needs to be done and how we can help.

So I think we’ve gone through a lot of the heavy lifting at this point in time. We may incrementally add over time and that space continues to have good momentum.

Greg Mesniaeff - Needham & Company

I guess my question was, are you seeing a continued increase in that non-Tier One base? And as that happens, what changes can we expect?

Thomas R. Stanton

We expect the continued positive movement there, so as far as changes I’m not sure what changes you’re talking about. If you’re talking about from an expense line?

Greg Mesniaeff - Needham & Company

Yes.

Thomas R. Stanton

I would say that it would incrementally grow with that revenue base growing, but probably at a slower rate because we’ve already made an awful lot of investment there.

Greg Mesniaeff - Needham & Company

On the topic of component costs you made some comments about Optical component pricing as your product mix you know shifts into that direction. What about some of your more traditional silicon costs you know related to HDSL and any commentary there?

Thomas R. Stanton

Yes, I don’t think Jim specifically said Opticals pricing was up. I think he talked about the fact we had to do an awful lot in a short period of time which means we expedited an awful lot.

Greg Mesniaeff - Needham & Company

Got it.

Thomas R. Stanton

In general our commodity pricing is stable.

Operator

Your next question comes from Chandan Sarkar - Auriga USA.

Chandan Sarkar - Auriga USA

My question is regarding the backhaul congestion that’s going on from some of the wireless carriers in the United States and I’m guessing this should give you a lift on your HDSL business. I know that’s been weak for other reasons and I’m just kind of curious if most of that benefit is already behind you or if most of it is ahead. And if it’s ahead of you is this like a multi-quarter thing, a multi-year thing or is it fairly compressed into the next few months?

James E. Matthews

Chandan this is Jim. Let me take a shot at that. We think we’re still you know on the front end of wireless capacity expansion, whether it be fiber or copper, and Ethernet over copper as well. So we think it’s a multi-quarter sort of thing. There’s going to continue to be fluctuations from quarters. There normally are.

Thomas R. Stanton

Yes. Specifically in my comments, Chandan I talked about the fact that Optical we expect, you know what we saw in Q3 was kind of the relatively early phase of deployment on some things that people are doing with Optical Access to sell side. So we would expect it to last. It’s definitely in the quarters if not the years.

Chandan Sarkar - Auriga USA

And just as a follow up to that, you know you guys have nearly 100% market share now I guess in HDSL. Can you sort of give us a rough ballpark if AT&T or Verizon choose to go more of a fiber route in any particular area on their backhaul, what kind of market share do you have there versus obviously the monopoly you have on HDSL?

Thomas R. Stanton

That’s a tricky one to answer because there’s an awful lot of competitive wrangling that’s going on. I would say in certain areas we have in excess of 50% and in some areas we have less than 50%.

Chandan Sarkar - Auriga USA

Do you think that’s mostly going to be Ethernet over Sonnet or some other architecture?

Thomas R. Stanton

In the near term you’ve going to see TDM over Sonnet, Ethernet over Sonnet and then you know longer term you’re liable to see, carriers are doing different things as you know.

Operator

Your next question comes from [Ari Benzinker] – Standard and Poor.

[Ari Benzinker] – Standard and Poor

Besides for the direct benefit from the broadband stimulus package during 2010, do you see the potential for the release of some pent up demand from carriers that may be held up spending projects in the hopes of funds but did not qualify?

Thomas R. Stanton

Yes. The answer is yes because I think that that market, that Tier Two, Tier Three market some of the players in that market kind of went on a diet going into this year, and definitely in the first half of this year, trying to see how they would position themselves for broadband spend. Some of those carriers have no intents at this point in time. They may not qualify or whatever rational reason they have as to not going after it. And those carriers that we’re in discussions with are talking about how they’re going to move forward with broadband expansion outside of the stimulus plan. So the short answer to your question is yes.

Operator

Your next question comes from Lawrence Harris - C. L. King & Associates, Inc.

Lawrence Harris - C. L. King & Associates, Inc.

I know this may be a difficult question to answer but you know what do you think your addressable market in terms of the broadband stimulus you know could be? You know obviously you know none of the winners have been announced. There could be a number of different approaches used. But you know how much do you think you could see in the way of revenues from this say over the next three years or so?

James E. Matthews

Larry this is Jim and that’s a very difficult question to answer as you suggested. You know we believe that over the years particularly over recent years we’ve built awareness in that group of customers. You’ve seen several announcements over the last few months in the terms of awards that we’ve had with that group of carriers as evidence of us building awareness. We think that our market share in that group will continue, drop in stimulus related projects or non-broadband stimulus related projects. We continue to build awareness specifically for broadband project funds as we sit here today and we will continue to do that through next year.

Thomas R. Stanton

Let me add one other little point there. I mentioned prior to this but it may not have gotten completely across and that is that the broadband stimulus funds that we’re talking about today, which were the $7.2 billion they have to be spent by September 30 of next year. So that piece will be done, although once you get chassis installed there’s incremental pieces on top of that. And whether the government decides to do something beyond that is still a debate, too. So a large chunk of that kind of spending then will happen next year.

Lawrence Harris - C. L. King & Associates, Inc.

And any you know comments regarding you know share repurchase? You know it’s been running I guess at a level below last year’s rate.

James E. Matthews

Right. Last quarter as you point out we purchased about 60,000 shares at an average price of $22.39. We will continue to be opportunistic. We continue to have about 3.3 million shares remaining in the program.

Lawrence Harris - C. L. King & Associates, Inc.

So you see it continuing at the current pace?

Thomas R. Stanton

Yes, yes, but again we continue to be optimistic. I mean the pace may vary from quarter-to-quarter, but we expect that the program will continue.

Operator

Your next question comes from [Paul Valentine] for Simon Leopold - Morgan, Keegan & Company, Inc.

[Paul Valentine] for Simon Leopold - Morgan, Keegan & Company, Inc.

A couple of questions on the TA 5000, I’m wondering if it’s crossed 10% of sales yet. I believe you mentioned it was above 5% last quarter. And how dependent is the fourth quarter level, I believe you called for TA 5000 revenues to be up sequentially but maybe you can clarify that for me. How dependent is that on revenue recognition versus new shipments?

Thomas R. Stanton

Revenue recognition, I think all of the [inaudible] right now.

James E. Matthews

Right. Right. The vast majority of TA 5000 shipments are recognized as revenue upon shipment. In terms of the level of revenue we are sequentially up in Q3. We have not yet passed the 10% mark but we’re very close to it.

[Paul Valentine] for Simon Leopold - Morgan, Keegan & Company, Inc.

And could you clarify did you call for an increase in Q4?

Thomas R. Stanton

Yes.

[Paul Valentine] for Simon Leopold - Morgan, Keegan & Company, Inc.

And in 2010 what proportion of the TA 5000 opportunity comes from, and again this is just trying to get your sense from Enterprise Ethernet versus wireless backhaul versus FTTN or FTTP? And are there other material applications we should be thinking about?

Thomas R. Stanton

Well I think all of the applications that you mentioned are applications that we’re shipping today. And those should grow over time, Paul. Does that answer your question? I’m not [inaudible].

[Paul Valentine] for Simon Leopold - Morgan, Keegan & Company, Inc.

Yes, that helps. And just one last one if I may and I apologize if you addressed this earlier, you know pulling on the Ericsson discussion earlier, if you sell products through a partner how should we think about assessing the impact on your gross margin?

Thomas R. Stanton

Yes, this is Tom. We did address that earlier and the answer was we expect over the long term, and I don’t mean by long term you know three or four years, I mean relative and we do typically have some costs right out of the gate that impact significant projects like this. But over the long term we expect it to be at the corporate average.

Operator

Your next question comes from Ehud Gelblum - Morgan Stanley.

Ehud Gelblum - Morgan Stanley

Markets, if we look at Internetworking and Net Vanta and then we look at Optical Access, Tom I think you said on the Optical Access side that there were some market share gains. That market itself clearly growing a lot. And on the Net Vanta side, for both of them if you could parse out how quickly you think each of those markets is growing versus how much gain are you getting from market share gains? Interested on the Optical Access side to see how fast the market’s growing as well as on the Net Vanta side to see is there any market growth there or are you achieving more from market share gains versus growth?

Thomas R. Stanton

Yes, I’m probably unfortunately not going to give you as much insight as you’d like. But that has to do with the situation we’re in. So we are to the Tier One customer, and I say Tier Ones because we have a couple of Tier Ones that we’re selling Optical Access to, we’re a relatively new entrant. So we will go into an area and many of these sales are region by region, so I can take a look at a region and say a quarter ago I had 20% market share, this quarter I have 55% market share. And I can look at it from that perspective. You may look at it well I was already into that Tier One anyway. And I don’t have that granularity across all the markets.

We are confident we gain market share in each of those regions. We’re also fairly certain that the market itself has grown in each of those regions. But I don’t know if I can be much more granular than that.

Ehud Gelblum - Morgan Stanley

So in the places where your market share has not grown and you haven’t taken new footprint, you’ve still been increasing?

Thomas R. Stanton

Yes. As well as in all of the cases in Tier One we have gained market share. If I take those aside and then look at the Tier Twos and Tier Threes, mainly the Tier Twos, Tier Threes there’s just not an awful lot of Optical that happens there. It’s hit or miss. Some the markets are growing, some the people are still doing some studying. So I would say that the market share growth that we’ve seen has been by far predominantly in the Tier Ones.

Ehud Gelblum - Morgan Stanley

What about the Internetworking side?

Thomas R. Stanton

Internetworking side predominantly market share gains. I would say we haven’t seen a real kind of inflection point or change in the overall environment. It does continue to get better. We’ve got new products that have come online that have allowed us to grow market share in areas that we weren’t necessarily the approved product or approved in that particular application. So I would say it was predominantly market share gains.

Ehud Gelblum - Morgan Stanley

Enterprise spending has not really picked up that much?

Thomas R. Stanton

You know it really hasn’t picked up that much for us. I won’t say that’s true for everybody but I would say the environment continues to get better. So I mean it probably is better, but I’d say it’s marginally better.

Ehud Gelblum - Morgan Stanley

And then finally on Ericsson, if you can just give us a little insight into how that process sort of evolved. Did you go into this RFP alongside them into AT&T? Or did they go into the process and then either on the suggestion of AT&T [audio impairment] themselves or from Ericsson come find you and say we need to fulfill this particular [audio impairment] of the RFP, we’d like you to do it? And in addition to this is there a preferred partner list there that you are now on that could potentially lead to additional joint projects?

Thomas R. Stanton

A load of really specific questions. I’ve answered before that we had been proposing the capabilities of our product line to AT&T for some time and had been working with them for some time on what we thought our products could do. And so the RFP and the requirements for the RFP you know we were hopeful that they would include some of the processes that we had and therefore that would make the domain strategy impact in this particular instance negligible. And I’d like to just kind of leave it at that.

Operator

Your next question comes from Bill Dezellem - Tieton Capital Management.

Bill Dezellem - Tieton Capital Management

You had referenced that there was a difference in terms of your HDSL success whether the carriers were expanding their sell side capacity and urban versus non-urban environment. I apologize for the rudimentary level of the question but would you please discuss kind of what and why the impact is different with the urban versus non-urban?

Thomas R. Stanton

Yes. The language there is not as crisp as we’d like. I think the way to look at is dense populations or dense sell side areas versus non-dense sell side areas. So where there’s an awful lot of density the bandwidth requirements in that particular sell side necessitate higher speeds and fiber connectivity. So we saw an increase in fiber connectivity which you can tie directly back to a focus on trying to increase the capacity of dense sell side which are typically in urban areas. Does that answer your question?

Bill Dezellem - Tieton Capital Management

Yes, I believe so. And therefore in the urban areas as that capacity expansion is taking place, that tends to be where you get your HDSL revenue increases from.

Thomas R. Stanton

Well that would be for fiber optics. So in urban areas where let’s say downtown New York, those sell sides are probably not connected up with HDSL. So where they’re going and adding capacity and that may be swapping products out or it may be they just kind of flipped the switch over to going to add from 8 T Ones to 12 T Ones or whatever they say okay at this point in time I need to go ahead and add fiber to that particular site. So see they’re adding incremental bandwidth which may be more fiber or converting to fiber or upgrading the speed of the existing fiber, but those typically happen in more urban and denser sell sides. For less dense sell sites you would still see them adding HDSL.

Operator

Your next question comes from Andrew Schopick - Nutmeg Securities.

Andrew Schopick - Nutmeg Securities

Tom, I’m going to ask you if you would care to comment on the current situation regarding Telstra and the Australian government. As you know Telstra’s not very happy with the proposed changes that the Australian government is trying to make to their telecommunications laws and there’s a very large national broadband network built out that’s you know planned. I wonder how this is affecting your current business with Telstra, whether you care to give any just general commentary and what you see playing out there.

Thomas R. Stanton

I think you have to have an incredibly good crystal ball to be able to say what’s going to happen there because that’s been a very fluid situation for almost four years now. I will say that we’ve seen some positive things come from it and that is if you’ll recall and it may be roughly four years ago we had another vendor, a very large vendor, that had come in and in effect was going to sole source their entire network. That of course put some of the business that we had there at jeopardy. That hasn’t come to fruition. There’s been an awful lot of ins and outs both from a vendor perspective and from a [inaudible] perspective within the various organizations. And at this point in time we’re actually more hopeful of being able to get our business Ethernet products into the network and I think some of that is a result of what’s going on there and the fact that the delays of this process have forced or really pushed some of the parties to go ahead and do something.

So that’s been a positive. As to how it’s going to turn out, I mean there’s an awful lot of political and business motives that are going on there that I wouldn’t try to speculate on.

Andrew Schopick - Nutmeg Securities

Tom, can you comment at all about the current level of anticipated product sales to Telstra and what you might anticipate in 2010 based on the current situation?

Thomas R. Stanton

You know if you ask the question on the fourth quarter and we’re talking about next year I’ll try to address it. I’d rather not do that today. I’ll talk to you about our current revenues there and our current revenues there are basically flat. They vary from quarter-to-quarter but if you look at it from a longer term snapshot they’re basically flat. We think the things that are going on there are incrementally positive, so one is they add life to our product because at this point in time we’re selling a broadband server that’s ATM based. Our mission has been for some period of time to move that service and to start selling them a Ethernet based product and I think we’re very close to success there. And that will play itself out. But as far as the incremental add to the revenue next year I would rather wait.

Andrew Schopick - Nutmeg Securities

Fair enough. Thank you.

Thomas R. Stanton

Vanessa I think one more question.

Operator

Yes sir. Your last question comes from Brian Coyne - Wedge Partners.

Brian Coyne - Wedge Partners

Just a quick one to follow up on the gross margin outlook for the fourth quarter, again would you say that that’s prominently or predominantly because some of the expedite costs that you experienced in 3Q won’t recur? And then looking ahead could you hazard a view perhaps in the next year, particularly with the impact of the broadband stimulus?

James E. Matthews

Well in regards to the fourth quarter, we do believe that a slight increase in gross margin would be the result of less expedite. In regards to 2010 we’re still anticipating a high 50’s range in terms of gross margins with the broadband stimulus. Hopefully that answers your question.

Brian Coyne - Wedge Partners

Yes that’s great. Thanks.

Thomas R. Stanton

Well thank you, Vanessa and thank you everybody for joining us on our call and we look forward to talking to you next quarter.

Operator

This concludes today’s conference call. Thank you for your participation. You may now disconnect.

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