ADTRAN Holdings, Inc. (ADTN) Q2 2018 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by, and welcome to ADTRAN’s Second Quarter 2018 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 cost, manufacturing efficiencies and other risks detailed in our Annual Report on Form 10-K for the year ended December 31st, 2017. 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, Erica, and good morning, everyone. We appreciate you joining our second quarter 2018 conference call. Our CFO Roger Shannon is here as well. Following my opening remarks on the quarter and what we expect to see going forward, Roger will go over the quarterly performance in greater detail and then we will take some of your questions. The headline for this quarter a mid-year reflection point is steady progress towards a stronger second half of the year as we advised last quarter. Overall the company performed well with quarter-over-quarter improvements in revenue, gross margins and cost controls, while we continue to make strategic investments in the development of future innovation. From a top-line perspective, revenues were up 6% at $128 million from the first quarter. Network solutions accounted for the bulk at a $115 million while services and support revenues contributed $13 million or 10% of the total company’s revenue for the quarter. Total revenue in our domestic markets came in at $68.2 million or 53% of the total and our International revenues continue to come in strong at $59.8 million or 47% of the total. In general, we are pleased with our level of engagement across domestic and International operators and strategic areas of software-defined access including 10 Gig EPON and GPON2 G.fast, our Mosaic Cloud Platform and our new Mosaic subscriber experience applications including insight device manager inactivate. In regards to the merger-related shift in spending with our Tier-1 domestic customers, I am pleased to see further clarity and meaningful progress towards stability. We saw a modest increase in revenue over the previous quarter and we have been awarded net new business. We are also in other projects with this customer at various stages of development ranging from initial scoping to field trials. We continue to gain further clarity on their priorities as they emerge from this transition. The cable MSO broadband access market remains a strategic priority for us. Building upon our recent acquisitions and organic developments, we are achieving meaningful revenue progress with Tier-1 cable MSO operators with our 10-Gig EPON remote optical line terminal and head-end solutions and our 10-Gig EPON optical network unit solutions. And as an adjacent market growth area we are pleased with what we are seeing to-date and expect this trend to continue. Within the carrier space, we continue to advance our 10-Gig and GPON2 solutions with a domestic Tier-1 operator and are approved for G.fast deployments out of region and have met the criteria and are continuing our first office application with a major Tier-1 carrier for in region shipments. Further, we are continuing to ship vectoring products to a large domestic Tier-2 operator have just begin those this quarter and it’s something that we expect to continue on for the next few quarters. Our international business is up 58% on a year-over-year basis with strong contributions from two European and Middle East operators as well as additional vectoring shipments and super vectoring shipments with regional EMEA operators. We have successfully introduced super vectoring into a Middle East operator as they begin a nationwide rollout. We have now shipped about 17.5 million VDSL2 vectoring or super vectoring ports globally to-date as operators look to maximize existing infrastructure while delivering the services their customers demand. Total gross margins on a quarter-over-quarter basis in both products and service segments is coming in at 39%. Our product gross margins are approved both domestically and internationally with a stronger overall mix led by super vectoring solutions internationally. As we head into second half of the year, we expect strengthening in our domestic markets for ultra broadband and Fiber-To-The-Home solutions. We anticipate a pickup in cap spending in Tier-1, Tier-2 and regional service provider market segments. We also continue to see strong traction in our SD access and EPON solutions. Additionally, we expect to see our G.fast solutions to begin ramping in the second half of the year domestically and in Australia. Our international G.fast revenue should help us offset seasonally lower spending with our Western European Tier-1 operator. In closing, investments in creating open vendor-agnostic software-defined access solutions enable us to not only drive innovation with the largest carriers, it also allows us to help all communication providers prepare for transition – to transition their networks to meet increasing subscriber expectations of faster, better, and more intuitive connectivity. The great common denominator of our time is our unequivocal desire for fast, ever present access to the world with a real-time on-demand experience. We are moving forward with our long-term mission to identify strategic opportunities and partner with those who share our mindset to grow a robust and healthy ecosystem through our Mosaic open alliance – through our Mosaic Open Network alliance. ADTRAN’s global leadership in software-defined access ensures we are well-positioned to help service providers who seek transformation to grow revenue, reduce cost and accelerate service delivery and deployment. With that, I’ll turn the call over to Roger and we’ll be happy to answer any questions you may have afterwards. Roger?

Thank you, Tom, and good morning. I’ll speak about our second quarter results and discuss what we see for the next quarter. During my report, I’ll be referencing both GAAP and non-GAAP results. As Tom stated, ADTRAN’s second quarter revenue came in at a $128 million, compared to a $184.7 million for quarter two of last year and $120.8 million we reported last quarter. Our network solutions revenues for the second quarter were $115.1 million versus the $155.5 million for quarter two of last year and $105.3 million reported for quarter one of 2018. Our Global Services & Support revenues in quarter two 2018 were $13 million, compared to $29.1 million earned in quarter two of 2017 and $15.6 million reported for the first quarter of 2018. Across our revenue categories, access and aggregation revenues for Q2 2018 were $84.7 million, compared to $138.6 million for quarter two of 2017 and $81.7 million last quarter. Customer devices revenues for the quarter were $34.6 million versus $33.8 million for quarter two of 2017 and $30.1 million for quarter one of 2018. Traditional and other products revenues for quarter two 2018 were $8.7 million, compared to $12.2 million for quarter two of 2017 and $9 million last quarter. Looking at revenues geographically, domestic revenues for quarter two 2018 were $68.2 million versus the $146.7 million we reported in quarter two of last year and $62.1 million in quarter one of 2018. Our international revenues for quarter two of 2018 were $59.8 million, compared to $38 million in quarter two of last year and $58.7 million for quarter one of 2018. We have published the reporting of 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 39%, compared to 45.8% for second quarter of 2017 and 32.9% last quarter. The year-over-year decreases in our gross margins were driven primarily by the decreased volume of our domestic business, and higher weighting of international business. This was partially offset by improved gross margins in our international products and domestic services portfolios in the current quarter. Our quarter-over-quarter gross margin improvements were across the board in our domestic and international mix and in our products and services segments. Total operating expenses on a GAAP basis were $62.8 million for quarter two of 2018, a decrease of $5.5 million, compared to $68.3 million for quarter two of 2017 and $3.6 million lower than the $66.4 million reported last quarter. On a non-GAAP basis, our Q2 operating expenses were $59.8 million, compared to $65.6 million in quarter two of last year and $60.6 million last quarter. The year-over-year decrease in operating expenses is primarily attributable to lower compensation and labor expense in the quarter. The quarter-over-quarter decrease in operating expenses was primarily the result of lower restructuring expenses and lower compensation and labor expense in the quarter just ended. The difference between GAAP versus non-GAAP operating expenses in Q2 is due to restructuring expenses, amortization expenses related to our acquisitions and equity-based compensation. Operating income on a GAAP basis for the quarter just ended was a loss of $12.8 million, compared to operating income of $16.4 million reported in Q2 of last year and an operating loss of $26.6 million reported in quarter one of this year. The decrease in Q2 GAAP operating income, as compared to Q2 2017 is attributable to lower revenues from lower domestic volumes and increased international mix, partially offset by favorable foreign exchange movements and lower operating expenses. The quarter-over-quarter increase in operating income is primarily driven by higher revenues with favorable mix and lower operating expenses. Non-GAAP operating income or adjusted EBIT for Q2 2018 was a loss of $8.9 million, compared to income of $19.2 million for quarter two of last year and a $18.3 million loss reported in quarter one of 2018. As described in the supplemental information provided in our operating results disclosure, stock-based compensation expense, net of tax was $1.4 million for quarter two of 2018, compared to $1.4 million reported in quarter two of last year and last quarter. Expenses related to amortization of acquired intangibles were $841,000 net of tax, compared to $582,000 in quarter two last year and $427,000 last quarter. Restructuring expense net of tax was $758,000 for the quarter just ended, compared to zero reported in quarter two of last year and $4.4 million last quarter. All other income net of interest expense for quarter two of 2018 was $1.6 million, compared to $1.5 million for quarter two of 2017 and $11.9 million last quarter, which included $11.3 million bargain purchase gain. The company’s tax provision for quarter two of 2018 was a tax benefit of $3.6 million, or an effective tax rate of 31.9%, as compared to a tax expense of $5.5 million, or 30.6% in quarter two of 2017, and $3.9 million tax benefit in first quarter 2018. The shift in tax from an expense of $5.5 million in quarter two of 2017 to a benefit in the current quarter was primarily driven by current year net losses in our domestic business. GAAP net income for quarter two of 2018 was a loss of $7.7 million, compared to income of $12.4 million for the second quarter of 2017 and a loss of $10.8 million last quarter. Non-GAAP net income for the second quarter of 2018 was a loss of $4.6 million, compared to earnings of $14.4 million in quarter two 2017 and a loss of $15.9 million last quarter. Earnings per share on a GAAP basis, assuming dilution was a loss of $0.16 per share, compared to income of $0.26 per share for the second quarter of 2017 and a loss of $0.22 per share for quarter one of 2018. Non-GAAP earnings per share for the second quarter of this year were a loss of $0.10, compared to earnings of $0.30 per share for quarter two of last year and a loss of $0.33 per share last quarter. Non-GAAP earnings per share exclude the effects of stock compensation expense, amortization of acquired intangibles, restructuring expenses and the bargain purchase gain related to the acquisition in the first quarter of 2018. We have provided a 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 $203.2 million at quarter-end after paying $4.3 million in dividends and repurchasing 184,000 shares of common stock for $2.6 million during the quarter. For the quarter, we produced $6.7 million of cash from operations. Net trade accounts receivable were $76.1 million at quarter end, resulting in a DSO of 54 days compared to 39 days at the end of the second quarter of 2017 and 60 days last quarter. The increase in DSO versus the same period last year is a result of a higher mix of international business in the current quarter, while the decrease from last quarter is mainly attributable to customer mix and the timing of shipments within the quarter. Inventories were $120.5 million at the end of the second quarter, flat to the $120 million from last quarter. Looking ahead to the next quarter, the book and ship nature of our business, the timing of revenues associated with large projects, the visibility of order patterns of the customer base into which we sell and the fluctuation in currency exchange rates in our international markets we sell into may cause material differences between our expectations and actual results. However, taking into account the previously disclosed merger-related review and slowdown in the spending of a Tier 1 customer, our current expectations are that third quarter of 2018 revenues will be in the range of $146 million. Also, 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 in the low 40% range. We expect that GAAP operating expenses for Q3 2018 will be approximately $62 million. Finally, we expect volatility in the quarterly tax rate for the rest of the year due to the anticipated mix of U.S. versus international income and the impact of new tax law is having on those earnings. While we had a tax benefit in the quarter just ended, we anticipate the consolidated tax rate for the third quarter to be an expense of approximately 40% due to international earnings. We believe the significant factors impacting revenue and earnings realized in 2018 will be the following: The macro spending environment to the carriers and enterprises; currency exchange rate movements; the variability of mix and revenue associated with project rollouts; professional services activity levels, 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. You can see this information at ADTRAN’s Investor Relations website by going to into www.adtran.com, and following the Investor Relations link. With that, I’ll now turn the call back over to Tom.

Great, thanks, Roger. Erica, we’re ready to open it up for any questions people may have.

[Operator Instructions] And we’ll go first to the line of Rod Hall with Goldman Sachs. Please go ahead.

Yes, good morning guys. Thanks for taking the question. I wanted to open up with just a question on what is driving exactly the pause in the U.S. I know a lot of that’s been merger-related, but wanted to ask whether you think people are also pausing because of the 5G fixed wireless programs that are being tested now and thinking about whether that might be a more efficient way to access homes and then, in fact the case what your participation level in those kinds of projects might be?

Yes, the first answer to your question is I haven’t heard anybody pausing because of 5G – potential 5G rollout. So, without a doubt and I’ve covered this, I think some last quarter. If I look at the math of the decrease in our domestic spending on a year-over-year basis it was a 100% attributable to that slowdown on that one customer. Having said that, we have the Tier-2 space has got some – it’s very much project-related and we had on a comparable basis some strong projects in the previous year that are not yet starting. And having said that, I did mention that we have a Tier-2 customer in the U.S. that’s now actually starting to deploy our vectoring product. So, there is pluses and minuses around the space, but I don’t think there is any big movement that is negative, I definitely haven’t heard anything about 5G. And then, what was the second part of the question, Rod?

Well, let me follow-up on that first one Tom and then I’ve got a second one. But the thought would be when do you – I mean, be it the revenue curve obviously it’s foreclosed and I am just wondering visibility continue to be pretty poor, but I just wonder kind of when you guys think you could get back in the ballpark of even $100 million of U.S. revenues? Do you think that that’s doable by the early part of next year? Or you just have no idea of when you might be able to get back to – something like that level or better?

So that – I think a few things have to happen. One of course, we have a couple of customers one of which I’ve mentioned were at the tail-end of the FOA for G.fast that would clearly move that up. The other is, as you are aware with NG-PON2. And I’d now recall the second part of your question is that where are you on 5G, which as you are probably aware has an impact on NG-PON2 deployments as well, as they are looking and I want to speak for that customer but their plans for wireless rollouts include NG-PON2. Either one of those coming on as strong as we are expecting they will come on would materially move us there. And of course one of them with actually in NG-PON2 pieces that has a got a very strong potential in and of itself. And then, other than that, there are project-related things that can come in at $15 million to $20 million a quarter even on the Tier-2 space that can move that number north of that. So, I think there are lot of different pieces. I think one of them we have to get through this FOA project and get that product rolling in mass and then the other big one of course is the one that you are aware of with NG-PON2.

Okay. And then, my second question was just international enough opportunity for better early price pop for you guys. Is that – do you feel like those revenue levels we’ve seen in the last couple quarters now are sustainable? And if they are, how long do you think you can sustain those or is that kind of the new normal for international?

Yes, let me touch one other piece which I didn’t miss, I mentioned in my comments, but it may have – may not have emphasized that the progress we are making in the MSO space is fairly material and that’s coming off of what has historically been a lower number. But just the opportunity that we see in MSOs for next year as products start really rolling out and we are just really starting to rollout 10 Gig could move that number to $100 million. So, I think there are kind of three different pockets that would actually impact that. As far as the international number, we will see a downturn in the European number next quarter. But we will see an uptick that’s fairly meaningful because of new rollouts of G.fast in Australia. So, it’s probably, now you think about – I think about it as kind of flattish for international with the expectation that our vectoring rollouts in Europe will come down sometimes they surprise us and they are little stronger than we expect.

Okay. Great. Thank you very much. I appreciate it.

Okay.

Thank you. And we’ll go next to the line of Paul Silverstein from Cowen. Please go ahead.

It’s all, Roger, I’ll apologize to you and to others on the call including Rod, if you’ve already answered these questions or in your prepared remarks. I’ve been having some audio problems and I do apologize hopefully not the case. But first off, the $100 million number you just cited Tom or you think you cited on with respect to MSOs, that number is relative to what, when you said the significant opportunity with respect to five rule and calendar 2019 moving that number up to $100 million, that’s $100 million from – or did I misunderstand your comments?

Yes, I think you – I think you – what the question was, the domestic revenue right now is sub a $100 million. I think it’s roughly in the six…

Okay. Through your friends it’s moving U.S. up to $100 million, got it.

Right, so. Yes, which I think $32 million and so, if you look at the MSO adders that itself could be strong. I don’t know if it would do it next year, but if you look at that plus in NG-PON2, plus G.fast and then the real kind of wildcard is what happens in the Tier-2 space, CAF will pick up in the second half, but we’ll have the normal slow start next year. So…

Right, that makes a lot more sense, because, correct if I am wrong, historically while you’ve been on little bit of revenue I think with cable MSOs it hasn’t been very much historically, is that correct?

That’s right. That’s absolutely correct. Sorry you haven’t – a matter of fact, I would venture to guess and this is a guess, because I haven’t really looked at it from a historical perspective but I would bet this is the strongest quarter we’ve ever had in MSOs and expect it to be materially stronger next quarter.

And so – again I apologize if you already said this, but would you characterize cable MSOs and I was seeing that was strongest, was that material this quarter? Or is it still naïve and meaningful driver?

It’s – yes, I am thinking it’s right there on the verge.

All right. I appreciate that. Tom, I think you might have said this historically, with respect to the two opportunities with Comcast relative to deep fiber, as we look to 2019 and beyond that – those opportunities measure in the tens and millions of dollars each?

I think it will be – well, yes. Yes, I am thinking about on an individual quarter, but you know how these things rollout, yes.

If we look over the annual period, smoothing out…

Yes, without a doubt. Yes, yes, yes, without – I mean, yes, honestly I am thinking on a quarterly basis. So, on a yearly basis, absolutely.

So, on a quarterly basis you are thinking these could be in the tens of millions, on a yearly basis you are thinking a $50 million to $100 million each?

I didn’t say each. But, I think it’s $50 million to $100 million that, right.

All right. I appreciate that. Let me move on. I think you answered this question part if not in full relative to Rod’s question, but Tom, it seems with all these projects, whether NBN, AT&T prospectively Verizon, Charter, Comcast et cetera, the key question, very key question has been timing/visibility. Your confidence today in terms of the timing of those rollouts over the next 12 months or so relative to 90 days ago, with the benefit of 90 days more information, how would you characterize – how confident are you that these respective projects are going to hit over the course of next six to 12 months?

They are certain ones I am very confident and there are certain ones I am less on. So, we’ll get out of the FOA for G.fast here in the U.S. The issue there is just when does that customer actually gets to a point to where they are really moving in a big way. So I still expect that to be a longer term rollout on the Australian NBN opportunity. I am as confident as you can be when you have purchase orders in hand and you are starting to ship. For NG-PON2, I think that’s – if I think about it from a six month timeframe, I am feeling pretty good from a six months timeframe, I would expect us to see there is – on the likelihood it’s some movement even later this year. But I don’t – but I think that that’s also – and I guess that kind of puts us in that six months timeframe that’s – I would say, we’d see some initial things later this year, but all those things can slide by a quarter or two, that one is probably the one that the timing is the least understood.

And there is super question of this quarter versus last quarter in terms of incremental positives or incremental negatives. Is it mostly around the visibility in terms of improvement or stability at CenturyLink and improvement in the U.S.?

Yes, so, I would think our visibility there is, without a doubt better. We have a good understanding of the piece of business that we have with them today. Right, rather that is CAF-related, as well as Vector and we are doing some vectoring projects with them and our ability – so, we know what those are and that’s – so we’ve got at a minimum stability there. I mentioned that we are working on a couple of other projects with them that could be potential adders. Some of those are on the product side, some of those are on the services side. But if I look at it from a baseline perspective and needless to say we are not counting any of that in our projections at this point. If I look at it from a stability perspective, I would say, we are much better off.

All right. One last question if I may Roger, I want to get you in here. Given all these projects with respect to the impacts, as you look out over the next 12 to 18 months in terms of margin recovery, do you think you could get back to the mid to upper 40s? Or is it too early to say? I mean, you obviously just put up some pretty big improvement without the benefit of significant revenue progress. Any thoughts you could share with us?

Yes, that’s certainly still our target as we discussed consistently. What, you saw improvement from Q1 to Q2. The primary drag on our gross margins has been the decrease in product and the manufacturing expense related to that. Now we have done quite a lot of work related to rightsizing that, but absolutely as the volumes pick up, we’ll see efficiencies in margin improvements across our gross margins and as we consistently talk about the U.S. margins have a positive profile compared to the international. So, that – really nothing to change in terms of our target and our expectations.

Thanks guys.

Okay.

Thank you. And we’ll go next to the line of Rich Valera from Needham & Company.

Thank you. First, I guess a question for you Roger on the 3Q revenue guidance. That was an unusually granular guide for you guys. Typically you give a range, I would say, typically at least at around $5 million or so but this is kind of a point number. So wondering if there is anything that gives you higher than typical visibility going into the third quarter relative to prior quarters. And then, and this maybe for one or both of you, maybe Tom. But I was wondering if you could kind of list out the projects that you see contributing the most incrementally from Q2 to Q3 kind of in size, order and suspect they include things like NBN and the ramp of the MSO business, but didn’t want to put words in your mouth, just to kind of give us a sense of what we should expect will be driving that revenue ramp from Q2 to Q3? Thank you. Hello.

Sorry, Rich. Can you hear me? So for starters, I did say…

Sorry, you seem to cut out there for a while. So, whatever you had just said, hopefully you can say that again.

Yes, my apologies. So I did say in the range of 146. But I think it kind of goes back to what Tom just said about the projects and the visibility. So, in our guide, we took an approach of what we feel good about – now there is some timing and some other things that we just have to see how plays out.

Yes, I mean, we have – we are in a little bit of an unusual case because of some of the International business that we have and it’s not really just with Australia where – we are typically a book and ship business and I would still characterize in general, our business as being book and ship, but the international mix that we have today happens to be a little more concrete in that, so, kind of at this point more directly. As far as the quarter-to-quarter comparison and it’s directly relating to that, so we do expect a downtick in our European vectoring customer, maybe not as predominant as we have seen historically. So, there may be, it’s a little bit stronger than – if we take the average of the quarter-to-quarter declines from second to third. Over the last few years, it’s probably a little bit better than that and then we have Australia starting to ship which is really on our – it’s grew truly a matter of us executing on the manufacturing side. And those will both – those in combination. We also – I talked about the super vectoring rollout in the Middle East. That will actually pick up in the quarter and as we actually have some vectoring customers that are relatively new. They are actually strong this quarter in Europe that are not the typical Tier-1 vector – vectoring customer that we have, that, so really good performance and we expect that to continue. So there are multiple points, but the two big ones are the Australia and the German Tier-1 carrier and their movements.

And how about NBN in terms of materiality Q2 to Q3?

Well, without specifically mentioning a customer, we expect material change in revenue between Q2 and Q3 for Australia.

Got it. That’s quite helpful. And then, I just wanted to make sure I understood the situation at CenturyLink with vectoring. So that was a huge revenue contributor for you guys up until Q3 of last year and obviously, it seems to have crossed most of the shortfall of revenue recently. So, what – can you say what the statuses of that program that you were doing which was kind of a – as I understood it sort of deploying across their whole footprint, I am kind of – I think the assumption is that program has been stopped towards, I am not sure how you would characterize it, but it sounds like you are doing some other vectoring revenue or vectoring business. Just trying to get a clear understanding of what’s going on there. Because obviously a very big chunk of vectoring has gone, but what is this additional stuff you are doing and I think you mentioned in your prepared remarks, Tom, you thought it would go on for I think you have a few more quarters. So I guess, that would suggest that has a tale to it, but it will also go away. So just wanted to get some clarity on that. Thank you.

Yes, so, I kind of – I could have been clear in my notes there in the way that I have at least presented the notes, and that was probably clear. There are a couple things going on in the U.S. in relations to vectoring. One is, we do have and this was reflective of my note is we do have in the Tier-2 space we are starting to deploy vectoring and that really doesn’t have a finite period around it. I have mentioned it as going on for couple of quarters, but really there is no end sight to that. So there it’s initially starting out kind of getting their plans together and what they want to do with it long-term, but, I don’t see a particular end to that. As far as our Tier-1 vectoring customers, of which there is one in the U.S., there is still some vectoring activity going on. But I think the way that we think about that customer is they are no longer proving it as a kind of a footprint-wide, let’s upgrade, they are doing it on a case-by-case basis. And there is vectoring activity going on. We actually expect that – I don’t want to get myself in trouble here. So, there are some used cases for vectoring that make an awful lot of economic sets. So, we expect as those used cases start servicing and they are servicing now like what we were going to be actually a pickup in vectoring with that customer as they really accelerate the deployment in the areas that are very economically advantageous to them. Having said that, they are doing this on a case-by-case versus kind of a footprint-wide expansion which is really the big change that we saw.

That’s helpful. Thanks, that’s perfect. Thanks, gentlemen, I appreciate it.

Okay.

Thank you. And we’ll go next to the line of Michael Genovese from MKM Partners.

Thanks very much. Hey, Tom, it seems like your business is much broader base than before. So for example, Deutsche Telecom, seasonally down in the second half, but still your overall international business hanging in there. Or it still seems to be some merger review overhang at CenturyLink, but you have a lot of things coming back domestically in the second half. So, can you just talk more about this broad base of customers and larger opportunities? I mean, is this different than anything you’ve seen in the history of the company or I mean, this is still a just another cycle or is there is something fundamentally different going on here?

Well, I think, from our perspective, I think there are two things going on, one is we are seeing – this comes and goes as far as amplitude on us fairly regular basis, but if you step back, the general trend towards, let’s say, 25 Meg is not enough and we have to do something about because we are losing our customer base. That has gotten louder and that’s on any particular customer that may – that can be project-related. So it comes and goes and we’ve seen that really kind of happen over the last couple of years, but if you look at the massive customers and I would say the trend is upward and in general, that trend itself is accelerating. So that’s a positive. I think in our nick area, the difference is, we’ve had to drive and you could basically – and you can make a strong pace as to the timing of that drive. But we’ve had to drive towards diversification of our revenue and that started when we really in earnest when we acquired the assets from NSN and really tried to grow our piece outside of the U.S. And historically, our customer base has been driven by large Tier-1 customers. We kind of guide into the Tier-2 and Tier-3 space, we saw benefit from that. But it was still dominated and to this day it’s still dominated by a very small handful of customers. So, our movement over the last three years has been to continue to try to break out of that. So the big change for us is now we have a stronger international footprint. So we have new customers finally coming online that aren’t just the one that we had that we had acquired and we also now have a foothold that we are feeling good about in the MSO space which we never had before and all of that has to do with diversification of our revenue base. And as we’ve seen, that’s really important for us.

Great. And can you maybe talk about what needs to happen on the gross margin? I think, the guidance here was low 40s. Just sort of you get sustainably into the mid-40s or you are slightly above that? What sort of has to happen between there and here?

I think, Roger touched on it and asking the other things there. But it’s – at this point in time, so we are always going to be hit by mix shifts, really international versus domestic that’s kind of the top-line thing that drives it the most. But if I look at the pricing today that are giving to customers versus my bill of material, right, it hasn’t materially changed from where we were before – when we were in the 45, 46 range. Our key right now is going to be volume. Right, we’ve got to get the volume back up and we’ve got to lower our kind of overhead cost associated with what we are doing here. We took a big stab at that in the first half of this year. So, we will see a benefit from that in the second half. But the easy fix to that is, just a pickup in our domestic business. Roger, any other comments?

That’s exactly right.

Okay, great. And then last one for me. Just on the early look at the fourth quarter, sort of top-line for the fourth quarter, should we think about typical ADTRAN seasonality, I mean, we are having a much weak second quarter, much better than seasonal sequential third quarter, fourth quarter seasonally normal or what?

I really need to not give guidance on the fourth quarter till we get through the third. And at this point in time what we would typically say I have no reason other than that, you know the projects and we have some timing things going on with the U.S. business. So half will be it should be good, but then again you get towards the winter months and they tend to slowdown. So if I look at it from a macro level, there is nothing I can tell you at this point in time other than seasonality. We’ll know more as we get through this quarter, but right now, I can’t tell you anything different than that.

Okay, thanks very much.

Okay.

Thank you. And we’ll go next to Tim Savageaux from Northland Capital. Please go ahead.

Good afternoon. Wanted to focus back on some of the dynamics around Q3 guidance and really kind of what’s driving that in a little more granularity. In assuming kind of a flattish to maybe slightly down profile internationally, that does imply a pretty good uptick in domestic revenues actually not that far off that $100 million target. But and I think, given your comments on CenturyLink and that ongoing review that our expectation should be flattish there as well. Assuming that’s accurate, we are looking at something on the order of a 40%, 45% sequential increase in domestic revenues, ex that, I think you – if I am doing my math right, number one, and I think you’ve kind of hinted towards maybe a Tier-2 ramp and cable strength, but is there – and maybe some seasonality I suppose. But is there anything else incremental there and we really haven’t touched on kind of Tier-3 spending trends. Anything to note there in terms of driving what appears to be some pretty extraordinary strength domestically?

So, I think, and of course we had a – at the number that we are at right now, that only takes a couple of million one or the other that actually – that can actually affect things. So, first of all, on the Tier-1 customer in the – on our vectoring Tier-1 customer in the U.S., if I look in at the total sales of that, then, I would expect that to be up and there is a couple of things. One is, we do expect kind of a little pickup in some of the vectoring projects we are doing. We also then expect a pickup in CAF spending with them. Some of the CAF-related projects that we have with them. So, to the extent I said, just flat, I think that that’s not correct. And Tier-2 is, I think the way that you characterize is correct that we do expect stronger CAF spending and just stronger spending in general. And then the MSO space you probably – you maybe – that maybe stronger than what you are modeling. Tier-3s will also be up and that has to do with CAF spending as well as just general market dynamics of Q2 to Q3. But, literally all of those pieces will be up.

Got it. Thanks.

Okay.

Thank you. And we’ll go next to George Notter from Jefferies. Please go ahead.

Hey guys. Thanks very much. I guess, I wanted to dig into this NG-PON2 project a little bit more. I am trying to better understand your confidence in generating revenue out of that project going forward. If I look at that situation, I think the initial trials are with the competitors’ products. I know they are doing trials in the fixed asset at NG-PON2 effort will be predicated on sort of penetration rates and economics of those initial trials and at the same time, they are focused on enterprise applications initially implies volumes that are lower than maybe if they are focused on residential. So the bigger picture here is, why do you believe if that really generates interesting amounts of revenue for ADTRAN at some point in the near intermediate future?

I mean, that’s a good question. I think you are right and we are always – once we get these products and that’s incumbent upon the carrier to do what it is that they are supposed to with them. And I agree with you on the characterization of the initial rollout of the business which is still by the way material business. Right, it’s not hundreds of millions, but it’s material business even on the enterprise side. Our understanding is that the plan of record to go as deeper than that and so to the extent that it stops that enterprise, it will be a nice adder, but it’s not nearly if they were to go into the residential side and the wireless side which is what our belief is, is that that’s what they are doing. But if they don’t, they don’t. So that is inherently a risk that we have with Tier-1s and we’ve been bitten before by that. At this point in time, our discussions with NG-PON2 customers that it’s - they are planning a fairly meaningful deployment next year.

Got it. Okay. So, does that then filter into your model, do you think what, Q1 of next year? Or is it mid-year? Or how do you sort of think about it if all goes well?

Yes, so we haven’t – of course we don’t forecast Q1 until next year and we’ll give some color on the full year in the fourth quarter call. Our expectations will be that we will be shipping in next year. I won’t – I think that we are liable to see some activity this year. But like you just mentioned, it’s the trial piece the key is, getting out of that trial build out and getting to tens and tens of cities which I am sure you are aware of, which is what we – our expectation is for next year. That may slide a little bit as to whether or not is explicitly starts in Q1, I don’t know and I would not forecast that at this point.

Okay. Okay, thank you.

All right. With that, I think we are - completed our call. So I appreciate everybody for joining us on our call this quarter. And we look forward to talking to you next quarter.

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