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ADC Telecommunications, Inc. (ADCT)

F4Q06 Earnings Call

December 12, 2006 5:00 pm ET

Executives

Bob Switz - CEO

Gokul Hemmady - CFO

Mark Borman - VP, IR and Treasurer

Analysts

Steven O'Brien - J.P. Morgan

Todd Koffman - Raymond James

Christian Schwab - Craig-Hallum Capital Group

Simon Leopold - Morgan Keegan

Jason Noland - Robert W. Baird

Marcus Kupferschmidt - Lehman Brothers

Tim Savageaux - Merriman

Eric Buck - Brean Murray

Presentation

Operator

Good afternoon. My name is Holly and I will be your conference operator. At this time, I would like to welcome everyone to the ADC Fourth Quarter Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions).

Thank you. Mr. Borman, you may begin your conference.

Mark Borman

Thank you, Holly. Good afternoon and thank you for joining us today on the call. Bob Switz, ADC’s President and CEO, as well as Gokul Hemmady, ADC’s CFO, are with me today.

Before we get started, I need to caution you that today’s conference call contains forward-looking statements, and that future events and results could differ materially from the forward-looking statements made today. Actual results may be affected by many important factors, including risks and uncertainties identified in our earnings release and in the risk factors included in Item 1A of ADC’s annual report on Form 10-K for the fiscal year ended October 31, 2005, and as may be updated in Item 1A of ADC’s subsequent reports on Form 10-Q or other reports filed with the SEC.

This earnings release can be accessed on ADC's Investor Relations section at www.adc.com/investor. ADC’s comments will be on a continuing operations and GAAP basis. Overview of the call will be, with Bob providing an update on ADC’s strategic direction. He will then turn the call over to Gokul, who will cover the financial results first and then provide forward-looking financial model guidance.

I will now turn the call over to ADC’s CEO, Bob Switz.

Bob Switz

Thank you, Mark, and good afternoon to all of you on the call. In 2006, we continue to position ADC for global growth. After a good first half start, growth slowed down due primarily to consolidation, deployment delays and customer inventory issues. However, we do feel we remain very well positioned for the resumption of spending. Accordingly, we continue to execute on our goal to become the leading global supplier of network infrastructure solutions to our customers.

In 2007, we plan further progress towards this goal through a combination of business execution excellence and competitive cost transformation in our core business, as well as balance sales growth through new product launches and business development initiatives. The strategic fundamentals of our business remain solid and we remain confident that we can deliver a long-term growth and profitability.

We believe we have significant growth opportunities ahead. But very clearly near-term visibility remains cloudy due to a variety of market factors, including firstly, our customers' FTTX inventory levels, which are currently higher than that which is needed to support near-term deployment rates. Second, capital spending is being deferred during extended regulatory reviews in merger integration activities related to the consolidation of significant customers in the United States.

And third, regulatory issues are impacting the timing of deployment of fiber-to-the-x networks in Europe, as well as in Australia. Once these near-term uncertainties are resolved, we believe our potential growth opportunities include large fiber-to-the-x projects for Verizon's FiOS, AT&T's Lightspeed, Deutsche Telekom's FTTN and other international opportunities, as well as benefiting from the resumption of normalized maintenance spending. We also see steady growth markets for next generation core fiber expansion, service provider data center bills and enterprise network upgrades.

Lastly, we see upside potential for network infrastructure automation, wireless capacity and coverage solutions, and wireless traffic backlog.

There are several key market developments that are expected to provide an opportunity to increase sales for ADC's next-generation core fiber-to-the-x network automation, wireless capacity and coverage, and enterprise solutions.

First, wireline and wireless subscribers are demanding new services for broadband content, such as video and music. Subscribers want bundled broadband communications anytime anywhere. Demands for higher bandwidth consumption are driving network upgrades that are expected to result in more ADC connectivity products and professional services sales.

Second, demand for triple-play service offerings over both, wireline and wireless networks, are driving service providers to consolidate. Our customers are consolidating and converging their networks to realize economies of scale, streamline operations, and speed the delivery of new and improved broadband services to residential business and mobile subscribers.

After these acquisitions close and are being integrated, we believe that the convergence of wireline and wireless networks provides ADC with opportunities for interconnecting the acquirer's and the acquiree's multiple video data and voice services over local access, as well as the long distance networks.

Third, the need for businesses to provide their employees with both wired and wireless applications is driving the emergence of the converged enterprise. New wireless applications and user interfaces must be integrated with the traditional fixed structured cabling. ADC is one of the only companies in the world capable of supplying a complete high performance, Wi-Fi and structured cabling infrastructure portfolio for the converged enterprise.

Lastly, competitive cost pressures are driving improved return on investment requirements by our customers. ADC has created cost effective solutions that are expected to drive growth of our broadband infrastructure and access products, as well as professional services. Based on these market developments, we are executing a four part strategy to grow long-term value in 2007 and beyond.

First, focus on targeted growth segments and geographies. In this area, ADC has added 158 new fiber-to-the-premise customers in 2006 for a total of 375 customers worldwide. We are also trialing our fiber-to-the-premise equipment in China. We introduced new fiber products for the next-gen core and installed numerous carrier data centers.

In 2006, we also introduced our Wi-Fi and WiMAX solutions for enterprise networks. And lastly we have started a growth council of ADC's senior business leaders worldwide to define and manage key efforts focused on ADC's future growth segments in fiber, wireless and enterprise networks, as well as fast growing regions, such as Asia.

Second, achieve product and service growth. We're developing innovative products and services to achieve organic growth in next generation networks, gaining market share in some of our existing markets and planning to acquire for global scale and presence. A good example of our innovation is our new ACX and ADX automated cross-connect products, both first-to-market solutions, to serve fiber-to-the-node and remote wireless applications by providing a flexible, scalable platform that allows carriers to remotely move, add and change services for our customers.

Deutsche Telekom and others have selected this automated solution to lower operational costs and allow quick and easy implementation of service changes. Another example is ADC being recognized by AT&T in 2006 for technical innovation in our OMX 600 optical distribution frame that provides advanced cable management features for protecting, managing and adding value to high speed networks. In 2006, we believe we gained market share in global fiber connectivity, and in the United States we believe we gained share in enterprise solutions and professional services.

Third, improved production and delivery efficiencies. We're aggressively executing our competitive cost transformation of ADC. To increase our profit margins, we are streamlining our product portfolio by reducing the number of part numbers and designing products for modularity. This streamlining should enable us to lower our cost from sourcing and manufacturing by being able to aggregate higher volumes of parts and modules to increase purchasing leverage, improving offshore and outsource benefits, reducing inventory and allowing customer requirements to be rapidly configured to order in region. We are also moving more of our manufacturing from the United States, Germany and Australia to low cost facilities in China, the Czech Republic and Mexico, where we've operated for many years.

Lastly, optimize operating expense. We are working to optimize our operating expenses by utilizing shared services to centralize functions, simplify our business structure and consolidate facilities to increase operating efficiencies.

To conclude my remarks, once the near term uncertainties are resolved, we are encouraged by our position in the markets and by our prospects to address the key growth areas of our customers' next-generation networks.

I'll now turn the call over to Gokul, who will provide a more detailed financial overview.

Gokul Hemmady

Thank you, Bob, and good afternoon everyone. Let me start with a few highlights of the quarter. First, we had strong year-over-year connectivity growth. Global fiber sales were up 12%, global copper sales up 5%, the enterprise sales were up 10%, and professional services were up 17%.

Second, GAAP diluted earnings per share was $0.38, which included a net tax benefit partially offset by various net charges. I will provide more details on this a little later.

Third, cash provided by operating activities from continuing operations of $39 million for a total of $94 million for the year. This annual cash flow performance compares to $70 million in fiscal 2005, clearly a great improvement year-over-year.

The biggest area for improvement in the quarter was gross margins at 30.2%, clearly a disappointment for us. We're addressing those areas that are not mix related with our competitive cost transformation efforts that Bob mentioned.

Now, let's review consolidated earnings in more detail. Our GAAP diluted earnings per share from continuing operations were $0.38 in the quarter, compared to $0.20 sequentially and $0.09 last year. In the fourth quarter, GAAP earnings included a net tax benefit of $46 million, or $0.35 per diluted share on an if-converted basis. This benefit consisted of a benefit of $49 million from a reduction of our deferred tax asset valuation reserve and a partial offset from additional income tax expense of $3 million related to a closure of a subsidiary.

This tax benefit was partially offset by net charges totaling $21 million, or $0.16 per diluted share on an if-converted basis, from the following. Amortization of purchased intangibles of $6 million, restructuring and impairment charges of $14 million, stock option compensation of $1 million, including selling and administration, and the write-off of an investment of $4 million to other income expense, partially offset by two benefits. First, $4 million from the Andrew merger termination fee net of expenses, also included in other income expense, and $1 million for an interest expense adjustment related to additional income tax on closure of a subsidiary.

Gross margins of 30.2% were lower than the third quarter of 32.7%, primarily as a result of lower volumes and mix within our FTTX business. Selling and administration expense continue to decline to $56 million in the quarter, compared to $61 million in the third quarter and $63 million last year. The improvement was due primarily due to the following factors. Completion of the FONS employee retention payments in the third quarter of $1.3 million, lower stock option compensation expenses in the fourth quarter, $1.1 million in the fourth quarter versus $1.9 million in the third quarter, elimination of incentive payments of about $2 million, and finally, continued cost reduction action.

Moving to other income and expense for the quarter, included in the interest line was higher interest income earned from higher interest rates and higher cash balances. In addition, there was approximately $1 million benefit from an interest expense adjustment related to prior income tax on a closure of a subsidiary.

In other income, the $4 million benefit from the Andrew merger termination was offset by two items, $4 million write-off of an investment, and approximately $1 million in expense for year-end adjustments from foreign exchange. Reviewing employee numbers, we ended the quarter at about 8,600 employees globally, which is down from about 9,100 at July 20, 2006, due to demand variations and cost reductions actions in the US as well as Mexico.

Moving to working capital, DSOs at 50 days in the quarter were at our 50-day goal. Our fourth quarter inventory turns were at 5.2 times, down from 5.5 in the third quarter and 5.3 one year ago. These turns were in line given lower sales volumes in the fourth quarters of 2006 and 2005. Strong collections on account receivables helped generate $39 million in total cash provided by operating activities from continuing operations in the fourth quarter.

Depreciation and amortization expense was $18 million in the fourth quarter and $17 million in the third. Property, equipment and patent additions, net of disposals, were a net expenditure of $10 million in the quarter, compared to $9 million sequentially. As a result of our strong cash flows, our total cash, cash equivalents and available-for-sale securities totaled $562 million on October 31, 2006, up from $527 million on July 28, 2006.

I will now provide financial modeling guidance. We are continuing to provide annual guidance that reflects our long-term business direction. As Bob mentioned, the strategic fundamentals of our business remains solid and we remain committed to strategically managing our business for long-term growth and profitability. We believe we have significant long-term growth opportunities ahead of us, but timing is uncertain as our near-term visibility into those opportunities remains cloudy. Our growth opportunities may be deferred until many of these uncertainties are resolved.

In fiscal 2005 and 2006, our sales fluctuated from quarter-to-quarter, something that is likely to continue. We expect sales in our first fiscal quarter of 2007 to be down from the fourth quarter of 2006 by around 15% due to the near-term visibility issues that we talked about. Additionally, the sequential percentage increase of sales in the second quarter of 2007 from the first quarter may be less than in comparable quarters in fiscal 2005 and 2006 depending on when these timing uncertainties are resolved. Assuming that these uncertainties get resolved in the first half of fiscal 2007, we expect to see a positive impact on our business in the second half.

Gross profit margins are expected to rise and decline following sales volume levels from quarter-to-quarter. On a continuing operations basis, we currently expect fiscal 2000 end sales -- 2007 sales to be in the range of 1.26 billion to 1.29 billion. Based on this sales guidance and subject to sales mix and other factors, GAAP diluted EPS from continuing operations in fiscal 2007 is estimated to be in the range of $0.53 to $0.63, which includes the following estimated EPS charges net of tax, amortization of purchased intangibles of $0.20 and stock option compensation expense of $0.07.

This guidance excludes potential future restructuring, impairment and acquisition related charges and certain non-operating gains and losses, as well as benefits from any reduction of the deferred tax asset valuation reserve, of which the amounts are uncertain at this time.

Moving to EPS, the calculation of our GAAP diluted EPS from continuing operations includes the if-converted method, which assumes that our convertible notes are converted to common stock if dilutive to EPS. This EPS calculation is specified in our earnings release.

Ending with income taxes, as of October 31, 2006, we had a total of 1 billion in deferred tax assets that have been offset by valuation of allowance of 972 million. This net asset is in other long-term assets on the balance sheet. Approximately 222 million of these deferred tax assets relate to capital loss carryovers, which can be utilized only against realized capital gains through October 31, 2009.

During the fourth quarter, we reduced the valuation allowance by 49 million attributable to deferred tax assets that are expected to be utilized over a two-year period. For financial modeling, we expect the effective tax rate to be 10% for each quarter, similar to 2006. As we generate pre-tax income in future periods, we currently expect to record reduced income tax expense until either our deferred tax assets are fully utilized to offset future income tax liabilities or the value of our deferred tax assets are fully restored on the balance sheet. Excluding the deferred tax assets related to capital loss carryovers, most of the remaining deferred tax assets are not expected to expire until after fiscal 2021.

In summary, in 2007, we intend to continue building ADC into the leading global network infrastructure company. Yes, our near-term visibility is cloudy, as Bob mentioned, but we remain extremely well positioned in our customers' deep fiber initiatives. Competitive cost transformation in our core business is a key focus area for us in 2007 and beyond. We remain committed to strategically managing our business for long-term growth, as well as profitability.

We'll now open the call to Q&A. Operator, can you give the right instructions for that please?

Question-and-Answer Session

Operator

Certainly. (Operator Instructions). And your first question today comes from the line of Steven O'Brien with J.P. Morgan.

Steven O'Brien - J.P. Morgan

Hi. Thanks for taking my question. I guess, first off, I wanted to ask about, I guess, some of the gross margin improvement initiative. Gokul, I guess, you have been talking for a couple of quarters now about some of the manufacturing realignment and granted, I guess, the fluctuation in quarterly results as kind of maybe maxed. What's going on in the gross margin. But, when do you think we could tangibly see some improvement from those initiatives?

Gokul Hemmady

I think -- let me address some of it and then Bob will add to it. I think you are continuing to see some of those impacts in the -- in our results. As you mentioned, it's being maxed by some of the other fluctuations from quarter-to-quarter. For example, in our Q4 versus Q3, gross margins declined by about 200 basis points. The primary driver of that was really volume sequential decline in revenues of about 10%. As also some mixed issues, as I mentioned, in our FTTX business where our major customer is buying more of the cabinets without the splitters that go into the cabinets, and therefore it's causing us a temporary margin issue. That we believe will get resolved as that customer resumes spending in a more normal fashion, starting in -- towards the end of our Q1 and into Q2.

We expect that in 2007, we'll continue to see gross margin cost reductions come into our gross margins. As Bob mentioned, we're -- we have focused on that over the last 12 to 18 months. We've been moving manufacturing to places like Mexico, to China, as well as the Czech Republic. We'll do that in a more aggressive fashion in 2007 and beyond. And in addition, we are also embarking on or continuing to aggressively look at competitive cost transformation project, where we simplify the way we do business, and therefore get more cost reductions. And, we believe that over the next two to three years, gross margin improvement in -- from that project could be anywhere from 100 to 150 basis point. So to answer your question, I think you'll continue to see cost reductions in -- come into our gross margins in 2007 and get back more into over the next two years.

Steven O'Brien - J.P. Morgan

Do you think that with your guidance being mostly up year-over-year on a full year basis that even though the fluctuation could mask a quarterly, we could see a full-year improvement in '07?

Bob Switz

I think there are scenarios in which gross margin could improve in 2007 over 2006. But our guidance right now would indicate that gross margins are probably relatively flat to maybe even slightly down from 2006. But there clearly things that could happen, especially from -- as our visibility improves, from a top line perspective, that gross margins could improve over 2006.

Steven O'Brien - J.P. Morgan

I guess, just lastly, if I could, and maybe this is more for Bob. Could you just comment briefly to the extent you can on how big an impact the timing of the AT&T merger, the Verizon, I guess, inventory situation and the DT regulatory situation? The magnitude on a relative basis each -- each are impacting your results heading into Q1, and which of these do you expect to sort of get results first? Is there some order you see? Is there -- and I will tell you to look in your crystal ball and tell right now, but where do you see signs for optimism among your customers?

Bob Switz

Yes. That is a tough question, but let me try and answer it as best I can. It's hard to predict when the merger will get approved. We all know the complexities around that and quite frankly the politics that is developed around it. So if we can be optimistic, let's be optimistic and let's say they get approval at the December 20 meeting.

Now, personally, I am not sure that that's going to happen, but let's say, they do. Then it's anybody's guess in terms of months or quarters as to when we really start to see a pickup in spending. And if we model it based on our experience with SBC in the AT&T acquisition, something in the range of six to nine months or so into the transaction, we really started to see what I would call incremental spending, okay.

Now, you will see a turn on of some of the normal spending, because there is maintenance work, there is basic stuff that has been held back as part of the process. So you will start to see that. And then, there is the incremental spending that comes with interconnecting the various networks and that's probably going to take a little more time. So, that could to be out in three to six months kind of range. And then, there is a resumption of broadband initiatives, and in the case of BellSouth, they have a slightly different architecture than AT&T's Lightspeed.

So, what we don't know is, do they turn that on and accelerate that to be competitive or is there is some consideration about alternative architecture. So, I would say it's that sort of timeframe, assuming December 20 approval. If you assume it goes into the new year, then you can kind of extend those timeframes that I have referenced based on when the approval date occurs. I guess, I would expect Verizon to potentially cure sooner. They are working off inventory, that's a different issue. That's based upon what they have in stock versus the demand for deployment. Gokul did mention, we have seen some efficiencies as well coming out of Verizon, where they may be using some other splitters that they have in some of their boxes to redeploy to other areas where they are potentially needed on a more current basis. So, it is just not working off cabinets, it's working off all aspects of the inventory. And then of course, setting a new demand planned for product based on the deployment schedule that they have set for the year. So, we think right now, potentially we should start to see, what we would call, some normalized spending sometime in the post or shortly after our fiscal first quarter may be a little sooner. But we aren’t expecting the big surge that we saw last year, because you are not going to have a million new homes passed added, as we did last year. So you are going to have 3 million homes with more efficient procurement pattern. So, we should see an uptick, but not a huge spike and that’s okay with us, because it allows us to plan and manufacture better as well.

In the case of DT, I think their first phase right now they will proceed with that without too much impact from the regulatory environment. It’s the subsequent phase how aggressively they decide to plan and deploy that that I think is more linked to the regulatory issues. And as I look at DT, it's more a function right now of them being able to move as fast as they would like deploying the balance of their broadband initiative in the first 10, 12 cities. So, I would say right now, we have said we expect that to be a second half event for us. At this stage, I would probably stick with that and say, it's probably remaining as a second half event and we'll update you on that as things occur over the course of the year, but we don’t see a change in that one at the moment.

Steven O'Brien - J.P. Morgan

That’s it. Thank you very much.

Operator

Your next question comes from Todd Koffman with Raymond James.

Todd Koffman - Raymond James

Yes, just as a follow-up on that inventory related to the fiber-to-the-premise deployment. It seems as though the carrier is entering more of a steady state deployment. And so, why wouldn’t your fiber connectivity business, sort of, just remain somewhat of a steady state at this level, maybe somewhat modestly higher? Why do you think there would be inventory work down and then a meaningful acceleration in the business a few quarters from now?

Bob Switz

It depends on -- what you mean is as meaningful, and we don’t exactly know how much inventory they are working off. We've heard various estimates, but it's a combination of repurposing efficiencies in how they deploy, as well as utilizing the inventory that's there. We are working with them to try to get a better sense of what their demand will be. But I think it is logical as they enter the new year, they tend to deploy really hard in that time of the year. There is a tendency to want to make sure that inventory is on hand. So, absence of product doesn’t delay the deployment. So, from what we can tell, given that the levels right now have been reduced so significantly, in order to do the 3 million, it would suggest that there is going to be a pickup starting some time after the first quarter.

Todd Koffman - Raymond James

Just a quick follow-up unrelated. In your opening remarks, you said about this four part strategy, improved production efficiencies, operating expense optimization. I mean, that sounds like you are setting the stage for what potentially could be a reasonably significant restructuring. Can you give any color or comment on typical words that would associate with major adjustments to the size and scale of the business?

Bob Switz

Yes. No, I don’t see that on the cards at all. We are talking about -- most of our major restructuring is well behind us and what we are really doing is positioning the company to deal effectively in the environment it currently operates in, which as you know, is a highly competitive environment and one where pricing is aggressive and competition is rigorous. So, we are doing nothing more really than some of the things we've been doing for a while. We are just trying to make the company highly cost competitive. We certainly are continuing to look at internal innovation to bring new products to market as we did with our ACX product and others. So, I wouldn’t read into those statements that that implies a restructuring. Those are just some of the major elements of how we see our self driving value in 2007.

Todd Koffman - Raymond James

Thank you.

Operator

Your next question comes from Christian Schwab with Craig-Hallum Capital Group.

Christian Schwab - Craig-Hallum Capital Group

Great, thank you. Gokul, are you going to make money in Q1?

Gokul Hemmady

Money in Q1, so you are talking about EPS?

Christian Schwab - Craig-Hallum Capital Group

Sure.

Gokul Hemmady

That depends on the -- I think we will make money in Q1 with EPS defined in certain fashion. Before some of the charges, excluding some of those charges and all that, we will make money, yes.

Christian Schwab - Craig-Hallum Capital Group

Okay. When we return to -- Bob, when we return to a normalized spending pattern, okay, whether it be three, six, nine months consolidation issues behind, inventories, as many regulatory deployment delays, what's your normalized organic growth rate going to be in that environment do you think?

Bob Switz

Yes, that’s a good question. And, I don’t think -- we have to be very careful on what we call the environment. You can have spikes in quarters, okay, just because of the way things happen. So we're thinking of our growth rate. We're looking at it more as an annualized type of a growth rate in this environment. And we've targeted the mid-ish single digits at this point in time, something that would be appropriate for us once we have some normalized spending. Now having said that, there can be spikes, okay, in various quarters depending on how fast and how aggressive and the timing of which our customers turn on.

Christian Schwab - Craig-Hallum Capital Group

Right. But so, we kind of would expect year-over-year growth rate of the business to be about 5% to 7%?

Bob Switz

Yes. We said that now that our long-term expectation and goal is in that 5 to 7 range, looking at it is a couple of points above average growth for the industry.

Christian Schwab - Craig-Hallum Capital Group

Right. And then if we return to that type of growth rate, and let's say we hit our number for this year, where do we see -- just following up further bit, maybe we can just get to a specific number here. When we return to say 350 plus million in revenue goal, what type of gross margins, let's just say, makes us still poor in fiber or not optimal. But the rest of the business is humming along and we're manufacturing for. What type of gross margins we'll return to now with a more optimized manufacturing process in a rationalized product line?

Gokul Hemmady

So, when we talk about an optimized manufacturing process and all that, I think we are looking at that kind of goal being beyond 2007. So, getting to 350 million a quarter in 2007 will be a different gross margin than probably in 2008, towards the end of 2008. So --

Christian Schwab - Craig-Hallum Capital Group

Just give me just two numbers. So let's say, we get there in July, because we better get there by July or we are not going to hit our number. So, in July what type of gross margin do we get then, say, we get all these efficiencies in 2008, what type of gross margin, just roughly?

Gokul Hemmady

So, if you're talking about July 2007, I don’t think the gross margins will be anything other than kind of the low thirties.

Christian Schwab - Craig-Hallum Capital Group

Low thirties, okay. And then, what type of improvement would you target internally then for 2008, say, now and then? Let's say, the --

Gokul Hemmady

[In the local] period of time, we believe that this competitive cost transformation project assuming no major shifts in mix, would get us about 100 to 150 basis points.

Christian Schwab - Craig-Hallum Capital Group

All right. So if you are doing 32% this July, you are talking 33, 33.5 in '08, is that right?

Gokul Hemmady

Yes.

Christian Schwab - Craig-Hallum Capital Group

Great. It appears to me that maybe you haven't fired enough people. I mean, what is our optimal quarterly goal of around this business with 5% to 7%?

Bob Switz

Optimal --

Christian Schwab - Craig-Hallum Capital Group

I mean, in order to get a lot of leverage, if only I take gross margins back. Let's say, gross margins improve from 31. At 31.7, they are going to average out, because this quarter's volume are so low, we get to 31, 31.5, maybe we take it to 32, 32.5 in '08. In order to get a lot of bang on the operating leverage, we either need to really not hire any more people or maybe we need to fire some more. Am I looking at that wrong or if you really believe --

Bob Switz

This is Bob. Let me answer part of it and I'd like Gokul answer some. I mean, we have taken quite of bit of -- a fair number of people out of the company. And Gokul has given you a long-term operating expense ratio to revenue that we are striving for. If you look at headcount, even in this quarter our headcount has come down. We're over 9,000 in July and we're around 8,700 and 8,500 in October. So, we've been very sensitive to, A, taking labor out of our cost. We also utilized shared service centers and low cost sites around the world as well. We have not been adding a lot of overhead spending, very little, probably none that I can think of at this point. We did make an adjustment in our go-to-market expenses at the end of 2006 to reflect the consolidation of our customer base. So, I'll let Gokul speak a little more to some of the expense side, but I think there's not a lot of room to take more meaningful expense out at current rate. The issue that we have, I think, that is more significant is, we have a platform that we think at current spending rates on a percent basis can sustain a lot of revenue growth. And so, the leverage for us comes more from increasing the top line and less from decreasing expenses, and that's why we suggested when we have talked about various types of -- or potential M&A transactions as a source of added volume, the leveragability of that increased revenue is pretty significant to our operating model.

Gokul Hemmady

Yes. I don’t know that there is much more to add. I think, as Bob said, there is -- we've shown over in '05, as well as '06, pretty decent operating expense leverage in our business model, because we are not talking about top line growth that is coming from completely new sets of products or completely new sets of customers. So, we have invested in our operating expense and that can sustain quite a bit of top line growth. Assumed in our guidance at these levels is the assumption that our operating expense will probably be relatively flat to modestly declining in '07 and that could potentially be the case even at higher top line growth levels.

Christian Schwab - Craig-Hallum Capital Group

Okay. So we should just assume that total operating expenses should remain in the low 70 million range a quarter?

Gokul Hemmady

We are going into '07 starting in Q1, because remember for all of '06 given the performance we have had, we paid really no variable incentives, if you will, to our businesses. Starting in '07, assuming certain performance levels, we will start accruing for some of those incentives, so there will be some addition to operating expense dollars, if you will, starting in our first quarter. So there will be some increases in '07.

Christian Schwab - Craig-Hallum Capital Group

One last question and I will be done. Let me just take some more [sense]. On that, what is your incentive based on? Are they going to be based on what, revenue, profitability, etcetera, etcetera?

Gokul Hemmady

It's based on revenue, profitability and cash.

Christian Schwab - Craig-Hallum Capital Group

And which one has the greatest weighting?

Gokul Hemmady

Profitability.

Christian Schwab - Craig-Hallum Capital Group

Great. Thank you, guys.

Operator

And your next question comes from Simon Leopold with Morgan Keegan.

Simon Leopold - Morgan Keegan

Thanks. I just wanted to get in couple of clarifications, and then sort of a philosophical question. On the first clarification, just looking at the discussion on the one-time items, I think you are pointing us to a pro forma EPS of about $0.19. Just wanted to see if you can clarify that? And then also looking at the forecast for the next quarter and looking back at the gross margin this quarter, is it appropriate to think of the volume related -- on gross margin as about 200 basis points and to think we should see something similar in the January quarter? And then I will leave you with more philosophical question, is around trending within the product segments. It seems to me that the biggest delta here is really in the fiber optic connectivity and that the biggest variable is when Verizon comes back. If you could talk a little bit about quantifying and ranking the issues that you described as creating the slowdown in the business. You mentioned the mergers and the regulatory issues and the inventory issues of fiber. If you could give us a little bit more help us to how to rank these on a relative basis? Thank you.

Gokul Hemmady

So, let me start with the first one on your EPS. So, yes, if you look at our -- the table that we provided to you along with our earnings release that gives the dollar impact, and if you do the math, you could come to the conclusion that you just outlined in your first question. So, that's probably right. Second, on the gross margin question, your sequential decline in gross margins of about 250 basis points, I would say, about 150 to 175 basis points, somewhere in that range, is volume related. The balance is largely, not all of it, but largely related to mix issues within the FTTX product line. So, as I said in my remarks, in Q3 we shipped more cabinet that were populated with splitters. In Q4 we seem to have done less of that, and therefore our margins on splitters are higher than cabinets and that's what caused some of the decline. And the third question, can you repeat that question briefly again, Simon?

Simon Leopold - Morgan Keegan

Yes. You walked us through number of factors that are causing the slowdown in sales. The merger -- the delayed mergers, the inventory for fiber-to-the-x, the regulatory slowdowns that are related to Telstra and Deutsche Telecom.

Gokul Hemmady

Right.

Simon Leopold - Morgan Keegan

And in my rough estimate of your segment performance relative to expectations, it seems to me that it was really the fiber-to-the-x that was the biggest delta --

Gokul Hemmady

In Q4.

Simon Leopold - Morgan Keegan

In Q4. And so, I am trying to think about when we go into next year, as each of these issues are resolved, the merger is closed, Verizon uses up inventory, how to gauge ramping that revenue back in as we address. So, I am trying to really get a good understanding of how do these compare? Is inventory twice as big of an issue, as delays in the merger? Does that helps you?

Gokul Hemmady

Yes. It helps me. So I'll answer it, and then Bob if you have anything you can add to it. In Q4, Simon, if you think about our revenue decline from Q3 to Q4, I would say, at a very high level 80% of that decline was related to FTTX. So, that's the first data point that might -- that might be helpful as you think about, when near-term visibility comes back in '07 how that might impact kind of quarter-to-quarter thinking, if you will. So, that's the first thing. Second, I would say -- so that is the biggest impact in Q4.

I would say that the second biggest impact is really the AT&T BellSouth merger, and then, more specifically spending on the BellSouth side as opposed to AT&T. I think we have said in the last three four weeks, as we have presented at conferences, that depending on when the merger closes, even after that it will take probably at least a quarter before spending gets back to normal levels. Now, that’s more speculation on our part rather than any scientific thinking. It could take little less, it could take little more. So, I don’t know whether I am being -- answering your question in great amount of detail, but those are -- that’s how we've -- what happened in Q4 and how we think about '07.

Bob Switz

I think Gokul answered the question, as well as I would have.

Simon Leopold - Morgan Keegan

Thank you very much.

Operator

And your next question comes from Ken Muth with Robert W. Baird.

Jason Noland - Robert W. Baird

Good evening. This is Jason [Noland] on Ken. I had a question on your long-term operating margin, Gokul, that's been given as 14% historically. That seems possible in a peak quarter, as you have spoken about on this call. But is that really something that we should consider as a functional trend?

Bob Switz

This is Bob, I'll take a crack at it and Gokul can chime in as well. It is a long-term goal and there are quite a few things implied in achieving the goal. One is the cost reduction program, our competitive cost transformation that Gokul referred to. And the other is an assumed amount of volume that creates the leverage we talked about earlier. And that volume can come from organic growth rates in our business and/or from acquisitions that we may also make during that period.

Gokul Hemmady

So the only thing I would add is, as Bob mentioned, it is a long term goal. I think that goal can be reached over the next three years or so, if one can get high single digit top line growth, number one. Number two, get to some of the cost reductions, i.e., the competitive cost transformation project, which would give us 100 to 150 basis points. And then the high single digit top line growth would, we believe, could give us operating expense leverage somewhere in the 300 basis point range. So, all of those three factors together could get us to that long-term operating margin goal.

Bob Switz

And it's also an adjusted number.

Jason Noland - Robert W. Baird

Right. Okay. And then just one final question, want to hear an update on your M&A thought? Thank you.

Bob Switz

Yes. Our M&A thoughts are consistent with what we've shared with you in the past. We are not deviating from the core strategy. The areas that were of interest to us remain of interest, maybe with one update. And I know I've mentioned this, but I’m not sure how broadly. But as we look at M&A geography, is an important area as well. And given our desire to be competitive and effective in emerging markets, particularly China, we clearly have an interest if we could find the right partner of making an appropriate acquisition in China to jumpstart our participation in that market, give us access to channel, to customers, as well as a reasonably scaled base to leverage from in terms of highly cost competitive products, not only for the Chinese market, for other emerging markets as well, such as India, eastern Europe, etcetera. So, from a geography standpoint, that area is of interest. Aside from that, things around the core strategy of outside plant, fiber, as well as enterprise solutions in wireless remain attractive to us. And on the financial side, of course, nothing has changed. We do expect what we do to be accretive, preferably within the first 12 months of following acquisition.

Jason Noland - Robert W. Baird

Thank you.

Bob Switz

Okay.

Operator

And your next question comes from Marcus Kupferschmidt with Lehman Brothers.

Marcus Kupferschmidt - Lehman Brothers

Hey, good afternoon, guys.

Gokul Hemmady

Good afternoon.

Marcus Kupferschmidt - Lehman Brothers

I wanted to clarify couple of the comments about margins, because we had a lot of discussion, lot of comments so far. If I think about the fourth quarter comments, largely the disappointment in the margins from what you kind of expected coming into the quarter, do you think it's largely driven by the mix within the fiber-to-the-x cabinet?

Gokul Hemmady

It's -- first of all, it's largely driven by, I would say, two-thirds of the margin decline sequentially is volume related.

Marcus Kupferschmidt - Lehman Brothers

Right.

Gokul Hemmady

A 10% decline sequentially in volume is about 150 to 175 basis point margin impact. That's the largest decline. And then the balance 75 basis points or so, I would say, is largely, not all, but substantially related to a mix within FTTX.

Marcus Kupferschmidt - Lehman Brothers

Okay. Because I -- so, it seems to me that the FTTX mix then you are not selling as many of those connectors.

Gokul Hemmady

In Q4.

Marcus Kupferschmidt - Lehman Brothers

It was a big issue in Q4. So, I guess, a couple of different things. If that's a big difference in the sales so much you thought, I would think you will be selling a lot less cabinets as you are not deploying lot of new cabinets in the winter. I mean, am I wrong that all that was connected together?

Gokul Hemmady

No. I think that's a good assumption.

Marcus Kupferschmidt - Lehman Brothers

So, if your sales for the quarter ends up at the high end of expectations, can you give us a sense of what did you sell more of than you were expecting, to make up the difference, because your 4Q revenues were good? I mean, it's not like you are at the low end of your guidance or below that.

Gokul Hemmady

Yes. I would point to two things and then Bob can add to it. Our sales revenues in EMEA were strong, number one, and as well as in Asia Pacific. So we -- from my point of view, we saw more of the upside, if you will, come from things outside the US. I think there were things within the US also that may have been marginally better or higher, but it did come from EMEA and Asia Pacific.

Bob Switz

Yes. I think structured cabling in the US was a contributor. But your assessment around Verizon was correct. Clearly, we had less hubs, less splitters. We did have some additional sales of lower margin products in place of those. So, I think your assumption there is correct.

Marcus Kupferschmidt - Lehman Brothers

Well, what kind of products would you be selling in, like, EMEA and APAC, to make up the difference there?

Bob Switz

Well, we have -- in EMEA and APAC we have our core carrier business, our access business in EMEA, structured cabling in EMEA, services in EMEA. So, it's the full ADC product line and what we saw up was a pickup in EMEA around several of those product areas.

Marcus Kupferschmidt - Lehman Brothers

Okay. And then just thinking about next year, can you give us a sense. We talked about these incentives for this year being cut back at year end. What was the total amount of incentives ADC accrued for bonuses, whether it's equity or cash or whatever? What kind of in the -- if you look at in our pro forma P&L, whether we -- [loss] we are having there that accounts for these incentives and what would that look like for ’07? What are you planning today in this guidance we are talking about?

Gokul Hemmady

Yes. So, it was very minimal, so it was close to zero. Very minimal incentives accrued for in '06. Going into '07, in our operating expenses, I would say that, if performances are at a certain level, i.e., let's call it plan, our incentives would be around 15 million, including in our operating expenses. Now even with that headwind, as well as inflation on other things, we are going through cost reductions, which is why I am guiding to an operating expense level that's either flat to slightly down. So, on the one hand I have these incremental expenses on incentives, as well as salary increases and other things. But we are working on cost reduction things that will offset that, and probably even more than offset that to get our operating expense either flat to slightly down.

Marcus Kupferschmidt - Lehman Brothers

Okay. And then clarify the gross margin. We talked about 100 to 150 basis point benefit for these new moves on the cost side -- the cost of goods sold. It’s kind of a three-year program, small amount next year. All this assumes, I guess, a steady state sales mix. But I mean, is it fair to assume the sales mix is steady state, because I think you have got a lot of interest in your deep fiber products, lot of those are below average margins, unclear how big automated cross-connects would be, I guess, that’s a better margin. But, doesn’t sales mix kind of work against you, unless Digivance has a really big year or something?

Gokul Hemmady

I agree with you, Mark. Yes, I think if all the deep fiber initiatives that we are involved in and we think our customers will get to over the next two to three years come out and happen. We believe that we have top line growth opportunities that are in far excess of what we are talking about here. So, on the one hand, it’s a good thing. Over a long period of time, we may have top line growth opportunities that far exceeds the mid single digit kind of levels. But on the other hand, in those scenarios where we approach double digits, or could be even higher, gross margins might be slightly lower, because of that mix issue.

But if we're talking about mid single digit kind of growth rate, on the one hand we believe that our core fiber, central office fiber business is very strong, will continue to be strong and is accretive to gross margins. But on the other hand, the outside plant fiber products will be slightly dilutive to gross margin, and therefore mix will be relatively neutral. And the other thing asides the mix, even with a static mix, the cost reduction initiatives are aimed at all of ADC's products. So, as we rationalize, as we eliminate SKUs, as we move in some cases customers to common product and/or upgraded product that also offers us opportunity for margin gains.

Marcus Kupferschmidt - Lehman Brothers

Thank you very much.

Bob Switz

Thank you.

Operator

Your next question comes from Tim Savageaux with Merriman.

Tim Savageaux - Merriman

Good afternoon.

Bob Switz

Good afternoon.

Gokul Hemmady

Hello.

Tim Savageaux - Merriman

Sorry, if I overlap here. I went out for a run and a cup of coffee during that question, if you ask me. So I'll try to ask without overusing the first person peril or being cavalier about people's jobs, I'll ask you the following. Which is, it seems like you are implying that your seasonality has changed here in talking about expectations for first half and yet for the total year and that you may be moving back toward, kind of, a more traditional second half stronger than first half type of progression. Do you mean to imply that or can you talk about your overall thoughts there with regard to any changes in seasonality?

Gokul Hemmady

Yes. I think we are implying a change more driven by our specific situation right now. So, we didn’t mean to imply that this is a permanent change. So, what was happening right now, Tim, is we have a near term visibility issue driven by three factors mainly, the AT&T/BellSouth merger, the deployment of potentially our ACX product from the timing perceptive with DT, as well as Verizon inventory. All those three things are telling us that near term visibility is cloudy, and therefore we are expecting Q1 sequential top line decline to be at the high end. Going into Q2, we don't know -- we think there will be sequential growth, but not as much as what we have seen in the past. We do believe that some of these things will get resolved in the first half, and therefore second half will be stronger. So, that's our feeling for 2007 and we wanted to make sure everyone understands that that seasonality is different from what we saw in '05 and in '06. Going into '08, who knows what's going to happen then. But that's certainly what we are seeing in '07.

Tim Savageaux - Merriman

Okay, thanks very much.

Operator

And your next question is from Eric Buck with Brean Murray.

Eric Buck - Brean Murray

Thank you. Yes, just a couple of things. First, again looking at the revenue line -- to be honest, I have tough time reconciling kind of your enthusiasm for the second half with what turns out to be essentially a flat year-over-year for the full year revenues. It is down 12%, first quarter would put you at essentially flat, down 13% would be flat for the first quarter. I understand the second quarter won't be as strong a sequential gain. But, you are looking at Verizon/BellSouth and new big deal with T-Com coming into play in the third quarter, fourth quarter not having a unusual follow up and a very easy comparison. It seems like either you are overly optimistic about when things will come back in the year or your revenue forecast is somewhat understated.

Gokul Hemmady

So, we do think that the near-term visibility is real, and therefore we are saying Q1 could be a 15% sequential decline, that’s what we said. In '05 and '06, Q2 has been a sequential growth of 25% to 30%. What we're saying right now is, we can't see those kinds of sequential growth rates, given the same factors we have talked about. So, sequential growth rate in Q2 would be much less than that. And so, if you assume a Q1 sequential decline of 15, a Q2 sequential growth rate that is much lower than the 25%, 30% that, the math just at our midpoint of guidance could imply a second half that is modestly stronger. And that’s what we've guided to until -- and until I think we see some of these events getting resolved, we believe that’s really the best course of action for us.

Eric Buck - Brean Murray

Okay. I guess the second question is, you talked about 15 million of potential incremental incentives, a flat revenue number and essentially flat EPS number year-over-year. I guess, the question is why would you be paying out 15 million of incremental incentives with that kind of performance?

Gokul Hemmady

Right. So you are absolutely right, and I didn’t -- which is why I've said at a certain performance level. I’m not suggesting to you that at these performance levels the number would be 15 million. Internally, we are absolutely as you can imagine, targeting a higher performance and at those kinds of levels our incentives would be 15 million. So, at the levels that we've guided to it will probably be half of that number or maybe even a little lower.

Eric Buck - Brean Murray

Okay. So to reach those numbers they would be fully earned and then some from the standpoint of incremental contributions to the bottom line?

Gokul Hemmady

Right.

Eric Buck - Brean Murray

Okay. Thanks.

Bob Switz

Alright. We'll take one more question.

Operator

We actually have no questions in queue at this time. So, I'd like to move to closing remarks.

Gokul Hemmady

Thank you.

Bob Switz

Thank you.

Operator

Ladies and gentlemen, that does conclude today's conference call. You may now disconnect.

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Source: ADC Telecommunications F4Q06 (Qtr End 10/31/06) Earnings Call Transcript
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