ADTRAN, Inc. Q2 2008 Earnings Call Transcript

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 |  About: ADTRAN, Inc. (ADTN)
by: SA Transcripts

ADTRAN, Inc. (NASDAQ:ADTN)

Q2 2008 Earnings Call

July 15, 2008 10:30 am ET

Executives

Thomas R. Stanton – Chairman and Chief Executive Officer

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

Analysts

Scott Coleman – Morgan Stanley

Vivak Arya – Merrill Lynch

Simon Leopold – Morgan, Keegan & Co.

Nikos Theodosopoulus – UBS

George Notter – Jefferies & Company Inc.

Greg Mesniaeff – Needham and Co.

Paul Silverstein – Credit Suisse

Blair King – Avondale Partners

Raimundo Archibold – Kaufman Brothers

Ehud Gelblum – JP Morgan

Bryan Coyne – FBR Capital Markets

Jack Monty – Lehman Brothers

Todd Koffman – Raymond James

[Rari Binsinger – Standard and Poor’s]

Operator

Welcome to the second quarter 2008 earnings release conference call.

During the course of the conference call ADTRAN representatives expect to make forward-looking statements which reflect management’s best judgment based on factors currently known. However, these statements involve risks and uncertainties, including the successful development and market acceptance of new products.

The degree of competition in the market for such products, the products in channel mix, component costs, manufacturing efficiencies and other risks are detailed in our annual report on Form 10-K for the year ended December 31, 2007 and form 10Q for the quarter ended March 31, 2008. These risks and uncertainties could cause actual results to differ materially from those in the forward-looking statements which may be made during this call.

(Operator Instructions) I would now like to turn the conference over to Tom Stanton, Chairman and CEO.

Thomas Stanton

Good morning everyone and thank you for joining us on our second quarter 2008 conference call. With me this morning again is Jim Matthews, our Senior Vice President and Chief Financial Officer.

This quarter’s performance was driven again by continued acceptance of our growth products including broadband access, optical access and internetworking. Combined, our growth businesses again achieved a new record level for the company led by 55% growth in our broadband access category. Optical access came in with a strong 36% year-over-year growth followed by internetworking which also reached record revenue levels.

In our traditional product areas, HDSL continued to show resiliency despite a soft SMB environment. HDSL revenues of $45.5 million were essentially flat to the same period last year. Traditional enterprise products were essentially flat to the first quarter and now equate to approximately 8% of the company’s total revenue.

As mentioned before, broadband access had a tremendous quarter due largely to the fiber to the node products. Our 1100 series products continue to gain acceptance and we are excited about the long-term growth potential of this category as we introduce new generations to meet growing customer demand.

Moving on to our 5000 series products, we remain on track with our major tier one awards. As some of you will recall we shipped our first tier one carrier late last year and that customer remains active as they continue to pre-deploy infrastructure and begin marketing their new service. We received initial orders from our second tier one carrier at the end of the second quarter. Although these are very positive steps for our company we would like to remind you that we are still early in the deployment cycle of these two carriers.

Similarly, our tier one, tier two and international accounts continue to move forward and our optimism remains very high for the long-term positive impact this series of products will have on our company. Although we are very pleased with the number of awards to date in our broadband access product family we should remind you that carriers require significant time to operationalize these complex products like the Total Access 5000 and fiber to the node series products and the timing of these opportunities can vary significantly from the anticipated date.

Optical access had a strong quarter with 36% year-over-year growth. Again this quarter was driven primarily by tier one carriers as we continue to gain traction with new awards in that market segment. Our internetworking business saw its seventh record revenue quarter within the last eight despite a sluggish spending in the SMB sector. This growth, although muted by economic conditions, continues to reflect the broad base support we are seeing as we work to leverage our carrier distribution channels and our growing bar dealer base. To support we are seeing confirms that our SMB solutions are meeting the needs of businesses that require integrated solutions for voice data and internet connectivity.

The economic environment experienced during the quarter was similar to what we experienced during the previous six month period with general weakness in our SMB markets and constrained spending by mid-tier carriers. However, clearly we continue to make good progress transitioning our company to a global systems level provider of IP centric solutions for both copper and fiber. This achievement makes us very excited about our global growth potential. We believe our growth business will continue to see strength based on market share gains related to both current and future product introductions and customer spending trends.

Our traditional business will continue to track on a macro level with enterprise demand, wireless network expansions, wire line capacity upgrades and general economic conditions. I would like Jim Matthews to review our results for the second quarter 2008 and our comments on the third quarter of 2008. We will then open the conference call up for questions.

James Matthews

Revenue for the second quarter was $131.2 million compared to $123.7 million in Q2 of 2007. Broadband access product levels for Q2 of 2008 increased 55% to a record $31.3 million compared to $20.2 million in Q2 of 2007.

Comparing Q2 of 2008 to Q2 of 2007 is a significant increase in Broadband access product revenues is primarily attributable to the 1100 series fiber to the node upgrades and 5000 series roll out of Ethernet over copper services, broadband digital loop carrier and other applications. Optical access revenues increased 36% to $13.4 million for the second quarter of 2008 compared to $9.8 million in Q2 of 2007. Comparing Q2 of 2008 to Q2 of 2007 the increase in optical access revenues was the result of continuing market share gains across numerous customers including tier one carriers.

Internetworking product revenues increased to a record $16 million in the second quarter of 2008 compared to $13.6 million in Q2 of 2007. Internetworking products continue to experience increasing momentum as a result of continuing efforts to improve enterprise channel focus and leverage carrier distribution.

In total our growth products grew 39% in the second quarter of 2008 compared to the same period the prior year. Carrier systems revenues were a record $57.7 million for Q2 of 2008 compared to $46.5 million for Q2 of 2007. Comparing Q2 of 2008 to Q2 of 2007 the increase in carrier systems revenues was primarily attributable to revenue increases in broadband access and optical access product categories.

Business networking revenues for Q2 of 2008 were $21.8 million compared to $22.2 million in Q2 of 2007. Comparing Q2 of 2008 to Q2 of 2007 the decrease in business networking revenues was primarily attributable to a decrease in traditional integrated access advise revenues partially offset by an increase in internetworking product revenues.

Loop access revenues were $51.7 million for the second quarter of 2008 compared to $55 million for Q2 of 2007. Comparing Q2 of 2008 to Q2 of 2007 the decline in loop access revenues was attributable to a decline in enterprise T1 and HDSL revenues. HDSL product revenues were $45.3 million in Q2 of 2008 compared to $46.3 million in Q2 of 2007.

As a result of the above, carrier network division revenues were $104.6 million and enterprise network division revenues were $26.6 million in Q2 of 2008. International revenue was $7.8 million for the second quarter of 2008 compared to $8.3 million in the second quarter of 2007. To provide the reporting of each of these categories we have published them on our Investor Relations page at www.Adtran.com.

Gross margin was 60.5% of revenue for the second quarter of 2008 compared to 59.5% for the second quarter of 2007. Comparing Q2 of 2008 to Q2 of 2007 the increase in gross margin percentage was primarily attributable to a more favorable product mix and lower manufacturing costs for the quarter.

Research and development expenses were $20.2 million in Q2 of 2008 compared to $19.5 million in Q2 of 2007. The increase in research and development expenses was primarily attributable to an increase in activities related to customer specific development efforts and [inaudible] costs related to Tier One carrier product approvals.

Selling, general and administrative expenses were $45.7 million for Q2 of 2008 compared to $26.2 million for Q2 of 2007. Stock based compensation expense net of tax was $1.8 million in the second quarter of 2008 compared with $2.1 million in the second quarter of 2007. Other income net of interest expense was $1.9 million in Q2 of 2008 compared to $2.8 million in Q2 of 2007. The decrease in other income net of interest expense for Q2 of 2008 was primarily attributable to lower investment balances as the result of our share repurchase program and lower interest rates.

The company’s income tax provision rate was 36.6% for the second quarter of 2008 compared to 35.2% for the second quarter of 2007. The tax provision rate for the second quarter of 2008 was unusually high primarily as the result of delays in Federal legislation required to extend research tax credits for the 2008 year.

Earnings per share assuming dilution for Q2 of 2008 were $0.34 compared to $0.28 for Q2 of 2007.

Inventories were $49.8 million at quarter end. Net trade accounts receivable were $62.7 million at quarter end resulting in DSO’s of 43 days for the second quarter of 2008 compared to 49 days for the second quarter of 2007. Net cash provided by operating activities for the second quarter of 2008 was a strong $30.7 million compared to $28.7 million for the same period in the prior year. Unrestricted cash and marketable securities totaled $248 million at quarter end after paying $5.8 million in dividends during the second quarter.

As you are aware, ADTRAN has traditionally seen sequential revenue increases from the second quarter to the third quarter. In the third quarter of 2008 we believe that revenue will grow sequentially and therefore year-over-year. Although our second quarter results reflect a good momentum we want to remind you that timing of near-term revenue associated with large projects we are engaged in combined with the possible impact of a slow enterprise spending environment make it difficult to predict the amount of sequential and year-over-year growth we expect to see in the third quarter.

We believe the larger factors impacting the revenue realized in the third quarter will be the following: Stability of our traditional product revenues, spending levels at our tier one and tier two carrier customers, order trends and traction at newer international customers, the adoption rate of our Total Access 5000 and 1100 series flash points, the adoption rate of our Optic 6100 with tier one carriers, continued growth in internetworking revenues and general economic conditions.

We believe we will execute in a range consistent to our historic operating model achieve revenue levels in the third quarter.

Thomas Stanton

We are ready to open it up for any questions we may have.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from Scott Coleman – Morgan Stanley.

Scott Coleman – Morgan Stanley

Maybe I could start with a housekeeping question in terms of what the customer percentages were this quarter Jim?

James Matthews

ATT came it at 24% of revenue, Verizon 11% and Qwest 20%.

Scott Coleman – Morgan Stanley

One of the things that stood out from the numbers was the lack of a buyback during the quarter. You have been pretty consistent over the last eight quarters. What was it that caused you to hold back in Q2?

Thomas Stanton

Scott, first of all I’d like to say that we really haven’t changed our view at all in terms of our buyback and the approach we are using in terms of it being an opportunistic approach. At times we do miss an opportunity within a quarter if we look back to the earlier part of the window that we would typically buy back in we did have an opportunity there but in hindsight we should have taken advantage of it but didn’t.

Again, going forward our view again hasn’t changed in terms of taking an opportunistic approach on this.

Scott Coleman – Morgan Stanley

Just to make sure I understand your comment about Q3, it sounds like you expect to grow as you traditionally have in Q3. The question is at what level? If you grow from here it sounds like you would expect to keep operating margins somewhere around the 25% level, at least in Q3. Is that the right way to interpret your commentary?

Thomas Stanton

Let’s take this approach perhaps. If we look at gross margin we continue to anticipate gross margins will be in the high 50’s range going forward. If we look at opEx, SG&A we anticipate will be flattish somewhat in the third quarter versus the second and we anticipate that R&D will probably move up a little in the third quarter.

Tax rate at a rate somewhat consistent to what we saw in the second quarter.

Scott Coleman – Morgan Stanley

When you talked about the stability of your traditional products and spending levels at tier one and tier two carriers it was the first two things that you mentioned as the factors that could affect revenue in Q3. Now the traditional products obviously had a very good quarter in Q2, maybe better than most were expecting. Is there any reason right now to think that falls off? Are you seeing anything that gives additional concern? Then a similar question on spending at tier one and tier two carriers. Have you noticed any change? DSO’s were down a lot. Did the quarter start to trend a little worse as you went through it? I’m talking about Q2. What is it that gives you incremental pause here?

Thomas Stanton

The quarter did not trend worse. In fact the order flow through the quarter was very, very consistent which obviously contributed to an improved DSO. It also contributed, while we are talking about order flow through the quarter, it also contributed positively to our gross margin. A consistent order flow allows us to more efficiently and effectively plan for shipments and meeting customer dates. We incurred significantly less, if not zero, expediting costs in the third [sic] quarter. Our freight costs were lower and our labor costs were lower.

No reason to believe that will not happen in Q3. Okay? Now Scott does that answer all your questions?

Scott Coleman – Morgan Stanley

It does.

Operator

The next question comes from Vivak Arya – Merrill Lynch.

Vivak Arya – Merrill Lynch

First this is just sort of a macro question. Tom you sort of addressed it in your opening remarks. The question is what is your view of carrier and enterprise spending trends as you look out in the second half? Are you seeing deals remaining on track or getting pushed out? What is the general mood of your customers versus the first half of this year?

Thomas Stanton

We are expecting a mood that is very similar. Let me speak to the carrier piece first. It is very similar to what we have seen over the last 6-9 months which is it is going to be very, very targeted on what they spend on. Tier two carriers have kind of lowered their spending levels and they are being very careful on how they spend and we kind of expect that same mentality going forward. Tier one carriers have specific projects that they want to move forward that help them in the long-term and I think they are spending on those projects and we really haven’t seen any change in the appetite. I think our kind of positive feeling going through the rest of this year and into the future is that we believe we are positioned well in a lot of those target areas both for tier one and tier two carriers.

So we believe as we continue to introduce new features and new products that we’ll be able to garner market share in areas we really haven’t played in before. On the enterprise side I would say it has been a slow environment definitely through this year. Our traditional enterprise products have taken the brunt of that. HDSL has held up very well and we are expecting it to continue to hold up well but it has more pieces than just the enterprise or SMB customer base that kind of help drive that momentum one way or the other. The rest of the enterprise products will continue to get market share in our internetworking products but the traditional enterprise products I wouldn’t be surprised if these didn’t continue to trail down.

Vivak Arya – Merrill Lynch

Specifically regarding some of your customers, especially Qwest which I think you have seen very strong deployments with what I am assuming is the TA1100, is that just a one or two or three quarter type cycle and then again it will trend down or do you see a longer term, 3-5 quarter type growth prospects ahead at Qwest? So it is just really the magnitude and growth prospects going forward.

Thomas Stanton

Qwest has been a growing customer of our both on the carrier side and on the enterprise side really for quite a number of quarters actually. We expect that there is still an awful lot of potential in that account. They buy multiple products. As you are probably aware we have received awards on additional products that have yet to be operationalized. I think that we will continue to see mixes in what they buy from quarter to quarter but we are definitely optimistic about the multi-quarter outlook on Qwest.

Vivak Arya – Merrill Lynch

The TA5000, you have a large win with a number of tier one carriers now. I’m reminded of a similar situation I think a year or two ago when there was a lot of promise and a lot of optimism around the remote outside plant DSLAMS. I think the market for that turned out to be perhaps smaller or perhaps not as big as expected. First of all is that a fair characterization? How would you really compare the addressable opportunities that you saw with that kind of product versus what you are seeing with the TA5000?

Thomas Stanton

I’ll quibble a little bit with the characterization in that. I think that the outside plant product a couple of years ago actually we did see a very large uptake and there was a period of time and we are going back literally two years or so where if I go back three years a majority of our sales were central office DSLAMS. We really started pushing our outside plant and remote terminal products. We saw a significant shift in the market towards those products and those products did very well.

Those products, the outside plant DSLAM, are exactly the product. Now it has matured since then and we have added features to things but it is exactly the product that we are now selling to every carrier in the U.S., or every major carrier in the U.S., including Qwest for their fiber to the node deployment and including Telemex for their fiber to the node deployment. So those products have been doing fantastic.

We expect those products to actually continue to grow even from this point. Now does the TA5000 have more potential than the 1100 series fiber to the node products? It plays in a lot more markets and those markets in and of themselves, any one of those markets or some of those markets, are just as big. So I think it is dependent upon us and how we execute and how much market share we can garner going forward but I would say we are just as optimistic if not more on the 5000.

Operator

The next question comes from Simon Leopold – Morgan, Keegan & Co.

Simon Leopold – Morgan, Keegan & Co.

I wanted to see if we can drill down a little bit on gross margin in the discussion. Jim had forecast a gross margin in the high 50’s range which is consistent in this quarter. You broke through that 60% barrier. I know we are discussing tens of basis points perhaps but if you could give us a little sense of what the key factors this quarter to take you over the 60% mark?

James Matthews

There are a few things. A portion of it was more of a favorable product mix. A portion of it again was attributable to the very consistent order flow we had across the quarter which enabled us to plan our orders in terms of manufacturing and shipments very efficiently thereby avoiding much of the expediting costs we have incurred in the past due to a more irregular quarter in terms of orders. We incurred less expediting costs. We also incurred lower labor costs as well. Also our inbound freight cost was down meaningfully as well in the quarter. So all of those things would contribute to a gross margin that we saw.

Thomas Stanton

I’ll add if you remember the last couple of quarters, let’s say if we go back three quarters, there were times in there where we had incentives in trying to grab market share. In one case we had kind of undue expediting costs as we had one carrier come in and buy a significant amount in a quarter and wanted it shipped in that same quarter and it kind of happened late in that quarter and we didn’t have those type of expenses happen this quarter.

Simon Leopold – Morgan, Keegan & Co.

I have had the impression and I’m wondering if this is still the case that your newer products within broadband, optical and internetworking tend to have a better than average gross margin whereas the more mature products in HDSL and carrier segment had a slightly worse than average gross margin. First of all is that the case? That is part of the reason why I was a little bit surprised about the gross margin this quarter given the mix.

James Matthews

My opinion is they have really trended towards the same point. We may get efficiencies for instance in HDSL if we have a very loaded order rate in HDSL and that efficiency played through in improved gross margin, the same way we can with our broadband products. I would say if you look at them on a major product set basis they are right in there with each other.

Simon Leopold – Morgan, Keegan & Co.

I think during the last call you had talked about the TA5000 revenue contribution being in the order if I recall correctly I think 5% of revenue, a number that I interpreted in the neighborhood of $6 million. Can you give us a similar commentary of where we were in the June quarter for that product?

James Matthews

I hate to keep breaking that out in such a granular level. So let me just give you from a high point. I would characterize our order flow within the 5000 as being basically consistent with what we saw in Q1 and if you think about it the reasons are straight forward. We have the new wins. We just received orders. We didn’t start shipping to that second tier one carrier so that impact hasn’t happened yet. The third tier one carrier is still expected towards the end of this year to receive orders so that hasn’t happened yet. We have won some approvals in some of these tier two carriers, more than what we had in let’s say exiting last year, and we are expecting those to come on in the second half. In general I would say the selling space was very similar to where we were in the first quarter and the Ethernet over copper customers are very large tier one that we did start shipping to is very early in their phase in the market for the service.

Simon Leopold – Morgan, Keegan & Co.

I assume in terms of the outlook for the progression for the TA5000, particularly those tier one customers, I assume you are forecasting what I call a normal progression and normal ramp for that kind of carrier as opposed to something expedited or slow?

Thomas Stanton

The high level answer to your question is yes you are correct. There are some more project oriented type wins that may swing us from quarter to quarter but in general over the long term I think the answer is yes.

Operator

The next question comes from Nikos Theodosopoulus – UBS.

Nikos Theodosopoulus – UBS

Your 10% customer historically you have had Embark in there fairly consistently and I noticed it dropped off this quarter. Was that both across the operating company and the distribution part or was it on one side? Can you give us some color on that?

James Matthews

I would say that we saw slowness in Embark in general. If that answers your question. If we talk about specific businesses. Let me just say in general we saw slowing. I wouldn’t attribute it to one particular segment.

Nikos Theodosopoulus – UBS

Can you give on the TA5000 you mentioned the tier two orders came in toward the end of the quarter, the second tier two customer, are those orders you think targeted to ship in the third quarter or would you say after the third quarter?

Thomas Stanton

The second tier one and yes, we expect to receive additional orders through this quarter and we will start shipping this quarter.

Nikos Theodosopoulus – UBS

Can you give an update on the trials for the 5000 overseas? You had talked about those and you said there were I think about a dozen or so and I know that BT announced today they are going to do a fiber to node deployment in the future. I’m just wondering is that an account you think you could penetrate or is that kind of a long shot given the lack of historical relationship.

Thomas Stanton

The lack of historical relationship absolutely hurts your odds of being able to penetrate any of these accounts and that is just one of the issues we have got to deal with. We’ve got to have some presence there for some period of time. Do I think BT is a potential customer and is a realistic potential customer. absolutely.

As far as the rest of the trials going on in our international space they are still ongoing. Of course they are farther along. We are hopeful we will secure awards. Maybe not shipments but awards on some of those 5000’s this year. I didn’t check on that exact number but I wouldn’t be surprised if we haven’t already done so. They are all moving forward and we are still optimistic about the long-term possibilities.

Operator

The next question comes from George Notter – Jefferies & Company Inc.

George Notter – Jefferies & Company Inc.

I guess I was just thinking about your Q2 guidance for sequential and year-over-year growth, I’m sorry, Q3 guidance for sequential and year-over-year growth. Any impacts that you expect there from Verizon? Obviously the labor contract there expires on August 2.

Thomas Stanton

We are not forecasting that. In the past when those things have happened they haven’t the duration or just because of the preparation didn’t affect things for us in any meaningful way and that is kind of what we are expecting here. If Verizon shuts down for an extended period of time then we have to rethink that but we are not expecting that at this point.

George Notter – Jefferies & Company Inc.

Coming back to the TA5000, certainly in some of the tier two opportunities Calex would be an incumbent vendor on many of those accounts. How do you see the competitive environment vis a vis Calex? Are you winning primary sources vis a vis Calex or secondary sources vis a vie Calex? What is your thought there?

Thomas Stanton

I’d say at this point it is all of the above. Calex is a good competitor. They did end up serving that market for some period of time. We think that there is absolutely space for us in every one of those accounts and many of those accounts and all of the tier two’s we have been able to show that value enough to be able to create that space. George, long-term we drive for market share and we’re confident in our position right now. I won’t ever say….Calex is a good company. They’ll continue to fight with us along the way.

Operator

The next question comes from Greg Mesniaeff – Needham and Co.

Greg Mesniaeff – Needham and Co.

I was hoping to curl down a little into the ATT customer, 24% of revenues in the quarter. More specifically if you can give us some color on to what extent is ATT deploying your products in its wireless backhaul infrastructure now that 3G ramp is fully underway? I was wondering if you could maybe give us similar color on Verizon as well.

Thomas Stanton

I think to the extent that all of these carriers upgrade their network capacity for 3G or for any reason for that matter that it is predominately and very near 100% if not 100% using the products that we are all familiar with. HDSL and [inaudible] based optical access for the most part.

Greg Mesniaeff – Needham and Co.

Are you noticing a transition towards moving away from traditional HDSL or T1 based backhaul to sort of wire based?

Thomas Stanton

No. Not at this point. There has been talk about that and we have participated in many conversations about that with many carriers and to my knowledge it is just not happening in any meaningful way at this point.

Greg Mesniaeff – Needham and Co.

So is it fair to say the relatively nice resilient HDSL business tone was due in part to the backhaul business?

Thomas Stanton

I think that would be fair to say.

Operator

The next question comes from Paul Silverstein – Credit Suisse.

Paul Silverstein – Credit Suisse

This may be more appropriate for Jim but Tom feel free. If you go back in time, I think it was the second half of 2005 when you all were generating 32-33% operating margin. I recognize that hasn’t exactly been the norm. Jim what would it take to get back there? Is that a possibility or is that just too far a stretch? You’re doing 60+% gross margins now. I understand that may not be sustainable either but is 30+ doable?

James Matthews

Paul I think it is all dependent on the revenue level. If we look back to the third quarter of 2005 that was at a record revenue level and could it happen again? Sure it could. But again, over the longer term we don’t think that would be sustained as we would again increase investment in R&D and sales and marketing again to grow the business and continue to feed the business.

Paul Silverstein – Credit Suisse

Jim if you just isolated volume in terms of the impact on operating margins can you quantify for us about a certain dollar amount for every blank dollars of revenue is an additional blank percentage point on operating margin?

James Matthews

Not at this point Paul. I think analysts are pretty much aware of our operating history and leverage on the operating line. I think I’ll leave it at that.

Paul Silverstein – Credit Suisse

One other question if I may. I apologize and I know you guys have explained this number of times as well as on this call. Tom can you go back over the visibility on roll outs with the tier ones on both the optical and TA5000 platform? I guess I’m still a little confused in terms of you are talking about a hunting license and a lot of it is dependent upon their ability to sell the service in terms of what quantity of product they are taking. Can you just give us a little more insight there?

Thomas Stanton

I think maybe the confusion is because we are talking about multiple products and also multiple customers and within that multiple applications. Within that big sphere of things then the potential is different. Let me start with the opti product line and just kind of step you through where we are on that.

With the Opti product line I think there are a couple of things we are looking for to continue to drive that business to what we think it can be. The first one was a Phase II deployment at the largest tier one carrier in the U.S. which was the tail end of last year. Since that point in time we have seen that optical product really do well in that carrier and it has grown meaningfully. It continues to see very strong growth quarter to quarter and we expect that to continue on. So I would say we are still early. We are two quarters now after the initial approval and it is where we though it should be.

The other tier one where we have wide scale approvals that business also is growing. It really started here again at the end of last year and it has been growing meaningful although smaller in size because the carrier is smaller.

The third Auerbach or approvals for not the entire application set. It is really for the business side and I think it is very well know that is Verizon Business not Verizon Telco. We continue to work towards getting approval at Verizon Telco but right now we are in Verizon business which is more customer oriented. We do have approvals going through to continue to add features and we expect that account to continue to grow for some period of time and it has done pretty well this year.

The other piece in the Opti line that we were looking for is we introduced OC48 products towards the end of last year and we were looking to get approvals within the tier two’s for those OC48 products and that has started happening early this year. We saw some up tick with customers like Embark and Windstream and we think there is a lot of potential there. If you look at the optical line across those accounts I think we have a lot of growth potential. Those accounts the hunting license thought you brought up is true. In the largest tier one they don’t have to buy our product but our product has significant advantages in my opinion compared to the competitive products and we have seen the momentum behind it so that we really believe we are not just believing our own press releases or whatever.

In the 5000, the first tier one approval happened at the end of last year, you are aware of that. Ethernet over copper. That is one that is success based. There is no hunting license from our perspective. That market is a market that there is no competitor selling against us in that network. The hunting license may be that what has to happen is that customer has to go out and sell services and they are just really in the early phases of marketing and starting to sell those services. I believe they are very, very optimistic about the potential of the marketplace and they believe business customers are going to go towards Ethernet connectivity and it is going to be a main avenue towards going to Ethernet connectivity.

In the other tier one that we just received orders for we are here again not a hunting license. It is if they are going to do this type of switch over they are going to use our equipment. It is project oriented so it will be region by region as they decide to go and upgrade these pieces and we’ve seen just the first pieces of that at the tail end of last quarter.

The third carrier on the 5000 and I believe in every win and we won multiple wins in all of these but in that third carrier we won three or four different application sets and in every one of those application sets I believe we are sole source. So it will be a commitment.

That was a long answer but I hope we covered what you were looking for.

Operator

The next question comes from Blair King – Avondale Partners.

Blair King – Avondale Partners

If you could outline any progress with Telemex. I know they have been a little lumpy but if you could give us some insight as to what their pipeline might look like for the balance of the year?

Thomas Stanton

They are a customer that as you know are new to us and we believe that there is potential for orders this year. They are going through the operationalizing of the equipment they bought. They also have initiatives on their own part on what they want to do with IPTV and rolling out video utilizing our products and I think that may affect the magnitude of what they do over the long-term but I don’t think it necessarily that approval or non-approval doesn’t necessarily affect whether or not they continue to buy equipment. Some of that up we expect at this time still to receive additional purchase orders this year. We think they will be meaningful purchase orders but like I said it is a new customer and we are still trying to learn the ropes there.

Operator

The next question comes from Raimundo Archibold – Kaufman Brothers.

Raimundo Archibold – Kaufman Brothers

I just wanted to follow-up on the internetworking product where we have seen some very strong growth but you did reference headwinds related to some softness in spending. Can you sort of walk us through what is driving the share gains, if you will, there and are you seeing that in specific types of applications or specific types of geographies?

Thomas Stanton

I think what is driving internetworking at this point if I had to pick the one biggest positive mover it has been the Auerbach account or the tier one carriers really driving in the product into the customer base. We won towards the tail end of last year or the middle of last year some awards at two of the tier one’s. Those awards basically have since grown to where we have more approvals now and as we get more approvals we are just getting more market share. I think that is what has affected those numbers the most. We think that will continue to be a positive driver. If I look at the bar base, the dealer base, I would say that it is not as robust as you would typically see in a normalized economy.

Raimundo Archibold – Kaufman Brothers

The carrier that you have the Ethernet over copper application for the TA5000 are you seeing that also driving more of the internetworking business or have you not seen that connection take place yet?

Thomas Stanton

There is a connection there in that one of the things that is positive about our Ethernet over copper product line is that with every Ethernet over copper central office or remote terminal I ship I also ship a net band determination router on the other end. So there is basically a 1:1 correlation there and that will drive it over time.

Operator

The next question comes from Ehud Gelblum – JP Morgan.

Ehud Gelblum – JP Morgan

I want to look at Q4. I know you don’t like to look more than two weeks over our noses but looking historically and I’m looking at your HDSL business separate from your growth products, your Q4 has traditionally been weak because of weak HDSL. Now, last year your Q4 you actually had up growth and down HDSL and you ended up in total being down slightly but not as much as in prior years. Your growth products now are increasing percentage obviously of your revenue and it sounds from what you are saying that growth products will continue to grow both in Q3 and Q4. Last quarter you gave us guidance that revenue would grow sequentially in both Q2 and Q3. Now I notice you wouldn’t go so far as to say revenue would grow sequentially two quarters out in Q4. When you look at your growth products do you feel confident they should grow at least in Q4 and so if you were to have a down Q4 for total revenue it would again be because of the unknown in HDSL and not because of your growth products?

Thomas Stanton

Let me start by giving you my take on the legacy products and what they do in Q4. I’d say traditionally what we have seen is every product has a decline in Q4. That is including growth products. The only thing that offsets that is if we end up winning particular market share in a particular region that is strong enough to offset it or if an approval comes on line that we have been waiting on and we have that initial build up for a product set. Other than that we typically see weakness across the board and I think we have probably explained on the fourth quarter conference call that we had some projects that got approved which really growth some products but in general we still say we saw the typical seasonality in the fourth quarter across the board. What that is maybe muted the growth we could have seen if we didn’t have that seasonality. So I would still expect seasonality across the board and not really just in HDSL for the fourth quarter.

Because of that we are not going to try and tell you where the fourth quarter sticks. The fourth quarter could be impacted by some of these approvals and some of these roll outs where the timing is around that same time frame but we just don’t know that right now. Forecasting Auerbach deployment would be very difficult. I don’t even know if I would call it a science.

Ehud Gelblum – JP Morgan

Do you think in October when you have your third quarter conference call you will have visibility on whether Q4 will be up or down?

Thomas Stanton

I would fully expect on the third quarter conference call to be able to give some additional color on the fourth quarter the way we traditionally do and give you the visibility that we have at that point in time.

Ehud Gelblum – JP Morgan

Would it at least be true that because of the growth products being a larger portion of your revenues that you have a little bit more of a deterministic ability to understand what your growth rate is versus before when HDSL was a larger piece?

Thomas Stanton

No. Well, maybe as we look forward a few quarters out that may be true. Right now we still have the problem of new products getting approved and getting through that approval cycle which could swing things. So I wouldn’t call it more deterministic at this point in time. I mean I dream of the time when that will be the case and that we will be shipping an awful lot of system level products that will require longer lead times but I would not say that is the case today.

Ehud Gelblum – JP Morgan

Your DSO’s being as low as they were it sounds like it is related to the high gross margin which Jim said your linearity was very linear for the quarter and therefore you could plan things a little bit better. I guess in general your linearity is a lot more back end loaded into the last quarter. What were the reasons for that linearity and do you expect that to continue into Q3 or would you expect it to go back into a much more back end loaded quarter bringing your DSO’s up and your gross margin down?

James Matthews

I wouldn’t say that every quarter is back end loaded. It varies quarter to quarter as you go through the year. However the first quarter is typically back end loaded and the fourth quarter is typically front end loaded. The second quarter was again a very consistent, almost to an unusual consistency across the entire quarter to enable us to realize some meaningful efficiencies. Whether or not that will happen in the third quarter in the same way we don’t know.

Thomas Stanton

I would say traditionally we see there wasn’t a real stand out month in those middle quarters that takes 50% of the revenues fall in that middle quarter or something like that. Traditionally they are smooth. This one was smoother than most.

Ehud Gelblum – JP Morgan

Can you give us some numbers around that because the DSO is still awful high?

James Matthews

It is high. It was…..

Ehud Gelblum – JP Morgan

Can you quantify the linearity this quarter versus other quarters?

James Matthews

Very, very linear. More linear than…it is probably one of our most linear quarters.

Ehud Gelblum – JP Morgan

But not front end loaded? Just completely linear?

James Matthews

Right.

Ehud Gelblum – JP Morgan

Fair Point. Is there any date on trying to get back in there or is that kind of a dormant situation?

Thomas Stanton

Fair Point? Well we do sell to Fair Point some of our product. I think it is probably specific to that particular roll out in the Verizon territories. I’d say there is no change at least from my visibility there is no change.

Operator

The next question comes from Bryan Coyne – FBR Capital Markets.

Bryan Coyne – FBR Capital Markets

First of all, Jim you talked about your opex being flat to slightly up on a sequential basis. I assume you are talking on a dollar basis. I guess just on that if you could just jolt out a bit on the cost structure. This quarters R&D and SG&A both declined as a percentage of sales. Do you think that involved any roll off of the Total Access 5000 start up costs?

James Matthews

No. The start up costs on the 5000 in terms of initial performance would have been more of a [inaudible] in the first quarter so now we did see some top line costs in the R&D line in the second quarter related to some 5000 application approvals.

Bryan Coyne – FBR Capital Markets

I guess that is what I was thinking about.

James Matthews

We will probably continue to see those via the 5000 or Opti as we package features going forward. So those were always there.

Bryan Coyne – FBR Capital Markets

Over the past couple of years your opEx during the third and fourth quarters has generally been sequential declining and then rebounding as a percent of sales largely on the seasonality of the sales. I guess going back to a couple of other questions that have been asked previously any reason to think that pattern really changes in 2008 and maybe does the slower enterprise demand trend influence that?

James Matthews

We are not expecting any discontinuities in the expense line for the rest of this year so I don’t see anything that should affect that.

Bryan Coyne – FBR Capital Markets

At ATT revenues again flat roughly against quarter-over-quarter and I was wondering if there was maybe a little bit of a mix shift. I think Greg referenced a little bit earlier. It sounds like HDSL had a little bit of a snap back in the first quarter with that carrier. If you could just comment on what happened in the June quarter?

Thomas Stanton

First of all it wasn’t flat. ATT was 24% and on a dollar basis ATT was up slightly. On a mix I would say the biggest thing that was the biggest contributor and correct me if I’m wrong here Jim was probably the growth in optical access.

James Matthews

Growth in optical access and some sequential growth in HDSL as well.

Operator

The next question comes from Jack Monty – Lehman Brothers.

Jack Monty – Lehman Brothers

Just a quick question on inventories. It seems like they grew modestly in the quarter. I was thinking is it fair to assume they will grow more as you meet demand for new products and perhaps maybe you build additional inventory as a cushion to make sure there are no mistakes with those product launches?

Thomas Stanton

I wouldn’t expect a significant increase in inventory. We shoot for a turnaround of 4.5 or so. We have been pretty consistent with that, plus or minus 0.2 and I would expect us to be able to manage that. I think from an inventory perspective we are at a manageable level. We are able to meet our customer requirements right now and I don’t see a big shift in that. The only thing that may change that is if we have at least one if not more, but mainly one customer that may come in and buy an awful lot of stuff and we’ll have to increase inventories at that time and if it doesn’t ship we may see a shift but that would be a short-term phenomenon.

Operator

The next question comes from Todd Koffman – Raymond James.

Todd Koffman – Raymond James

Just a clarification on the TA5000 with regard to the second tier one that you said you received initial orders for. Is there any opportunity at that carrier to deploy the TA5000 in an Ethernet over copper deployment or has that vendor already made its decision regarding deployment for that service?

Thomas Stanton

It can be confusing depending on which tier one we are talking about so let me give you a little bit more color. The application for that tier one is ADTM to Ethernet aggregation so it is putting 5000 in the central offices. They will terminate existing DSLAMS and they will convert or aggregate that traffic and convert that traffic over to Ethernet. That carrier has not made a decision on Ethernet over copper.

The other tier one carriers have made decisions on Ethernet over copper and the other tier one carriers for mass deployment, of course one of them we have already announced we won, I think we are in a very, very good position with both of the carriers that have made decisions or are deciding to roll forward with Ethernet over copper. Did that answer your question?

Todd Koffman – Raymond James

Yes. Just a quick follow-up. For that second tier one where you are deploying the TA5000 for ADTM for Ethernet aggregation what is the timing for them to maybe decide as it relates to Ethernet over copper or is that still completely up in the air?

Thomas Stanton

That is still completely up in the air. I think when we talk about Ethernet over copper it is real easy to get confused with that and Ethernet over TDM and there is some other things going on in that arena of trying to convert services over to an Ethernet backing. So Ethernet over copper is kind of made for Ethernet and that is kind of fresh stuff you can think of. That carrier has not made that decision yet. To the best of my knowledge that carrier has not made the decision to even move forward with that product at this point in time.

Then there is the how do I convert my existing legacy network over to an Ethernet for the 5000 there is a tremendous job and we are in discussions with all the carriers about the different phases of that.

Vanessa I think this will be our last question. We’re about out of time.

Operator

The final question comes from [Rari Binsinger – Standard and Poor’s].

[Rari Binsinger – Standard and Poor’s]

I just was hoping you could provide more color on your statement of constrained spending by you mentioned the lower tier customers. Is it because of the housing slow down or just consumers are being more cautious on what they are spending on access technologies?

Thomas Stanton

I think the note with the mid-tier carriers and as to rationale I would really like to leave it to them to explain but I do think that most of the mid tier carriers have been really cautious in their capEx spending, at this point in time really for a year. In fact we even saw periods of that prior to a year ago. I would say that environment hasn’t gotten worse. I would say it is just the same in how they are being cautious in spending money and even to the approval cycles about how they spend on things. I don’t know if I would attribute it specifically to the economic environment more so than just the methodology in which they run their company today.

Thank you very much Vanessa and thank you very much for joining us on our conference call and we look forward to seeing you a quarter from now.

Have a good day.

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