UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-Q
For the Quarterly Period Ended September 30, 2004
OR
For the Transition Period from to
Commission File Number 0-24612
ADTRAN, INC.
(Exact name of Registrant as specified in its charter)
901 Explorer Boulevard, Huntsville, Alabama 35806-2807
(Address of principal executive offices, including zip code)
(256) 963-8000
(Registrant’s telephone number, including area code)
Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock, as of the latest practicable date:
Class
Outstanding at November 5, 2004
Quarterly Report on Form 10-Q
For the Quarter Ended September 30, 2004
Table of Contents
ItemNumber
Page
Number
1
2
3
4
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
ASSETS
Current assets
Cash and cash equivalents
Short-term investments
Accounts receivable, less allowance for doubtful accounts of $599 and $1,746 at September 30, 2004 and December 31, 2003, respectively
Other receivables
Income tax receivable
Inventory, net
Prepaid expenses
Deferred tax assets
Total current assets
Property, plant and equipment, net
Other assets
Long-term investments
Total assets
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable
Unearned revenue
Accrued expenses
Accrued payroll
Income tax payable
Total current liabilities
Deferred tax liabilities
Other non-current liabilities
Bonds payable
Total liabilities
Commitments and contingencies (see Note 11)
Stockholders’ equity
Common stock, par value $0.01 per share; 200,000 shares authorized; 79,652 and 79,294 shares issued at September 30, 2004 and December 31, 2003, respectively
Additional paid-in capital
Accumulated other comprehensive income
Retained earnings
Less treasury stock at cost: 2,786 shares at September 30, 2004
Total stockholders’ equity
Total liabilities and stockholders’ equity
See notes to consolidated financial statements
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Sales
Cost of sales
Gross profit
Selling, general and administrative expenses
Research and development expenses
Operating income
Interest income
Interest expense
Net realized investment gain
Other income (expense), net
Income before provision for income taxes
Provision for income taxes
Net income
Weighted average shares outstanding
Weighted average shares outstanding assuming dilution (1)
Earnings per common share – basic
Earnings per common share – assuming dilution (1)
Dividends per share (2)
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation
Gain on sale of long-term investments
Loss on sale of property, plant and equipment
Deferred income taxes
Income tax benefit from exercise of non-qualified stock options
Changes in operating assets and liabilities:
Accounts receivable, net
Prepaid expenses and other assets
Accrued expenses and other liabilities
Net cash provided by operating activities
Cash flows from investing activities:
Purchases of property, plant and equipment
Proceeds from disposition of property, plant and equipment
Proceeds from maturities of held-to-maturity investments
Purchases of held-to-maturity investments
Proceeds from sales of available-for-sale investments
Purchases of available-for-sale investments
Net cash provided by (used in) investing activities
Cash flows from financing activities:
Proceeds from stock option exercises
Purchases of treasury stock
Dividend payments
Net cash used in financing activities
Net increase (decrease) in cash and cash equivalents
Effect of exchange rate changes
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements of ADTRAN, Inc. (“ADTRAN”) have been prepared pursuant to the rules and regulations for reporting on Quarterly Reports on Form 10-Q. Accordingly, certain information and notes required by generally accepted accounting principles for complete financial statements are not included herein. In the opinion of management, all adjustments necessary for a fair presentation of these interim statements have been included and are of a normal and recurring nature. Certain reclassifications have been made to the 2003 consolidated financial statements in order to conform to the 2004 presentation. These reclassifications had no effect on previously reported net income, cash flows from operations, cash flows from investing activities, or total stockholders’ equity.
Operating results for the three and nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected to occur for the year ending December 31, 2004. The interim statements should be read in conjunction with the financial statements and notes thereto included in ADTRAN’s Annual Report on Form 10-K for the year ended December 31, 2003.
On October 13, 2003, the board of directors declared, effective December 15, 2003, a two-for-one stock split to be effected in the form of a stock dividend of one share of common stock for each outstanding share of common stock for stockholders of record on December 1, 2003. Share and per share amounts, including stock options, in the accompanying Consolidated Statements of Income and Notes to Consolidated Financial Statements have been retroactively adjusted to reflect this stock split.
2. INVENTORY
At September 30, 2004 and December 31, 2003, inventory consisted of the following:
Raw materials
Work in progress
Finished goods
Inventory reserve
3. COMPREHENSIVE INCOME
Comprehensive income consists of net income, unrealized foreign currency translation adjustments (net of deferred taxes) and unrealized gains and losses on marketable securities (net of deferred taxes).
Foreign currency translation gain (loss), net of deferred taxes
Change in unrealized gain (loss) on available-for–sale securities, net of deferred taxes
Total comprehensive income
4. EARNINGS PER SHARE
A summary of the calculation of basic and diluted earnings per share (EPS) for the three and nine months ended September 30, 2004 and 2003 is as follows:
For the Three Months Ended
September 30, 2004
Basic EPS
Income available to common stockholders
Effect of Dilutive Securities
Stock options
Diluted EPS
Income available to common stockholders plus assumed conversions
For the Nine Months Ended
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September 30, 2003
The following options were outstanding during the respective periods shown below, but were not included in the computation of that period’s diluted EPS because the options’ exercise prices were greater than the average market price of common shares, therefore making them anti-dilutive under the treasury stock method.
Anti-Dilutive Options Outstanding
Three Months Ended
Nine Months Ended
739
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5. SEGMENT INFORMATION
ADTRAN operates two reportable segments: (1) the Carrier Networks Division and (2) the Enterprise Networks Division. We evaluate the performance of our segments based on gross profit; therefore, selling, general and administrative expenses, as well as research and development expenses, interest income/expense, net realized investment gain/loss, other income/expense, and provision for income taxes are reported on an entity wide basis only. There are no inter-segment revenues.
The table below presents information about the reported sales and gross profit of ADTRAN’s segments for the three and nine months ended September 30, 2004 and 2003. Asset information by reportable segment is not reported, since ADTRAN does not produce such information internally.
Carrier Networks
Enterprise Networks
Total
The table below presents sales information by geographic region for the three months and nine months ended September 30, 2004 and 2003.
Sales by Geographic Region
United States
Foreign
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Sales by Product
The Digital Business Transport (DBT)/Total Reach® category is comprised of revenue from ISDN and DDS transport and connectivity products sold to carrier and enterprise customers. The High-bit-rate Digital Subscriber Line (HDSL)/T1 category is comprised of revenue from HDSL related carrier products and T1 CSU/DSU enterprise products. The Systems category includes revenue from Total Access narrow band products, M-13 multiplexers, integrated access devices and new products comprised of NetVanta routers, ethernet switches, internet security products, DSLAM products, and optical access products.
The table below presents sales information by product for the three and nine months ended September 30, 2004 and 2003.
Digital Business Transport (DBT)/Total Reach®
High-bit-rate Digital Subscriber Line (HDSL)/T1
Systems
6. LIABILITY FOR WARRANTY RETURNS
ADTRAN’s products generally include warranties of one to 10 years for product defects. ADTRAN accrues for warranty returns at the cost to repair or replace the defective products at the time revenue is recognized. ADTRAN engages in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers. Our warranty obligation is affected by product failure rates, material usage and other rework costs incurred in correcting a product failure. The liability for warranty returns totaled $1,601 and $1,541 at September 30, 2004 and December 31, 2003, respectively. These liabilities are included in accrued expenses in the accompanying consolidated balance sheets.
Nine months ended September 30, 2004
Additions
Charged(Credited) to Costs& Expenses
Warranty liability
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7. STOCK-BASED COMPENSATION
ADTRAN applies APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations in accounting for its stock option plans. Had compensation cost for ADTRAN’s stock-based compensation plans been determined based on the fair value at the grant dates for awards under those plans, consistent with the method prescribed in SFAS No. 123, Accounting for Stock-Based Compensation, net income and earnings per share would have been reduced to the pro forma amounts indicated below:
Pro Forma Net Income & Earnings Per Share
Net income – as reported
Less: stock-based compensation expense, net of tax
Net income – pro forma
Earnings per share:
Basic-as reported
Basic-pro forma
Diluted-as reported
Diluted-pro forma
The pro forma amounts reflected above are not representative of the effects on reported net income in future years because, in general, the options granted typically do not vest for several years and additional awards are made each year. The fair value of each option grant is estimated on the grant date using the Black-Scholes option-pricing model with the following weighted-average assumptions:
Expected dividend yield
Expected life (years)
Expected volatility
Risk-free interest rate
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8. STOCKHOLDERS’ EQUITY
A summary of the changes in stockholders’ equity for the nine months ended September 30, 2004 is as follows:
Balance, December 31, 2003
Change in unrealized gain on marketable securities (net of deferred taxes)
Unrealized foreign currency translation (net of deferred taxes)
Exercise of stock options
Purchase of treasury stock
Balance, September 30, 2004
On January 20, 2004 the board of directors declared a quarterly cash dividend of $0.08 per common share to be paid to stockholders of record at the close of business on February 3, 2004. The payment date of the quarterly dividend was February 17, 2004. The quarterly dividend payment was $6,365.
On April 13, 2004 the board of directors declared a quarterly cash dividend of $0.08 per common share to be paid to stockholders of record at the close of business on May 4, 2004. The payment date of the quarterly dividend was May 18, 2004. The quarterly dividend payment was $6,341.
On July 12, 2004 the board of directors declared a quarterly cash dividend of $0.08 per common share to be paid to stockholders of record at the close of business on August 3, 2004. The payment date of the quarterly dividend was August 17, 2004. The quarterly dividend payment was $6,258.
ADTRAN issued 396 shares of common stock to fulfill stock option exercises during the nine months ended September 30, 2004. The stock options had exercise prices ranging from $8.69 to $37.18. ADTRAN received proceeds totaling $5,046 from the exercise of these stock options during the nine months ended September 30, 2004.
ADTRAN repurchased 2,826 shares of its common stock through open market purchases at a total cost of $70,209 during the nine months ended September 30, 2004 and had the authority to purchase an additional 1,498 shares.
9. RECENTLY ISSUED ACCOUNTING STANDARDS
In March 2004, the Financial Accounting Standards Board (“FASB”) reached consensus on the guidance provided by Emerging Issues Task Force Issue 03-1 (“EITF 03-1”), The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. The guidance is applicable to debt and equity securities that are within the scope of FASB Statement of Financial Accounting Standard (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities and Certain Other Investments. EITF 03-1 specifies that an impairment would be considered other-than-temporary unless (a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment and (b) evidence indicating the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. The disclosure provisions of EITF 03-1 for investments accounted for under Statements 115 and 124 were effective for annual reporting periods ending after December 15, 2003. In September 2004, the EITF delayed the effective date for the measurement and recognition guidance included in paragraphs
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10 through 20 of EITF 03-1. The disclosures required of EITF 03-1, paragraphs 21 and 22, have not been deferred. We continue to evaluate all existing and future investments in order to determine the applicability of EITF 03-1.
On March 31, 2004, the FASB issued an exposure draft of a proposed standard that, if adopted, will significantly change the accounting for employee stock options by requiring us to expense stock options, commonly referred to as equity-based compensation. Comments on the exposure draft were due by September 7, 2004. On October 13, 2004, the FASB delayed the effective date of the proposed standard until the interim period beginning July 1, 2005. We anticipate that if the new standard is adopted, the standard will impact ADTRAN’s financial position and results of operations (see Note 7 for a discussion of the ADTRAN’s current treatment of stock-based compensation).
During September 2004, the Emerging Issues Task Force (“EITF”) released Issue 04-08, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share.” Issue 04-08 provides guidance on when the dilutive effect of contingently convertible debt securities with a market price trigger should be included in the computation of diluted earnings per share (“EPS”). The guidance is effective as of December 31, 2004 and would be applied by retrospectively restating previously reported EPS. We anticipate that the adoption of this guidance will not have a material effect on the computation of EPS as we do not have contingently convertible debt. In addition, the FASB is amending FAS 128 to make it consistent with International Accounting Standard 33, (IAS 33), and to make EPS computations comparable on a global basis. The amended standard is expected to be effective for all periods ending after December 15, 2004. We anticipate that the adoption of the amended standard will not have a material effect on the computation of our EPS.
10. RELATED PARTY TRANSACTIONS
We employ the law firm of one of our directors emeritus for legal services. All bills for services rendered by this firm are reviewed and approved by our chief financial officer. We believe that the fees for such services are comparable to those charged by other firms for services rendered to us. We paid $91 and $80 during the nine months ended September 30, 2004 and 2003, respectively, for these legal services.
One of our non-employee directors is the President – Customer Markets, of one of our significant customers who is also a vendor. In the normal course of business, we receive payments from and make payments to this customer. For the nine months ended September 30, 2004 and 2003 we received payments, directly and indirectly, from this customer in the amount of approximately $18,234 and $20,420, respectively, for products supplied to this customer. In addition, for the nine months ended September 30, 2004 and 2003 we paid this customer $571 and $357, respectively, for services provided to us.
11. COMMITMENTS AND CONTINGENCIES
We have certain contingent liabilities resulting from litigation or other matters arising in the normal course of business. Although the outcome of any litigation and other matters can never be certain, it is our opinion that the outcome of such contingencies will not materially affect our business, operations, financial condition or cash flows.
During the nine months ended September 30, 2004, there have been no material changes in contractual obligations and commercial commitments from those discussed in our most recent Form 10-K filed on March 12, 2004. We do not have off-balance sheet financing arrangements and have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of or requirements for capital resources. We have committed to invest up to an aggregate of $7,900 in two private equity funds, of which $2,100 has been invested to date. The duration of each of these commitments is five years with $2,900 expiring in 2005 and $5,000 expiring in 2007.
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12. SUBSEQUENT EVENTS
On October 11, 2004, ADTRAN announced that its board of directors declared a quarterly cash dividend of $0.08 per common share to be paid to stockholders of record at the close of business on November 2, 2004. The payment date will be November 16, 2004. The quarterly dividend payment will be approximately $6,200. The board of directors presently anticipates that it will declare a regular quarterly dividend so long as the present tax treatment of dividends exists and adequate levels of liquidity are maintained.
On October 4, 2004, the Working Families Tax Relief Act of 2004 was signed into law. This legislation extended the research and development (R&D) tax credit for 18 months, from July 1, 2004 to December 31, 2005, allowing U.S. companies conducting qualifying research and development activities to receive a tax credit of up to 10 percent of R&D spending. The additional tax credit is estimated to be approximately $620 for this fiscal year and will be reflected in the fourth quarter tax rate.
On October 22, 2004, the American Jobs Creation Act of 2004 was signed into law. This legislation repeals export tax benefits, which have historically reduced our effective tax rate. This legislation transitions the repeal by allowing 100 percent of 2004, 80 percent of 2005 and 60 percent of 2006 export benefits. The legislation also transitions in a new tax deduction for US manufacturing, which will benefit ADTRAN. We do not expect the legislation to have any material effect on our 2004 tax expense and are currently evaluating the impact on future years.
During the first 5 days of November 2004, ADTRAN repurchased 497 shares of its common stock at an average price of $21.61 through open market purchases.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements made by or on behalf of ADTRAN. ADTRAN and its representatives may from time to time make written or oral forward-looking statements, including statements contained in this report, in our other filings with the Securities and Exchange Commission (SEC) and in our reports to our stockholders. Generally, the words “believe,” “expect,” “intend,” “estimate,” “anticipate,” “will,” “may,” “could” and similar expressions identify forward-looking statements. We caution you that any forward-looking statements made by us or on our behalf are subject to uncertainties and other factors that could cause such statements to be wrong. Some of these uncertainties and other factors are listed below. They have been discussed in our most recent Form 10-K filed on March 12, 2004 with the SEC. Though we have attempted to list comprehensively these important factors, we caution investors that other factors may prove to be important in the future in affecting our operating results. New factors emerge from time to time, and it is not possible for us to predict all of these factors, nor can we assess the impact each factor or combination of factors may have on our business.
You are further cautioned not to place undue reliance on these forward-looking statements because they speak only of our views as of the date that the statements were made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
The following are some of the risks that could affect our financial performance or could cause actual results to differ materially from those expressed or implied in our forward-looking statements:
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The foregoing list of risks is not exclusive.
OVERVIEW
ADTRAN designs, develops, manufactures, markets, and services a broad range of high-speed network access products utilized by providers of telecommunications services and enterprise end-users. We currently sell our products to a large number of carriers, including all Regional Bell Operating Companies (RBOCs), and to private and public enterprises worldwide.
Sales and earnings continue to grow due to our strategy of increasing unit volume and market share through the introduction of new products and succeeding generations of products having lower selling prices and increased functionality as compared to both the prior generation of a product and to the products of competitors. An important part of ADTRAN’s strategy is to reduce the cost of each succeeding product generation and then to lower the product’s selling price based on the cost savings achieved. As a part of this strategy, we seek to be a high-quality, low-cost provider of products in our markets. ADTRAN’s success to date is attributable in large measure to our ability to design our products initially with a view to their subsequent redesign, allowing both increased functionality and reduced manufacturing costs in each succeeding product generation. This strategy enables ADTRAN to sell succeeding generations of products to existing customers, while increasing our market share by selling these enhanced products to new customers.
Our sales and earnings increased from the third quarter of 2003 to the third quarter of 2004. The quarter-over-quarter increase in sales and earnings is attributable to an increase in sales of our HDSL/ T1 products, partially offset by decreased sales of our Digital Business Transport (DBT)/Total Reach products. The decrease in Digital Business Transport (DBT)/Total Reach sales is the result of newer and higher-speed technologies replacing the lower-speed technology of ISDN and DDS products. DBT/Total Reach is a
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declining market, which is being replaced by our higher-speed DSL technology. The increase in gross margin, as a percentage of sales, is primarily related to manufacturing efficiencies, the timing differences between the recognition of cost reductions and the lowering of product selling prices and the sales of higher margin new products.
Our operating results have fluctuated on a quarterly basis in the past, and operating results may vary significantly in future periods due to a number of factors. We normally operate with very little order backlog. A majority of our sales in each quarter result from orders booked in that quarter and firm purchase orders released in that quarter by customers under agreements containing non-binding purchase commitments. Furthermore, a majority of customers typically require prompt delivery of products. This results in a limited backlog of orders for these products and requires us to maintain sufficient inventory levels to satisfy anticipated customer demand. If near-term demand for ADTRAN’s products declines, or if potential sales in any quarter do not occur as anticipated, our financial results could be adversely affected. Operating expenses are relatively fixed in the short term; therefore, a shortfall in quarterly revenues could significantly impact ADTRAN’s financial results in a given quarter. Further, maintaining sufficient inventory levels to assure prompt delivery of our products increases the amount of inventory which may become obsolete and increases the risk that the obsolescence of such inventory may have an adverse effect on our business and operating results.
ADTRAN’s operating results may also fluctuate as a result of a number of other factors, including increased competition, customer order patterns, changes in product mix, timing differences between price decreases and product cost reductions, product warranty returns, and announcements of new products by ADTRAN or our competitors. Accordingly, ADTRAN’s historical financial performance is not necessarily a meaningful indicator of future results, and, in general, management expects that ADTRAN’s financial results may vary from period to period.
Critical Accounting Policies
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements. These policies have been consistently applied across our two reportable segments: (1) Carrier Networks Division and (2) Enterprise Networks Division.
We participate in cooperative advertising and market development programs with certain customers. We use these programs to reimburse customers for certain forms of advertising, and in general, to allow our customers credits up to a specified percentage of their net purchases. Our costs associated with these programs are estimated and accrued at the time of sale and are included in marketing expenses in our consolidated statements of income. We also participate in rebate programs to provide
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sales incentives for certain products. Our costs associated with these programs are estimated and accrued at the time of sale, and are recorded as a reduction of sales in our consolidated statements of income. Sales returns are accrued based on historical sales return experience, which we believe provides a reasonable estimate of future returns. Product returns are generally limited to customers who purchase our products under specific sales agreements that govern their rights of return.
Prior to accepting a new customer, we perform a detailed credit review of the customer. Credit limits are established for each new customer based on the results of this credit review. Payment terms are established for each new customer, and collection experience is reviewed periodically in order to determine if the customer’s payment terms and credit limits need to be revised. We maintain allowances for doubtful accounts for losses resulting from the inability of our customers to make required payments. If the financial conditions of our customers were to deteriorate, resulting in an impairment of their ability to make payments, we might be required to make additional allowances. If circumstances change with regard to individual receivable balances that had previously been determined to be uncollectible (and for which a specific reserve had been established), a reduction in our allowance for doubtful accounts may be required. Our allowance for doubtful accounts was $599 thousand and $1.7 million at September 30, 2004 and December 31, 2003, respectively.
We review our investment portfolio for potential “other-than-temporary” declines in value on an individual investment basis. We assess, on a quarterly basis, significant declines in value which may be considered other-than-temporary and, if necessary, recognize and record the appropriate charge to write-down the carrying value of such investments. In making this assessment, we take into consideration a wide range of objective and subjective information, including but not limited to the following: the magnitude and duration of historical decline in market prices, credit rating activity, assessments of liquidity, public filings, and statements made by the issuer. We generally begin our identification of potential other-than-temporary impairments by reviewing any security with a market value that has declined from its original or adjusted cost basis by 25% for more than six months. We then evaluate the individual security based on the previously identified factors to determine the amount of any write-down. Actual losses, if any, could ultimately differ from these estimates. Future adverse changes in market conditions or poor operating results of underlying investments could result in additional losses that may not be reflected in an investment’s current carrying value, thereby possibly requiring an impairment charge in the future.
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We also invest in privately held entities and record our investments in these entities at cost. We review our investments in these entities periodically in order to determine if circumstances (both financial and non-financial) exist that indicate that we will not recover our initial investment. Impairment charges are recorded on investments having a cost basis that is greater than the value that we would reasonably expect to receive in an arm’s length sale of the investment.
RESULTS OF OPERATIONS – THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2003
SALES
ADTRAN’s sales increased 8.6% from $106.2 million in the three months ended September 30, 2003 to $115.3 million in the three months ended September 30, 2004. Sales increased 23.7% from $282.9 million in the nine months ended September 30, 2003 to $349.9 million in the nine months ended September 30, 2004. The increase is primarily the result of increasing unit volume and market share gains. The increase in overall sales from the third quarter of 2003 to the third quarter of 2004 is primarily attributable to an increase in sales of our High-bit-rate Digital Subscriber Line (HDSL)/T1 products, partially offset by decreased sales of our Digital Business Transport (DBT)/Total Reach products. The increase in overall sales from the nine months ended September 30, 2003 to the nine months ended September 30, 2004 is primarily attributable to an increase in sales of our Systems products and HDSL/T1 products, partially offset by decreased sales of our DBT/Total Reach products. The increase in HDSL/ T1 revenue is primarily attributable to increasing Carrier Networks sales of our HDSL based Total Access 3000 broadband platform. The increase in Systems revenue in nine months ended September 30, 2004 is attributable to sales of DSLAMs, Integrated Access Devices, optical access products and NetVanta products.
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Carrier Networks sales increased 12.1% from $73.6 million in the three months ended September 30, 2003 to $82.5 million in the three months ended September 30, 2004 and increased 27.7% from $193.5 million in the nine months ended September 30, 2003 to $247.2 million in the nine months ended September 30, 2004. The increase in Carrier Networks sales from the third quarter of 2003 to the third quarter of 2004 is primarily attributable to market share gains of our HDSL based Total Access 3000 broadband platform. The increase in Carrier Networks sales from the nine months ended September 30, 2003 to the nine months ended September 30, 2004 is primarily attributable to new product acceptance of and market share gains in DSLAMs and optical access products. Carrier Networks sales as a percentage of total sales increased from 69.3% in the three months ended September 30, 2003 to 71.5% in the three months ended September 30, 2004 and increased from 68.4% in the nine months ended September 30, 2003 to 70.6% in the nine months ended September 30, 2004.
Enterprise Networks sales increased 0.6% from $32.6 million in the three months ended September 30, 2003 to $32.8 million in the three months ended September 30, 2004 and increased 14.9% from $89.3 million in the nine months ended September 30, 2003 to $102.6 million in the nine months ended September 30, 2004. The increase in Enterprise Networks sales from the third quarter of 2003 to the third quarter of 2004 is primarily attributable to market share gains in NetVanta products, partially offset by decreased sales of our traditional products. The increase in Enterprise Networks sales from the nine months ended September 30, 2003 to the nine months ended September 30, 2004 is primarily attributable to new product acceptance of and market share gains in Integrated Access Devices and NetVanta products. Enterprise Networks sales as a percentage of total sales decreased from 30.7% for the three months ended September 30, 2003 to 28.5% for the three months ended September 30, 2004 and decreased from 31.6% for the nine months ended September 30, 2003 to 29.4% for the nine months ended September 30, 2004.
Foreign sales increased 60.5% from $4.3 million in the three months ended September 30, 2003 to $6.9 million in the three months ended September 30, 2004 and increased 67.7% from $12.7 million in the nine months ended September 30, 2003 to $21.3 million in the nine months ended September 30, 2004. The increase in foreign sales is attributable to an overall increase in demand in Australia and Canada.
COST OF SALES
As a percentage of sales, cost of sales decreased from 44.5% in the three months ended September 30, 2003 to 42.0% in the three months ended September 30, 2004 and decreased from 45.0% in the nine months ended September 30, 2003 to 42.2% in the nine months ended September 30, 2004. Carrier Networks cost of sales, as a percent of division sales, decreased from 45.6% in the three months ended September 30, 2003 to 43.2% in the three months ended September 30, 2004 and decreased from 46.1% in the nine months ended September 30, 2003 to 43.6% in the nine months ended September 30, 2004. Enterprise Networks cost of sales, as a percent of division sales, decreased from 42.2% in the three months ended September 30, 2003 to 39.0% in the three months ended September 30, 2004 and decreased from 42.4% in the nine months ended September 30, 2003 to 38.9% in the nine months ended September 30, 2004. These decreases in cost of sales as a percentage of sales are primarily related to manufacturing efficiencies, the timing differences between the recognition of cost reductions and the lowering of product selling prices and the sales of higher margin new products.
An important part of ADTRAN’s strategy is to reduce the product cost of each succeeding product generation and then to lower the product’s price based on the cost savings achieved. This strategy, as described above, sometimes results in variations in ADTRAN’s gross profit margin from quarter to quarter due to timing differences between the recognition of cost reductions and the lowering of product selling prices. In view of the rapid pace of new product introductions by ADTRAN, it is difficult to predict the gross margin for any particular financial period.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses increased 7.7% from $20.6 million in the three months ended September 30, 2003 to $22.2 million in the three months ended September 30, 2004 and increased 12.1%
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from $61.1 million in the nine months ended September 30, 2003 to $68.5 million in the nine months ended September 30, 2004. The increase in selling, general and administrative expenses is primarily related to the increase in sales expense, related to higher sales, annual merit increases and an increase in bad debt expense, primarily due to $977 thousand of bad debt expense recorded in the second quarter ended June 30, 2004, principally related to financial difficulties at one of our customers. The receivable was written off in the three months ended September 30, 2004.
Selling, general and administrative expenses as a percentage of sales decreased from 19.4% in the three months ended September 30, 2003 to 19.3% in the three months ended September 30, 2004 and decreased from 21.6% in the nine months ended September 30, 2003 to 19.6% in the nine months ended September 30, 2004. The decrease in selling, general and administrative expenses as a percent of sales is due to our continued control of discretionary spending as sales increased. Selling, general and administrative expenses as a percent of sales will fluctuate whenever there is a significant fluctuation in revenues during the periods being compared.
RESEARCH AND DEVELOPMENT EXPENSES
Research and development expenses increased 26.0% from $15.0 million in the three months ended September 30, 2003 to $18.9 million in the three months ended September 30, 2004 and increased 15.6% from $42.9 million in the nine months ended September 30, 2003 to $49.6 million in the nine months ended September 30, 2004. The increase in research and development expense is primarily related to an increase in new product approvals and development activities. As a percentage of sales, research and development expenses increased from 14.1% in the three months ended September 30, 2003 to 16.4% in the three months ended September 30, 2004 and decreased from 15.2% in the nine months ended September 30, 2003 to 14.2% in the nine months ended September 30, 2004. The decrease in research and development expenses as a percent of sales in the nine months ended September 30, 2004 is due to our continued control of discretionary spending as sales increased. Research and development expenses as a percent of sales will fluctuate whenever there is a significant fluctuation in revenues during the periods being compared.
ADTRAN will continue to incur research and development expenses in connection with its new products and its expansion into international markets. ADTRAN continually evaluates new product opportunities and engages in intensive research and product development efforts. ADTRAN expenses all product research and development costs as incurred. As a result, ADTRAN may incur significant research and development expenses prior to the receipt of revenues from a major new product group.
INTEREST INCOME
Interest income decreased 28.6% from $2.1 million in the three months ended September 30, 2003 to $1.5 million in the three months ended September 30, 2004 and decreased 16.4% from $6.7 million in the nine months ended September 30, 2003 to $5.6 million in the nine months ended September 30, 2004. This decrease is primarily related to lower interest rates associated with shorter-term securities in our investment portfolio.
INTEREST EXPENSE
Interest expense remained relatively stable at $632 thousand and $644 thousand in the three months ended September 30, 2004 and 2003, respectively, and remained stable at $1.9 million in each of the nine months ended September 30, 2004 and September 30, 2003.
NET REALIZED INVESTMENT GAIN
Net realized investment gain increased from $0 in the three months ended September 30, 2003 to $646 thousand in the three months ended September 30, 2004 and increased from $226 thousand in the nine months ended September 30, 2003 to $590 thousand in the nine months ended September 30, 2004. This increase was primarily the result of the sale of public equity securities associated with the realignment of our investment portfolio.
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OTHER INCOME (EXPENSE)
Other income (expense), comprised primarily of miscellaneous income, gains and losses on foreign currency transactions and scrap raw material sales, decreased from income of $976 thousand in the three months ended September 30, 2003 to expense of $33 thousand in the three months ended September 30, 2004 and decreased from $1.9 million in the nine months ended September 30, 2003 to $858 thousand in the nine months ended September 30, 2004. This decrease is primarily related to a cash settlement from a former customer, relating to the prior year, during the three months ended September 30, 2003, and a decrease in gains on foreign currency transactions and scrap raw material sales during the nine months ended September 30, 2004.
INCOME TAXES
Our effective tax rate decreased from 33.2% in the three months ended September 30, 2003 to 31.2% in the three months ended September 30, 2004 and increased from 31.5% in the nine months ended September 30, 2003 to 32.1% in the nine months ended September 30, 2004. The increase in our year to date tax rate is primarily related to a higher mix of taxable income and lower research and development tax credits and economic incentive credits as a percent of taxable income.
NET INCOME
As a result of the above factors, net income increased $1.6 million from $17.2 million in the three months ended September 30, 2003 to $18.8 million in the three months ended September 30, 2004 and increased $20.4 million from $40.1 million in the nine months ended September 30, 2003 to $60.5 million in the nine months ended September 30, 2004. As a percentage of sales, net income increased from 16.2% in the three months ended September 30, 2003 to 16.3% in the three months ended September 30, 2004 and increased from 14.2% in the nine months ended September 30, 2003 to 17.3% in the nine months ended September 30, 2004.
LIQUIDITY AND CAPITAL RESOURCES
Fifty million dollars of the expansion of Phase III of our corporate headquarters was approved for participation in an incentive program offered by the Alabama State Industrial Development Authority (the “Authority”). Pursuant to the program, on January 13, 1995, the Authority issued $20.0 million of its taxable revenue bonds and loaned the proceeds from the sale of the bonds to ADTRAN. The bonds were originally purchased by AmSouth Bank of Alabama, Birmingham, Alabama, (the “Bank”). First Union National Bank of Tennessee, Nashville, Tennessee, (the “Bondholder”) purchased the original bonds from the Bank and made further advances to the Authority, bringing the total amount outstanding to $50.0 million. The incentive program enables participating companies to generate Alabama corporate income tax credits that can be used to reduce the amount of Alabama corporate income taxes that would
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otherwise be payable. We cannot be certain that the state of Alabama will continue to make these corporate income tax credits available in the future, and therefore, we may not realize the full benefit of these incentives. Through September 30, 2004, the Authority had issued $50.0 million of its taxable revenue bonds pursuant to the incentive program and loaned the proceeds from the sale of the bonds to ADTRAN. We are required to make payments to the Authority in the amounts necessary to pay the principal of and interest on the Authority’s Taxable Revenue Bond, Series 1995, as amended, currently outstanding in the aggregate principal amount of $50.0 million. The bond matures on January 1, 2020, and bears interest at the rate of 5%. Included in long-term investments are $50.0 million of restricted funds, which is a collateral deposit against the principal amount of this bond. In conjunction with this program, we are eligible to receive certain economic incentives from the state of Alabama that reduce the amount of payroll withholdings that we are required to remit to the state for those employment positions that qualify under the program.
In July 2003, the board of directors elected to begin declaring quarterly dividends on our common stock, and anticipates that it will declare a regular quarterly dividend so long as the present tax treatment of dividends exists and adequate levels of liquidity are maintained. The board declared a quarterly cash dividend on January 20, 2004 of $0.08 per common share to be paid to holders of record at the close of business on February 3, 2004, with a payment date of February 17, 2004. The quarterly dividend payment was approximately $6.4 million. On April 13, 2004, the board of directors declared a quarterly cash dividend of $0.08 per common share to be paid to stockholders of record at the close of business on May 4, 2004. The quarterly dividend payment was approximately $6.3 million. On July 12, 2004, the board of directors declared a quarterly cash dividend of $0.08 per common share to be paid to stockholders of record at the close of business on August 3, 2004. The quarterly dividend payment was approximately $6.3 million. On October 11, 2004, the board of directors declared a quarterly cash dividend of $0.08 per common share to be paid to stockholders of record at the close of business on November 2, 2004. The payment date will be November 16, 2004. The quarterly dividend payment will be approximately $6.2 million.
On October 13, 2003, we announced that our board of directors declared, effective December 15, 2003, a two-for-one stock split to be effected in the form of a stock dividend of one share of common stock for each outstanding share of common stock for stockholders of record on December 1, 2003. Share and per share amounts, including stock options, in the accompanying Consolidated Financial Statements and Notes to Consolidated Financial Statements have been adjusted to reflect this stock split.
Our working capital, which consists of current assets less current liabilities, increased 16.7% from $220.1 million as of December 31, 2003 to $256.8 million as of September 30, 2004. The quick ratio, defined as cash, cash equivalents, short-term investments, and net accounts receivable, divided by current liabilities, increased from 4.87 as of December 31, 2003 to 6.63 as of September 30, 2004. The current ratio, defined as current assets divided by current liabilities, increased from 6.46 as of December 31, 2003 to 8.28 as of September 30, 2004. The increase in these liquidity ratios is primarily related to increases in cash and cash equivalents, short-term investments, accounts receivable and inventory. The increase in cash and cash equivalents and the corresponding decrease in long term investments is primarily related to the continued shortening of the average life of the investments in our investment portfolio. Additionally, the liquidity ratios were also affected by the change in our income tax position. As of December 31, 2003, we had an income tax receivable of $11.6 million. This income tax receivable was generated in the fourth quarter of 2003 from the tax benefit associated with the exercise of non-qualified stock options. During the first quarter of 2004, we received a tax refund for this overpayment. As of September 30, 2004, we had an income tax receivable of $2.7 million. This income tax receivable was generated in the third quarter of 2004 from a tax refund filing related to a prior year. During the fourth quarter of 2004, we received this tax refund.
We receive an income tax deduction for the difference between the exercise price and the market price of non-qualified stock options upon exercise by employees. We recorded $2.7 million and $23.6 million during the nine months ended September 30, 2004 and the year ended December 31, 2003, respectively, as an income tax deduction for the difference between the exercise price and the market price of non-qualified stock option exercises.
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At September 30, 2004, our cash on hand of $144.2 million and short-term investments of $25.0 million placed our short-term liquidity in cash, cash equivalents, and short-term investments at $169.2 million. At December 31, 2003, our cash on hand of $132.1 million and short-term investments of $11.9 million placed our short-term liquidity in cash, cash equivalents, and short-term investments at $144.0 million. This increase is primarily attributable to our ability to generate cash from operations, the sale of long-term investments and the purchase of short-term bonds, the movement of bonds maturing within one year from long-term investments to short-term investments, and the proceeds received from the exercise of employee stock options.
At September 30, 2004, our long-term investments decreased by 25.9% to $173.1 million from $233.7 million at December 31, 2003. This decrease is primarily attributable to the sale of long-term investments, and the movement of bonds maturing within one year from long-term investments to short-term investments. Long-term investments at September 30, 2004 and December 31, 2003 include a restricted balance of $50.0 million related to our revenue bonds, as discussed above. We intend to finance our operations in the future with cash flow from operations and our remaining borrowed taxable revenue bond proceeds. We believe these available sources of funds to be adequate to meet our operating and capital needs for the foreseeable future.
Net accounts receivable increased 22.9% from December 31, 2003 to September 30, 2004. Our allowance for doubtful accounts decreased $1.1 million from December 31, 2003 to September 30, 2004 primarily as a result of the write-off of accounts receivable for a customer who entered Chapter 7 bankruptcy proceedings. Quarterly accounts receivable days sales outstanding increased 9 days from 42 days as of December 31, 2003 to 51 days as of September 30, 2004. This increase in accounts receivable and quarterly accounts receivable days sales outstanding is caused by seasonality of sales. Other receivables decreased 33.4% from December 31, 2003 to September 30, 2004, primarily resulting from variations of timing of payments from subcontractors. Quarterly inventory turnover decreased from 4.86 turns as of December 31, 2003 to 4.44 turns as of September 30, 2004. The decrease in inventory turnover is attributable to an increase in inventory in anticipation of increased sales.
Accounts payable decreased 6.4% from December 31, 2003 to September 30, 2004. Accrued expenses increased 41.0% from December 31, 2003 to September 30, 2004. These changes are primarily related to the variations of timing of payments, an increase in new product approvals and development activities, and an increase in our rebate accrual. Capital expenditures totaled approximately $5.1 million and $4.3 million for the nine months ended September 30, 2004 and 2003, respectively. These expenditures were primarily used to purchase computer hardware, computer software, manufacturing equipment, and test equipment.
In July 2001, the board of directors approved the repurchase of 2 million shares of ADTRAN common stock on a pre-split basis. The total number of shares authorized were not affected by the stock split. During April 2004, with the purchase of 323,400 shares, we completed our July 2001 share repurchase plan at a total cost for the plan of $39.7 million.
On April 29, 2004 the board of directors approved the repurchase of up to 4 million shares of ADTRAN common stock through open market purchases from time to time as conditions warrant. As of September 30, 2004, we had repurchased 2,502,100 shares of our common stock at a total cost of $62.2 million and had the authority to purchase an additional 1,497,900 shares.
We issued 396,831 shares of common stock, of which 39,230 shares were treasury stock, for $5.0 million during the nine months ended September 30, 2004, to accommodate employee stock option exercises. During 2003, we issued 4,529,271 shares of common stock, of which 4,125,242 shares were treasury stock, for $55.1 million to accommodate employee stock option exercises.
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We have used, and expect to continue to use, the cash generated from operations for working capital, dividend payments, and other general corporate purposes, including (i) product development activities to enhance our existing products and develop new products and (ii) expansion of sales and marketing activities.
During the nine months ended September 30, 2004, there have been no material changes in contractual obligations and commercial commitments from those discussed in our most recent Form 10-K filed on March 12, 2004. We do not have off-balance sheet financing arrangements and have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of or requirements for capital resources. We have committed to invest up to an aggregate of $7.9 million in two private equity funds, of which $2.1 million has been invested to date. The duration of each of these commitments is five years with $2.9 million expiring in 2005 and $5.0 million expiring in 2007.
EFFECT OF RECENT ACCOUNTING PRONOUNCEMENTS
In March 2004, the Financial Accounting Standards Board (“FASB”) reached consensus on the guidance provided by Emerging Issues Task Force Issue 03-1 (“EITF 03-1”), The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. The guidance is applicable to debt and equity securities that are within the scope of FASB Statement of Financial Accounting Standard (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities and Certain Other Investments. EITF 03-1 specifies that an impairment would be considered other-than-temporary unless (a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment and (b) evidence indicating the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. The disclosure provisions of EITF 03-1 for investments accounted for under Statements 115 and 124 were effective for annual reporting periods ending after December 15, 2003. In September 2004, the EITF delayed the effective date for the measurement and recognition guidance included in paragraphs 10 through 20 of EITF 03-1. The disclosures required of EITF 03-1, paragraphs 21 and 22, have not been deferred. We continue to evaluate all existing and future investments in order to determine the applicability of EITF 03-1.
During September 2004, the Emerging Issues Task Force (“EITF”) released Issue 04-08, “The Effect of Contingently Convertible Debt on diluted Earnings per Share.” Issue 04-08 provides guidance on when the dilutive effect of contingently convertible debt securities with a market price trigger should be included in the computation of diluted earnings per share (“EPS”). The guidance is effective as of December 31, 2004 and would be applied by retrospectively restating previously reported EPS. We anticipate that the adoption of this guidance will not have a material effect on the computation of EPS as we do not have contingently convertible debt. In addition, the FASB is amending FAS 128 to make it consistent with International Accounting Standard 33, (IAS 33), and to make EPS computations comparable on a global basis. The amended standard is expected to be effective for all periods ending after December 15, 2004. We anticipate that the adoption of the amended standard will not have a material effect on the computation of our EPS.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ADTRAN has not conducted transactions, established commitments or entered into relationships requiring disclosures beyond those provided elsewhere in this Form 10-Q.
ITEM 4. CONTROLS AND PROCEDURES
(a)Evaluation of disclosure controls and procedures. Our chief executive officer and chief financial officer are responsible for establishing and maintaining “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e)) for the company. Our chief executive officer and chief financial officer, after evaluating the effectiveness of our disclosure controls and procedures as of the end of the period covered by this quarterly report, have concluded that our disclosure controls and procedures are adequate and effective in timely alerting them to material information relating to us (including our consolidated subsidiaries) required to be included in our periodic SEC filings.
(b) Changes in internal control over financial reporting.There were no changes in our internal control over financial reporting that occurred during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Item 2(a) and (b) are inapplicable.
(c) Stock Repurchases
The following table sets forth ADTRAN’s repurchases of its common stock for the months indicated. All shares were purchased in open market transactions.
Period
July 1, 2004
July 1, 2004 – July 31, 2004
August 1, 2004 – August 31, 2004
September 1, 2004 – September 30, 2004
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ITEM 6. EXHIBITS
Exhibits.
Description
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
(Registrant)
Date: November 8, 2004
/s/ James E. Matthews
James E. Matthews
Senior Vice President - Finance and
Chief Financial Officer
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EXHIBIT INDEX
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