ADC Telecommunications F3Q06 (Qtr End 7/28/06) Earnings Call Transcript (ADCT)

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ADC Telecommunications (ADCT)
Q3 2006 Earnings Conference Call
August 29, 2006, 5:00 p.m. EST Executives March 1, 0000 ET

Analysts

Tim Daubenspeck, Pacific Crest Securities

Paul Silverstein, Credit Suisse

Kenneth Muth, Robert W. Baird

Vivek Arya (Tal Liani), Merrill Lynch

Gunther Karger, Discovery Group

Simon Leopold, Morgan, Keegan & Company

Amitabh Passi (Nikos Theodosopoulos), UBS

Steven O’Brien, JP Morgan

Marcus Kupferschmidt, Lehman Brothers

Richard Church, Unterberg

Operator

Good afternoon, my name is Carol and I will be you conference operator today. At this time, I would like to welcome everyone to the ADC Third Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question and answer session. If you would like to ask a question during this time simply press * then the number 1 on your telephone keypad. If you would like to withdraw your question, press * then the number 2 on your telephone keypad. Thank you. Mr. Mark Borman, you may begin your conference.

Mark Borman, Vice President, Treasurer and Investor Relations

Thank you, Carol. Good afternoon and thank you all for joining us today. Bob Switz, ADC’s President and CEO and Gokul Hemmady, ADC’s CFO, are with me today.

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

This earnings release can be accessed at the Investor Relations section of ADC’s website at www.adc.com/investor. ADC’s comments will be on a continuing operations and GAAP basis. We will also refer to adjusted results derived from the reconciling items of restricting impairment charges, amortization of purchase intangibles, FONS employee retention expense, stock option compensation expense, and certain non-operating gains and losses included in our GAAP results. These reconciliations of GAAP results to adjusted results are included in today’s earnings release. APS France Services business has been classified as a discontinued operation and is no longer in the reported results of the third quarter 2006 and prior periods.

Bob will provide an update of ADC’s strategic direction. He will then turn the call over to Gokul, who will cover the financial results first and then provide forward-looking financial model guidance. I will now turn the call over to ADC’s CEO, Bob Switz. Bob…

Robert Switz, Chief Executive Officer and President

Good afternoon and thank you, Mark. Well, we certainly had an active quarter with regard to our financial results, our attempt to merge with Andrew, and the continuation of our efforts to become the global leader in communications network infrastructure, a goal which we’ve been executing on since 2003. As for our third quarter, we are pleased to report better than guided sales of $344 million and adjusted EPS of $0.30 compared to our preliminary outlook provided on July 19th.

A highlight for the quarter was continued strong year-over-year sales growth of 77% in Fibercon activity. Excluding FONS Fibercon activity sales growth was 15%. With the FONS acquisition Fibercon activity now comprises 29% of total ADC sales compared to 18% one year ago. Copper and enterprise connectivity sales also contributed to year-over-year growth at 5% each in the quarter, as well as professional services at 6% growth. The remaining 7% of our business, wireless and wireline access products, declined year-over-year as expected due to reduced demand. Looking forward, carrier consolidation, wireline-wireless convergence, subscriber retention and growth, and network evolution to internet protocol communication services create strong potential for ADC’s solutions to connect our customers to next-generation wireless broadband video, data, and voice services.

Accordingly, we continue to execute on our goal to become the leading supplier of network infrastructure solutions to our customers worldwide. We will seek to accomplish that goal through a combination of business development initiatives, new product developments, and execution in our core business. The strategic fundamentals of our business remains solid and we remain confident that we can deliver long-term growth and profitability.

I would like to highlight several key market developments that are driving ADC’s long-term growth potential. First, carrier consolidation and wireline-wireless convergence, both are creating strong demand for our connectivity solutions. We are interconnecting the acquirer and acquiree company’s networks and connecting multiple voice, video, data, and wireless services over local access and long-distance networks. Second, subscriber retention and growth initiatives are driving network upgrades that are expected to result in more ADC connectivity sales.

Third, quad-play service offerings that utilize voice, video, data, and wireless are being demanded by sophisticated subscribers. They want bundled broadband communications anytime, anywhere. Again, this is a very positive trend for sales of ADC’s infrastructure products and professional services. And fourth everything IP is creating new growth opportunities for our infrastructure products and professional services.

I’d now like to review our four-part strategic to growth value. First, we are targeting growth segments where carrier and enterprise customers need network infrastructure solutions for wireless, broadband, video, data, and voice services as well as solutions for original equipment manufacturers. Specifically, we are targeting the fiber to DX wireless capacity in coverage, metro ethernet, and enterprise network upgrades. We are differentiating ourselves with strong customer service, quality, delivery, and long-term relationships.

Second, we are innovating with products and services to achieve organic growth in next-generation networks, gain market share in existing markets, and acquire for a global scale and presence. A good example here is our new automated cross-connect products to serve fiber to the node and remote wireless applications by providing a flexible, scalable platform that allows carriers to remotely move, add, and change services for customers. This system helps carriers lower operational cost and allows quick and easy implementation of service changes.

Another example is AT&T recognizing ADC in June for technical innovation in our OMX optical distribution frame that provides advanced cable management features for protecting, managing, and adding value to high-speed networks.

Third, our delivery of products and services is moving closer to our customers within region, sales, and manufacturing. We will also source materials globally for best price and quality and utilize lower cost manufacturing locations to improve profit margins. We have established regional engineering prototype and automation centers to compliment our high volume, low cost manufacturing centers in each of our major regions of the Americas, AMEA, and Asia-Pacific. To that end, we are moving more of our manufacturing to low-cost facilities in China, the Czech Republic, and Mexico.

Fourth, we are working to optimize general and administrative expense by utilizing shared service centers as centralized functions in simplifying our business structure for further operational efficiencies.

To conclude, we remain committed to strategically managing our business for the long term and expect the kind of quarter-to-quarter fluctuations we experienced in 2005 and again in 2006; it will continue to be an inherent part of our business. Given the current environment in which our larger wireline and wireless customers are consolidating and integrating operations, these short-term variations can be difficult to plan for, and we do not believe they are reflective of long-term prospects for our business.

In this consolidating environment we are not alone in the industry with the view that acquisitions to add product breadth and diversity as well as relevant scale are required to serve customers who increasingly have broader communication service offerings. We still expect to grow our business year over year and remain confident that we can deliver long-term growth and profitability in our business.

Looking to 2007, we are encouraged by our prospects as we address our customers’ key growth areas and next-generation networks from the core and central office through the outside access plant to residential and business premises as well as mobile subscribers. We see exciting growth opportunities in connecting next-generation networks in the areas of FTTX, IPTV, carrier ethernet, VoIP, wireless data, distributed antennae systems, and high-definition video.

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

Gokul Hemmady, Chief Financial Officer and Vice President

Thank you, Bob, and good afternoon everyone. We had a better than guided quarter in four key areas: first, better than expected sales as Bob described. Second, adjusted operating margin of 10.9% compared to 10.6% in the previous quarter. Third, adjusted EPS of $0.30 compared to our July 19th guidance of $0.25 to $0.28. Finally, cash provided by operating activities from continuing operations of $25 million for a total of $55 million year-to-date. This year-to-date performance compares to $19 million for the first nine months of fiscal 2005. As Bob covered our topline progress, I will review our profitability and cash flow performance in more detail.

I would like to start with the removal of the EPS PROM services business from continuing operations. Professional services are now very close to break even. On an adjusted results basis, professional services were profitable in the quarter. Our goal is to operate this business segment profitably without including its product pull through or ADC product sales. All sales and operating income of ADC’s products sold by professional services are included in our broadband infrastructure and access operating segment.

Now, let’s review consolidated earnings. Our GAAP diluted earnings per share from continuing operations were $0.20 in the quarter compared to $0.21 sequentially. In the third quarter, GAAP earnings included amortization of purchase intangibles of $7 million, FONS employing retention expense of $1 million, restructuring and impairment charges of $3 million, and stock option compensation of $2 million for a total adjustment of $13 million which is 3.9% of sales or $0.10 per diluted share resulting in an adjusted diluted earnings per share of $0.30.

The third quarter adjusted operating margin of 10.9% improved compared to the second quarter as a result of lower operating expense, more than offsetting lower gross margins. Gross margins of 32.7% were lower than the second quarter of 34% because of lower volumes primarily in our higher margin core business.

Adjusted operating expenses in the third quarter were 21.8% of sales compared to 23.4% in the second quarter as a result of reduction in incentive accruals resulting from our lower second half outlook. This resulted in adjusted operating income of $37 million, which is slightly down from $38 million in the second quarter.

Moving to other income and expense for the quarter, included in the interest line is approximately $2 million for interest due on prior year’s income taxes. This tax interest expense was partially offset by a credit in the other income line for custom stack accruals that are no longer needed. Reviewing the employee numbers, we ended the quarter with about 9100 people globally, which is down from about 9300 at April 27, 2006, due to decreasing manufacturing workforce in Mexico.

Moving to working capital, as we have discussed on prior calls, this is the first year that we put working capital management incentives in place. DSOs at 49 days in the quarter again outperformed our 50-day goal for the second quarter in a row. Our third quarter inventory terms were at 5.5 times, down from 6.5 in the second quarter and 5.8 one year ago due to impacts of both customer consolidation activity affecting current spending rates and customers’ current inventory levels being higher than current deployment rates.

Our good operating margin performance partially offset by working capital investments helped generate $25 million in total cash provided by operating activities from continuing operations in the third quarter.

Depreciation and amortization expense was $17 million in the third quarter and the second quarter. Property equipment and patent editions net of disposals were a net expenditure of $9 million in the quarter compared to $7 million sequentially. As a result of our strong cash flows, our total cash, cash equivalents, and available for sale securities totaled $527 million on July 28, 2006, up from $510 million on April 27, 2006.

I will now provide financial guidance. We are continuing to provide annual guidance that reflects our long-term business direction. We remain committed to managing our business with a longer term strategic perspective and expect that quarter-to-quarter fluctuations will continue to be a natural part of our business. These short-term variations can be difficult to plan and we do not believe they are critical to the long-term prospects of our business.

We believe that our expansion into markets for FTTX, wireless, and enterprise products as well as changes in the seasonality of customer spending due to FTTX and other broadband initiatives has changed the historical seasonality of our business.

We expect future sales in our first fiscal quarter will be lower than in other quarters. This is because of the number of holidays in that quarter and the development of annual capital spending budgets that many of ADC’s customers undertake during that time. In addition, in fiscal 2005, ADC’s sales in the fourth quarter were sequentially lower than third quarter sales, a situation that we expect will also occur in fiscal 2006.

In fiscal 2005, the growth of our sales outpaced sales growth in our industry generally, and this has been one of our primary goals for fiscal 2006. ADC now believes that it will grow sales in fiscal 2006 consistent with the growth experienced generally within our industry. There are two primary reasons for this shortfall to our goal. First, we believe one or more of our FTTX customers have become more efficient in their use of FTTX products in fiscal 2006, such that they need to buy less products to reach the same number of homes versus what was needed in fiscal 2005. Second, as customers have consolidated, we believe they have deferred certain spending decisions while they focus on integration activities.

We currently expect annual 2006 sales to be in the range of $1.27 billion to $1.285 billion. Based on this sales guidance and subject sales mix and other factors, GAAP diluted EPS from continuing operations in fiscal 2006 is estimated to be in the range of $0.51 to $0.56 and adjusted EPS to be in the range of $0.88 to $0.93.

The $0.37 of estimated reconciling items include restructuring charges in the first nine months of 2006 of $0.06, amortization of purchase intangibles of $0.22, FONS employee retention expense of $0.05, stock option compensation expense of $0.08 offset by Andrew merger termination fee, net of merger expenses of $0.04. This guidance excludes potential future restructuring impairment and acquisition related charges and certain non-operating gains and losses of which the amounts are uncertain at this time. Also, the FONS employee retention expenses ended in the third fiscal quarter of 2006.

Based on this annual guidance and subtracting nine months of actual results, fourth quarter sales are in the range of $295 million to $310 million, GAAP EPS is in the range of $0.12 to $0.17, and adjusted EPS is in the range of $0.15 to $0.20 using the following reconciling items -- amortization of purchase intangibles of $0.05, stock option compensation expense of $0.02, offset again by Andrew merger termination fee net of merger expenses of $0.04.

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

Ending with income taxes, as of July 28, 2006, we had a total of $943 million in deferred tax assets that have been offset by a nearly full valuation reserve and the results have been shown on the balance sheet at an insignificant amount. This lower balance reflects a reduction of $89 million due to an adjustment of tax losses on the prior year tax reserves. Approximately $226 million of these deferred tax assets relate to capital loss carryovers which can be utilized only against realized capital gains through October 31, 2009.

As we generate pretax income in future periods, we currently expect to record reduced income tax expense until either our deferred tax assets are fully utilized to offset future income tax liabilities or the value of our deferred tax assets are restored on the balance sheet. Excluding the deferred tax assets related to capital loss carryovers, most of the remaining deferred tax assets are not expected to expire until after fiscal 2021.

In summary, we are focused on making progress towards our goal of 14% operating margins by executing on our strategy to capture customer spend on the upgrade of voice, video, and data networks as well as work to take market share, and continue work toward reducing manufacturing cost and operating expenses as a percent of sales in 2006 and 2007.

That concludes our prepared remarks. We will now open the call for questions. Operator, can you give right instructions please?

Question-and-Answer Session

Operator

Yes. At this time, ladies and gentlemen, if you would like to ask a question, simply press * then the number 1 on your telephone keypad at this time. And that’s * and number 1 for any questions or comments on today’s presentation. Your first question comes from the line of Time Daubenspeck with Pacific Crest.

Tim Daubenspeck, Pacific Crest Securities

Thank you. My question is on the FTTX efficiencies. When you talk about the efficiencies, connecting more homes with the same efficiency, is that due to pricing pressure or are we talking about kind of unit efficiencies, it’s unclear whether this is subscriber related or because of pricing declines they are able to connect more of the same dollar spend?

Robert Switz, Chief Executive Officer and President

This is Bob. It’s something slightly different. It’s essentially a learning experience as they’ve deployed these products, and some of it comes from, depending on where they place their cabinets, to be able to utilize less cabinets to serve the same amount of homes passed, and also looking at their initial thinking on the capacity of splitters going in initially versus adding additional splitters later as requirements dictate. So, to use your words, I would say it’s more of unit efficiency.

Tim Daubenspeck, Pacific Crest Securities

All right, and then just a followup on the accruals, can you talk about the total dollar impact of accrual reversals in the quarter please?

Gokul Hemmady, Chief Financial Officer and Vice President

Yeah, it was probably between a penny to a penny and a half.

Tim Daubenspeck, Pacific Crest Securities

Can you do it in millions?

Gokul Hemmady, Chief Financial Officer and Vice President

Yeah, it’s about $1.3 million to $2 million.

Tim Daubenspeck, Pacific Crest Securities

Thank you very much.

Operator

Your next question comes from the line of Paul Silverstein with Credit Suisse.

Paul Silverstein, Credit Suisse

Bob, I thought you all were shifting manufacturing resources down to Mexico. If I heard your comments correctly, your head count actually went down by 200 because of taking out head count in Mexico, is that a function of the decreased business activity you’re seeing?

Robert Switz, Chief Executive Officer and President

Yeah, some of it is a function of lower volume expectations and also, as I’ve mentioned on previous calls, we are shifting production all around the world and there is some production that took place in Mexico that’s being shifted to China, and that also accounts for some job reductions.

Gokul Hemmady, Chief Financial Officer and Vice President

And Paul that as also, as you remember, was a function of our FONS acquisition where we are trying to get the best of both worlds, where we found that FONS has certain efficiencies with their outsource relationships in China, whereas we have efficiencies manufacturing internally in Mexico.

Paul Silverstein, Credit Suisse

Bob, I assume at this time given the regulatory situation in Germany, Australia, France, etc. that beyond Verizon there’s really not a lot to talk about on the FTTX side?

Robert Switz, Chief Executive Officer and President

FTTX, as well, we’re participating in a number of broadband initiatives. So, on the FTTN side we play as well, and in Europe I think you’re aware there are several PTTs that are looking at deploying and we certainly expect to participate in those endeavors, both from the utilization of the KRONE block as well as our new automated cross-connect product. So, I think the important point to make here is that we’ve been moving in a direction that supports all broadband deployments and we’re not specifically FTTP.

Paul Silverstein, Credit Suisse

So, relative around your comment on the four trials, all the major carriers in China had ongoing trials and there were roughly a dozen or so trials in Europe give or take, any update to that?

Robert Switz, Chief Executive Officer and President

No, I don’t have anything more specific to say about those trials at this point. Other than what I said in the past is that those parts of the world obviously are moving at a slower pace than what we’ve seen in the U.S. We do expect to participate, but at this time Paul I couldn’t be more specific than that.

Paul Silverstein, Credit Suisse

Okay, one more question if I may before I passed it on. Obviously the products had a lot of promise given its specs, but it’s been relatively disappointing to say the least, at least from a timing perspective, any update you can give us in terms of visibility on re-ramping going forward?

Robert Switz, Chief Executive Officer and President

Well, I would agree with you. I think I’m as disappointed as you and everybody else that the customer base didn’t move faster there to provide some line item support to coverage and capacity. As we’re looking out into 2007, as our crystal ball shapes up, I think we could expect some things to develop in ’07 based on the type of activity that we’ve seen as we’ve moved into the latter half of this year around the customer base. We’re hopeful that some of that moves into real dollar spending in ’07, plus we’re also working on international opportunities that weren’t readily available to us during the course of 2006. So, we are expecting growth in these events at this point in ’07.

Paul Silverstein, Credit Suisse

Thanks a lot.

Operator

Your next question comes from the line of Ken Muth with Robert Baird.

Kenneth Muth, Robert W. Baird

On Verizon, when they talked about kind of the BPON and GPON pricing and having some price concessions go through to other vendors, has ADCT experienced any price concessions on their products as well that were allowed?

Robert Switz, Chief Executive Officer and President

No, we have not experienced any incremental price reduction request.

Kenneth Muth, Robert W. Baird

Okay, and then any 10% customers in the quarter?

Robert Switz, Chief Executive Officer and President

Absolutely, we have one.

Kenneth Muth, Robert W. Baird

Can you state who that is?

Robert Switz, Chief Executive Officer and President

You could probably guess, it’s Verizon.

Kenneth Muth, Robert W. Baird

Okay, and last thing, it sounds like there’s a lot going on the fiber side, do you think there’s a possibility of losing market share?

Robert Switz, Chief Executive Officer and President

In fiber?

Kenneth Muth, Robert W. Baird

Yeah.

Robert Switz, Chief Executive Officer and President

Oh no, we’ve been taking market share in our fiber business. Our core fiber business outside of FTTX is up by 30%, so we’ve done well in that part of our business and expect to continue to do well.

Kenneth Muth, Robert W. Baird

Okay, thank you.

Operator

Your next question comes from the line of Tal Liani with Merrill Lynch

Vivek Arya, Merrill Lynch

Thanks, it’s Vivek Arya on Tal’s behalf. Both my questions again are going back to this FTTX efficiency. Given that Verizon will pass the same number of homes next year as it did this year, it’s about $3 million or so, once you factor in these efficiencies and any annual price breaks that are prearranged, is it possible that the FTTX business actually declines next year.

Robert Switz, Chief Executive Officer and President

Yeah that’s an interesting question. I would say at this point, no, because we have additional products coming on. Obviously, if we didn’t participate in any new areas, there could be certainly some risk of that. But, the MDU side of our business has been not that contributory this year. It’s expected to next year. We also expect to participate in that which is the preconnectorized cabling products, and that should start for us in 2007. So, I think we will continue to see growth by virtue of these new product editions.

Vivek Arya, Merrill Lynch

And inventories, they increased significantly on a sequential basis, yet you’re guiding to a sequentially down quarter, how do I reconcile that?

Gokul Hemmady, Chief Financial Officer and Vice President

I think you’re seeing inventory turn down because when we announced on July 19th, our forecast at that time was different. We changed our forecast primarily related to Verizon as well as customer consolidation activity, and at that time we had that kind of inventory on hand so we are not suggesting that after that forecast came down we started building inventory. We are now doing everything to minimize that inventory, so I don’t think the two are linked in that way, Vivek.

Vivek Arya, Merrill Lynch

Okay, and just one last thing, from a more strategic and longer term point of view, now that Andrew is not an option, Bob, how do you think about the long-term strategy for the company. Because in the past you had said that increasing scale is the strategy for the company and that was the reason to go after Andrew, and now that that is not an option, how do you think about potential M&A opportunities?

Robert Switz, Chief Executive Officer and President

I think Andrew is only one of many options, and there other ways to increase scale. We’ve shared with you over many years the fact that we’ve been very active, studying opportunities outside the company to scale and capability to the company. So, I think people shouldn’t look at Andrew as the end of the strategy. Andrew was one part and I would argue, I’ll make my final point on Andrew here on this call, it could have been an outstanding opportunity for ADC. I think there were a lot of things that were misunderstood about that, which is unfortunate. It met an awful lot of criteria and it would have served us well in the long term. So, unfortunately that didn’t come to pass, but it’s one of many opportunities to gain scale, broaden portfolio, and support the company’s core strategy. Within our strategy of being the infrastructure leader, there are many paths to get there organically and inorganically. That was the one that was on the table and we said over time that if an opportunity came along that was sizable in nature, made sense, fit our strategy that we would take advantage of that opportunity, and Andrew was a very, very unique opportunity to do that. We tried to execute it, but there are a lot of other things for us to do. We are still committed to gaining scale. The industry continues to speak to that. You’re going to see a continuation of vendors consolidating to support larger customers. So, from a text book standpoint, the strategy is well supported and there are plenty of opportunities. We want to be careful as we have been and make sure that we focus on the right opportunities. But, you don’t have to win every battle to win a war and we’re focused on the war and there are plenty of other opportunities for us.

Vivek Arya, Merrill Lynch

Thank you.

Operator

Your next question comes from the line of Gunther Karger with Discovery Group.

Gunther Karger, Discovery Group

With regard to the international versus domestic revenue distribution, what are those percentages currently and projected over the next year?

Gokul Hemmady, Chief Financial Officer and Vice President

Gunther, in this quarter we had 39% of our revenues internationally. I think as we’ve said in the past that our goal is to be kind of at a 50/50 level. In the past, we were close to that 50% level. Since then, as you know, our U.S. business has grown much more than international with deployments of FTTX at Verizon, but we are looking at ways to grow the international business to get it closer to 50%.

Gunther Karger, Discovery Group

Okay, thank you.

Operator

Your next question comes from the line of Simon Leopold with Morgan Keegan.

Simon Leopold, Morgan, Keegan & Company

Thanks, I wanted to see if we could get a little bit of a clarification and this maybe something you’ve disclosed earlier regarding the restatements with discontinued operation. You’ve given us the April quarter numbers but not the January quarter. I just want to see if you could walk through what you’ve backed out there in terms of the historical. And then I’d also like to get a little bit of color, when you’re looking at the forecast, how you’re seeing some of the segments trend. It seems to me that your enterprise business was where you got the upside this quarter, if that’s where you were surprised if you could confirm that or if it came from something else, and how you see that segment trending typically with the seasonality in Europe that we typically see in the October quarter, will that starts to fall off in October? Thank you.

Gokul Hemmady, Chief Financial Officer and Vice President

So, Simon, I think you have page 10 of our release where you have the nine-month results and from there if you take the second quarter and the third quarter you should get our first quarter from there. I’m not sure if I misunderstood your question, but if you take that page 10, we’ve given you nine months, we’ve given you the second quarter, and of course you have our third quarter. So, from all of those things you should get our restated first quarter.

Simon Leopold, Morgan, Keegan & Company

Okay, yeah I’m just being lazy, sorry.

Gokul Hemmady, Chief Financial Officer and Vice President

We can send that to you.

Robert Switz, Chief Executive Officer and President

No, we can’t, you will need to squeeze it off the income statement, Simon.

Simon Leopold, Morgan, Keegan & Company

Okay, and in terms of the trends in question on the segment, if you could tell us a little bit about where the upside came relative to your July guidance?

Robert Switz, Chief Executive Officer and President

When you say trending are you talking about sequentially or year over year?

Simon Leopold, Morgan, Keegan & Company

I tend to think in terms of sequentials if that would help.

Gokul Hemmady, Chief Financial Officer and Vice President

So, our enterprise business, Simon, had a pretty decent sequential growth, I think it was around 15% or so. As we’ve told you in the past, Simon, in our first quarter as we deployed SAP in AMEA we went through some transition issues which we feel we kind of recovered in the second quarter and we’re fully up to steam in the third quarter. So, I think the threat came more from AMEA. I think the U.S. business has always been very strong, has in ’05 grown year over year at about 25% to 30%, we expect ’06 to be a pretty decent growth business in enterprise in the Americas region. So, I think the third quarter the strength was more AMEA.

Simon Leopold, Morgan, Keegan & Company

And when we look at the October quarter, should we think about normal seasonality in AMEA as leading to a sequential decline then for enterprise?

Gokul Hemmady, Chief Financial Officer and Vice President

Yeah, I think there probably will be a smaller sequential decline, although we’ve guidance for the full year and therefore the fourth quarter on revenues. As you know, most of that decline comes from FTTX going down as well as some of the cabinet business that we’ve been talking about in Europe going down from the third quarter and fourth quarter and a smaller reason will be AMEA enterprise business going down from a seasonality perspective.

Simon Leopold, Morgan, Keegan & Company

Great, that’s helpful, thank you.

Operator

Your next question comes from the line of Nikos Theodosopoulos with UBS.

Amitabh Passi, UBS

Hi, this Amitabh Passi on behalf of Nikos. Gokul, my first question was for you. I missed the comment, I think you had said something about fiscal first quarter guidance where it indicated how revenues might turn in the quarter; I didn’t exactly catch what you had said.

Gokul Hemmady, Chief Financial Officer and Vice President

Yeah what I said in my prepared remarks that like every year we expect our first quarter of ’07 to be a seasonally down quarter because it’s a January quarter, there are a number of holidays in that quarter. In the past, we’ve witnessed anywhere from an 8% to 15% sequential topline decline in that quarter. So, the number of holidays as well as the fact that our customers are kind of between budget cycles impact that quarter for us. That is what I said.

Amitabh Passi, UBS

And the second question was also a clarification, did you say that your services business this quarter on an EBIT level was positive?

Gokul Hemmady, Chief Financial Officer and Vice President

If I exclude the special charges, i.e. the amortization of intangibles, restructuring, as well as the stock option expense, then it was break even without any product pull through. With product pull through it was profitable I think about $5 million in operating income.

Amitabh Passi, UBS

Okay, great, thanks. Then the third question is how should we think about OpEx going forward; I mean you’ve essentially come down roughly from sort of a 28% to 29% of sales to the 22% range, is that a level you think is a expandable as a percent of sales or if you’re more comfortable talking in terms of outflow dollars, and just trying to get a sense of what we should expect.

Gokul Hemmady, Chief Financial Officer and Vice President

I think I would talk in absolute dollar terms only for the short term. So I think for the fourth quarter you should be expecting operating expense dollars to be in the range of the third quarter, so I wouldn’t expect any major changes. It maybe slightly higher than the third quarter but not by a big margin. Over the longer term we think about our operating expense as a percent of revenue. Our goal as we’ve stated in the past is to get to operating expenses at 20%. Based on some of the remarks that Bob made around operating expense efficiencies that we are thinking of in terms of shared services centers, deployment of our SAP in Asia-Pacific and other things, we do believe that that combined with topline growth the goal of 20% operating expense as a percent of revenue is achievable. So that remains our goal.

Amitabh Passi, UBS

Okay, thank you.

Operator

You next question comes from the line of Steven O’Brien with JP Morgan.

Steven O’Brien, JP Morgan

Hi, thanks for taking my question. A quick question on Andrew was there any impact on sales this quarter or perhaps on the expense side a slow down in your efforts to consolidate manufacturing while there was some focus I guess on Andrew?

Robert Switz, Chief Executive Officer and President

Yeah, there was none of any of that. Fundamentally, the basic reason is we have most of our business outside of wireless, so it was focusing on its daily business all through the M&A period. So, most of the work that was taking place with Andrew mainly focused around people for the most part that had corporate staff functional responsibilities. Our sales force remains highly focused on the sale of our wireline products. So, both from a cost focus and moving factories, virtually all of them quite frankly fall in our connectivity business because service doesn’t have any and our wireless-wireline are outsorced. So, we had no distractions during the period as a result of Andrew. If you look at what happened during the period, it’s fundamentally that three of our top 10 customers slowed down during the quarter for the reasons that we had mentioned earlier -- one as a result of inventory and an outlook of better utilization of product, and the other two as a result of being part of a large M&A transaction. That was really the issue.

Steven O’Brien, JP Morgan

Thanks, I really appreciate Bob, and if I could kind of continue with that discussion, you mentioned in your opening remarks you saw carrier consolidation as an opportunity, which seems somewhat counter intuitive given the cause in spending you’re seeing right now. Can you comment on that and comment on whether your acquisition strategy necessarily has a wireless component to it, is that the focus?

Robert Switz, Chief Executive Officer and President

The consolidation is a blessing and a curse, and that was mainly a U.S. focused comment. As they consolidate, we do gain service business helping them connect their networks and put together their operating networks as one company. Overall, consolidation is not a good thing, but in our case we do benefit in the initial stages as networks come together. So, that’s where we get the plus out of it. Your other question, I’m sorry, refresh me please.

Steven O’Brien, JP Morgan

It was with your acquisition strategy and a focus on the wireless.

Robert Switz, Chief Executive Officer and President

No, our acquisition strategy is both wireline and wireless. We certainly like to add some scale to the wireless piece of our business. Certainly Andrew would have done more than that, but to the extent that companies fit our strategic ambition they can be wireless or wireline like with FONS for instance, which essentially is a wireline acquisition but fell at the heart of our fiber strategy and our desire to move closer to the edge in fiber and participate in the D-fiber initiatives more closely. KRONE was a wireline acquisition but it got us enterprise capability and got us a career product compatible with European standards as well as global participation. So, we’re not relegated just to wireless. We certainly like to expand our capability to more broadly include wireless participation, but it can be in either of those domains.

Steven O’Brien, JP Morgan

Thanks.

Operator

And once again, ladies and gentlemen, for any questions or comments simply press * and the number 1 from your telephone keypad. Our next question comes from the line of Marcus Kupferschmidt with Lehman Brothers.

Marcus Kupferschmidt, Lehman Brothers

Good afternoon guys. I wanted to ask a couple of questions about fourth quarter before I just try to ask a big picture question. Just to clarify the fourth quarter guidance for EPS, the $0.15 to $0.20, is that a pro-forma number or a GAAP number?

Gokul Hemmady, Chief Financial Officer and Vice President

$0.15 to $0.20 is an adjusted EPS number.

Marcus Kupferschmidt, Lehman Brothers

Okay, great. I think it’s been said but I want to clarify, in terms of the recent change and the expectations for the fourth quarter, it’s recorded a decline of roughly $50 million from what you thought before. It sounds like that the fiber to the PROM business could be down even more than we thought plus there is some consolidation leading to incremental pauses beyond what we thought, is that capturing it?

Gokul Hemmady, Chief Financial Officer and Vice President

I think there are three elements to it, and two you’ve captured. Number one is the FTTX business caused by the inventory issues. The second one I think some of the effect is the carrier consolidation. And third, with one of our large European carriers where we’ve sold cabinets, that cabinet business is falling off in the fourth quarter. That’s a much smaller effect to that $50 million number that you talked about, but it is a small impact to our revised guidance. We were expecting that business to be offset by some of the connectivity that we would sell to that customer. We believe that that’s more a ’07 event now.

Marcus Kupferschmidt, Lehman Brothers

Okay, so the thing about the sale mix then, it sounds to me like you’re getting penalized because you’ll lose some of the higher margin products through the consolidation but at the same time you benefit by less fiber to the PROM revenues, so it’s a kind of a wash on the sales mix?

Gokul Hemmady, Chief Financial Officer and Vice President

Yeah, so I would expect gross margins to be kind of in the range of the third quarter. It might be slightly lower because of lower volume.

Marcus Kupferschmidt, Lehman Brothers

Sure. Just help us understand thinking of obviously the consolidation with two of your big wireline customers in the U.S. is an issue, how do you think about going forward, the bigger picture here? One thing I think is interesting, BellSouth does a lot more with ADC than SBC does, the revenues to ADC traditionally have been much bigger for BellSouth than SBC even though the SBC now works in a much bigger network. So, how do you think about the merger kind of going forward beyond the integration, how should we think about it?

Robert Switz, Chief Executive Officer and President

It’s really hard to say. We don’t expect anything to change at BellSouth, so let’s start with that. We do expect to be able to leverage some of our capabilities and services at BellSouth, maybe a little further into SBC/AT&T. So, we’re looking at ways that we can take all of our good positioning and leverage that across a larger customer. Now, in looking at that, we’d certainly like to be able to find more diversity over time and not be as dominated by what’s going to be two large customers as we will be obviously going into ’07. So, diversification of the customer base is a goal of ours. I just think it’s a natural goal. We’d love to continue to grow with our two large customers and we likely will, but we certainly like to expand our customer base and broaden our product offering to mitigate some of the ripple effect that happens when you are beholden to large customers. So, our goal over time as it has been is to continue to try and diversify ourselves geographically by customer and through additional product offerings. It’s really hard to say but I would expect not to see too terrible of a negative effect if any by this combination. I would expect us to be able to gain some degree of incremental participation as a result of it.

Gokul Hemmady, Chief Financial Officer and Vice President

Just one clarification, Marcus, to your comment on SBC BellSouth, that comment is true when you look at overall revenues for ADC, but if you look at product revenues our product revenues at SBC are probably larger than BellSouth.

Marcus Kupferschmidt, Lehman Brothers

Okay, thanks.

Operator

Your next question comes from the line of Rich Church with Unterberg.

Richard Church, Unterberg

Thanks. With regards to Deutsche Telekom, they obviously completed their 10 city phase, but I believe the next phase is for 40 cities supposedly starting in early calendar ’07, are you just not going to be a participant in that deployment or do you not expect that deployment to start?

Robert Switz, Chief Executive Officer and President

Yeah, I think at this point we have no reason to expect not to be able to participate in additional deployments. We are expecting to move to the next phase with DT and at this point we are pretty comfortable that we’ll participate with them with our new product, the automated cross-connect product.

Richard Church, Unterberg

Okay, but do you have any sense of timing of the next phase?

Robert Switz, Chief Executive Officer and President

You know, I think we’re going to see that in ’07.

Richard Church, Unterberg

Okay, and given that it’s 40 cities versus 10 cities, do you think it’s an equal kind of opportunity versus what you delivered for them in’06 or larger?

Robert Switz, Chief Executive Officer and President

At this point, I think we’re of a mind, assuming that we participate that the opportunity is certainly large if not larger depending on their ability to deploy.

Richard Church, Unterberg

Okay, is your hesitance around some of the EU regulations and the battle that they’re waging?

Robert Switz, Chief Executive Officer and President

Yeah, you’ve got all of that in there, like Verizon, like our deployments, these are big complicated network deployments and there’s plenty of opportunity with these for things to quite frankly happen and cause unpredictability. So, it’s nothing more than that.

Richard Church, Unterberg

Okay, thanks a lot.

Operator

Your next question is a followup question from the line of Paul Silverstein with Credit Suisse.

Paul Silverstein, Credit Suisse

Bob, with respect to your previous question regarding Deutsche Telekom, I just want to make sure when you say that if you participate, do you have any reason to be concerned that you will not be participating in the next phase, has there been any communication that was suggested to you that your participation was a one-shot deal?

Robert Switz, Chief Executive Officer and President

No, I have no reason to believe that. I believe we will participate, but we’re not sitting here in a position to factually verify that.

Paul Silverstein, Credit Suisse

Understood, thank you.

Mark Borman, Vice President, Treasurer and Investor Relations

We’ll take one more question and then we’ll end the call.

Operator

If there are any more questions press * and 1 at this time.

Mark Borman, Vice President, Treasurer and Investor Relations

All right, thank you for being with us today.

Operator

Thank you, ladies and gentlemen. That concludes today’s teleconference, you may now disconnect.

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