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Executives

Thomas R. Stanton - Chairman and Chief Executive Officer

James E. Matthews - Chief Financial Officer, Principal Accounting Officer, Senior Vice President of Finance, Treasurer, Secretary and Executive Director

Analysts

Roderick B. Hall - JP Morgan Chase & Co, Research Division

Amitabh Passi - UBS Investment Bank, Research Division

Michael Genovese - MKM Partners LLC, Research Division

Eric A. Ghernati - BofA Merrill Lynch, Research Division

Simona Jankowski - Goldman Sachs Group Inc., Research Division

Timothy J. Quillin - Stephens Inc., Research Division

Richard Valera - Needham & Company, LLC, Research Division

William J. Dezellem - Tieton Capital Management, LLC

Paul Silverstein - Cowen and Company, LLC, Research Division

ADTRAN (ADTN) Q3 2013 Earnings Conference Call October 9, 2013 10:30 AM ET

Operator

Ladies and gentlemen, thank you for standing by, and welcome to ADTRAN's Third Quarter 2013 Earnings Release Conference Call. [Operator Instructions]

During the course of the conference call, ADTRAN's representatives expect to make forward-looking statements, which reflect management's best judgment based on factors currently known. However, these statements involve risks and uncertainties, including the successful development and market acceptance of core products, the degree of competition in the market for such products, the product and channel mix, component costs, manufacturing efficiencies and other risks detailed in our Annual Report on Form 10-K from the year ended December 31, 2012, and Form 10-Q for the quarter ended June 30, 2013. These risks and uncertainties could cause actual results to differ materially from those on the forward-looking statements, which may be made during the call.

It is now my pleasure to turn the call over to Mr. Tom Stanton, Chief Executive Officer of ADTRAN. Sir, please go ahead.

Thomas R. Stanton

Thank you, Steve. Good morning, everyone. Thank you for joining us for our third quarter 2013 conference call. With me this morning is Jim Matthews, Senior Vice President and Chief Financial Officer.

I like to begin this morning by discussing the details behind our Q3 results, and I'll end with some comments on what we see for the future. As stated in our press release, revenues for the quarter were $177.4 million, exceeding our initial estimates. Highlights in this quarter included a significant increase in our European business and continued strength in our Enterprise business. Our Carrier Networks division revenues came in at $141.3 million, showing an increase on both a sequential and year-over-year basis. The Broadband Access category led this increase as we realized initial shipments to a large European carrier of our newly introduced vectoring products. Our Enterprise division Q3 sales totaled $36.1 million, a strong 20% year-over-year increase driven by our Internetworking category, which on a combined product basis, including both Enterprise and Carrier products, grew 22% year-over-year. Total company domestic revenues came in at $113.2 million, with International revenue coming in at a record $64.2 million.

On a product basis, our core product areas, which include Broadband Access, Internetworking and Optical, reached an all-time record of $158.1 million, representing a record 89% of total company revenues. More specifically, Broadband Access achieved $98.1 million in revenue bolstered by increasing shipments in GPON and initial vectoring technology shipments to Europe. U.S. shipments of our IP DSLAM and Fiber-to-the-Node products remain stable on a year-over-year basis, but were down sequentially due to timing associated with Tier 2 and Tier 3 Broadband Stimulus project completion and the associated revenue recognition, as well as an overall tepid environment. The strongest product areas were the hiX 5600 platform, followed by the Total Access 5000 platform and our 1100 Series Fiber-to-the-Node products.

Moving on, our Internetworking product category came in at $43.3 million, showing solid year-over-year growth in all major product areas. Highlights for the Enterprise division included the initial launch of our hosted Voice over IP service at a Tier 1 carrier, and the selection of our Bluesocket virtual Wi-Fi solution at another Tier 2 carrier for hotspot deployment. Finally, during the quarter, we launched our ProCloud hosted Wi-Fi service to the broader market here in the U.S.

From a channel perspective, we continue to see strong demand for new dealers joining our team. During the quarter, we yet again added approximately 100 new ADTRAN VARs, continue our effort of making ADTRAN products easily available to the Enterprise market. The division experienced an increase in sales through both its U.S. VAR channel, as well as its Carrier distribution network on both the year-over-year and sequential basis. Finally, our optical revenue saw improvement on both the year-over-year and sequential basis, coming in at $16.6 million, helped by increasing broadband-related shipments and increasing market acceptance of our optical network-edge product line. During the quarter, we received our first major Tier 2 transport award for our ONE product line.

From an overall perspective, the customer environment in the third quarter was very similar to what we saw in the second, with Enterprise activity improving, and the Carrier business on a macro level, stable with some areas of strength. In the Tier 1 space, our major projects remain on track with significant shipments of our vectoring technology having begun in the third quarter. As I previously mentioned, we do expect seasonality to affect our quarter-to-quarter performance; however, we expect the project to grow meaningfully next year and to continue to contribute materially over the next several years.

In the U.S., the major Tier 1 award we have previously spoken about remains on track with shipments expected to begin around the middle of next year.

In the U.S. Tier 2 and Tier 3 markets, we believe the USF to CAF transition continues to hold promise as more carriers have embraced the revised SEC funding regulations.

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

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

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

James E. Matthews

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

Optical product revenues for Q3 of 2013 were $16.6 million compared to $16 million for Q2 of 2013 and $11.2 million for Q3 of 2012. Carrier Systems revenues for Q3 of 2013 were $120.8 million compared to $105.5 million for Q2 of 2013 and $111.6 million for Q3 of 2012.

Business Networking revenues for Q3 of 2013 were $44.2 million compared to $45.4 million for Q2 of 2013 and $36.6 million for Q3 of 2012. Loop Access revenues for Q3 of 2013 were at $12.4 million compared to $11.3 million for Q2 of 2013 and $13.9 million for Q3 of 2012.

HDSL product revenues for Q3 of 2013 were $11.5 million compared to $10.3 million for Q2 of 2013 and $12.9 million for Q3 of 2012. As a result of the above, Carrier Networks division revenues for Q3 of 2013 were $141.3 million compared to $123.3 million for Q2 of 2013 and $131.9 million for Q3 of 2012.

Enterprise Networks division revenues for Q3 of 2013 were $36.1 million compared to $38.9 million for Q2 of 2013 and $30.2 million for Q3 of 2012. International revenues for Q3 of 2013 were $64.2 million compared to $34.7 million for Q2 of 2013 and $49.2 million for Q3 of 2012.

To provide the reporting of each of these categories, we have published them in our Investor Relations webpage at adtran.com.

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

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

Stock-based compensation expense, net of tax, was $1.9 million for Q3 of 2013 compared to $1.8 million for Q2 of 2013 and $2 million for Q3 of 2012. Supplemental information for acquisition-related expenses, amortizations and adjustments in connection with recent acquisitions are provided in our operating results disclosure.

All other income, net of interest expense for Q3 of 2013 was $2.8 million compared to $2.8 million for Q2 of 2013 and $3.4 million for Q3 of 2012. The company's income tax provision rate was 18.9% for the third quarter of 2013 compared to 32.4% for the third quarter of 2012. The lower tax rate for the third quarter of 2013 partially relates to significantly improved profitability of the acquired Broadband Access business.

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

Non-GAAP earnings per share exclude the effect of acquisition-related expenses, amortizations and adjustments related to acquisitions and stock compensation expense. The reconciliation between GAAP earnings per share diluted, and non-GAAP earnings per share is provided in our operating results disclosure.

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

Unrestricted cash and marketable securities, net of debt, totaled $425.3 million at quarter end after paying $5.2 million in dividends and after repurchasing 0.6 million common shares for $14.2 million.

Due to the book-and-ship nature of our business and the timing of near-term revenues associated with large projects, it is our policy not to give specific guidance for the quarter or for the year. However, we would like to give color to help you formulate your views on our near-term business outlook.

We typically experience seasonal declines in revenues in the fourth quarter of the fiscal year. For the fourth quarter of 2013, we expect total company revenues will decrease sequentially in the range of high single-digit to low teens percentage points. We expect GAAP gross margins for the fourth quarter will be in the mid- to high-40s percentage point range, but higher than gross margins of 56.5% experienced in the third quarter. We expect GAAP operating expenses for the fourth quarter will increase slightly on a sequential basis. We anticipate a higher tax rate in the third quarter due to an expected sequential decline in revenues of the recently acquired Broadband Access business, which will result in reduced profitability. We expect the consolidated tax rate for Q4 to be in the mid- to high-30s percentage point range to pretax income. We believe the larger factors impacting the total revenue we realize for the fourth quarter of 2013 will be the following: The macro spending environment for carriers and enterprises; professional services activity levels, both domestic and international; the timing of revenue related to Broadband Stimulus projects; and the adoption rate of our Broadband Access platforms. Tom?

Thomas R. Stanton

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

Question-and-Answer Session

Operator

[Operator Instructions] And we'll take our first question from Mr. Rod Hall from JPMorgan.

Roderick B. Hall - JP Morgan Chase & Co, Research Division

I guess I want to focus in on the revenue guidance which is weaker than we had anticipated a little bit. Just to kind of get you guys to comment on what is -- what's happening there. It sounds -- it feels like Germany is actually -- or Europe, let's say, is actually going a little bit better, maybe than we had anticipated. So just wondering if you guys can juxtapose what's going on there with the overall revenue trajectory into Q4. I know you kind of flagged that this would be an issue last quarter as well. And then, my second question would just be on OpEx. Can you comment on -- whether you think you got further downward flexibility in OpEx. I think, you came in a little bit lighter than you had anticipated in this quarter. Is that something that you think you can -- continue to do as we look forward? It doesn't feel like it necessarily for next quarter, but just generally, what's your flexibly on OpEx?

Thomas R. Stanton

Sure. Let me talk a little about the revenue, I'll let Jim to cover the OpEx piece. On the revenue piece, we did talk about a decline in the fourth quarter. We've been talking about seasonality. The definition of seasonality depends on how far back you go, and we tried to give a range that kind of covered what we've seen over the last few years. The reality is, we still are very much a book-and-ship business, so we don't know what happens until it happens. Without a doubt, there was -- we had a strong Q3 with our European customer, and it's not yet fully known what their order pattern is going to be for Q4. They are a relatively new customer. Last quarter or last year, our first year, we actually did see a pretty significant pullback in Q4. And this year, we're expecting the same type of pullback. So that, plus the fact that it's a new project and we shipped an awful lot, leaves us just kind of cautious about the fourth quarter there. The only other big variable is, we do have, and I mentioned it a little bit in my notes, we have Broadband Stimulus projects that are hanging out there for completion, and the actual completion data on those always varies. So I think you're seeing us give a broader range than normal because of those 2 variables. Jim, you want to cover the...

James E. Matthews

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

Roderick B. Hall - JP Morgan Chase & Co, Research Division

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

Thomas R. Stanton

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

Roderick B. Hall - JP Morgan Chase & Co, Research Division

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

Thomas R. Stanton

Some of this has to do with the kind of where the budget situation moves. And of course, that actually moves around quite a lot, this time of the year, for many large carriers. I don't -- I'm not aware of anything that is regulatory, anything external that's driving their demand profile. They are full guns on deployment of vectoring technology and rehabbing their existing footprints. And that's all -- none of that has anything to do with -- what our cautiousness is in the fourth quarter.

Operator

We'll take our next question from the line of Amitabh Passi from UBS.

Amitabh Passi - UBS Investment Bank, Research Division

Tom, I guess, first question for you. I was hoping -- can you shed some light in terms -- or specifics, just in terms of your Broadband Access business in the U.S. It looks like overall U.S. revenues were down 11% sequentially. Just trying to understand some of the dynamics you might have seen in the quarter. And then any update on Telmex? And then Jim, just one quick one for you. Deferred revenues, can you just give us a sense on what's going on there?

Thomas R. Stanton

Yes, so first on the U.S. piece. I also talked a little bit about the revenue recognition piece on the Broadband Stimulus piece. And that was probably the biggest -- in fact I'm sure that was the biggest declining piece where we have revenue out there and projects out there and it's a matter -- has to do with the customer completion on that. We have targets for that, and they do vary from quarter to quarter. As far as the overall demand, I will tell you, we haven't -- if you look at the Tier 2 and Tier 3 space, it's pretty much the way it has been throughout the year. We saw a little bit of a pickup in second quarter. And it kind of has just been meandering. This may be the best word for that. The Tier 1 space, the real big pickup that we expect is when we actually start shipping the Tier 1 carrier that we have spoken about in the past. All of that is still moving forward at a very fast pace, and we feel good about that. At some point in time, with the CAF piece and with what's going on in general and kind of the general starvation of the network, we think the Tier 2s and Tier 3s will pick up, but we definitely didn't see that in the second quarter -- excuse me, third quarter.

James E. Matthews

Amitabh, in terms of your deferred revenue question, we have 2 pieces of deferred revenue. Basically, the short-term portion, which declined and the non-current portion, which I think was slightly up. But in net, it was down. In total, deferred revenues were down about $5 million from Q2. Those relate, obviously, to contracts globally, both domestic and internationally. Contracts that require us to set up deferred revenues and then those deferred revenues waterfall, so to speak, based on revenue recognition. There's nothing particularly unusual happening there. As we go forward over the longer term, as we enter contracts that require us to establish deferred revenue balances, that balance will continue to fluctuate. But certainly, this quarter was down as we recognize levels of revenue from those deferred revenue balances. So that's really the long and short of it.

Operator

We'll take our next question from Mr. Michael Genovese from MKM Partners.

Michael Genovese - MKM Partners LLC, Research Division

I have 2 questions. The first is, do we think that this quarter will be -- or third quarter, I should say, should be bottom for gross margins? Or is there a risk that as the European Tier 1 comes back next year and the U.S. Tier 1 starts in the middle of next year, that we could see gross margins down at this level or below again? And then secondly, there's a bigger sequential increase in Enterprise revenues than in Internetworking revenues. If you could just kind of explain what -- outside of Internetworking, what other products drove the Enterprise increase, that would be helpful.

Thomas R. Stanton

Let me cover the first, and Jim, I don't know if you have that in front of you on the Enterprise piece?

James E. Matthews

Yes, I'll address his question on Enterprise. So sorry, Michael, your first question again? Could you reask...

Michael Genovese - MKM Partners LLC, Research Division

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

Thomas R. Stanton

So let me take a stab at that, Jim, you could modify things. The shift that we saw -- we've been talking about third quarter being kind of the bottom of gross margins for some time now. And that had to do with the fact that we knew vectoring was going to start shipping in a big way and that the balance between the U.S. business and the European business would be tilted more heavily for the European business than it typically is. And that's still our thought. You'll see improvement in fourth quarter, you'll see improvement over this quarter. We don’t expect it to be at that same imbalance in first quarter either, and then you'll see DT start picking up again in the second quarter. At that point in time, we have other pieces of revenue that are coming in, as well as we have a cost reduction that is scheduled for some time about middle of next year with the European business. So current vision is that we're looking at the bottom right now. Jim?

James E. Matthews

Michael, in terms of your question on revenue trends, I just want to reconfirm something. Now, in terms of revenue recognition for EN, we're actually sequentially down, okay. With Internetworking we're sequentially down just a little. Okay? So Internetworking category was not down as much sequentially as EN because our Carrier Networks division has a certain amount of their revenues that relate to Internetworking products for their division, okay, for certain solutions that are deployed.

Operator

And we'll take our next question from Mr. Eric Ghernati from Bank of America Merrill Lynch.

Eric A. Ghernati - BofA Merrill Lynch, Research Division

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

Thomas R. Stanton

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

Eric A. Ghernati - BofA Merrill Lynch, Research Division

And I had 1 more question -- 2 more questions, please. I thought I heard you say DT should pick up in Q2, but initially, I believe the expectations were for a sequential decline in Q4, then a ramp back up in Q1. Is that not the case anymore or has something changed?

Thomas R. Stanton

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

Eric A. Ghernati - BofA Merrill Lynch, Research Division

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

Thomas R. Stanton

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

Operator

And we'll take our next question from Simona Jankowski from Goldman Sachs.

Simona Jankowski - Goldman Sachs Group Inc., Research Division

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

Thomas R. Stanton

The -- on the project piece, my sense is, those projects, some of them will get finalized. We really don't know the answer to that, that has to do with the budgeting and the workflow associated with the carriers. Some of them will be cleaned up this quarter, but I wouldn't say we would -- that we would be on the normal run rate that we experienced, for instance, in the second quarter until probably towards the tail-end of first quarter. That's just my guess right now, based off of kind of what we're hearing. On the market share pieces, we will pick some up. We did ship a little bit. We saw a little shift in third quarter. We'll pick some more up in fourth quarter, but I would expect those also to be kind of more towards next year. And that's kind of what we're forecasting right now if you look at our fourth quarter number.

Simona Jankowski - Goldman Sachs Group Inc., Research Division

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

Thomas R. Stanton

Yes.

Simona Jankowski - Goldman Sachs Group Inc., Research Division

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

Thomas R. Stanton

That's a really good question. We do know that there are -- that has the potential to hurt probably more of the CAF funding than on the Broadband Stimulus piece. And it can definitely slow down paperwork. I'm not aware because the slowdown that we saw on that was earlier in the third quarter. I'm not aware of any specific things, but I wouldn't tell you that, that's out of balance. But I will also tell you that -- kind of where our project completion timelines are right now, assuming they get this funding piece closed in the next 6 months, I think, we're okay.

Simona Jankowski - Goldman Sachs Group Inc., Research Division

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

Thomas R. Stanton

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

Simona Jankowski - Goldman Sachs Group Inc., Research Division

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

Thomas R. Stanton

Right. And 1 thing to note that happened is, we did see Tier 2s and a Tier 1 carrier step up for CAF Phase 1 in a meaningful way, where they were actually matching funds. All of those have to be done in the 3-year period of time, and most of those people are in the planning stages right now.

Simona Jankowski - Goldman Sachs Group Inc., Research Division

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

Thomas R. Stanton

Most of the margins improvements--we had picked up about 10 points since the acquisition of the business, and most of those margin improvements are baked in. We see incremental margin improvements pretty much every month on 1 piece or another piece, but the real meaningful stuff is going to be middle of next year.

Simona Jankowski - Goldman Sachs Group Inc., Research Division

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

James E. Matthews

We had 1 domestic 1, Simona.

Operator

We'll take our next question from Mr. Tim Quillin from Stephens Incorporated.

Timothy J. Quillin - Stephens Inc., Research Division

Would you be able to say what percent of revenue the 2 10% customers represented?

Thomas R. Stanton

Tim, not at this point.

Timothy J. Quillin - Stephens Inc., Research Division

Okay. So that will come out in the Q?

Thomas R. Stanton

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

Timothy J. Quillin - Stephens Inc., Research Division

Let me ask you this. Of the International revenue sequential increase, is that largely or fully attributable to your large European customer?

Thomas R. Stanton

They're definitely largely attributable to a large European customer.

Timothy J. Quillin - Stephens Inc., Research Division

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

Thomas R. Stanton

I think the thing that -- well, you're right, we have been pulling out expenses out of the R&D side. Actually it's been an ongoing process that we've been on. I don't see at this direct point in time, a meaningful decrease because of the R&D projects that we have going on with those 2 large carriers. So we have very stringent deliverables on the U.S. carrier that -- and it's a very broad product set that's looking at being deployed. So it takes multiple product areas and we just -- we have very right timelines around that. And the same thing with the European carrier. We have the initial phase of deployment, but there are additional technologies, things like system level vectoring, and I had mentioned before that we had won some more Enterprise-related business with that same very large carrier, and those right now are project-related R&D efforts. So I don't see a big step-down from here.

Timothy J. Quillin - Stephens Inc., Research Division

And would you expect to be able to hold operating expenses roughly at the same levels for a year or 2? So I understand not being able to bring those back, but maybe as you grow revenue be able to leverage those?

Thomas R. Stanton

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

Timothy J. Quillin - Stephens Inc., Research Division

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

Thomas R. Stanton

We literally have a redesign of several modules that are very high running modules and represent a large percentage of the total bill of material at the system. So they're actually new products that will be introduced into that network around the middle of next year.

Operator

And we'll take our next question from Mr. Rich Valera from Needham & Company.

Richard Valera - Needham & Company, LLC, Research Division

I wanted to follow up on some of the earlier gross margin questions. As I understand it, the NSN business was supposed to be at around the mid-40% gross margin level at this point. I know you've highlighted unusually low margin in this 3Q due to, I believe, primarily 2 factors. One is the mix of heavily chassis oriented and the other is expediting cost. And I'm wondering if you can give any sense of the relative pressure from those 2 factors, because doing some simple math, it seems like the margins on that business are probably closer to 30% than 45%. And just trying to understand how much of that is really one-time in nature or very short-lived in terms of expediting cost and how much might be -- take a longer term to recover.

Thomas R. Stanton

Let me -- and Jim may take issue with me on this, but let me give you kind of my view on it. So we were -- if you think about the business, the U.S. business being kind of in the -- let's say, in the 50s, low- to mid-50s type number, and our BBA business, we had talked about getting into the low 40s. That's kind of the baseline that I think you should work from. First of all, I think we're not -- if you think about the low 40s, I think we're closer to that number than the 30s on the BBA business. And we expect it to go up from there. So there was no doubt, there was a -- let's say, a few point -- not 5, but a few point impact because of the chassis shipment and the expedite charges, but I'd still say we're closer to the 40s than the 30s -- than the low 30s or 30%.

James E. Matthews

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

Richard Valera - Needham & Company, LLC, Research Division

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

Thomas R. Stanton

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

Richard Valera - Needham & Company, LLC, Research Division

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

Thomas R. Stanton

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

Richard Valera - Needham & Company, LLC, Research Division

Right. And just one more if I could. With respect to just your pipeline of global Broadband Access opportunities, you sounded pretty optimistic about that, Tom, in your prepared remarks. Any other color you could give us on that, and -- I know you don't want to try to predict wins, but do you think in the next, say, 12 months that you have potential to secure 1 or more additional really large deals? And I guess also, I'd say, do you have the capacity to handle them given -- it sounds like there's very significant sort of custom R&D associated with each 1 of these deals? Could you even handle another 1 or 2 DT, AT&T type deals without mentioning names?

Thomas R. Stanton

The answer to that question is yes. And I will tell you, the custom deals, I mean, we have 2 big projects. But there are many customers and the size gets much smaller, where they still need particular variations on feature sets. So the custom feature sets in the carrier business typically to the, not just for the largest ones, but also for the smaller ones. The difference with the large Tier 1 carrier we're talking about is, that it affects, because the rollout is -- and the award is very broad in the product set, it affects many different products. But we make those priority calls on a day-to-day basis, not just for those 2 customers, but for the additional customers. The answer to your question is yes. And in the next 12 months, can we -- do we think we can secure another one? Those are 2 very, very large ones. I can tell you, if you let me step down 1 level from those 2, because those are probably the 2 biggest going on in the world, then the answer to your question to that is yes.

Operator

We'll take our next question from Mr. Simon Leopold from Raymond James.

Unidentified Analyst

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

Thomas R. Stanton

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

Unidentified Analyst

Do you see, maybe, any opportunities for you to expand it outside that? Or just kind of in line with what you guys...

Thomas R. Stanton

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

Unidentified Analyst

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

Thomas R. Stanton

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

Operator

And we'll take our next question from Mr. Bill Dezellem from Tieton Capital Management.

William J. Dezellem - Tieton Capital Management, LLC

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

James E. Matthews

Bill, the -- first of all, to kind of give a brief overview of the rules. With a newly acquired business, the rules say that we're not in the position to take a, call it a tax benefit on losses that we've accumulated, thus far. However, when it flips to a profit in a particular quarter, okay, we are -- assuming that profit is not yet in excess of the accumulated loss, we don't take a tax charge or tax provision, okay? Now, as we develop a longer history in that business of profitability, the rate should normalize. But we're not quite outside that period yet, okay. So the tax rate for that business, once you get into a normalized profit run, is a little bit lower than statutory rates here in the U.S., to kind of give you a feel for it. But again, we're not in a position now to where we can recognize a normal provision or normal benefit from a quarterly loss until we're outside of that initial period of the situation that we're in now. Does that answer your question?

William J. Dezellem - Tieton Capital Management, LLC

I think so. So let me make sure that I'm clear. Since you're anticipating the European business to increase again in Q1 and Q2, it would -- it sounds like it would be reasonable to think that the tax rate for ADTRAN, as reported, would be lower in each of those quarters, but maybe about the time that the Tier 1 U.S. competitor or customer starts to ramp, you've also had enough history coincidentally in Europe. And so you see higher profits from the U.S., and you have your history in Europe, which means you go from that 0 tax rate on your profits to a normalized tax rate?

James E. Matthews

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

William J. Dezellem - Tieton Capital Management, LLC

Great. That is helpful. And then second area I would like to go down is the Tier 2, Tier 3 competitors. I believe that there were some comments that in terms of their spending, they're really starving their networks to -- you didn't say quite that strongly, but to some degree, and that also seems to tie with some delays with Broadband Stimulus. I guess, there are 2 questions inherent here. Are those 2 comments tied together and related? And then secondarily, doesn't that imply that there's a pent-up demand that then is beginning to develop?

Thomas R. Stanton

Well, I think they are. I think for some carriers, they are tied together, and maybe for other carriers, they're not. What we had typically seen is that, when people significantly reduce their spendings in the network, as they have over, let's say, the last 2 years or so, that they have to play catch-up. They play catch-up not only because competition has moved on, but because they've got to have competitive speeds and it affects not only the access portion of the network, but all the way through, including the transport piece. So, I think the answer to your question is yes.

William J. Dezellem - Tieton Capital Management, LLC

And that starving that they have done is a result of waiting for the Broadband Stimulus projects or are there 2 different things going on here?

Thomas R. Stanton

I think there are 2 different things going on. I think in general, we just saw capital pullback in that space. And I think it affected much of the carrier space. And then secondarily on -- for certain carriers, the Broadband Stimulus piece is kind of, maybe, exacerbated or -- let's say that CAF piece has, maybe, exacerbated the issue.

Operator

And we'll take our next question from Mr. Paul Silverstein from Cowen and Company.

Paul Silverstein - Cowen and Company, LLC, Research Division

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

Thomas R. Stanton

Jim?

James E. Matthews

Yes, I think that's the right range.

Thomas R. Stanton

So when you say Broadband Access, Paul, are you referring to the acquired business, is that right?

Paul Silverstein - Cowen and Company, LLC, Research Division

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

James E. Matthews

No. No, it's not right.

Thomas R. Stanton

No, no, no. We have -- the Broadband Access business, outside of the acquired business, has gross margin certainly well above the acquired business.

Paul Silverstein - Cowen and Company, LLC, Research Division

Understood. But...

Thomas R. Stanton

It's in the 50s.

James E. Matthews

It's in the 50s, yes.

Paul Silverstein - Cowen and Company, LLC, Research Division

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

Thomas R. Stanton

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

Paul Silverstein - Cowen and Company, LLC, Research Division

Right. And 1 other on gross margin. Again, I apologize. I know you addressed it, but I didn't understand the response. Is it -- the low 40s you referenced earlier in the conversation in response to your previous question, that low 40s number was what?

Thomas R. Stanton

That's for broadband, for the acquired Broadband Access business, the European business.

Paul Silverstein - Cowen and Company, LLC, Research Division

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

Thomas R. Stanton

It's fluctuating in that range. Depending on the particular product ordered on any period of time. If you remember, we talked early on when -- after the acquisition of the business that we saw greater than normal fluctuations because of chassis versus line card sales and the fact that chassis sales were -- because of historical reasons, so that very low gross margins. That continues to be the nature of that business. So there are quarters where we're below 40%, there are quarters where we're above 40%. And what we have said is, you take it on a normalized basis, over a large enough period of time, over just a meaningfully large period of time, that we're in the above 40s portion. That's still the same.

Paul Silverstein - Cowen and Company, LLC, Research Division

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

Thomas R. Stanton

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

Paul Silverstein - Cowen and Company, LLC, Research Division

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

Thomas R. Stanton

Yes, that's the right way to think about it.

Paul Silverstein - Cowen and Company, LLC, Research Division

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

Thomas R. Stanton

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

Paul Silverstein - Cowen and Company, LLC, Research Division

All right. And I apologize, 1 final question if I may. On the other potential pieces of business out there in VSO vectoring, I assume -- and specifically in Europe, is financing a factor in any of those deals, to the best of your knowledge?

Thomas R. Stanton

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

Paul Silverstein - Cowen and Company, LLC, Research Division

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

Thomas R. Stanton

I don't know. I will tell you that we're not involved in anything where financing is at this point in time, a big driver. I mean, the financing that you're talking about with some of the Eastern vendors had been around for a long time. It just hasn’t been the decision point, at least in the deals that we're actively pursuing.

Operator

And we have no further questions at this time.

Thomas R. Stanton

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

Operator

This does conclude today's program. You may now hang up at any time.

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