ADTRAN Holdings, Inc. (ADTN) Q2 2017 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by, and welcome to ADTRAN's Second Quarter 2017 Earnings Release Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. [Operator Instructions] During the course of the conference call, ADTRAN representatives expect to make forward-looking statements, which reflect management's best judgment based on factors currently known. However, these statements involve risks and uncertainties including the successful development and market acceptance of core products, the degree of competition in the market for such products, the product and channel mix, component costs, manufacturing efficiencies and other risks detailed in our Annual Report on Form 10-K for the year ended December 31, 2016. These risks and uncertainties could cause actual results to differ materially from those in the forward-looking statements, which may be made during the call. It is now my pleasure to turn the call over to Tom Stanton, Chief Executive Officer of ADTRAN. Sir, please go ahead.

Thank you, Lynn. Good morning, everyone. Thank you for joining us for our second quarter 2017 conference call. With me this morning is Roger Shannon, Senior Vice President and Chief Financial Officer. I'd like to begin this morning by discussing the details behind our second quarter results, and I will end with some comments on what we see on the future. Roger will then discuss our Q2 performance in more detail, and he will then open the call up for any questions that you may have. As we stated in our earlier press release, revenues for the quarter were $184.7 million, a second quarter record and up 14% over the second quarter of last year. Our networking solutions revenues, including both international and domestic markets, came in at $155.5 million, up 12% over the same period last year. And our services and support revenues came in at $29.1 million, a 21% growth over last year. Revenues for our domestic markets came in at $146.7 million or 79% of the total, while our international revenues were $38 million for the quarter or 21% of the total. On a year-over-year basis, our domestic revenues increased 10%, and our international business was up 31% over the same period last year. Both numbers were driven by increasing demand for our ultra-high-speed solutions. Moving down a little deeper, our access and aggregation category had a strong performance, up 36% over the same period last year with growth both domestically and internationally. Customer devices was down 17% over the same quarter last year, impacted mainly by an accelerated Ethernet infrastructure build, which occurred in Q2 of last year. Finally, our traditional products and other categories were down 38% versus the same quarter last year, mainly due to the expected slowdowns in our older generation HDSL products. I mentioned last quarter, our efforts on a broad base of technologies, including G.fast, NG-PON 2, 10-gig PON, and of course, our Mosaic cloud platform developments. These development efforts are targeted for not only expanding our market share on our existing customer base, but also enabling our expansion into adjacent markets. I am glad to say in the second quarter we made progress on both fronts. During the quarter, we exited our G.fast and Mosaic tech trail and moved into full deployment or production status with a major Tier 1 carrier here in the U.S. During the quarter, we completed lab testing and began first deployment of our 10-gig EPON solution with a major U.S. cable MSO, a significant milestone for our company. The quarter also saw us launching our first Tier 1 deployments of our XGS-PON solution, utilizing the industry's first deployed virtual OLT with a Tier 1 U.S. carrier. This implementation utilized our Mosaic software defined access platform. And as of today, we have over 10 global Tier 1 carriers who have either selected or are field trialing Mosaic for deployment. Also yesterday, we announced our trial with Deutsche Telekom for the world's first 212 megahertz G.fast solution, providing over a gigabit of speed with enhanced upstream performance over a single pair of copper. And finally, I am pleased with our announcement yesterday of our contract win with NBN, the government owned carrier in Australia to provide software, hardware and services as they move forward in deploying their Fiber-to-the-Curb network. This was a material win for our company and we expect to begin shipments in the first half of 2018. Looking forward, our focus remains on being the world's most comprehensive access solution provider with clear industry-leading solutions for software defined access, fiber access and ultra-high-speed copper. With the world's most complete access virtualization products, we believe we are well positioned to capitalize on the evolution in access as carriers around the world upgrade their infrastructure to meet customer demand. I'd now like Roger Shannon to review our results for the second quarter of 2017 and provide some comments on the third quarter of 2017 as well. We'll then open up the call for any questions that you may have. Roger?

Thank you, Tom, and good morning. I will speak about our second quarter results and discuss what we see for the next quarter. During my report, I will be referencing both GAAP and non-GAAP results. As Tom stated, ADTRAN's second quarter revenue was $184.7 million, which is up 14% compared to $162.7 million for quarter two of 2016, and up 8% from the $170.3 million we reported last quarter. Our network solutions revenues for the second quarter were $155.5 million, up 12% from the $138.5 million for Q2 of last year, and up 8% from $143.6 million reported for Q1 of 2017. Our services and support segment continued its strong year-over-year and quarter-over-quarter growth, as Q2 2017 revenues were $29.1 million, up 21% compared to the $24.2 million earned in quarter two of 2016, and up 9% versus the $26.7 million reported for the first quarter of this year. Across our revenue categories, access and aggregation revenues for quarter two in 2017 were $138.6 million, up 36% compared to $102.2 million for quarter two of 2016. Customer devices revenues for the quarter were $33.8 million, down 17% compared to $40.9 million for quarter two of 2016, and down 7% compared to $36.3 million for quarter one of 2017. Finally, traditional and other product revenues for quarter two 2017 were $12.2 million, down 38% compared to $19.6 million for quarter two of 2017, and down 12% compared to $13.9 million for quarter one of 2017. Looking at revenues geographically, domestic revenues for quarter two were $146.7 million, up $13.1 million or 10% from the $133.6 million we reported in quarter two of last year and up $27.4 million or 23% from the $119.3 million in quarter one of 2017. Our international revenues for quarter two were $38 million, or up 31% compared $29.1 million in quarter two of last year, but down 26% as expected from the $51 million at quarter one of 2017. We published the reporting on each of these categories on our Investor Relations webpage at adtran.com. For the quarter, we had two 10% of revenue customers. Our GAAP gross margins for the second quarter of this year were 45.8% compared to 48.5% at the second quarter of 2016 and 43.3% in the last quarter. The year-over-year decrease in our current quarter gross margins was driven primarily by higher domestic services and international revenues versus the same period last year. Our gross margin improvement over last quarter's results is attributable to higher domestic revenues and a favorable mix of services. Total operating expenses on a GAAP basis were $68.2 million for quarter two of 2017 compared to $64.1 million for quarter two of 2016, and $66.7 million for quarter one of 2017. While our SG&A expenses were down quarter-over-quarter, our R&D expenses were up over last quarter as expected. On a non-GAAP basis, our Q2 operating expenses were $65.5 million compared to $62.3 million in quarter two of last year and $63.8 million last quarter. The quarter-over-quarter increase in operating expenses was the result of customer-specific research and development projects. The year over year increase in operating expenses was the result of the previously mentioned customer-specific projects, performance and equity-based compensation, amortization of acquisition-related intangibles and ERP project implementation expenses. The difference between GAAP versus non-GAAP operating expenses in Q2 is due to amortization expenses associated with our active EPON and RFoG product acquisition in the third quarter of last year and equity-based compensation. Operating income on a GAAP basis for the quarter just ended was $16.4 million, up 11% compared to the $14.8 million reported in Q2 of last year, and up 134% versus the $7 million that we reported in quarter one of 2017. The increase in Q2 GAAP operating income as compared to Q1 is attributable to higher revenues along with stronger gross margins that were slightly offset by higher operating expenses. The year-over-year increase in operating income is attributable to higher revenue, partially offset by the previously explained lower gross margin percentage and higher operating expenses. Non-GAAP operating income for Q2 2017 was $19.2 million compared to $16.8 million for quarter two of last year and $10.1 million for quarter one of 2017. As described in our supplemental information provided in our operating results disclosure, stock-based compensation expense net of tax was $1.4 million for quarter two of 2017 compared to $1.3 million reported in quarter two of last year and $1.5 million in quarter one of this year. Expenses related to the amortization of acquired intangibles were $582,000 net of tax compared to $293,000 in quarter two of last year and $713,000 last quarter. All other income net of interest expense for Q2 of 2017 was $1.4 million compared to $1.6 million for quarter two of 2016 and $1.3 million last quarter. The year-over-year decrease in all other income is the result of lower investment gains in the quarter versus the comparable period. As previously communicated, gains and losses from our FX hedging program resulting from an increase in our international business were recognized in other income. The company's tax provision for Q2 of 2017 was an expense of $5.5 million or an effective tax rate of 30.6%, compared to a tax provision rate of 37.8% for quarter two of last year, and 20.3% in quarter one of 2017. The decrease in the tax rate versus quarter two of last year was primarily due to stronger international revenues in the current quarter. As we discussed last quarter, quarter one's lower tax rate was primarily due to benefit it's recognized from foreign tax filings and a greater mix of international revenue. Net income for Q2 2017 was $12.4 million compared to $10.2 million in quarter two of last year, and $6.7 million in quarter one of 2017. Non-GAAP net income for the second quarter of 2017 was $14.4 million compared to $11.9 million in quarter two of 2016, and $8.9 million last quarter. Earnings per share on a GAAP basis assuming dilution for the second quarter of 2017 were $0.26 per share compared to $0.21 per share in quarter two of last year, and $0.14 per share for quarter one of 2017. Non-GAAP earnings per share for the second quarter of this year were $0.30 compared to $0.25 per share for quarter two of last year and $0.18 per share for quarter one of this year. Non-GAAP earnings per share exclude the effects of amortization of acquired intangibles and stock compensation expense in each respective quarter. We provided reconciliation between diluted GAAP earnings per share and diluted non-GAAP earnings per share in our operating results disclosure. Now turning to the balance sheet, unrestricted cash and marketable securities net of debt totaled $249.3 million at quarter end after paying $4.4 million in dividends and repurchasing just under 595,000 shares of common stock for $11.8 million during the quarter. For the quarter ADTRAN produced $11.5 million of cash flow from operations. Net trade accounts receivable were $79.9 million at quarter end, resulting in a DSO of 39 days compared to 50 days at the end of the second quarter of 2016, and 45 days at the end of quarter one of 2017. The year-over-year and quarter-over-quarter improvements and our current quarter DSO are attributable to customer mix and the timing our shipments within the quarter. Inventories were $114 million at the end of the quarter just ended, up from $112.8 million last quarter. The increase in inventory in the quarter is due to customer specific projects. Looking ahead to next quarter, the book and ship nature of our business, the timing of revenues associated with large projects, the variability of order patterns of the customer base into which we sell, and the fluctuation in currency exchange rates in international markets we sell into may cause material differences between our expectations and actual results. However, our current expectations are that third quarter 2017 revenues will be flat versus the quarter just ended. Taking into account the potential impact of currency exchange rates and anticipated mix, we expect that our third quarter gross margins on a GAAP basis will be flattish with the quarter just ended. We are also expecting GAAP operating expenses for Q3 2017 to be flattish with the quarter just ended. Finally, we anticipate the consolidated tax rate for the third quarter to be in the low 30% range. We believe the significant factors impacting revenue and earnings realized in 2017 will be the following. The macro spending environment for the carries and enterprises, currency exchange rate movements, the variability of mix and revenue associated with project rollouts, professional services activity level, both domestic and international, the timing of revenue related to the Connect America Fund projects, the adoption rate of our broadband access platforms and inventory fluctuations in our distribution channels. Finally, I'd like to encourage our listeners to visit ADTRAN's new investor relations website by going to www.adtran.com in following the investor relations link. We've made our investor relations website much easier to navigate and much more user friendly. We've also added resources such as interactive financials to provide insight into our performance. With that, I'll now turn the call back over to Tom.

Great. Lynn, at this point, we're ready to open it up for any questions people may have.

[Operator Instructions] And we'll take our first question from Rod Hall with JPMorgan. Please go ahead. Your line is open.

Yeah, hi guys. Good morning and congrats on a good quarter here. I just wanted to ask a couple of questions. First of all, could you guys comment on the large G.fast customer in the U.S., like how much revenue was that in the quarter? And how are you feeling about visibility there? And just talk a little bit about that. And then, also I know last quarter you guys talked about these fiber access delays that I think pushed some of that G.fast rollout into the second-half. What - can you update us on those delays in terms of access? Are they still planning delays out there or is that now moving forward a little bit better? Thanks.

So, appreciate the call. So, we did start shipping this quarter. I wouldn't call it a material shipment, but to be honest with you, just to get it into production is a material move. So we're very happy with that. If you recall, there are two phases of that project, so there is an out-of-region phase and an in-region phase. The out-of-region phase, which is outside of their traditional footprint is actually what started. The in region phase is still targeted towards the second - well, tail end of the year, third-ish - third quarter, fourth quarter, right around that pivot point. And we just expect it to ramp from here. So I would say initial shipments started and we just expect it to ramp from here. They have told us about some particular projects. I think they've actual been in the press a little vocal about that as well. I know there are some things written on it. But exactly what that ramp will be, we still don't know. And at this point in time, I'm not - I don't think that there is any material thing impacting the deployment of the service. So I just think we're expecting a normal ramp. Did that answer your question?

Yeah. Thanks, Tom. I'm just wondering like if that's ramping on through the third quarter, why the guidance is flat. Is it because you guys think that the likelihood is that the acceleration really happens more towards the back end of the year? It sounds like that's kind of what you are saying. I just wanted to clarify that.

Yeah, I think you're exactly right. Without - this is something we have no track record on. So without having that record it's kind of hard to forecast. But my expectation is they will get better at it, they'll get faster at it. They'll be more aggressive at selling it and then it will just kind of build throughout the year. So I would expect more momentum in the fourth quarter than the third quarter.

And could you make some comment about those planning delays that you guys have flagged earlier in the year? Is that still a factor or do you see those kind of moving forward little bit quicker or what's happening?

I'll be honest with you. That's kind of slipped in my mind, exactly what we're talking about, planning delays. I know that there were issues initially with getting the fiber to some of the MDUs. There were also issues with kind of - just normal when you're going out and selling out of region of the tactical and logistical plans on that. Having said that, I don't want to speak for that customer. That's a very touchy customer about that. And I am - as far as I'm concerned, they're doing a fantastic job.

Okay. Great. And I just - one other thing, on the MSO customer, is that a new customer for you? And, I mean, could that be a 10% customer or is it [all ready], [ph] I mean, could you just give us some kind of color on that MSO deal that you guys talked about earlier in the call?

Not a 10% customer by any stretch, never has been a 10% customer for us. I wouldn't say there - we may have sold them some things. But it's practically a new customer. I don't know - we sell switches and things to a lot of different customers, but for infrastructure, without a doubt a new customer.

Okay. Great. That's helpful. Thank you very much.

Okay.

Thank you. And we'll take our next question from Richard Valera with Needham & Company. Please go ahead. Your line is open.

Thank you. I was wondering if you could give us an update on your international customers, particularly your German one and how they were in the quarter and how you see that trajectory for the balance of the year.

I think that they were pretty much right on track, maybe a little stronger than we expected. What we typically see with that customer is they kind of - Q1 is typically stronger and we see them tail off towards tail end of the year. Last year was a little bit of an anomaly. But that's what our expectations are here as well. We would at this point in time expect them to tail off in third and fourth quarter. Fourth is kind of - sometimes they come in and wants you to do incremental work for them, definitely got hit with that last year. But at this point in time, that's not what our plan is.

Got it. And then, there is a CPE-related…

Yes.

…program you've been talking about with that customer for…

Thank you for remembering. Yes, right.

Can you give us an update on that? It sounds like you're closer to that maybe…

We started shipping, yes, so that was really good. So we actually did ship. We shipped a little bit in Q1 if I recall, Roger than, of course, we shipped in Q2. It has not ramped yet. That service is I don't know how broadly available it is yet, but we would expect that to ramp on through 2018.

Great. Just final one. Mexico, it sounded like had been in a bit of a holding pattern due to I think some sort of political and regulatory stuff there. Is there any update there, or still kind of status quo?

Yes, the update is no change. They really are still. They are - we have as you know - you may know, we had several things that are queued up in the lab and ready for approval. But as far as capital budget for our type of equipment, we have not seen the change.

That's great. Thanks for the update.

Okay.

Thank you. And we'll take our next question from Paul Silverstein with Cowen. Please go ahead. Your line is open.

Thanks, guys. Two questions if I might. One, for Roger, going back to the DT question, I appreciate there is sensitivity about any individual customer. But there has been some recent press about DT and the German regulatory authority having conversations. The regulators probably want them to open up the networks. Regulators always want carriers to do in DT, talking about how that would adversely impact rollouts if they had to do that. Any insight you could share there? I saw the recent announcement on the G.fast trials, but any insight that you can share? And then the other question is, Roger, if you could give us an update on your thoughts on where gross margin can go to and the key drivers in getting there. Now, that you've done Mosaic, I assume that would have, as that gets traction, it seems that that would have a meaningful positive impact. And I know there are some other offsets in the services side, et cetera, but if you could update us that would be great. Thank you.

Yes, as far as DT is concerned, I mean, this is not the - there is periodically negotiations, let's say, that go on between carriers and their governments. And if you'll recall, Paul, that happened about a year-and-a-half ago or so when they really started talking about Super-Vectoring and through that negotiation they got the right to expand their footprint by another 15% or so. I do think that without - in Europe there is a strong demand for bandwidth, which is one of the reasons that you're seeing faster movement on G.fast as well. But as far as them talking to us directly, we really see no change in their plans. They plan on rolling out, continuing to roll out Vectoring, they plan on rolling out Super-Vectoring next year and then you'll see them follow on with G.fast. And that's the current plan of record that they shared with us. As far as gross margins, you want to touch that?

Yes, as far as gross margins, like we mentioned, the gross margins for the quarter we just ended were slightly above our prior expectations and driven by the mix both within the product set and with services. We're guiding for gross margins to be flattish in the next quarter. We've consistently said our expectations are for gross margins to go up. If you recall, our quarter one gross margins were negatively impacted by the higher shipments on greenfield MSANs [ph] or European Tier 1. I'm not going to at this point get kind of beyond where we're looking into next quarter. On the mix, we do - there is variability within the services. We consistently say that services is lower than corporate average gross margin, but is accretive at the operating income level, but we do see some variability in that mix and we saw that in the current quarter.

Guys, one more if I might. Returning to Rod's question on the new cable customer that you referenced, maybe I misheard, but in terms of - I understand it's not 10% today. But could that be a 10% customer in terms of the project or projects you're doing for them? Does it have that type of potential over time?

Their stated - the answer is, it does have that potential over time. But I don't think I would expect to see that near term.

I appreciate it. I'll pass the line. Thank you.

Okay.

Thank you. We'll take our next question from Simon Leopold with Raymond James. Please go ahead. Your line is open.

Great. I want to just follow-up and clarify the gross margin in the last quarter. And I did hear the answer last question, but I am still a bit confused. So you have had indicated that you expected - I believe lower gross margin for June and you've reported, given that we thought would be kind of flattish versus the March quarter. And I guess all of this has attributed the trend, the expectation to the international mix, basically higher international coinciding with lower gross margin. Yet, in this June quarter we saw a very dramatic shift in international from the last two quarters. I guess, what I'm really trying to understand here was where you surprised by this mix shift and so - should we think that in this quarter you had a negative surprise, meaning, your international business fell off completely offset by a positive revenue surprise that net it out to a gross margin upside? Am I reading too much into this? Can you help me understand?

Yes, thank you. First of all, I don't think, I mean, I am not sure about the comment about material change from what you're thinking in revenue on international, but let me - so there are couple of things that without on a macro perspective international versus domestic make always has impact. Where we saw improvement that came in - that we were happy about one is - the biggest one is probably in the services gross margin profile in the U.S. that we saw meaningful uptick. There some of that is I think we're just getting better at it. Some of it has to do with services mix itself, but if I look at the mix of services versus any other mid-quarter - first quarter is typically got a different feel to it. It wasn't - there wasn't anything really strange about the mix, I just think - honestly, I think we are just getting more efficient at it. We've been doing it now for a couple of years, and I think we are managing it better. And that was probably the biggest material change from what we thought coming into the quarter.

So, geographically [indiscernible] surprise you?

Pardon. Say it again?

So I just want to confirm that the geographic mix shift in June did not surprise, you expected that?

No. The international business came in, it's pretty much exactly where expected on a revenue and a gross margin profile expected.

Okay. That's very helpful. The other thing I really want to ask about was the opportunity and prospects you say at a BT in light of the fact that BT recently has seem to renew its interest in fiber to home technology, and it looks like they're issuing some new tender. So while you didn't get a leading position in their G.fast initiative that you participated in, it sounds like they're looking at some new prospects and fiber to home technology, and perhaps being encouraged by the regulatory agencies in the UK. Could you talk a little bit about how you see that market opportunity evolving for ADTRAN?

I can, I mean, anytime there is an opportunity in the access space with the customer of that size, then we tend to focus on it and typically win more than our fair share. But I would tell you that a tender with a company and we've been through - we just went through a tender with them, takes a very long time. So it would be something that - and it's - it would be real speculative to talk about, and I think that even understanding the sizing of that opportunity right now, it's probably premature. But it is something that we would be going after, of course, and we've already got relationship and things build in that carrier.

And one last one, you also announced the NBN deal yesterday. Could you give us some perspective on how do you think about the materiality of that particular opportunity? Thank you.

It's one that we've been excited about and we've been working towards literally for over two years. It's - they are - because their government entity, they are very public with - and I think even our press release we talk about reaching over million homes. It's a material win for us, so it's - I think the key to us now is getting out of the lab and getting it rolling out. And we feel good where we are, we've already had a relationship with them, our strengthened with our Mosaic cloud platform which is being used to manage a large percentage of their access network. So I don't know what else to tell you other than, yes, it is a material win for us. We think that it would actually be meaningful in our numbers and the key to us now is to be able to execute on finishing up the lab process.

But just to close on that NBN comment, I assume this is something they're multi-sourcing that they've been purchasing broadband access products from others in the past, I assume…

It is a multi-source - yes, there is more than one source in their network in most areas at this point. But let me just say, we feel pretty good with how we're positioned.

Great. Thank you very much for taking the questions.

Okay, sure.

Thank you. And we'll take our next question from Michael Genovese with MKM Partners.

Thanks a lot. First question on the XGS-PON deployment with a Tier 1 U.S. carrier, was there actually revenue in the second quarter? How material was it if so? And is it - has the timeline of that moved up, because I thought it was going to be a 2018 event?

Yes, I think, what I was trying to touch here, so there were a couple that are farther along as far as the carriers' plans. The MSO one is one that's fairly far along. Of course, the G.fast here in the U.S. is fairly far along, NBN is fairly far along. This one is less far along. The reason for me to bring that up is really the fact that we are the first vendor to actually produce and be able to ship a virtual OLT, and a Mosaic environment. And although this is being rolled out, I would say probably it's not something in and of itself that I think will be material in the short-term. I think it's more longer-term play.

Okay, great. And then my other question or questions are sort of bigger picture in nature, couple of related questions here. I think in this kind of pre 5G era that were in, you seem to be in the sweet spot, because there is not a lot of wireless access going in. And it seems like to get to 5G carriers realize they have to upgrade their wired access networks. So - but still at the same time, we have a lot of copper still in the last 1000 feet. So the first question is this, in a couple of years when 5G positively influx, when 5G access spending starts to go up, do you still think wired access will still be in the sweet spot at that point or will we start to see a shift to wireless spending? And then secondly, how long until fiber - fiber all the way to the prem becomes a bigger business than the solutions that have copper on the last 1000 feet?

Yes, that's a really - that last one of course is a really good question. So let me start with the 5G, and we absolutely see 5G as being accretive to the business. The key with 5G is, as the technology proves itself how - what are going to be use-cases. But just to build that infrastructure itself, which like you said it's going to be predominantly 5 or similar to where 4G is, just the multitude, the kind of exponential growth in connection points is really good for the access business. So we see the build of that network being accretive to our overall performance. Where does - to the extent that we are able to deliver a gigabit plus of services over copper in a much more cost efficient manner than fiber, I think there still a real demand. And I think people are positioning themselves for a fight, let's say between now and 2020, on being able to keep that residential customer in house or in their - within their domain. So when does it go to fiber, it's a - without 5G we'll probably help push that, because you'll have a lot more route and that will help. But it's that last, that access to that fiber, which is why G.fast is so popular at this point in time. That last piece will not be really driven by 5G. So it's probably sometime. I think the strengthening, as you probably can remember wasn't that long ago, we thought 50 megabits was the most you're getting out of copper. And we just did a trial where we're delivering 1.2 gigabits over copper and meaningfully changing the economics of deploying that type of service to a customer. So if I've told you today it would be wrong, and more than likely it'd be to - I would say a date that's probably too quick, because we are able to continue to find things out. When it moves to fiber, I think that would be great. That's a strong business for us. We are well positioned with what we're doing with virtualization and our whole XGS-PON and NG-PON 2 efforts, but I still think it's the period of time still a ways away.

Okay, great. Thanks very much and congrats on the good quarter.

Thank you very much.

Thank you. And we'll go next to George Notter with Jefferies. Please go ahead. Your line is open.

Hi, thanks very much. I guess, I wanted to ask about the professional services business. Philosophically, I think the way to characterize a bigger picture here is somebody is bigger operators essentially kind of wind streams of the world, others they're experiencing cost pressures in their business and they're pushing more and more of that labor piece on to the vendors. Can you just talk about - are you seeing that increasingly or are you getting more new efforts to engage with you on services. And what's your approach to doing that business? Is it all business is worthwhile? Or are there certain pieces of the business that you would like to do and turn away other pieces? Like how do we think about services philosophically overtime for ADTRAN? Thanks.

Yes, I think the frame of the question is different than the way we frame it. We don't view them as pushing that off, we view them as business that we are trying to go after. We think it's accretive, we think we are getting better and better at it. We think we are getting more efficient, and it's not just a matter of how good are you handling your internal piece. One of the keys to this is having an ecosystem of contract support personnel they can actually - that you can work with and you can get to know and you can drive kind of point to deficiencies with those particular contractors. So we like the business, and we absolutely are trying to grow that business. We do say no, we at the end of the day it has to be something that is good for shareholders and good for the company to be able to do. But I'd say we are getting good at it. So I think if it makes sense for other people, there's a good chance for makes sense for us. We are having said that we're still saying no periodically. Interactions with other customers is wrong, actually just in the last six months, we've had more people come to us, can talk to us about what we can do for them. One of the things that drives that is if you look at CAF spend itself, if you look at some of these projects related with particular cities or particular regions where they're trying to grow, they just don't have the staff there, and bring them on board and then figure out how to handle them longer term is difficult for them. So we can come in and offer effectively a turnkey service what we do project management. We meet our dates, we meet our cost targets. That's meaningfully important to them. So it's a good business for us. I don't see as backing away from that at this point.

Got it. Great. Thank you.

Okay.

Thank you. And we'll go next to Greg Mesniaeff with Drexel Hamilton. Please go ahead. Your line is open.

Yes, thank you. I wanted to ask you guys about some data points relative to your increase in international sales, which were up 31% year-over-year. With that number one, your SG&A seems to be very nicely under control as far as levels? And number two, your DSOs came down year-over-year and quarter-over-quarter despite the pickup in international? So I am wondering, how you could sort of give us some backdrop as to how you're managing to put up those types of data points in the fates of our higher international sales mix?

Hey, Greg. That's a great question. It's - first of all, I'll give a lot of credit to our team our relationship with our customers and our collections process and just the mechanics of that are very strong. This year, this quarter in particular, we've seen really good linearity across the quarter, across the month. And those sales and that has had some positive impact. And just the mix of the customers themselves, there's - we've had longstanding and good processes in place for how we work with them, how they pay. So it's just been on our part of continues improvement and working with them, and then improving our processes on getting those collections done.

Probably the biggest impact was linearity. We had a very linear quarter. And if you think about our international customers they tend to be strong at the first half of the year, right. So they were strong at the beginning of the year - or the quarter than the back end of the quarter.

That's right.

So it's fair to say that vacation season in Europe is going to probably be a factor in the flat guide you gave for the third quarter?

We would expect our European business to be down in the third quarter.

Great. All right. Thank you.

Okay.

Thank you. And we'll go next to Doug Clark with Goldman Sachs. Please go ahead. Your line is open.

Great. Thanks for taking my question. My first one is kind of a conceptual customer question. If you look at some of your core customers, specifically the U.S. Tier 2s in general, there are some liquidity and M&A related potential disruptions. I am just wondering if your conversations and your outlook for those customers reflect any kind of conservative in - conservatism in that or if you just see them continue into spend on projects regardless.

You always have to be mindful of that. But at the end of the day, you factor in what you know and one of the things that we always have going for us is we tend not to get too far ahead of our headlights, so talking about next quarter especially when you're talking about projects that are - that you are doing an awful lot of the work associated within the last year, you plan a little better and a little tighter that we typically would. We've had discussions about potential impact. Right now, we are being told no changes that, in fact, we are being encouraged to make sure that we don't let off the gas and slow anything down. And I have no reason to discount that, other than the fact that I do know that there is a potential for that anytime that you have a meaningful change in ownership. So we just be mindful of that and continue to try to factor that in.

Okay, great. That makes sense. And that's helpful. My other question is a bit of two-part just looking in second half of the year. Looking back at past year, the services mix did pick-up in the second half. I am wondering if that's as a percentage of sales. I am wondering if that a reasonable expectation to be made. And then also last quarter you were talked about some projects causing kind of higher R&D and OpEx levels that might trial off. Is that still the case going forward?

That is the case, but they won't trial off next quarter. So they are continuing on. And you are correct in that in the guides that we gave in third quarter does include a pick-up in the services business.

Okay, great. Thanks for taking my question.

Okay.

Thank you. And we'll go next to Bill Dezellem with Tieton Capital. Please go ahead. Your line is open.

Thank you. I have a couple of questions. First of all relative to your inventory levels being up versus a year ago. Would you anticipate holding these inventories at this level given that your business run rate is now higher? Or are you thinking that you're going to be able to bring those down?

That inventory level, Bill, is up due to customer projects and that increase has been primarily in field inventory. So you have equipment out at customer locations and sites that's in process of being deployed. So I think a lot of that is just you kind of do the nature of the projects that are underway with those customers.

Bill, let me add one little piece of that, I think, where our inventory level was a year-ago was not optimized either. So my hope is we tend to think of inventory as internally. We tend to think of inventory as kind of net of field inventory, because field inventory something that we, de facto have purchase orders on and trying to finish up and that's kind of a different drive. So if you look at just inventory in-house, it basically flat as I cry from Q2, and I'd love to see some improvement depending on what the demand level is and our ability to forecast that demand level though. If it's kind of flat, which I would be happy with it.

Great. So the net of it is the increase, we should be happy with it, because as product in the field being that's ready to be deployed and the in-house you are very comfortable with that positioning?

Yes. I would like it to be better, because we probably have operations people listening to this call. I would like it to be better, but we are not in a bad space. I do know if you get too tight, you'll run into a problem. But I do think we can improve from here.

Great. Thank you. And I hope those operations people do what they need to make that.

They're doing a great job. Thank you.

Let's jump to R&D for just a quick moment. You'd mentioned earlier in the comments that the increase in R&D was a function of customer projects. Are you in a position to talk about what those projects are in? And how long you anticipate the higher spending to last with those projects?

Sure. It's really one project that's driving, if not the majority - if not all, but by far the majority. And that is in NG-PON 2 RFP that is out on the street. And in fact we've announced it, right, I mean, Verizon has mentioned that. We are doing a trial with them. And that's the biggest impact. They are - technically, it's definitely a next generation network. So it includes components. It includes everything that you would think of as next generation SD-Access. And it incorporates functionality that was not included in what we would call the access domain two years ago, so it's technically an aggressive project. So that's driving our staffing right now.

Great. That's helpful. Thank you. And then, lastly, cap spending. Would you provide additional color on how you were seeing that unfolding both this year and the future?

I would expect it to probably pick up from Q2 to Q3 a little. It was down a little from Q1 to Q2. But that is all based off of when projects get closed. They have particular milestones that they have to meet. And you tend to see a pickup in sign-off activity and getting things turned up as those milestones approach. So I think you'll see some variability in that. But basically it's kind of at a run-rate that is consistent with what we talked about.

And as we go forward in the coming years, would you anticipate basically holding at this run-rate? Is that kind of the way to think about it?

I think for the Tier - let me just call it the Tier 2, right, the rate of return, I will get the rate of return.

Yeah, the price gap.

Yeah, the price gap here. The rate of return carrier piece will be coming on. So that hasn't yet started. In fact, there are many, many RFPs out there associated with - I think it was over 100 different ACAM [ph] customers that are also going to participate in CAF and those have not started yet.

And when will those start by your estimation?

Probably early 2018, let's say, first-half 2018.

Great. Thank you.

Okay. All right.

Thank you. Now, we'll go next to Tim Savageaux with Northland Capital. Please go ahead. Your line is open.

Excuse me. Hi, thanks very much. And thanks for taking my question. Wanted to start kind of on the major Tier 1 engagement front, I mean, these big deals appear to be stacking up a little bit. Sounds like - these potentially on the way to four new 10% customers, but feel free to correct me on that. But I wanted to kind of title around and focusing on - to focusing on Verizon in terms of whether you're close enough to begin to size that opportunity. I think last quarter you talked about some acceleration in activity. You just made a reference here on this call to a lot of R&D. So as - well, and you mentioned these big deals. And I will say, I think Verizon is doing NG-PON 2, not XGS-PON. So that other time it was about another Tier 1 carrier…

Right. And by the way, I didn't say that that was a 10% opportunity, the other one. I just said that it takes some time.

Oh, I know that. I know that. And I would speculate that that's CenturyLink at least from my perspective. But as you look at these - well, since I brought it up, I mean, what - if we look at G.fast, NBN, cable MSO, you've already talked about the potential for those over time. I assume you'd put Verizon in that category as well.

That's correct.

And given that we're getting pretty close, I'll ask you, since it's my tradition on this call to ask whether you care to talk in a more granular fashion about that. Verizon opportunity relative to either the kind of commitments they're tossing around with Corning or what we saw in the original BPON ramp for Verizon back in the day understanding they're smaller from a wire-line perspective than they were.

Right. And probably one thing I should mention, right, the more 10% customers you have the higher it is to be a 10% - harder it is to be a 10%.

Understood. That's difficulty of the math, but I think a good news problem overall.

Right. And I definitely understand your comment on Verizon. And the problem I have here is I can't talk about what their strategy is without getting, of course, them upset. So if the way that we think about the project and through conversations with different people at Verizon, we feel that it's without a doubt is material as anything that we're doing. And so, the key to this - the key to that coming to fruition of course is, every carrier changes their plan. And so, the key to this is how much of what their current plan is holds up, either it gets bigger or smaller over time. But the only way that we can think about it is based off the current information we have and based off the current information we have it is a very large opportunity…

I will…

You can ask me a specific question that you think I can answer. I would do that, but I don't want…

You know what, I will take that. I think that's great. And I just want to follow up, but I think there was some lingering concern heading in on CenturyLink and M&A and Frontier kind of falling apart a bit, about, well, how the U.S. business might fare and at least as I look at it and the question is to kind of confirm and amplify on this, it looks like your network business, that is taking out CPE services in the U.S. was very, very strong in the quarter, of something like 50%, 60% sequentially, 40% year-over-year. I wonder if you could talk about that kind of U.S. network product focus business and what's really driving that, because those are sort of a hyper growth numbers and maybe not the sort we would expect to see if we peel back these onions, right, with taking out the legacy where you saw big decline year over year, taking out CPE et cetera?

I think there are multiple things. Without a doubt, we have one large customer that is doing a fairly extensive 100-meg rollout. And that 100-meg rollout has been very positive for us because of our market position there and the fact that we have a very broad product set going into there. That customer also as you know does fiber access as well and I think we've done a good job of - on picking up market share within that segment as well. But you have multiple carriers either looking at deploying. They're all talking about how do I keep my customer. And some of that has to do with true end customer demand. Some of that has to do with the fact that you got major cable companies here in the U.S. that everybody knows is in the midst of rolling out 3.1. And so, as you know, if you lose that customer it's very difficult to get him back, right? So I think you have a lot - all of the carriers regardless of their financial situation trying to figure out what are their key markets that they have to hang on to and then how do they deliver something, let's say, north of 75 to 100 meg that actually allows that customer to be sticky and they can withstand a 3.1 rollout. And I think at a macro-perspective that's just what's happening and I think it's going to get heated as we roll them into 2018, because of the fact that that's when you really start seeing meaningful deployments from the MSOs.

Thanks very much and congrats on a real nice quarter. I'll pass it on.

Thank you, Tim.

Thanks.

Thank you. We'll go next to Orin Hirschman with AIGH Investment. Please go ahead. Your line is open.

Hi, congratulations on the progress here. Following up on the last question, if you look at the overall picture, compared to six months ago and a year ago, both - if I can ask you separated out between the [indiscernible], what would you say from 50,000 feet? Are we beginning to see the pressure or are we investing at this point finally after years of kind of false starts and lows? What would give you any conviction that this time it will be different?

I think we're past the false start pace. I think from at least just from my perspective, we have been thinking for some period of time that there were two things that were positive to get the market going again. And as I'm sure you recall, our investors recall, it was way back in 2012 that we actually saw the decline in investment in the access market here in the U.S. And it's taken up until last year. And we started seeing an increase last year of course. And I think the two catalysts were, one we just spoke about, which is the competitive landscape changing with the deployment of 3.1 in the MSO space. And the second I think was CAF. I think CAF was a catalyst that gets people building again and relooking at their architecture and thinking what they could do with it. And I think those two drivers are what got us here today. And so we don't feel like - we feel it is past of false start. That does not mean there won't be bumps in the road, because at the end of the day we're still selling to a relatively handful of customers. So any change in one customer could affect it. But if you look at the overall scope of what's going on from the largest carriers here in the U.S. to the smallest, they're all on the same train, right, they're all doing the same thing. There are differences in timing on any individual one, but the movement is upward. So I think the difference is those two catalysts coming into real play here.

Okay. And just going back to what you were referencing and NG-PON 2 being a very difficult project from a technical perspective, is it still in questions on being able to do anything from a technical perspective as opposed to just fine-tuning things, meaning is there any lack of optical components necessary to hit price points and be more even specific on the question?

No, there is not a question of feasibility. This is all about implementation.

Okay, great. Okay, congratulations again.

Okay. Thanks very much.

Thank you. And we'll go next to Fahad Najam with Cowen. Please go ahead. Your line is open.

Tom, thank you for squeezing my question in, I had a question on the G.fast opportunity. If I go back last quarter, you had sort of walked through a scenario where you still expected the ramp on the G.fast opportunity with a Tier 1 U.S. operator to start in second-half 2017. Do you think that has moved forward and you saw the ramp in the second quarter? And then, just to be clear, this 10%, this XGS wasn't part of that 10% revenue, right?

Hey, that was not, the XGS was not a meaningful piece to that. And as far as the ramp, nothing has really changed. We thought we would start seeing initial shipments in the second quarter. That's what we saw and we would expect to just to kind of ramp from here.

So on a sequential basis, you expect the ramp to come in third quarter, ramping up through fourth quarter with [indiscernible].

That ramp, yeah, honestly to be more direct, it will - we expect it to be higher in third quarter and then higher in fourth quarter. But we expect that ramp to continue to go on through 2018.

Got it. Thank you very much.

Okay. I think at this point, we're out of time. So I appreciate everybody joining us for the call. And we look forward to talking to you next quarter.

This does conclude today's program. Thank you for your participation. You may disconnect your line at any time. And have a wonderful day.