ADC Telecommunications F3Q07 (Qtr End 8/3/07) Earnings Call Transcript

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ADC Telecommunications (ADCT) F3Q07 Earnings Call September 5, 2007 5:00 PM ET

TRANSCRIPT SPONSOR
Wall Street Breakfast

Executives

Mark Borman - Investor Relations

Robert E. Switz - President, Chief Executive Officer, Director

James G. Mathews - Chief Financial Officer, Vice President

Analysts

Tim Savageaux - Merriman, Curhan, Ford & Co.

Amitabh Passi - UBS

Brian Coyne - Friedman, Billings, Ramsey

Steven J. O'Brien - JP Morgan

Simon Leopold - Morgan Keegan

James Falkoff – Robert W. Baird

Jack Monte - Lehman Brothers

Eric Buck - Brean Murray, Carret & Co.

Ningning Tang - Craig-Hallum Capital Group

Operator

I would like to welcome everyone to the ADC third quarter earnings conference call. (Operator Instructions) Mr. Borman, you may begin your conference.

Mark Borman

Thank you, Heather. Good afternoon and thank you for joining us today. Bob Switz, ADC's President and CEO, as well as Jim Mathews, 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 other risk factors included in Item 1(a) of ADC's Annual Report on Form 10-K/A for the fiscal year ended October 31, 2006; and, as may be updated in Item 1(a) of ADC's subsequent reports on Form 10-Q and/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. Bob will provide an update of ADC's strategic direction. He will then turn the call over to Jim who will cover the financial results and then provide forward-looking financial model guidance.

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

Robert E. Switz

Good afternoon and thank you, Mark. I'll first start with comments on our third quarter results and then update you on our long-term plans to grow sales and earnings. We continued to outperform expectations in 2007 with strong third quarter results. Even though several customers have not yet returned to normal spending following their mergers, we had better than expected sales strength in our connectivity, wireless and services business and have seen resumed sales growth outside of the United States. We are particularly pleased with the continued progress we've made in improving profitability.

Excluding inventory write-off charges from the ACX product line exit, restructuring of our German operations and fixed asset impairment related to the ACX program, our adjusted gross margins slightly exceeded 35%, the highest we have seen since the fourth quarter of 2005. While we exited our existing ACX product line, we will continue to monitor the development of the broader automation market and may determine to pursue this market in a modified manner if future conditions warrant.

This quarter’s and the second quarter’s earnings show the leverage power of ADC's operating model when our business units collectively deliver high sales volumes. While our business can be volatile due to the timing of large customer projects, positive fluctuations with high sales volumes have very favorable incremental profit margins. On a number of occasions in the past we've experienced the negative side of this volatility. In this quarter, we have seen the benefits of positive volatility relative to expectations.

We remain focused on our work to build ADC's long-term value as a leading global network infrastructure company. We grow by bringing our customers worldwide cost effective and reliable solutions to help them deliver high bandwidth and value content to their residential, business and mobile subscribers.

Let's now review some of our growth opportunities. ADC grows by selling connectivity solutions where networks are changing and evolving. As a result of these changes and evolution, new equipment is being connected to new and old networks in new ways. ADC's comprehensive infrastructure solutions are used from the central office through the outside plant and into the enterprise network. We see a tremendous amount of connectivity opportunities as voice, video and data services converge in the wireline and wireless networks of carriers and in enterprises. We also see opportunities when networks are interconnected in mergers and consolidations such as the Verizon-MCI and SBC- AT&T, BellSouth-Cingular network integrations.

Similar to the strength we saw in the second quarter, our equivalent broad-based sales performance in the third quarter was an excellent example of our success in supplying these comprehensive solutions to our global customers. Sales in our global connectivity business unit in the third quarter of 2007 were in line with our strong second quarter of 2007. The following products drove these results:

Sales of global fiber connectivity products benefited from strong demand for central office products. Central offices are being upgraded to provide the necessary infrastructure to support fiber to the X and high density, data center deployments in the United States. In the quarter, we also made significant progress in sales of central office fiber products outside of the United States.

We were also pleased to see our FTTX sales reflect a more level spending pattern by Verizon in 2007 compared to 2006.

Global copper connectivity products continued to benefit from stable, yet high level demand for central office connectivity for wireless data infrastructure and upgrades of cable and telco networks to support video services. In the quarter, we also saw progress for central office copper products outside the United States. Outside plant copper sales were in line with the second quarter, yet down year-over-year, as a result of the expected decrease in sales of outside cabinets in Europe. As you'll remember, we had a very large one-time piece of business last year from DT relating to outside plant cabinets.

In enterprise connectivity, products also increased 8% from the second quarter and were in line on a year-over-year basis. Demand was driven primarily by new buildings and increased footprint with our global accounts.

Moving to other businesses, our wireless sales continued strong as the Digivance wireless coverage and capacity solution continued its deployments with existing customers. Our HDSL products continued to serve the maintenance market at expected lower levels. Professional Services showed improvement on the strength of a build out of fiber networks with AT&T and a modest increase at Cingular.

Sales outside the United States resumed growth to 38% of ADC sales, primarily driven by strong demand throughout the Asia Pacific region. Asia Pacific sales grew 28% year over year and 16% sequentially. Strength in the region was seen across our fiber, copper, and enterprise connectivity products.

Let's now move to a couple large projects which most of you are somewhat familiar. Verizon was 17% of our sales this quarter, and continues to be on track to pass a cumulative 9 million homes by the end of 2007. We continue to supply Verizon with a broad spectrum of fiber to the premise solutions from the central office through the outside plant for the 6 million homes they have passed already, and the 3 million additional homes they expect to pass in 2007.

Our nine months sales of all ADC products and services to Verizon are up 6% year over year as they are spending at a more level pattern in 2007 compared to 2006. We are selling solutions for both homes passed at 3 million per year and homes penetrated out of the 9 million that are expected to be passed by the end of this year.

The new consolidated AT&T was 16% of our sales this quarter, and buys ADC's broad range of infrastructure solutions. Our nine month sales to Legacy AT&T, which is the former SBC and AT&T long distance, were up 59% year over year. This growth is driven by Project Lightspeed deployments and the long distance build out of its ultra available network of fiber rings.

While Legacy SBC and AT&T long distance spending is on track for 2007, non-maintenance spending at Legacy BellSouth has not resumed at a normal pace for this time of year; however, we did see a small increase in Cingular spending in the third quarter over the second quarter of this year. Our nine month sales to BellSouth are down 23% year over year and our Cingular sales are down 65% for the same period. Excluding BellSouth and Cingular from ADC's nine month sales, consolidated ADC grew 6% year over year. Given that merger integration takes time, we remain cautious as to when and at what rate we can expect BellSouth and Cingular spending to return to historical levels. When BellSouth and Cingular spending returns to traditional levels, we believe that can be a positive upside to our outlook.

At Sprint Nextel, a Top 5 customer who has completed their acquisition integration, our nine month 2007 sales are up 85 % compared to last year.

Looking forward to 2008, we are anticipating the return of normalized spending when the AT&T merger integration of BellSouth and Cingular is completed. We believe we are well positioned to grow our shares in fiber, copper, and enterprise connectivity markets. We also are pleased to see the potential in international markets beginning to be realized in the following areas:

Strong growth in the Asia Pac region where we are investing resources in this high potential connectivity region;

Market share gains with our copper and fiber connectivity products in the EMEA and Asia-Pac regions;

In the EMEA region, we are actively engaged in FTTX opportunities in Saudi Arabia, Slovakia, Poland, Austria, Germany, Belgium, France and Norway; however, these may not result in full scale deployments in the near term but do support our ongoing growth opportunity.

The Asia Pacific region also has a growing number of potential FTTX opportunities, based on expressed interest in public announcements. Many of these opportunities will likely take time to develop into full scale deployments. They include carriers and private developers in Australia, China, Malaysia, the Philippines, Singapore, Taiwan, Indonesia and Hong Kong.

Canada is also deregulating its local telecom market to allow incumbents, cable TV and competitive carriers to compete for residential and business customers, which we believe will stimulate competitive spending.

Finally, we are starting to see FTTX opportunities appear in the Latin American market.

A new growth opportunity that is expected in 2008 is our new FlexWave all-IP radio access network solution that allows wireless operators to meet the growing coverage and capacity demands of advanced wireless services while at the same time containing costs through flexible IP backhaul. Everyone has had the experience of being in a location with no wireless signal and unable to make a call. Most of us have also had the experience of having a signal but still being unable to get a channel to send or receive messages. In the industry these problems are called coverage, no signal, and capacity; insufficient resources for the services you desire. With increasing wireless handset capability and increasing user dependence on wireless devices, these two problems are getting worse rather than getting better.

Usage patterns are increasingly indoors, at home and work rather than in the car, and bandwidth intensive with data and video services. More tall towers are not the answer; rather small, highly capable radio heads and distributed antenna systems with broadband backhaul are the answer. In the Internet, in enterprise networks, and in wireline public networks, the technology has moved from circuit-based technology to packet-based technology, and the packet technology of choice is Internet protocol. We believe that wireless networks also will evolve to IP, first for backhaul and ultimately for end-to-end communications. This is a technological revolution that will be driven by the coverage and capacity problems as well as economics.

ADC has a long history in wireless coverage with important digital wireless intellectual property. We have been investing in a portfolio of new products built on this vision of the next generation radio access network. We are building and marketing IP radio access nodes and distributed antenna systems for several important application areas: the home, business, and outdoor venues such as campuses, public sites and hard to serve areas like tunnels and canyons. These products are designed to address both coverage and capacity for emerging data and video-intensive wireless handsets. We will be introducing these products out to the market over the next few quarters and already have seen an enthusiastic reception from service providers trying to solve the dual problem of coverage and capacity, cost effectively.

To conclude my comments, we are pleased to see the benefits of our highly leverageable operating model produce strong profitability at these high sales volumes. Inasmuch as we have some concentration around Verizon and AT&T, both this quarter and the second quarter results demonstrated the power of our broad-based sales strength across our core business.

We also are pleased with the resumption of international growth in the current quarter. These high sales results combined with favorable sales mix and steady progress on our competitive cost transformation program are contributing to our strong earnings growth and cash flow generation.

Looking forward, we will provide guidance for 2008 in our next earnings call in December; however at this time, we expect to continue our growth in 2008 at or above industry average rates. I'll now turn the call over to Jim Mathews who will comment on the quarter’s financial results.

Jim Mathews

Thanks a lot, Bob and good afternoon to everyone. We appreciate you joining our call. It's my pleasure to share with you the highlights of our strong third quarter results. First of all, third quarter sales were $346 million which came in stronger than expected. This was just 1% below the strong sales results that we produced in the second quarter of 2007 and was actually 1% above the third quarter of 2006.

Second, we produced gross margins of 32.8% but these actually increased to 35.4% after adjusting out a $9 million inventory charge for the exiting of our ACX product business. This 35.4% compares favorably to 34.5% that we generated in the second quarter of 2007.

Third, our GAAP diluted earnings per share were $0.14. This included a total of $0.23 of charges for the ACX product line inventory, restructuring and impairment charges, acquisition-related items and stock option compensation expense.

Fourth, total cash provided by operating activities from continuing operations was $30 million in the quarter. Our cash flows have been strong in the past nine and 12 months as well, with cash provided by operating activities from continuing operations at $106 million and $144 million over the last nine and 12 month timeframes respectively.

Now, to review these consolidated earnings in a bit more detail. As stated, our GAAP diluted earnings per share from continuing operations were $0.14 in the quarter. This compared to 73% sequentially in the second quarter and $ 0.20 in the third quarter of fiscal 2006. As previously noted, this quarter’s $0.14 EPS number includes $0.23 of charges for the following: $0.07 inventory charge for ACX product line exit, $0.09 of restructuring and impairment charges, $0.05 of acquisition-related charges, and $0.02 of stock option compensation expense. The large restructuring and impairment charges in the quarter were primarily a result of costs associated with reducing our operations in Germany and writing down assets related to the ACX product line.

The sequential comparison to the second quarter’s $0.73 EPS need to consider that the results in the second quarter included a non-operating gain of $0.43 from the sale of our big band networks position and that was partially offset by $0.04 of net restructuring and acquisition related charges and $0.01 of stock option compensation expense.

During the quarter, gross margins were 35.4%, which again exclude the ACX inventory write-off. This improved from the second quarter of 34.5%, primarily as a result of the efforts we've made in our competitive cost transformation initiative which is a multi-year process to achieve cost leadership and other efficiencies across our businesses. Selling and administration expense was $64 million in the third quarter, which was in line with the $63 million recorded in the second quarter. Within selling and administration expenses, R&D costs of $18 million was also in line with the second quarter.

Moving on to working capital, DSOs were 45.9 days, again better than our 50 day goal. This was in line with the 45.2 days we produced in the second quarter, but actually were an improvement of 3.5 days from the 49.4 days in the in the same quarter one year ago. Our third quarter inventory turns were at 5.3 times. This was the same as in the second quarter of this year, though slightly below the 5.5 turns that we reached one year ago.

Our strong earnings were partially offset by some uses of cash for working capital purposes but we nonetheless generated $30 million in total cash from operating activities from continuing operations in the third quarter.

During the quarter, depreciation and amortization expense totaled $17 million, the same as in the second quarter. Property, equipment, and patent additions net of disposals represented expenditures of $6 million in the third quarter and $9 million in the second quarter.

As a result of our strong cash flows our total cash, cash equivalents and available for sale securities totaled $695 million as of August 3, 2007 which was up $19 million from the quarter ended on May 4 of 2007.

I'm now going to provide some annual fiscal 2007 full year financial modeling guidance. At this time we're going to be raising our 2007 annual sales and earnings guidance ranges. Prior to providing the specifics of that guidance, however, I'd like to point out some of the factors that we consider as we look ahead to the full year results.

While our results in the fourth fiscal quarter of 2007 are likely to be less than in the proceeding second and third quarters due to seasonality, we do not expect the results in the fourth quarter of fiscal 2007 to fluctuate as sharply as last year due to a more level spending pattern by a key customer in 2007 compared to 2006.

We also believe that there are significant long-term growth opportunities ahead of us; however, forecasting the timing of these opportunities remains difficult due to several uncertainties which include how long and to what degree spending by some of our substantial customers will be deferred during the integration period following their mergers.

Second, rates at which new networks are built and related subscribers adopt the new service deployments.

Third, when regulatory reviews of our customers new networks are resolved; and,

Fourth, when decisions are made regarding capital allocation to new network and service initiatives.

These factors could shift the quarterly timing of some sales opportunities both in the fourth quarter of fiscal 2007 and throughout fiscal 2008. Gross profit margins are expected to rise and decline with sales volume levels from quarter to quarter as we have seen them in the past.

With those items as background, on a continuing operations basis, ADC currently expects its 2007 sales to be in the range of $1.308 billion to $1.313 billion. Based on this annual sales estimate and subject to sales mix and other factors, GAAP diluted EPS from continuing operations in 2007 is estimated to be in the range of $1.11 to $1.15.

Those numbers include the following estimated charges and benefits each net of tax: they include amortization of purchased intangibles of $0.18 per share; restructuring and impairment charges of $0.09 per share; the ACX product line inventory charges previously discussed of $0.07 per share; stock option compensation expense of $0.05 per share, and a benefit from a non-operating gain on the sale of the big band networks stock of $0.43 per share.

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

The calculation of our GAAP diluted EPS from continuing operations includes the if converted method which assumes that our convertible notes are converted into common stock if they are dilutive to EPS. The details of the EPS calculation specified in the if converted method is included in our earnings release.

Finally, with respect to our income tax position, as of August 3, 2007 we had a total of $980 million in deferred tax assets that have been offset by a valuation allowance of $936 million. This net asset is primarily in other long-term assets on our balance sheet. Approximately $213 million of that amount is related to capital loss carryovers which can be utilized only against realized capital gains available through October 31 of 2009.

During the fourth fiscal quarter of 2006, we reduced the valuation allowance by $49 million, attributable to deferred tax assets that are expected to be utilized over a two-year period.

For financial modeling, we expect the effective tax rate looking forward to be 10% for each quarter. As we generate pre-tax income in future periods, we currently expect to record reduced income tax expense until either our deferred tax assets are fully utilized to offset future income tax liabilities, or the value of our deferred tax assets are fully restored on the balance sheets.

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 remain committed to managing our business strategically for long-term growth and profitability. We are executing a multi-faceted and multi-year approach to growing value for our shareholders in a market with ever increasing competitive pressures. We intend to continue building ADC into the leading global network infrastructure company.

If the current timing uncertainties of our sales opportunities are resolved favorably, particularly with respect to BellSouth and Cingular, we would expect to see a positive impact on our outlook.

We will now open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Tim Savageaux.

Tim Savageaux - Merriman, Curhan, Ford & Co.

Good afternoon and nice quarter. I had a question about you had made some comments about growth expectations for 2008 and those are relative to industry averages. Without getting too specific, I wonder if you might be able to put that into a little more context. You are closing a year here where you are probably going to grow on the order of 2%. I would imagine you would look at that as being below the industry average for 2007. I would like to hear your commentary on that.

I would assume that you are talking about something in the mid-single digit range but wanted to see if I could get a little more clarity on that.

Robert E. Switz

Yes, if I give you too much clarity, I’ll be giving you that guidance that I’d be giving you in December, so let me take a different approach to it. The 2% growth, Tim, that you refer to, keep in mind that that growth came with a couple of large customers not spending at normal rates, so that puts somewhat of a drag on this year’s growth. We also had a comp issue, comparing with this year, we did not have the $60 million in BT Cabinet business that we had last year, so let me just throw those out as some reference points.

Tim Savageaux - Merriman, Curhan, Ford & Co.

Okay, and if I could follow-up on that real quickly, I would imagine you wouldn’t look at up 60% at telephone and up 80% at Sprint as sort of comparable or normalized either, so assuming that kind of washes out and understanding you are impaired a little bit, I guess what you are telling me is that you feel like the low single digits is towards the low end of what you ought to be able to do.

Robert E. Switz

I think what I would say is rather than, you know, again give guidance that I didn’t intend to do, I would say that there are some things that we see going into next year. We do see a more stable return around the customers that weren’t spending. We have some growth expectations around some of our wireless products. We see a continuation of our FTTX initiatives, as well as central office fiber.

I think the way we are looking at it is we see this is a year that, the one passing, that some of the anomalies that we faced this year and maybe the latter part of last year, dissipate.

Tim Savageaux - Merriman, Curhan, Ford & Co.

Okay. Thanks very much.

Operator

Your next question comes from Amitabh Passi.

Amitabh Passi - UBS

Hi, this is Amitabh Passi on behalf of Nikos Theodosopoulos. Bob, I was wondering if you could just help me understand the gross margin movement this quarter. You know, copper connectivity sales as a percent of total sales declined sequentially and they tend to be your higher margin products, and this is all on lower sales volume quarter over quarter, and yet we saw 100 basis points movement in margins. So I am just trying to understand how much of this is purely volume driven versus ongoing cost reductions and any additional color you can provide there.

Robert E. Switz

Sure. I’ll let Jim Matthews jump into this in whatever detail he would like but in general, I’ll make a high level comment that a fair amount of this does reside in margin improvements, margin improvements coming from our competitive cost transformation program. We did in certain parts of our product portfolio have the opportunity for some modest pricing improvements as well, so I would say as we look at the gain, I would lean more in the direction of margin benefits through those types of activities as opposed to pure volume and, quite frankly, mix as well. Jim.

James G. Mathews

Reiterating what Bob said, I would attribute it primarily to margin results and indeed to many of the cost transformation efforts that we have seen. We certainly did have some benefit from strong sales in product lines where we have better-than-average margins but the bulk of the results that we’ll produce relative to both the second quarter of ’07 and more particularly, the third quarter of ’06, were driven by many initiatives that we’ve articulated in the past.

Amitabh Passi - UBS

So is it fair to assume that despite a sequential decline, you should be able to keep margins sort of in the 33% to 35% range next quarter?

Robert E. Switz

You know, I think we’ve given a range historically that we’ve cited in that 32-ish to 34 range, so I think that’s probably still a good range for the time being. I wouldn’t want to stretch it up as high as 35 at this point. Although, depending on activities in the quarter, that may be possible.

And the problem with it is really truly understanding on a timing basis when some of our cost reductions actually find their way into results.

Amitabh Passi - UBS

Okay, thank you. I’ll jump back in queue.

Operator

Your next question comes from Brian Coyne.

Brian Coyne - Friedman, Billings, Ramsey

Good afternoon. Nice quarter. Just a couple of things; Bob, you mentioned a few of your 2008 priorities just for looking at revenue growth. I was wondering if you might be able just to, you know, maybe rank a few of those, if you could, just in terms of the impact. I think you mentioned, for example, the return at BellSouth, market share expansion, footprints in existing customers, international markets and new products.

Robert E. Switz

You know, I think it’s kind of all of the above. Let me talk a little. Internationally, we’ve made great progress. We’ve spent some money this year, particularly in the Asia region, modest amounts of money, trying to support our global go-to-market channels, and I think that’s beginning to have some results.

We have seen a fair amount of activity that could manifest itself as growth in ’08 around FTTX, as well as some of our wireless applications. We do expect to see better performance in EMEA. We’ve been working now for a period of time to really harness some of the cross-selling benefits that we thought we would get with Krone. We were slow to get those in EMEA but I think some changes and some things that we’ve done recently suggest that we should start to see that benefit. I think we’ve seen some in this quarter relative to some of our fiber activities, so we should start to see that.

We have some new products coming to market that should also support our growth. The enterprise business has stayed fairly solid for us and we’ve had good market share gains, particularly in the large new builds. I think we will see a benefit coming out of both Cingular and BellSouth, although it’s hard to predict exactly what that is because it is going to gravitate around spending plans.

We see some opportunity in our services business for some added service market share in the AT&T BellSouth Cingular organization in the Southeast, so we see that as share, potentially a business share gain in the services area.

So it is -- there’s a number of activities and areas that we are focused on that we see, you know, we are reasonably optimistic about going into 2008. Of course, the central office, the CO-based fiber business remains very strong as well, as people continue to migrate to fiber solutions.

Brian Coyne - Friedman, Billings, Ramsey

That’s great. One thing you didn’t mention, I guess it might be just a small amount, is pricing increases or firm pricing, let’s say, relative to what you’d normally expect, maybe some price decreases. Is that having an impact as you look into 2008, maybe particularly on the enterprise side?

Robert E. Switz

We’ve seen a little benefit in this quarter. That was part of the margin improvement. We’ve seen some benefit in the structured tabling business. You know, as you know, on large tenders and the likes of that, it’s highly price competitive so we are not going to benefit across the board from price increases. But there are selected small areas where that’s a possibility.

Also, we’ve been working with our customers to try and standardize on a fewer number of our products and that’s a benefit both to them and both to us, if we can reduce the number of SKUs that we currently have to service. Also, as part of that process, hopefully upgrade some customers to more capable equipment as part of that migration from some reasonably and fairly old equipment that they’ve had in their networks.

So a little bit of benefit, not a lot but you know, a little bit always helps.

Brian Coyne - Friedman, Billings, Ramsey

Great. Sounds good. Thanks again.

Operator

Your next question comes from Steven O'Brien.

Steven J. O'Brien - J.P. Morgan

Thanks for taking the question. Can I touch on the guidance again for 2007? If I’m doing my math right and you take sort of the midpoint of guidance here and subtract the previous three quarters, we’re looking at a quarter in Q4 that is in the 315 to 320 range, down about 8% sequentially versus Q3. I think your Q4 last year was down about 10% sequentially.

So touching on that, what do you mean when you say that you don’t expect as much fluctuation, as it seems like the fluctuation is only mildly better?

Robert E. Switz

You know, I think last year we had quite a bit of gyrating in the third and fourth quarters. I think we fell off, particularly at Verizon and BellSouth Cingular, pretty substantially, although I don’t have the percentages at the top of my head. But to us, quite frankly, this feels like a -- quite frankly, if nothing else, an expected decline as opposed to a surprise decline. We are associating it with a couple of factors.

I think technically, I think we have one less shipping day in the fourth quarter, so you can assign whatever number you want to one day of shipping but it is real dollars. We have quite a bit of wireless. We have some wireless expectations that are a good pipeline but they need to turn themselves into real orders.

BellSouth and Cingular, as we’ve said, aren’t quite coming back. We are also watching closely some of the FTTP deployments that are related to new housing starts as well. That’s an area that we are all very much painfully aware of what’s gone on in that industry. Some of the customers that acquire or deploy FTTP solutions do that in greenfields in and around new developments, so we are factoring that in and watching that carefully.

The Verizon as well, we are expecting less sales from Verizon in the fourth quarter than we had in the third quarter based on what we know today of what their deployment needs will be and the mix of products that will be part of fourth quarter deployment and purchasing.

So it’s a number of factors. I don’t think it’s -- I wouldn’t call it volatile. I would say it is in line with the order patterns and the deployments of our customers and in line with our ongoing assessments.

Steven J. O'Brien - J.P. Morgan

Okay, fair enough. On a different topic, your expense levels have been pretty flat the last three quarters and your employee headcount, 9,100, appears to be roughly where it was maybe coincidentally, maybe not, last year at this time. Can you continue to or do you continue to expect to see the potential for margin improvement on the operating line as we go forward, even as gross margin may fluctuate, I guess, with the overall top line?

Robert E. Switz

I’ll comment briefly and I’ll turn it over to Jim. I think the answer is yes, we are looking to be as efficient as we can in the operating expense area. We’ve given you some guidance around, or at least goals around percent of sales for op-ex. We continue to be very efficient in where we place costs, looking for low cost regions to do things in, as well as leveraging our resources in all of our global operations.

I’ll let Jim provide additional commentary on it but we are very focused on driving as low op-ex to revenue as we possibly can, and as we’ve mentioned in the past, the flip side of it, one is controlling op-ex in real dollars and as a percent of sales, but one of the pieces of that is the leverage you get from revenue growth because we don’t need to throw a lot of expense on the P&L to support pretty good chunks of revenue. Jim.

James G. Mathews

We are putting quite a focus on operating expense. When you look at our global footprint, obviously there’s -- this is where Bob has spoken many times to the opportunity of utilizing our operating leverage and we know that to be able to enjoy that as we grow top line, we’ve got to put very conscious efforts into controlling operating expense.

Nonetheless, we continue to produce a product through R&D and we have not really cut back on R&D. We see that remaining in the 5% to 6% of sales range.

As Bob mentioned earlier, we are putting as many jobs in low cost regions as possible when it makes good business sense and we see the benefit of that. You noted the fact that the headcount year over year is relatively flat. There is a bit of a peak that we see probably in the spring of each year as we respond to volume needs that we are anticipating, but we find that we are able to do those generally in our Mexico manufacturing operations with temporary workers, so that is a very efficient way for us to manage around our capacity needs.

So while we do continue to be faced with all of the operating expense pressures that you would expect in a global company, we put an awful lot of focus on trying to manage those effectively and constantly ask the question of what do we no longer need to do in exchange for where there are opportunities to spend dollars wisely, and I think you are seeing that in the results.

For the third quarter, if you make the adjustments that we typically call out and I believe most of the analyst community excludes from our results when we articulate those various items, on that adjusted operating income basis we actually were about a little over 12% for the third quarter. We’ve noted in the past that our longer term goal is to try to drive that up to the 14% or above range, so obviously we are very pleased with the progress we’ve made in that regard.

Steven J. O'Brien - J.P. Morgan

Thanks a lot.

Operator

Your next question comes from Simon Leopold.

Simon Leopold - Morgan Keegan

Thanks. I want to see first if we could just get a clarification on the earnings guidance on a pro forma basis. I believe you are suggesting $0.28 to $0.32. Is that correct?

James G. Mathews

No, on the adjusted basis?

Simon Leopold - Morgan Keegan

Yes, on the adjusted basis for the October quarter.

James G. Mathews

I think you need to look at your math.

Simon Leopold - Morgan Keegan

Okay, and then drilling down in terms of thinking about some of the trending from a customer perspective, Bob mentioned earlier an expectation that Verizon might be sequentially down. If he could expand on that with the sense of what we can see from other key customers, including Deutsche Telecom and then the elements of AT&T, if we look at it from a perspective of Cingular BellSouth, if you could try to quantify your expectations in the guidance for how you see the moving parts from a customer perspective. Thanks.

Robert E. Switz

In terms of the big customers, Verizon will be, at least at this point I think Verizon will be down a little based on the mix of products that will be going into Verizon. I would expect less hubs than we’ve seen through most of the year, because hubs tend to get deployed out first, and of course those are the big sticker items and then you start dropping down into equipment that is closer to the home, such as terminals and vats and some drop cables. Those are lesser valued items, so collectively in the outside plant area, we would expect to see sales trail off mainly because of that shift in the product mix, as well as some seasonality that starts to set in towards the end of the year.

So I don’t think there’s anything unusual there with Verizon. In fact, it’s been a very orderly year with them. So far, they’ve made my life very pleasant compared to the two prior years, so I see very good progress in improvements in their deployments, their logistics, and their procurement and forecasting.

So I would associate it -- and you shouldn’t read anything into it relative to Verizon. I think it’s a normal pattern and reflects the work effort that is going on in the deployment shifting closer to home activities.

In BellSouth Cingular, I would expect BellSouth -- I’m not expecting a pick-up there in the fourth quarter. There’s no evidence that that will take place and it seems to be mainly maintenance level spending. No signs of program spending yet, and again we’re associating that with finalizing their integration and deciding what they are going to do with their networks longer term.

I can say there has been, coming out of AT&T, relative to BellSouth there’s been I think some public commentary around moving Lightspeed into Atlanta. I think there’s some truth to that. I don’t think that makes our fourth quarter. We might see some of that in our first fiscal, if that indeed does happen, and then some consideration of Lightspeed going into the Miami market as well, so I think there’s signs that some of the program-based spending at BellSouth, as part of the AT&T family, will begin to start. I just don’t think we are going to see that in our fourth quarter.

At Cingular, it’s possible at Cingular we could see a little pick-up. They picked up a little bit this quarter so that could extend itself. I don’t expect it to be spectacular but directionally I think it’s going in the right direction.

Legacy AT&T, as we mentioned earlier, or AT&T long distance SBC, you know, they’ve been going strong and I would expect a reasonable continuation of that activity. Sprint and Nextel has come back fairly solidly, so again I think an extension of that activity in the fourth quarter moderated a little bit is likely.

DT, if we take the cabinet business out for year-to-year comparisons, our business with DT has been up this year. I can’t say that I’m expecting anything extraordinary in the fourth quarter, other than probably normal business.

That’s kind of a highlight of some of the larger customers. I don’t know if that does it for you or not.

Simon Leopold - Morgan Keegan

That’s great. Are there any I may have missed? Are you in exposure to British Telecom or any of the other major upgrades that are going on around the world that we should think about?

Robert E. Switz

Not that’s going to be meaningful in the fourth quarter.

Simon Leopold - Morgan Keegan

Okay. Thank you very much.

Robert E. Switz

Certainly going forward, there are activities at a lot of PTTs, a lot of carriers outside the U.S. on a number of fronts that we are engaged with, but I wouldn’t expect anything in the fourth quarter.

Simon Leopold - Morgan Keegan

Okay. Thank you.

Operator

Your next question comes from Ken Muth.

James Falkoff - R.W. Baird

This is James Falkoff on for Ken. Can you add any color to your comments on the strength in Asia-Pacific, like any specific regions that are strong? And then, sort of related, where the most immediate FTTX opportunities are?

Robert E. Switz

Yes. Bear with me a second -- you know, in Asia-Pac we’ve had good progress in our enterprise business. We have established ourselves I guess you could say a strong market position in one of the verticals, namely casinos. And we’ve had significant business coming out of Macau. We’re on a lot of new build business as part of that particular market. Some of our copper products as well have done well in Asia-Pac.

I think Australia, parts of Southeast Asia have provided us with decent business, Malaysia, so I think it is fairly broad-based and across both fiber, copper, as well as enterprise products.

James Falkoff - R.W. Baird

And regarding the FTTX opportunities that you see?

Robert E. Switz

Yes, FTTX, a lot of activity, some trials, but that’s a market that hasn’t turned into meaningful orders yet. We are expecting we will start to see that in ’08. In Australia, there’s activity going on there as well as the other markets I’ve mentioned a little bit earlier on the call. I would not attribute that to this quarter but that is certainly something we can look forward to.

And the area that I mentioned was India as well. We did very well in India with [Tata] on some structured cabling business.

James Falkoff - R.W. Baird

Okay, great and then I was just wondering if maybe you could be a little more specific on the progress on the cost transformation initiatives. In the past, you’ve mentioned 150 basis points as sort of a target for gross margin improvement. Can you quantify at all maybe how far along we are in achieving that and how much we have left to go, how much runway we have still?

Robert E. Switz

That’s a hard question to answer that precisely but let me take a stab at it and then I will ask Jim to clean up for me, if I stray too far.

I think some of the things that we saw this quarter reflect full and partial benefits of CCT, so some of that will roll in. Some are related to specific products and events. Those that are related to specific products, of course, the benefit will fluctuate with the volume of those products sold in any given quarter, so I would say the progress that we’ve made on CCT towards that 150 basis points that we’ve talked about, if I look at that in terms of what we achieved in the third quarter, our own internal forecast for our full year achievement, then I would say we are essentially on target. We are tracking towards that 150 basis points and I think we’ll see, as we get into next year, assuming all the other conditions are normalized, I think we’ll see -- we are going to see that benefit trickle in a little bit each quarter and we’ll report on it as we did this time, relative to how much of the margin in this quarter was cost reduction related versus mix or volume.

James G. Mathews

When we look at the margin improvements, we can trace many of those, much of that progress, I should say, back to initiatives that were a part of our cost transformation. Having said that, sometimes it’s difficult to blame the full impact because, of course, these are also up against other cost pressures and various things that we have. But as Bob said earlier, based on all measures that we are taking a look at, we believe we are on track and of course, as you would expect, these initiatives as they phase in tend to ramp up. So for example, if you look at the specific third quarter benefit year over year, you would see more of an impact than you would on a year-to-date basis because of that phase in trend.

I would reiterate Bob’s comment that we are on track and we think probably in some of these initiatives, we are a bit ahead, probably in others, we are lagging where we want to be but on balance that we are well on the way to meeting the targets.

James Falkoff - R.W. Baird

Okay. Thank you.

Operator

Your next question comes from Marcus Kupferschmidt.

Jack Monte - Lehman Brothers

Hi, this is Jack [Monte] in for Marcus. Maybe if you could comment a little bit on the M&A strategy, if you continue to look for niche acquisitions in the Asia-Pacific region. And then maybe as a second segue after that question, if you talk about the expiration or the pay down in debt, the $200 million in debt over the next year and how you see financing those acquisitions if they could be larger.

Robert E. Switz

I’ll take part of the question, anyway. On the M&A front, we’ve had a very busy year. We have been, as we’ve mentioned to you on previous calls, looking for appropriate candidates to support our strategy. I think it’s fair to say now that there’s not a large acquisition imminent, okay, so our focus mainly has been on smaller, very strategic supportive type filler acquisitions.

We have had some success identifying desirable partners in emerging markets, so there is activity going on there and there are a number of other smaller companies that we think support our strategy very nicely and meet the criteria, our criteria for a solid acquisition.

So nothing to announce on today’s call but we have been very active and I think it is fair to say that we’ve identified a number of desirable candidates.

Jack Monte - Lehman Brothers

Great. Thank you.

Robert E. Switz

Jim will pick up the --

James G. Mathews

Yes, with respect to the overall management of the debt on the balance sheet, as you know, $200 million of the convertible outstanding comes due in June of next year. We certainly feel that our current cash resources are adequate to pay that out of existing cash.

As we just reported, we were approaching $700 million in cash as of the end of the third quarter. We are continuing to generate positive cash flow from operations, so we feel that even with the need to maintain working capital and to the extent that we have certain cash that’s embedded in foreign operations that we might not freely repatriate, nonetheless we feel like we’ve got actually quite a bit of available funds to do a relatively small or even potentially medium-sized acquisitions, even with the pay-down of the debt due in June of next year.

That said, we recognize that there may be needs for us to access the capital markets and when we feel it’s the right time to do that and appropriate, we would look for the right opportunities to do just that.

Jack Monte - Lehman Brothers

Thanks, guys.

Operator

Your next question comes from Eric Buck.

Eric Buck - Brean Murray, Carret & Co.

Good afternoon, guys. I had first a clarification in terms of the earnings per share calculation. I believe if you take your $0.23 and add it back to the 14 GAAP number, you are looking somewhere in the $0.37 range but that I would assume would put you into the dilutive category and that there actually should be some reduction to that number on a pro forma basis, so confirm that and then, when we look at your full-year guidance, is that -- what’s the share count that’s assumed in that full-year guidance?

James G. Mathews

You are correct that actually with the adjustments, it does throw you into the diluted calculation, so you use the 132 million shares. Nonetheless, it does with rounding come to the $0.37 per share on that basis.

With the add back of the convertible interest, there is not a big swing there anyway and it’s not that far from that break-even point, so once you have made that adjustment for the number of shares, it still calculates out.

Eric Buck - Brean Murray, Carret & Co.

Okay, and that’s about 3.4 million add back?

James G. Mathews

Yes, that’s correct, for the quarter.

Eric Buck - Brean Murray, Carret & Co.

Okay, so are you making the same assumptions for the full year that the add back would wash with the higher share count?

James G. Mathews

Yes. Generally, we are in that -- yes, exactly. We are also in the -- not that far from sort of the break even point with respect to whether the convertibles are dilutive or not, so it’s not going to change those numbers.

Mark Borman

It’s pretty close either way. If you do the calculation and pick the lowest number.

Eric Buck - Brean Murray, Carret & Co.

Okay, and then for Bob, you talked quite a bit about the wireless area and development efforts there. As I recall, most of the products that are actually in the portfolio in the moment are actually on an OEM basis, and I’m wondering whether that’s an area that might be a prime focus for acquiring or is my impression that most of the products there are not OEM?

Robert E. Switz

The emerging family of products at this point, there’s a number of them that are being developed in-house, like our Flex Wave product. Certainly we have partnerships with IP access and one other that, E-Band, that also contribute but we are on a track, quite frankly, to try and own our intellectual property, develop our own family of products, and we would also consider acquisition to support the portfolio in this part of our business.

Eric Buck - Brean Murray, Carret & Co.

Okay, thanks.

Operator

Your next question comes from Christian Schwab.

Ningning Tang - Craig-Hallum Capital Group

Hi, this is Ningning Tang calling in on behalf of Christian Schwab. I have two questions; first is on Digivance, can you give us some more color there? Last quarter, it was kind of really strong last quarter and how about this quarter and going forward?

And the second question is on operating expenses; previously you talked about a slight increase in the second half. Is that still true because this quarter, the operating expense came in relatively flat? So shall we assume a higher operating expense in the fourth quarter and how about ’08? Thank you.

Robert E. Switz

I’ll let Jim answer the op-ex question. On Digivance, most of the sales of our wireless business are Digivance sales, so it is the bulk of the business right now. So I wouldn’t say there is really a discernible difference quarter to quarter.

James G. Mathews

They were relatively flat quarter over quarter. On op-ex, we still expect to see a modest increase in op-ex in the fourth quarter. Some of that is related to foreign currency translation. We also had certain spending that we had planned to do earlier in the year, particularly with some of our product development in the wireless area that is pushed into the fourth quarter. So there is a modest bump-up in the fourth quarter op-ex, as we had stated in our previous guidance.

Ningning Tang - Craig-Hallum Capital Group

Thank you.

Operator

(Operator Instructions)

Mark Borman

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

Operator

Okay. Your final question comes from Tim Savageaux. Tim, your line is open.

Mark Borman

Okay, we’ll end the call. Thanks for being with us today and we look forward to seeing you in the coming months.

Operator

This concludes today’s conference call. You may now disconnect.

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