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ADTRAN (NASDAQ:ADTN)

Q2 2012 Earnings Call

July 11, 2012 10:30 am ET

Executives

Thomas R. Stanton - Chairman of the Board and Chief Executive Officer

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

Analysts

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Jim Suva - Citigroup Inc, Research Division

Michael Genovese - MKM Partners LLC, Research Division

Mark McKechnie - ThinkEquity LLC, Research Division

Simon M. Leopold - Raymond James & Associates, Inc., Research Division

Ehud Gelblum - Morgan Stanley, Research Division

Richard Valera - Needham & Company, LLC, Research Division

Jonathan Kees - Capstone Investments, Research Division

Eric A. Ghernati - BofA Merrill Lynch, Research Division

Jeffrey T. Kvaal - Barclays Capital, Research Division

Blair King - Avondale Partners, LLC, Research Division

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the ADTRAN's Second Quarter 2012 Earnings Release Conference Call. [Operator Instructions] During the course of the conference call, ADTRAN representatives expect to make forward-looking statements, which reflect management's best judgment based on factors currently known. However, these statements involve risks and uncertainty, 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 for the year ended December 31, 2011, and Form 10-Q for the quarter ended March 31, 2012. These risks and uncertainties could cause actual results to differ materially from those in forward-looking statements, which may be made during the call.

It's now my pleasure to turn the conference over to Mr. Tom Stanton, Chief Executive Officer of ADTRAN. Please go ahead, sir.

Thomas R. Stanton

Thank you for joining as for our second quarter 2012 conference call. With me this morning is Jim Matthews, Senior Vice President and Chief Financial Officer. I'd like to begin this morning by discussing some details on our Q2 results, including our thoughts on the spending environment and its impact on our near-term outlook.

As you can derive from our press release issued last night, the spending environment in the markets we address deteriorated in the second quarter, with the most significant changes affecting our domestic Tier 1 carrier customers and several areas served by our Enterprise products division.

During the quarter, we achieved revenues of $184 million, and if we exclude our recently acquired NSN BBA business, revenues were $161.4 million. The $161.4 million represents a sequential increase of 19.8% for our organic business but a year-over-year decrease of 12.4%. Our acquired business came in at $22.6 million in range with our expectations. In total, our CN division had organic revenues of $130.1 million, again, in line with our expectations.

During the quarter, we saw the expected acceleration of our Tier 1 Fiber-to-the-Node build-out and the resumption of planned activities in the Tier 2 and Tier 3 markets. However, we experienced a heightened sense of consciousness and budget uncertainty with both large and small carriers, which resulted in project delays and an uneven order flow.

We are confident that our market position remains strong with no meaningful market share loss, where we have incumbency, and we continue to add new customers at a rate consistent with our performance over the last 2 years. The macro environment impacted our Enterprise division, and more importantly, our Internetworking products, which grew 6% year-over-year, the smallest increase since the first quarter of 2009. The impact was felt across nearly all product areas with the exception of our virtual wireless LAN segment, which continued to build strength with both resellers and carriers. From a channel perspective, only our reseller base showed growth, a likely result of our increasing focus in this area.

Looking at our business from a product segment perspective, our organic Broadband Access segment was up both sequentially and year-over-year, driven by our Fiber-to-the-Node platforms as we saw meaningful increases in shipments to a domestic Tier 1 carrier, coupled with a strong performance in Latin America. This area also helped by a strong performance by the Total Access 5000 platform in the Tier 2 and Tier 3 markets, where we continue to add in excess of 20 new carrier customers per quarter.

Our Optical business was impacted by the slower Tier 1 sales, although it was partially offset by an increase of our newly released ONE product line. Also during the quarter, we received approvals from 2 additional Tier 2 carriers for our ONE products and began initial shipments to 1 of those 2.

Looking at our business from a geographic perspective, U.S. sales were down 19% year-over-year for the quarter, driven predominantly

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products to Tier 1 carrier customers.

As most of you know, who follow the company, the decline in these product areas has been expected, and we continue to drive the focus of the company towards packet-based technologies.

Conversely, it is important to note that total international revenues represented nearly 30% of the total company revenue, and our organic international revenues grew 32% year-over-year as we continued our global -- or goal of geographic and customer diversification.

We closed on the NSN Broadband Access business on May 4 this year, and I'm pleased to report we remain on track with our integration activities. During the quarter, we successfully on-boarded the required personnel, negotiated terms of supply agreements with all the major vendors and began production of selected products using ADTRAN's supply chain. It is our belief that in the years to come, ADTRAN's growth will be influenced by our ability to expand our geographic presence and our relevance with Tier 1 carriers around the world. This business, with its entrenched incumbency at large carriers outside of North America, will without a doubt substantially accelerate our initiatives and increase our odds for long-term success.

Finally, during the quarter, it has become apparent that customer settlement in the current environment from both an economic and regulatory perspective has deteriorated. This was reflected in the second quarter results by slowing Enterprise demand and company with increased -- increasing uncertainty in purchasing decisions. Although we remain confident in our ability to grow market share in the future, the environment has impacted our visibility to near-term business trends.

I would now like Jim Matthews to review our results for the second quarter of 2012 and our comments on the third quarter of 2012. We will then open up the comments for any questions. Jim?

James E. Matthews

Thank you, Tom. Good morning, everyone. Revenue for the first quarter was $184 million compared to $184.2 million for Q2 of 2011. Broadband Access product revenues for Q2 of 2012 were $106 million compared to $77.1 million for Q2 of 2011. Internetworking product revenues for Q2 of 2012 were $35 million compared to $33 million for Q2 of 2011. Optical product revenues for Q2 of 2012 were $14 million compared to $22 million for Q2 of 2011. Carrier Systems revenues for Q2 of 2012 were $126.8 million compared to $112.3 million for Q2 of 2012 -- I'm sorry, Q2 of 2011. Business Networking revenues for Q2 of 2012 were $36.6 million compared to $35.7 million for Q2 of 2011. Loop Access revenues for Q2 of 2012 were $20.6 million compared to $36.2 million for Q2 of 2011. HDSL product revenues for Q2 of 2012 were $19.5 million compared to $34 million for Q2 of 2011.

As a result of the above, Carrier Network division revenues for Q2 of 2012 were $152.7 million compared to $150.5 million for Q2 of 2011. Enterprise Networks division revenues for Q2 of 2012 were $31.3 million compared to $33.7 million for Q2 of 2011. International [ph] revenues for Q2 of 2012 were $53.

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$23.4 million for Q2 of 2011. To provide the reporting of each of these categories, we have published them on our Investor Relations web page at adtran.com.

Gross margin was 51.7% of revenue for Q2 of 2012 compared to 55% for Q1 of 2012. The lower gross margin compared to Q1 of 2012 was largely attributable to lower gross margins for the recently acquired NSN Broadband Access business. Gross profit for the quarter was negatively impacted by $1.2 million attributable to amortization,

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to revenues and to cost of goods sold.

Total operating expenses were $68.3 million for the second quarter of 2012 compared to $55.5 million for the second quarter of 2011. The increase in operating expenses from Q2 of 2011 -- from Q2 of 2011 to Q2 of 2012 was primarily attributable to 2 months of operating

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Access business and Bluesocket, including amortizations, integration and other expenses in connection with these acquisitions and increased staffing costs. Amortization costs included on operating expenses totaled $0.4 million for the quarter. Integration and other acquisition-related expenses included in the operating expenses were $2.7 million for the quarter.

Stock-based compensation expense, net of tax, was $1.9 million for Q2 of 2012 compared to $1.8 million for Q2 of 2011. In the quarter, we recorded a bargain purchase gain of $1.8 million, net of tax, related to the acquisition of the NSN Broadband Access business. This amount represents an estimate of the excess fair value of net assets acquired as compared to the consideration exchanged. Supplemental information for acquisition-related expenses, amortizations and adjustments in connection with the Broadband Access business and Bluesocket acquisitions are provided in our operating results disclosure.

All other income net of interest expense, excluding the bargain purchase gain for Q2, was $4.2 million compared to $4.7 million for Q2 of 2011. The company's income tax rate provision was 35.7% for the second quarter of 2012 compared to 34% for the second quarter of 2011. Removing the effect of the bargain purchase gain previously mentioned, our income tax provision rate would have been 37.7% for the second quarter. The tax provision rate for the second quarter of 2012 does not include benefits from research tax spreads due to delays in legislation. The tax provision rate for the second quarter of 2011 included benefits from research tax credits and increased benefits from employee stock option exercises.

Earnings per share on a GAAP basis, assuming dilution for Q2 of 2012, were $0.33 compared to $0.56 for Q2 of 2011. Non-GAAP earnings per share for the quarter were $0.38 compared to $0.59 for the second quarter of 2011. Non-GAAP earnings per share exclude the effect of acquisition-related expenses, amortizations and adjustments related to the acquisitions of the NSN Broadband Access business and Bluesocket 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 $103.8 million at quarter end compared to $95.8 million at the end of Q1 of 2012. The increase in inventory levels for the quarter relates to inventories required as part of the Broadband Access acquisition, partially offset by a reduction in organic inventory levels. Net trade accounts receivable were $118.5 million at quarter end resulting in DSOs of 59. The higher DSO levels was primarily the result of trade receivables incurred during the months of May and June in the acquired Broadband Access business and the timing of shipments in the organic business during the quarter.

Unrestricted cash marketable securities, net of debt, totaled $494 million at quarter end after paying $5.7 million of dividends and after repurchasing 455,000 common shares worth $13.4 million. Due to the book and ship nature of our business and the timing of near-term revenues associated with large product -- projects, it is our policy not to give specific guidance for the quarter for the year. However, we would like to give color to help you formulate your views on our near-term business outlook.

For the third quarter of 2012, we expect the sluggish economic environment will negatively impact our revenues. And therefore, we are cautious going into the third quarter. With that in mind, we are planning for total company revenues to be flat to slightly up on a sequential basis. We expect GAAP gross margins for the third quarter to be roughly flat from second quarter levels. Our expected GAAP gross margins will be net of purchase price adjustments to revenues and the cost of goods sold in the range of $1.1 million to $1.5 million. We expect GAAP operating expenses for the third quarter to be in the range of $71 million to $73 million as they will include a full 3 months of the acquired Broadband Access business.

GAAP operating expenses for the quarter will -- GAAP operating expenses for the quarter, we expect, will include acquisition-related amortizations of $500,000 and integration and other acquisition-related expenses of $600,000 to $800,000.

As a result of delays to extend legislation for research tax credits for the 2012 year, we anticipate our tax rate for the second quarter will be in the range of approximately 37%. This tax rate provision is in range with the tax rate incurred in the second quarter, excluding the bargain purchase gain.

We believe the larger factors impacting the organic revenue we realized -- or the total revenue that we realized for the second quarter of 2012 will be the following: the macro spending environment for Carriers and Enterprise, the adoption rate of our Total Access 5000 platform, professional services activity levels both domestic and international, upgrades from mobile broadband infrastructure and the timing of revenue-related to Broadband Stimulus projects.

Tom, back to you.

Thomas R. Stanton

Right, Jim, thank you. Blake, at this time, we're ready to open up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] It looks like our first comes from the side of Sanjiv Wadhwani from Stifel, Nicolaus.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Tom, just a broad level question on Tier 1 budgets. Are you getting the sense that, given sort of weakness in the first half, that budgets are still unchanged in -- for the full year or essentially have been ratcheted down for the full year?

Thomas R. Stanton

Well, I hate to speak for the customer base. And my sense is that there's still a sense that there'll be some accelerated spending in the second half, I think, is what the verbiage is. But that's something that we're not planning on ourselves. So we're assuming that the environment is kind of what the environment is and that the spending levels at most of the carriers will stay consistent to what we saw in the first half.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Got it. Did you see a normal sort of sequential uptick in the second quarter? Or was it way below the normal seasonality? Just in terms of given that first quarter was weak, I'm just trying to gauge as to where the second quarter essentially came out, do you think, in terms of spending.

Thomas R. Stanton

It was actually somewhat lumpy. I mean, actually, came out -- we came out of the quarter -- the previous quarter, and we saw a pretty good order flow. And that stayed consistent for some part of the first month and then we saw a slowdown, and then we saw a pick back up in the end of the quarters. So it definitely was not a normal seasonal quarter for us. And I can look at different market segments and talk about different pieces. I've touched on some of those in my notes. Definitely the Tier 1s, other than the Fiber-to-the-Node build-out that I mentioned, was slower than what we normally see. And we saw some project delays in the Tier 2 accounts. Now those project delays right now are scheduled for just later in the year, including the third quarter. But our take on that is, they have been fluid enough for us at this point in time just to discount that potential start and just see kind of how things roll out through the third quarter and the fourth quarter.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Got it, that's helpful. Just one quick question, Jim, as far as NSN is concerned, if you look at the 2 months that you had in the June quarter, are we still looking at about -- run rate of about $36 million or so for the September quarter?

James E. Matthews

Well, Sanjiv, we do expect a sequential increase in revenues from Q2 to Q3 for BBA, just by the

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But in terms of getting specific guidance on the revenue level for Q3 for BBA, at this point, I don't think we're prepared to do that, other than saying that we do expect to give -- to see sequential increase.

Thomas R. Stanton

I think maybe a better way to look at it and -- there is pressure that we're seeing in Europe. But to be honest with you, nothing like what we're seeing here. So I think the uncertainty around BBA has to do with the fact that we're 3 months into it -- 2.5 months into it, I guess. So the way that we're looking at that and trying to be as cautious as we can is basically say, "Let's take 2 months and add another month to it." And that's kind of the range that we're looking at.

Operator

Next we'll go to the side of Jim Suva from Citi.

Jim Suva - Citigroup Inc, Research Division

First, a clarification question then my main question. The clarification was [indiscernible], did I hear correctly you're expecting kind of Q3 guidance in total company to be flat and that even includes the, I believe, an additional full month of the NSN.

[Audio Gap]

My actual question after that clarification is, from the gross margins, it looked like core ADTRAN before the acquisition continued to deteriorate here for the gross margins when you don't include the acquisition integration. Can you talk just a little bit about that and why margins should be flat going forward when one would expect you'd start to see some synergies and improvements from NSN? And is this kind of the new permanent reset to the ADTRAN model for margins?

Thomas R. Stanton

Let me cover the first one, touch on the second one and turn it over to Jim. The answer to your question is, the total company, including the acquired NSN BBA business, we're expecting flat to slightly up in the Q3 period. So that will include all of the revenues for the 3 months in Q3 with NSN. On the second piece, we have 2 months now of NSN margins. And the margins on the NSN business came in basically in line with what we had projected and what we had talked about. And if you blend those 2 margins, we're within the range of what it is that we thought was going to happen for the total company. We had some one-off expenses, mainly a warranty expense that was in excess of $1 million that we that occurred in Q2, which is not something that is typical for us and that did impact slightly. Jim, do you want to add some?

James E. Matthews

Right. And as we look at Q3, in terms of the BBA business, we do expect to see some cost improvements in the cost of sales area or some gross margin improvements. However, the flip side of that is that we will see a full 3 months of BBA at lower than our organic rev -- organic business. So there's that to consider, as well, in our view of the Q3 gross margins.

Thomas R. Stanton

So if you look at Q2 to Q3 organic, I would say there were no surprises there. And I would say Q2 gross margins were in line with what we had said. And Jim, if you mind just kind of restating what our gross margin outlook was for BBA target?

James E. Matthews

Well, yes. As we said on the -- on prior calls, we expect the BBA gross margins to start out in the low 30s. And then as we progressed through the quarters, we expect to see improvements. And actually, we said in the last call that we expect to see the full savings of our supply chain transition in Q1 of next year. So that has not changed. And we expect that gross margins on BBA will improve between now and then to reach that point. That answer your questions, Jim?

Jim Suva - Citigroup Inc, Research Division

Yes. Thank you very much, gentlemen.

Operator

Next, we'll go to the side of Michael Genovese from MKM Partners.

Michael Genovese - MKM Partners LLC, Research Division

Because it sounds like the -- in the second quarter, there was one U.S. Tier 1 that was strong in Broadband Access and then there were 2 weaker customers. And my question is, is that a function of the products that you sell, which are mostly legacy products and kind of a lack of getting newer products into those customers? Or do you think that this is an overall CapEx issue? And you may have been asked this earlier, but I guess I'll just ask again because I might have missed it. Do you think that CapEx in the second half for the year in the U.S. will be flat to lower than it was in the first half of the year?

Thomas R. Stanton

I would tell you what we're forecasting is a challenging CapEx environment, which would stay flat to lower. I think we're probably thinking more flat than lower. To answer your questions on the Tier 1s and give you a flavor on the rest of the pieces -- I mean, it is very rare that every customer on our customer list comes in exactly as we expect coming into the quarter. But what you typically have and what has been consistent with us over the last few years up until last quarter was an upside on the other customers, where they spend past what they initially had projected to you or we had projected ourselves where it covers any downside. And I think that's typical with most businesses. What we saw this quarter was very little of upside spending. We had a lot of customers that met their plans and expect the majority of customers met their plans, but we had very, very few customers that exceeded their plans. And then we had a handful of customers that did not. The largest customer actual impact was a Tier 1 carrier and that carrier buys a significant amount or had bought a significant amount of legacy products, predominantly HDSL. And we saw, especially on a year-over-year basis, a significant decrease in HDSL sales to that customer, which accounts for 100% of the shortfall that we saw in the quarter. And it does make us cautious about going forward as to what the revenue leverage with that customer is going to be. That, in combination with seeing very little upside or being nervous about very little upside potential with the rest of the customer base, kind of places us where we are.

Michael Genovese - MKM Partners LLC, Research Division

Okay, great. And then just one follow-up. On the Tier 2 business, can you tell us where we stand with kind of the regulatory mandated access line upgrades? It seems like last year or the year before, there was Tier 2 carriers buying Tier 1 access lines, which have upgraded. Are we done with that now? Are we toward the end of it or we're still in the middle?

Thomas R. Stanton

I would say we're definitely more towards the middle and maybe the front half of the middle than done. I do think that, that customer base is being as cautious as any. So they're planning their builds very carefully. And sometimes we see movement in the timing of those builds and that some of the uneasiness that you're hearing from our tone today.

Operator

Next, we'll go to the side of Mark McKechnie from ThinkEquity.

Mark McKechnie - ThinkEquity LLC, Research Division

So a couple of questions. One, you break out -- or can your break out your 10% customers and how big they were in the quarter?

James E. Matthews

Mark, what we can do is talk to the fact that we had 2 10% customers in the quarter, but we refrain from naming those at their request.

Mark McKechnie - ThinkEquity LLC, Research Division

Okay. Can you tell me how big they were or just that they were bigger than 10%?

James E. Matthews

Yes, both of those were bigger than 10%. But in terms of providing more data than that, again, we've been requested not to do.

Mark McKechnie - ThinkEquity LLC, Research Division

Okay, got you. And then on the NSN acquisition price, I looked at your cash flow statement, am I right -- is it -- I saw a $7.5 million number in there on that cash flow statement. Is that what the net -- what you paid for NSN?

Thomas R. Stanton

Well, if an amount was paid, it would've been bracketed. And as you can see, that amount was not bracketed.

Mark McKechnie - ThinkEquity LLC, Research Division

Okay. So it was either that or less is what you paid? I mean, what else would have been in that $7.5 million number?

James E. Matthews

Well, Mark, I mean what that means is that we actually received consideration of that amount, rather than paying it out.

Mark McKechnie - ThinkEquity LLC, Research Division

Oh, okay, okay. Oh, actually, it was a positive number. So you got -- you -- the acquisition came with a check to you.

James E. Matthews

Right. That's one way to look at it.

Mark McKechnie - ThinkEquity LLC, Research Division

Yes, got you. Okay. And then, hey, just on your guidance, the -- I know you just guided for September. And it's flat, which is obviously different than the normal seasonality, especially with NSN kicking up. Again, you're not giving guidance beyond that but strange seasonality out there. Would you think about December being up sequential versus the normal down? Or is the -- would it still make sense to expect the down sequential December?

Thomas R. Stanton

At this -- first of all, it's very difficult for us to forecast that in the environment. We typically wouldn't forecast 2 quarters out. I would say the normal seasonality is not normal for us at this point in time. And I think there are multiple things for that. I think the environment itself is one where we're seeing delay.

[Audio Gap]

I also think that HDSL was a big driver of some of that seasonality in the past. And the HDSL number is becoming more and more inconsequential. So we don't expect to see that kind of pickup that you would typically see and that -- and potentially that volume in Q4. But having said that, I don't want to set any expectations at all in Q4 until we get closer to that period of time just because of the uncertainty. And I think, at this point, it would -- right now, it would be -- it just would be inappropriate.

Operator

Next, we'll go to Simon Leopold from Raymond James.

Simon M. Leopold - Raymond James & Associates, Inc., Research Division

Just a couple of quick clarifications. Understand your issues on the 10% customer details, but could you just clarify if one was domestic and one was international?

Thomas R. Stanton

I think that would be accurate, Simon.

Simon M. Leopold - Raymond James & Associates, Inc., Research Division

Okay, that was pretty easy. And then in terms of this revenue forecast for the third quarter, obviously, you're talking about the acquired business contributing more given that you've got it for a full quarter. It clearly implies something else is contributing less sequentially. Is that in a particular business element, business segment, broadbrush? I guess what I'm trying to get at is, what will be down sequentially in September, offsetting the full quarter of the NSN acquisition?

Thomas R. Stanton

Well, I can tell you the way that we're doing it, and it may not be as scientific as you'd like us to be. But when we roll up all of the numbers, the Enterprise environment is somewhat challenging. If I take a look at what our people say things they're going to do, to be honest with you, they're thinking more flattish than anything. If I look at the domestic carriers' spending and really, let's say, the organic carriers' spending, things look more flattish than down. And then there are the projects that I had talked about that have been delayed. So there's potential there but -- and then we lay in BBA, which we had talked about basically taking the 3 months versus 2 months. But we're taking the aggregate those numbers in the balance doing a haircut on those because of the uncertainty in the environment. And we've seen -- in the past, we would haircut less and still be able to exceed those numbers. But we see very little upside movement, and there are always carriers that will disappoint. So it's really that thought process.

Simon M. Leopold - Raymond James & Associates, Inc., Research Division

Okay. And then just in terms of the Internetworking business, that was -- the degree of the sequential decline was what was most surprising to me. I'm just wondering from your expectations going into the quarter and your original forecast for June, what were the biggest surprises to you? And in terms of Internetworking, I guess what I'm trying to think about here is, is this really a reflection of the macro

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inventory in the channel? And if it's inventory in the channel, how long do you think it takes to work that to a level, where you get back to normal patterns?

Thomas R. Stanton

I think it's the macro. And I think the macro leads to inventory in the channel. But I think at the end of the day, it's the macro. I don't think that we saw an increased drive towards increasing inventories in the channel. But I do think when you see a slowdown, then depending on the timing

[Audio Gap]

I think it's a predominant factor. I do think that it's a more macro piece. And I will say it hit pretty much in most segments. I mean, we saw a slowdown in switching, and we saw a slowdown in routing. We saw a slowdown in IP gateways, and we saw a slowdown in most of the distribution channels.

[Audio Gap]

of that would be the reseller distribution channel, which now also has Bluesocket products and then Bluesocket itself, which was up. But other than that, it's kind of hard to find anything that really stood out.

Operator

Our next question comes from Ehud Gelblum from Morgan Stanley.

Ehud Gelblum - Morgan Stanley, Research Division

A couple of things. First of all, just want a little clarity on something you said earlier. Originally, I think one of the questions was, do you think you have -- you're seeing a falloff in the types of products you're selling in the sense that do you have the right products that your Tier 1 customers are buying? Or is the problem a more overall CapEx issue? I think you answered that, that you thought it was an overall CapEx issue but then said that one of your large Tier 1 customers that predominantly bought HDSL and the falloff on a year-over-year basis was primarily the falloff in HDSL. And so that would sort of indicate to me that perhaps they're not buying HDSL anymore. They're buying more package-based products. And so perhaps, they're buying other types of products instead. I'm still trying to get to the sort of the more global picture is have they moved from your -- the products that you've been selling for some time, other types of products or have they just stopped spending entirely?

Thomas R. Stanton

Yes. Let me just give you what I can talk about because I'm not going to try to forecast as to whether or not they stopped spending entirely. I would say that they -- if you look at the -- not all the Tier 1s as you're aware, but if you look at subset of the Tier 1s, they have predominately bought our legacy products. Now we have gotten many products approved at those Tier 1s that have not rolled out. We've talked about our pivot project. We've talked about IT aggregation projects. We've talked about Ethernet over Copper. They have not rolled out in mass. As you know, we've also an OEM management with Ericsson. That has not rolled out in mass. So there are things that are sitting there that have not rolled out, that have been either approved or going through the process. Most of them had been approved but have not turned on. So I look at that subset of Tier 1s and see that, yet we have a large portion of our revenue to them being legacy product sales, predominantly HDSL as you're aware. And HDSL has definitely turned off without those other ones turning on. But that is not a new thing. That is actually -- we've seen that decline over the last at least a year or so, and I think we've been very open about that. But what we had in the past is enough of the other customer base to kick in to really overcome whatever that was and still post solid growth. What we've seen at this point in time is that those other carriers have really turned cautious. And those other carriers, as I think you're aware, we have very strong new product momentum. But we have hit a slower portion in time right now where their spending level is. But with that -- with the Tier 1 subset that I'm talking about, there is a shift that needs to occur with their spending with us that has not happened yet. Did that answer your question?

Ehud Gelblum - Morgan Stanley, Research Division

And then, what do they say? Did they say, "We're just not sure if we have a budget, right now?"

Thomas R. Stanton

I think, in general, yes. It's not -- and it's not a -- well, no, no, no. Let me -- I'm not speaking to their total budget for this year. When I talk about our particular project, it is we do not have the budget for those projects at this point in time. We're focused on 4G or something else. And we do want to do those or plans are to do those, but they're not at this point in time.

Ehud Gelblum - Morgan Stanley, Research Division

Okay. You always had great visibility on how your products are being used. At the end of the day, how much was for backhaul? How much was for other types of things? Do you have a sense as to -- do any of your projects, do you think, projects that you're working on, besides HDSL, dovetail in the 4G build and other types of backhaul builds? Or do you think right now, you're pretty much more exposed to just rural broadband access?

Thomas R. Stanton

Yes, I think there are some projects that we have that are still sitting in the queue that do that. May -- for instance, some of the approvals that we have previously received that may have an impact on that. Our Optical business has traditionally played in different areas of the network. But I would still say it was predominantly HDSL. And HDSL is just not being used for 4G. I think there is another exacerbating factor -- I hesitate to bring it up with you because I think it can be confusing. But we had talked about the fact that 4G was not -- HDSL was not a big part of 4G. But that, that's actually probably more fiber-based than anything else, and we had seen that downtick. There is still a very good demand for HDSL in the business market where we have seen an increase in reuse that is -- reusing plugs that are being decommissioned, that is higher than anything we had ever seen before. And that has impacted the number. There is not a lot we can do about that at this point in time. If I look at the demand of HDSL itself, it is down. But the decrease in HDSL is significantly lower than what that demand decrease has been or actually significantly steeper. And it has to do with reuse. In other words, I think we're going to spend a lot of time talking about it because it is kind of it is what it is. And HDSL is down to a level now to much just less of an issue for us.

Ehud Gelblum - Morgan Stanley, Research Division

Right. Optical Access, however, does play in the backhaul and perhaps 4G, are you surprised they're still weak?

Thomas R. Stanton

I was surprised at the weakness in Optical. Because it does -- actually, it does play in several of those areas and how that reflect to the overall capital environment, I won't try to guess.

Ehud Gelblum - Morgan Stanley, Research Division

Okay. And one quick one, on your organic large international customer, that obviously was very large this quarter. Does that drop off next quarter? And is that the offset to the increase in NSN, that you're thinking about?

Thomas R. Stanton

No. I mean, I think if you think of our business as generally -- the way that we are forecasting our business is generally flattish. And I think that, that's kind of the general sense of almost every segments.

Ehud Gelblum - Morgan Stanley, Research Division

So NSN is up.

Thomas R. Stanton

NSN is up because it has an additional month.

Ehud Gelblum - Morgan Stanley, Research Division

Right. So something has to be down as someone has mentioned before. And does that end up being that you're planning international customers to fall back?

Thomas R. Stanton

Yes. And I tried to explain that earlier. I would think -- I would say flattish with a haircut on most of the segments. But to that particular customer, flattish is the right way to be thinking about it.

Operator

Next, we'll go to the side of Rich Valera from Needham.

Richard Valera - Needham & Company, LLC, Research Division

Earlier in the year, you'd were pretty optimistic about Broadband Stimulus contributing incrementally in the back half of the year. I'm wondering what the current status is or your thoughts on that.

Thomas R. Stanton

Broadband Stimulus was -- there's some positive and some negative. From a shipment's perspective, it was kind of flat to what we saw in Q1. We're really -- we're looking more for a sequential uptick. From a booking perspective, it was a very strong quarter. Of course, those shipments will occur. We will recognize revenue in those shipments in the quarters to come. So I would say from a bookings perspective, it's right where we are. From a shipments perspective, it was slightly disappointing.

Richard Valera - Needham & Company, LLC, Research Division

But you would expect sequentially better revenue in 3Q, 4Q from Broadband Stimulus off the bookings you were seeing in 2Q?

Thomas R. Stanton

There's the potential for that, but those -- there are a lot of different approvals and things and rollout variations. So there's definitely the potential for that. But I don't want to say that, that's some big uptick that we're expecting in Q3.

Richard Valera - Needham & Company, LLC, Research Division

Great. And can you give us an update on a Tier 1 OPTI opportunity, which you mentioned. I think it was in lab trials last quarter. How that's progressing? And do you think that will result in revenue in either 3Q or 4Q?

Thomas R. Stanton

That is a customer that we're always have a forecast on. But, yes, that is still progressing. We're at the very tail-edge end of that. And hopefully, we'll monetize that this year. But we haven't done -- but that's about all I can say about it. There's -- that is still alive and active, and we're still working with that customer on getting the final things wrapped up.

Richard Valera - Needham & Company, LLC, Research Division

Is it fair to say nothing baked into 3Q for revenue from that opportunity?

Thomas R. Stanton

That would be fair to say.

Operator

Our next question comes from Jonathan Kees from Capstone Investments.

Jonathan Kees - Capstone Investments, Research Division

Just wanted to get a clarification. In Q1, there -- one reason for the shortfall there was an IT system coming online. Did that resolve itself? Was that not affecting Q2?

Thomas R. Stanton

That was not a factor in Q2, and it has resolved itself. And we had talked about Tier 1s spending being sluggish, mainly with legacy products in HDSL. That was not the case with our Fiber-to-the-Node products, which is where we saw that slowdown.

Jonathan Kees - Capstone Investments, Research Division

Okay. And I guess I'm a little surprised because HDSL has been decreased in terms of percentage of revenues. It's about 10% for this quarter. And yet it still has enough of an impact on revenues. Are you guys to be concerned for it to bring down Tier 1 sales as a whole? But isn't the expectation for HDSL to just continue to decrease

[Audio Gap]

and less and less of a factor?

Thomas R. Stanton

That's exactly the case. If you look at the year-over-year period, which is where you really notice the stark difference in HDSL, it was a very big decrease in HDSL on a year-over-year basis. On a sequential basis, it was basically flat. So I do think that reuse still continues to be pressure on that and could continue to grow. But in general, we're just expecting that to continue to decline over the next few quarters or probably the next few years.

Jonathan Kees - Capstone Investments, Research Division

Okay, all right. So being less and less of a factor then. All right. So it just mean the Tier 1s have not been ordering the applications that they've approved. And the -- I guess not to bring up something that's already been asked before, but just to make sure I've got it right here. Is your forecasting for challenging CapEx in the second half. But in your conversations with the carriers, I guess, I'm asking you this way, you're hearing more of a slowdown or delay rather than a cancellation. Is that a correct way of looking at it?

Thomas R. Stanton

That is definitely the right way to look at it. I have not heard of any significant cancellations. And there were some that are probably more optimistic on second half CapEx than others. But I would tell you, plans change though. So in general, we think it'll just be a sluggish capital environment for our equipment. I'm not trying at all to forecast the entire capital universe out there.

Jonathan Kees - Capstone Investments, Research Division

Okay. And for Tier 2s, that's a new development. Is that just more of a short-term hiccup? Or is that now in the same bucket as Tier 1 in terms of slowdown possibly for the second half?

Thomas R. Stanton

Yes, I'm trying -- I want to be as factual as I can as far as what we're hearing and kind of what we're planning, which may be slightly different because of the fact that everything that people plan on doesn't come into play or doesn't actually happen. I would expect a strong -- I mean, I will tell you the feedback we're getting is a stronger capital spend in the second half than in the first half. To the extent that we discount that, it is because we have multiple businesses. And to the extent that, that one is up, then we're giving ourselves some leeway for some other piece to be down. But if you talk to me specifically about Tier 2s, I will say that the current sentiment is that there'll be stronger, much more -- or actually, I should say, much more activity in the second half than we saw in the first half.

Jonathan Kees - Capstone Investments, Research Division

Okay. And it sounds like also for the Tier 3, especially with the Stimulus, it should be picking up in the second half or there's potential...

Thomas R. Stanton

Yes. And I would say that's a very similar sentiment to the Tier 3s that I just mentioned on the Tier 2s. I hope I'm not confusing the issue here. But the answer to your question is yes.

Jonathan Kees - Capstone Investments, Research Division

Okay, all right. Then with Enterprise, that this -- you're looking for that to be flattish in the September quarter. Is that just short term? Or are we talking about something for the second half, something more pronounced, more elongated than just the third quarter?

Thomas R. Stanton

I hate to say it, but I think that has more to do with the macro environment than anything else. And whether or not end users or businesses are actually in the mood to upgrade that their infrastructure with our type of equipment or not, and so I would say that, that environment will turn when we see a turn. I'm not going to try to forecast to turn in that environment. The way that we're forecasting it at this point in time gives us some comfort and we're -- and being able to meet or hopefully exceed numbers.

Jonathan Kees - Capstone Investments, Research Division

Okay, all right. And if I may, one last question. DSOs were up pretty dramatically in the quarter, just some elaboration in there.

Thomas R. Stanton

Which sales, I'm sorry?

Jonathan Kees - Capstone Investments, Research Division

DSOs.

Thomas R. Stanton

DSOs were up.

James E. Matthews

Oh, yes, yes. So good question, Jonathan. So as you know, we acquired the NSN BBA business. Now in that acquisition, it did not include bringing over an accounts receivable balance. So therefore, in the month of May and June, we built receivables in that business as we shipped product. So we ended the quarter with about $22 million in receivables for that business and again, that occurred over only 57 days, right? So the way you compute DSOs, you actually have to divide it by 91 days rather than 57, right? So that certainly drove DSOs up, a substantial part of the increase in DSOs for the quarter, okay? So as we go through Q2, we think that we'll see some level of normalization, if you will, for that.

Operator

Next, we'll go to Eric Ghernati from Bank of America.

Eric A. Ghernati - BofA Merrill Lynch, Research Division

Just a few questions. Can you -- actually, just to clarify, is your order flow right now for the month of July like flattish with June or down versus June?

Thomas R. Stanton

That's -- we don't typically talk about that granularity. But I would -- but I will give you the color. I would say it's more -- it's flattish from where we exited the previous quarter.

Eric A. Ghernati - BofA Merrill Lynch, Research Division

Okay. The -- just want to look back at the Internetworking business. The -- I mean, the performance was in stark contrast with what's -- one of your distributors as discussed back in their results like a few weeks ago. Can you just describe what happened exactly? Like which areas -- like which, not products, but which customer base, it is non-distributors that saw the biggest -- like your direct-to-business was weaker than the channel business or...

Thomas R. Stanton

Well, we have 3 major areas that we sell the products to the reseller base, which is through the distribution channel that you're talking about. And we also sell to large carriers and then we sell to CLECs and smaller carriers. And that's where we tend to categorize and actually run them internally. I would say we saw pressure in the reseller base, but the resellers were actually up. And that may be what you're talking about. But I would still say we saw pressure there and kind of elongated order times or deal times. And then in the other 2 basis, we actually saw a tick-down.

Eric A. Ghernati - BofA Merrill Lynch, Research Division

And then can you just remind us again like about the -- because it seems that the flattish gross margin on a sequential basis for the December quarter does not take into account a side of it but you have like a one-timer from Q2 that should go away in Q3. It seems like you're implying that even with the -- I mean, if you do the math, even with the additional one month, you should still see some improvements in gross margins for the organic business. Just walk us through why that's not happening?

Thomas R. Stanton

We have to turn it on the warranty issue and then we have the incremental one month on the NSN BBA, and I'll let Jim...

James E. Matthews

Yes. So Eric, I mean, the range -- we attempt to give a range of gross margin outcomes in terms of our view for Q3. Might we be spot on to Q2? I doubt it. There may be some differences there in terms of 30 basis points. We may come out better. But again, I'm just trying to set an area of expectation, really more than an exact expectation for gross margins. So we do have a number of things that are playing. Yes, we have some benefits from the fact that certain things are not reoccurring in Q3 as we expect. But on other hand, we have a full 3 months of

[Audio Gap]

in organic margins. We do expect some level of improvement on BBA gross margins, but we think that we'll see gross margins somewhere in the range of what we experienced for Q4.

Eric A. Ghernati - BofA Merrill Lynch, Research Division

Can you -- as you look in the -- as you look for the year, can you just discuss what your market share will be at your largest customer? Your direct competitor, of course, is banking on some share gains in the back half of this year and starting next year. Can you just discuss what your expectations are?

Thomas R. Stanton

Our expectations are no share shift this year at all. So we're expecting -- I think we're meeting all of the requirements, and I think we're doing a good job. And I think the communication

[Audio Gap]

open, and I don't expect any share shift.

Eric A. Ghernati - BofA Merrill Lynch, Research Division

And is that a function of you just being more aggressive? Or is it them not performing? What do you think that attributed to? Because it would seem like your largest customer would, if anything, like -- has committed to them being part of the network?

Thomas R. Stanton

Well, they are part of the network. I think the way -- it's my interpretation of what the customer has told us is that they want 2 vendors and that they have 2 vendors. And they want the 2 vendors approved in multiple areas. So you can imagine, we've done a lot of work on getting approved on the legacy CenturyLink piece. And from that point on, that they will allow vendors to sell into the network. And it's really up to the regions as to what they actually choose. And we feel like we're in a very good position. I think the way to think about that is more of a hunting license than any particular regional award, and that's the way

[Audio Gap]

Operator

Next, we will go to the side of Jeff Kvaal from Barclays.

Jeffrey T. Kvaal - Barclays Capital, Research Division

Tom, I think that this one is for you. Could you -- would you categorize the

[Audio Gap]

uninspiring nature of CapEx spending in the U.S. Is that kind of a new, new situation? Or is this -- are the carriers saying, "Well, we're waiting for the macro to get better. But we really do need to do things." And then I think what's interesting to me is that where we hear a lot about the macro weakness is in international markets. For you, those seem to be going well. Why are those markets going well and -- relative to U.S. when those markets are actually the ones where the macro, if anything, is for the worst than it is here?

Thomas R. Stanton

So I would -- first of all, I would -- I'm really hesitant on trying to project that we are forecasting the overall capital spend. We're talking about the capital spend that's in relation to the particular products that we sell. So I'm not at all trying to say that all CapEx for the U.S. is going to be this or that. And as far as our customers, is this a new piece. I would say definitely -- I mean, there has been, I would say, uneasiness and maybe slow capital spend starting into the year. I would say people were, at that point in time, thinking that the budgets will be approved and things will roll on. And I would say we'll just continue to see the same sluggishness in Q2 that we saw in Q1, except in Q1 there is this general belief that things would turn back on. And they didn't turn on to the extent that I think we had planned. So in general, you could say it's not a new animal. But I would say it increased -- that, that conservatism increased for us in Q2. And we're expecting similar conservatism in Q3. As far as the international market versus -- capital versus where our performance has been, there are -- first of all, most of that business, if we talk about the NSN BBA business is new. And I think that they have gone through probably some capital constraint or tightness for some period of time. And what we are doing is picking up the ball at a point in time, where the capital is already tight. That doesn't mean that it couldn't become tighter. But I think that a lot of the downtick that you would have expected in a capital-constrained environment has already happened in this business. And so that's where we feel better about the relative place that they are versus if it had been at a peak and we were actually catching it on its way down. And then we have other customers, one that's more predominant than the others, that had very specific things, very targeted things that they're trying to get done. And we happen to be right square in the sweet spot of that.

Jeffrey T. Kvaal - Barclays Capital, Research Division

The growth that you posted there suggested a decent amount of share gain, is that a fair assessment? And then can you talk a little why these are happening, and perhaps who you think you're able to take the share from?

Thomas R. Stanton

Sure. The share gains have been happening over some period of time. The incumbent in that particular customer is Ericsson and Alcatel-Lucent. And Huwaei is also in there. And I think it has to do with the unique design of our architecture, which fits very, very well into their network architecture. And I think it makes us incredibly competitive and meet their overall speed and performance requirements that they're looking for. And I think we're somewhat unique in being able to do that. But that share shift has happened over the last 2 years, and we continue to benefit from that and be able to work into there.

Jeffrey T. Kvaal - Barclays Capital, Research Division

Is that premise why outside of the 10% international customers that you have?

Thomas R. Stanton

By the premise, you mean the thought itself?

Jeffrey T. Kvaal - Barclays Capital, Research Division

Well, it seems like you're able to do well outside of that one customer as well, because of the same general premise.

Thomas R. Stanton

Yes. It's the same general -- yes and no. I mean, that product that we're selling, the majority of it is on 1100 Series products, which is a very unique product in the market. The 5000 is -- if you look outside of that customer, I would say we have a mix of both 5000 customers who buy it for different reasons than the 1100 Series products. But in every case, we have to be able to differentiate ourselves. We do not have the same in-country presence as most of our big competitors, so we really do have to differentiate ourselves.

Operator

Next, we'll go to Blair King from Avondale Partners.

Blair King - Avondale Partners, LLC, Research Division

I just have a couple of quick questions -- a couple -- maybe a little bit of a rehash here, too. But just first, Jim, what -- can you give us a sense as to what percentage of the sales were services this quarter?

James E. Matthews

Blair, I don't have that number. But even with the BBA acquisition, it still remains something less than 10% of total company revenue.

Blair King - Avondale Partners, LLC, Research Division

All right. I just wanted to go back to the margin question. I know it came up a couple of times but maybe a more generic way of asking the same question is, just kind of looking at the ADTRAN core gross margin in the second quarter, at least the implied margin versus just say the margin from the first quarter of 2011 or the second quarter of 2011, there's just a -- there's a pretty dramatic downtick. And I guess I just haven't heard a good explanation for that outside of -- there are -- I understand the service mix. I understand the transportation cost. I understand all that. But even last quarter, there was lower volume associated with the gross margin. But then this quarter, the volume goes up, and the gross margin appears to actually be down sequentially. And so I'm just curious, I think a lot of people are confused. And if there's any way to just give a little bit of background as to what's going on in the business to drive that would be really helpful, Jim.

James E. Matthews

Yes, so there's one increment that we did bring up. We did have a warranty cost, a run-through in the quarter that doesn't typically happen. But that was, as Tom said, just in excess of $1 million, which is certainly a negative -- an incremental negative as it relates to the prior quarter and year-over-year, okay? And there's some other things. Yes, I'm not quite sure how people were picking this up in their view for gross margins. But in terms of the purchase price accounting or adjustments that are happening on the revenue line and also on the cost of sales line related to the purchase of NSN and that was just over $1 million in Q2. And we expect it to be just a bit more than that and a range just a bit more than that in Q3 because of the full 3 months that we have into it. So those are some of the other things that I can offer there, Blair, in terms of reconciling what's happened.

Blair King - Avondale Partners, LLC, Research Division

Right. And then is there any way to kind of give a little bit of color on the BBA manufacturing runs? And you mentioned some products had been moved and others hadn't -- have the -- there's been high run rate products, low run rate products. Or what happened so far?

Thomas R. Stanton

I think the big key to us was actually starting the build itself, which means that we actually have a new facility up and running. And I'm sure, I know that the schedule includes initially the higher running rate products. So -- but if you ask me, I don't have the exact product in front of me and what the actual run rate of that -- of those particular products are. Let me reflect back to you exactly what the moves are and so -- and kind of tell you where we are within the process. We are in the midst of moving products from manufacturing in Germany to manufacturing at locations -- at a new location for us in Hungary. We have started that process and have very good momentum and we will through, I think, the majority of that process, Jim, through Q3. And then we also have -- and that's at a new facility for us, and -- which is an ADTRAN supply chain facility with one of our existing subcontractors that are located in other parts of the world. We also have another phase, which we are in the midst of, and we'll accelerate in Q3, which is moving some pieces from even Hungary and then moving those -- or from Germany at the same time and moving the

[Audio Gap]

Asian manufacturers under the existing umbrella that we have. So there's 2 steps there. And a large percentage of those, if not most of those, will be accomplished this year. I don't know if I added confusion there or have actually...

Blair King - Avondale Partners, LLC, Research Division

No, no. It's clear. And then the last question is, Jim, no one has asked you about the deferred revenue build. I suspect that has something to do with the NSN acquisition as well. But if you could talk about what that is or if that's more stimulus-related.

James E. Matthews

Oh, absolutely, Blair. The bulk of those deferred revenue increases, both in short term or long term, relate to the BBA acquisition. We acquired a substantial number of contracts. And those contracts were multi-element agreements that include customer care revenues, that have built up that deferred. There are level of Broadband Stimulus deferred revenues as well in that number. But I got to tell you the larger piece, which would be BBA-related.

Thomas R. Stanton

Okay. Blake, at this point, I see we're past our time. So I appreciate everybody calling in today. And hopefully, we'll have a positive call in Q3. Thank you very much.

James E. Matthews

Thank you.

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