UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-Q
For the Quarterly Period Ended March 31, 2005
OR
For the Transition Period from to
Commission File Number 0-24612
ADTRAN, INC.
(Exact name of Registrant as specified in its charter)
(I.R.S. Employer
Identification No.)
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 April 30, 2005
Common Stock, $.01 Par Value
Quarterly Report on Form 10-Q
For the Quarter Ended March 31, 2005
Table of Contents
Page
Number
Financial Statements:
Consolidated Balance Sheets as of March 31, 2005 (Unaudited) and December 31, 2004
Consolidated Statements of Income for the three months ended March 31, 2005 and 2004 – (Unaudited)
Consolidated Statements of Cash Flows for the three months ended March 31, 2005 and 2004 – (Unaudited)
Notes to Consolidated Financial Statements – (Unaudited)
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Quantitative and Qualitative Disclosures About Market Risk
Controls and Procedures
Unregistered Sales of Equity Securities and Use of Proceeds
Exhibits
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
(In thousands)
March 31,
2005
December 31,
2004
ASSETS
Current assets
Cash and cash equivalents
Short-term investments
Accounts receivable, less allowance for doubtful accounts of $344 and $361 at March 31, 2005 and December 31, 2004, 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 shares issued at March 31, 2005 and December 31, 2004
Additional paid-in capital
Accumulated other comprehensive income
Retained earnings
Less treasury stock at cost: 4,368 shares at March 31, 2005 and 3,238 shares at December 31, 2004
Total stockholders’ equity
Total liabilities and stockholders’ equity
See notes to consolidated financial statements
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CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
(In thousands, except per share amounts)
Three Months Ended
Sales
Cost of sales (See Note 1)
Gross profit
Selling, general and administrative expenses (See Note 1)
Research and development expenses
Operating income
Interest income
Interest expense
Net realized investment gain (loss)
Other income, 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)
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CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation
Loss (gain) on sale of long-term investments
Gain 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
Proceeds from sales of available-for-sale investments
Purchases of available-for-sale investments
Net cash 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, as discussed below, have been made to the 2004 consolidated financial statements in order to conform to the 2005 presentation. These reclassifications had no effect on previously reported net income, cash flows from operations, or total stockholders’ equity.
Operating results for the three months ended March 31, 2005 are not necessarily indicative of the results that may be expected to occur for the year ending December 31, 2005. 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, 2004.
In the first quarter of 2005, ADTRAN reclassified certain purchasing costs related to procurement of materials from selling, general and administrative expenses (SG&A) to cost of sales. The tables below present the reclassified cost of sales, gross profit, SG&A expenses and the related adjustment for the prior eight quarters.
June 30,
September 30,
Cost of sales
SG&A expenses
Reclassification adjustment
2003
Gross margin
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2. INVENTORY
At March 31, 2005 and December 31, 2004, 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 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 months ended March 31, 2005 and 2004 is as follows:
Income
(Numerator)
Shares
(Denominator)
Per-Share
Amount
Basic EPS
Income available to common stockholders
Effect of Dilutive Securities
Stock options
Diluted EPS
Income available to common stockholders plus assumed conversions
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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 ADTRAN’s common shares, therefore making them anti-dilutive under the treasury method.
Anti-Dilutive Options Outstanding
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 following table presents information about the reported sales and gross profit of our reportable segments for the three months ended March 31, 2005 and 2004 reconciled to net income. Asset information by reportable segment is not reported, since we do not produce such information internally.
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Sales by Market Segment
March 31, 2005
March 31, 2004
Carrier Networks
Enterprise Networks
Selling, general and administrative expense
Research and development expense
Other income (expense), net
The table below presents sales information by geographic region for the three months ended March 31, 2005 and 2004.
Sales by Geographic Region
United States
Foreign
Total
Sales by Product
The Digital Business Transport (DBT)/Total Reach® category is comprised of revenue from Integrated Services Digital Network (ISDN) and Digital Data Services (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, Digital Subscriber Lines Access Multiplexer (DSLAM) products, optical access products and NetVanta products comprised of access routers, ethernet switches, and Virtual Private Network (VPN) products, and other access products.
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The table below presents sales information by product for the three months ended March 31, 2005 and 2004.
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 ten 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 product failures. The liability for warranty returns totaled $1,605 and $1,560 at March 31, 2005 and December 31, 2004, respectively. These liabilities are included in accrued expenses in the accompanying consolidated balance sheets.
Three months ended March 31, 2005
Balance at
Additions
Charged
(Credited) to Costs
& Expenses
Warranty liability
7. STOCK-BASED COMPENSATION
ADTRAN applies Accounting Principles Board (“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 Statement of Financial Accounting Standard (“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
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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
8. STOCKHOLDERS’ EQUITY
A summary of the changes in stockholders’ equity for the three months ended March 31, 2005 is as follows:
Balance, December 31, 2004
Change in unrealized gain on marketable securities (net of deferred taxes)
Unrealized foreign currency translation (net of deferred taxes)
Exercise of stock options
Balance, March 31, 2005
On January 24, 2005 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 4, 2005. The payment date of the quarterly dividend was February 16, 2005. The quarterly dividend payment was $6,114. 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.
ADTRAN issued 24 shares of treasury stock to fulfill stock option exercises during the three months ended March 31, 2005. The stock options had exercise prices ranging from $8.69 to $18.03. ADTRAN received proceeds totaling $265 from the exercise of these stock options during the three months ended March 31, 2005.
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ADTRAN repurchased 1,154 shares of its common stock through open market purchases at a total cost of $20,737 during the three months ended March 31, 2005 and had the authority to purchase an additional 4,847 shares.
9. RECENTLY ISSUED ACCOUNTING STANDARDS
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 a portion of domestic manufacturing expenditures, which will benefit ADTRAN. The legislation did not have a material effect on our 2004 tax expense. ADTRAN expects the net effect of the phase out of the extra-territorial income (ETI) and phase in of this new deduction to result in a decrease of between 0.50% to 0.75% in the effective tax rate of 2005.
In November 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 151, Inventory Costs – An Amendment of ARB No. 43, Chapter 4. SFAS No. 151 amends the guidance in Accounting Research Bulletin (ARB) No. 43, Chapter 4, Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Among other provisions, the new rule requires that items such as idle facility expense, excessive spoilage, double freight, and rehandling costs be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal” as stated in ARB No. 43. Additionally, SFAS No. 151 requires that the allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005, and is required to be adopted by ADTRAN effective January 1, 2006. We do not expect SFAS No. 151 to have a material impact on our consolidated results of operations or financial condition.
In December 2004, the FASB issued SFAS No. 123R, Accounting for Stock Based Compensation. SFAS No. 123R revises the guidance in SFAS No. 123 and supercedes APB 25 and its related implementation guidance. SFAS No. 123R focuses primarily on the accounting for share-based payments to employees in exchange for services, and it requires a public entity to measure and recognize compensation cost for these payments. SFAS No. 123R is effective for the first fiscal year beginning after June 15, 2005 (fiscal year 2006 for ADTRAN). SFAS No. 123R requires ADTRAN to recognize the cost of employee services received in exchange for its equity instruments. Currently, in accordance with APB 25, we record the intrinsic value of stock-based compensation as expense. Accordingly, no compensation expense is currently recognized for fixed stock option plans as the exercise price equals the stock price on the date of grant. Under SFAS No. 123R, ADTRAN will be required to measure compensation expense over the options’ vesting period based on the stock options’ fair value at the date the options are granted. SFAS No. 123R allows for the use of the Black-Scholes or a lattice option-pricing model to value such options.
ADTRAN has determined that it will use the Black-Scholes option-pricing model to calculate the fair value of its options. As allowed by SFAS No. 123R, ADTRAN can elect the Modified Prospective Application, which applies the Statement to new awards and modified awards after the effective date, and to any unvested awards as service is rendered on or after the effective date, or the Modified Retrospective Application, which can apply the statement to all prior years for which SFAS No. 123 was effective. ADTRAN is currently evaluating which method of application will be used. For a discussion of our stock-based compensation plans and agreements, see Note 7.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets – An Amendment of APB Opinion No. 29. SFAS No. 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, Accounting for Nonmonetary Transactions, and replaces it with an exception for exchanges that do not have commercial substance. SFAS No. 153 specifies that a nonmonetary exchange has commercial substance if the future
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cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is effective for periods beginning after June 15, 2005, and is required to be adopted by ADTRAN effective July 1, 2005. We do not expect SFAS No. 153 to have a material impact on our consolidated results of operations or financial condition.
10. RELATED PARTY TRANSACTIONS
We employ the law firm of our director 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 reasonable and comparable to those charged by other firms for services rendered to us. We paid $31 and $31 during the three months ended March 31, 2005 and 2004, respectively, for these legal services.
One of our non-employee directors is the Vice Chairman – Planning and Administration, 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. We believe these payments are reasonable. For the three months ended March 31, 2005 and 2004 we received payments, directly and indirectly, from this customer in the amount of approximately $4,615 and $5,714, respectively, for products supplied to this customer. In addition, for the three months ended March 31, 2005 and 2004 we paid this customer $149 and $136, respectively, for services provided to us.
11. COMMITMENTS AND CONTINGENCIES
We have certain contingent liabilities from time to time from litigation for employment or other matters arising in the normal course of business. Although the outcome of any litigation 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 three months ended March 31, 2005, there have been no material changes in contractual obligations and commercial commitments from those disclosed in our most recent Form 10-K filed on March 11, 2005. 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 $7,200 in two private equity funds, of which $2,300 has been invested to date. The duration of each of these commitments is five years with $1,300 expiring in 2005 and $3,600 expiring in 2007.
12. SUBSEQUENT EVENTS
On April 18, 2005, 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 May 5, 2005. The payment date will be May 19, 2005. The quarterly dividend payment will be approximately $6,000.
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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 11, 2005 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:
The foregoing list of risks is not exclusive.
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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 the four largest telecommunications providers, and to private and public enterprises worldwide.
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 for the first quarter of 2005 decreased from those for the first quarter of 2004. The quarter-over-quarter decrease in sales and earnings is attributable to a decrease in sales of our HDSL/ T1 products and a decrease in sales of our Digital Business Transport (DBT)/Total Reach products, partially offset by increased sales of our Systems 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 declining market, which is being replaced by our higher-speed DSL technology. The increase in Systems products sales is due to increased shipments of NetVanta and optical access products. 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 consolidated financial statements. These policies have been consistently applied across our two reportable segments: (1) Carrier Networks Division and (2) Enterprise Networks Division.
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Sales returns are accrued based on historical sales return experience, which we believe provides a reasonable estimate of future returns. The majority of Enterprise Networks products are sold in the United States through a non-exclusive distribution network of major technology distributors and system integrators. These large distribution organizations then sell to an extensive network of value-added resellers and system integrators. Value-added resellers and system integrators may be affiliated with us as a channel partner, or they may purchase from the distributor in an unaffiliated fashion. Our distributors may return products to us that are damaged or defective upon receipt for replacement. Additionally, our distributors may return unused and unopened product for stock-balancing purposes when such returns are accompanied by offsetting orders for products of equal or greater value.
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 selling, general and administrative expenses in our consolidated statements of income. We also participate in rebate programs to provide 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.
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 deteriorate, resulting in an impairment of their ability to make payments, we may be required to make additional allowances. If circumstances change with regard to individual receivable balances that have previously been determined to be uncollectible (and for which a specific reserve has been established), a reduction in our allowance for doubtful accounts may be required. Our allowance for doubtful accounts was $0.3 million and $0.4 million at March 31, 2005 and December 31, 2004, respectively.
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amount equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual future demand or market conditions are less favorable than those projected by management, we may be required to make additional inventory write-downs. Our reserve for excess and obsolete inventory was $4.6 million and $4.8 million at March 31, 2005 and December 31, 2004, 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 the write-down, if any. 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.
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.
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returns totaled $1.6 million at March 31, 2005 and December 31, 2004. These liabilities are included in accrued expenses in the accompanying consolidated balance sheets. Our estimates regarding future warranty obligations may change due to product failure rates, shipment volumes, and other rework costs incurred in correcting a product failure. If our estimates change in the future, the liability for warranty returns we have established may be increased or decreased, impacting future cost of goods sold.
RESULTS OF OPERATIONS – THREE MONTHS ENDED MARCH 31, 2005 COMPARED TO THREE MONTHS ENDED MARCH 31, 2004
SALES
ADTRAN’s sales decreased 8.3% from $114.0 million in the three months ended March 31, 2004 to $104.6 million in the three months ended March 31, 2005. The quarter-over-quarter decrease in overall sales is primarily attributable to a decrease in sales of our HDSL/T1 products and a decrease in sales of our DBT/Total Reach products, partially offset by increased sales of our Systems products.
Carrier Networks sales decreased 2.3% from $78.2 million in the three months ended March 31, 2004 to $76.4 million in the three months ended March 31, 2005. The quarter-over-quarter decrease in Carrier Networks sales is primarily attributable a decrease in sales of our HDSL products, partially offset by increased sales of our Systems products. Carrier Networks sales as a percentage of total sales increased from 68.5% in the three months ended March 31, 2004 to 73.1% in the three months ended March 31, 2005.
Enterprise Networks sales decreased 21.7% from $35.9 million in the three months ended March 31, 2004 to $28.1 million in the three months ended March 31, 2005. The quarter-over-quarter decrease in Enterprise Networks sales is primarily attributable to a decline in sales of CSU/DSUs and integrated access devices, partially offset by an increase in sales of NetVanta products. The decrease in integrated access devices is primarily related to a former customer who ceased business in the second quarter of 2004. Enterprise Networks sales as a percentage of total sales decreased from 31.5% for the three months ended March 31, 2004 to 26.9% for the three months ended March 31, 2005.
Foreign sales increased 50.9% from $5.3 million in the three months ended March 31, 2004 to $8.0 million in the three months ended March 31, 2005. 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 42.9% in the three months ended March 31, 2004 to 42.4% in the three months ended March 31, 2005. Carrier Networks cost of sales, as a percent of division sales, decreased from 44.3% in the three months ended March 31, 2004 to 42.2% in the three months ended March 31, 2005. The 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. Enterprise Networks cost of sales, as a percent of division sales, increased from 39.9% in the three months ended March 31, 2004 to 42.9% in the three months ended March 31, 2005. The increase in Enterprise Networks cost of sales, as a percent of division sales, is primarily related to lower net selling prices of traditional products, partially offset by increased 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.
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SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses increased 5.0% from $21.8 million in the three months ended March 31, 2004 to $22.9 million in the three months ended March 31, 2005. The increase in selling, general and administrative expenses is primarily related to increases in insurance costs and professional service costs related to Sarbanes-Oxley compliance.
Selling, general and administrative expenses as a percentage of sales increased from 19.1% in the three months ended March 31, 2004 to 21.9% in the three months ended March 31, 2005. The increase in selling, general and administrative expenses as a percent of sales is due to lower sales in the three months ended March 31, 2005. 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 10.1% from $14.8 million in the three months ended March 31, 2004 to $16.3 million in the three months ended March 31, 2005. 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 13.0% in the three months ended March 31, 2004 to 15.6% in the three months ended March 31, 2005. The increase in research and development expenses as a percent of sales in the three months ended March 31, 2005 is due to the above factors and lower sales in the three months ended March 31, 2005. 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 9.1% from $2.2 million in the three months ended March 31, 2004 to $2.0 million in the three months ended March 31, 2005. This decrease is primarily related to a reduction in our long-term investments resulting from our use of proceeds from the disposition of long-term investments for the purchase of ADTRAN common stock and our dividend payments.
INTEREST EXPENSE
Interest expense remained relatively stable at $583 thousand and $644 thousand in the three months ended March 31, 2005 and 2004, respectively.
NET REALIZED INVESTMENT GAIN (LOSS)
Net realized investment gain (loss) increased from a net loss of $126 thousand in the three months ended March 31, 2004 to a net gain of $481 thousand in the three months ended March 31, 2005. This increase was primarily the result of the sale of public equity securities associated with the realignment of our investment portfolio.
OTHER INCOME (EXPENSE)
Other income (expense), comprised primarily of miscellaneous income, gains and losses on foreign currency transactions and scrap raw material sales, remained relatively stable at $360 thousand and $368 thousand in the three months ended March 31, 2004 and 2005, respectively.
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INCOME TAXES
Our effective tax rate increased from 32.5% in the three months ended March 31, 2004 to 34.4% in the three months ended March 31, 2005. The increase in our year to date tax rate is primarily related to prior year research and development tax credits realized during the first quarter of 2004.
NET INCOME
As a result of the above factors, net income decreased $5.2 million from $20.4 million in the three months ended March 31, 2004 to $15.2 million in the three months ended March 31, 2005. As a percentage of sales, net income decreased from 17.9% in the three months ended March 31, 2004 to 14.5% in the three months ended March 31, 2005.
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”). Wachovia Bank, N.A., Nashville, Tennessee (formerly 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 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 March 31, 2005, 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% per annum. 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, our 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 24, 2005 of $0.08 per common share to be paid to holders of record at the close of business on February 4, 2005, with a payment date of February 16, 2005. The quarterly dividend payment was approximately $6.1 million. On April 18, 2005, 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 5, 2005. The quarterly dividend payment will be approximately $6.0 million.
Our working capital, which consists of current assets less current liabilities, decreased 2.1% from $266.4 million as of December 31, 2004 to $260.8 million as of March 31, 2005. The quick ratio, defined as cash, cash equivalents, short-term investments, and net accounts receivable, divided by current liabilities, decreased from 6.83 as of December 31, 2004 to 6.28 as of March 31, 2005. The current ratio, defined as current assets divided by current liabilities, decreased from 8.40 as of December 31, 2004 to 7.60 as of March 31, 2005. These liquidity ratios have remained relatively stable with the small fluctuations primarily related to the change in our income tax position. As of December 31, 2004, we had an income tax receivable of $2.4 million. This income tax receivable was primarily related to amended tax filings for additional federal research and development tax credits. During the first quarter of 2005, we received this tax refund. As of March 31, 2005, we had an income tax payable of $6.3 million.
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At March 31, 2005, our cash on hand of $48.9 million and short-term investments of $134.1 million placed our short-term liquidity in cash, cash equivalents, and short-term investments at $183.0 million. At December 31, 2004, our cash on hand of $57.6 million and short-term investments of $124.8 million placed our short-term liquidity in cash, cash equivalents, and short-term investments at $182.4 million.
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 $0 and $2.2 million during the three months ended March 31, 2005 and 2004, respectively, as an income tax deduction for the difference between the exercise price and the market price of non-qualified stock option exercises.
At March 31, 2005, our long-term investments decreased by 3.9% to $161.0 million from $167.6 million at December 31, 2004. 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 March 31, 2005 and December 31, 2004 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 1.8% from December 31, 2004 to March 31, 2005. Our allowance for doubtful accounts remained relatively stable at $344 thousand and $361 thousand at March 31, 2005 and December 31, 2004, respectively. Quarterly accounts receivable days sales outstanding remained stable at 56 days as of March 31, 2005 and December 31, 2004. Quarterly inventory turnover remained stable at 4.29 turns as of March 31, 2005 and December 31, 2004.
Accounts payable decreased 2.8% from December 31, 2004 to March 31, 2005. Accrued expenses increased 21.6% from December 31, 2004 to March 31, 2005. These changes are primarily related to the variations in the timing of payments. Capital expenditures totaled approximately $2.6 million and $1.1 million for the three months ended March 31, 2005 and 2004, respectively. These expenditures were primarily used to purchase computer hardware, computer software, manufacturing equipment, and test equipment.
During February 2005, with the purchase of 1,000,700 common shares at an average price of $17.96, we completed our April 29, 2004 stock repurchase plan. On February 11, 2005, ADTRAN announced that its board of directors approved the repurchase of up to an additional 5,000,000 shares of its common stock. This plan will be implemented through open market purchases from time to time as conditions warrant. During February 2005, we purchased 153,351 shares at an average price of $18.03 under the new share repurchase plan. As of March 31, 2005, we had repurchased 1,154,051 shares of our common stock in the first quarter of 2005 at a total cost of $20.7 million and had the authority to purchase an additional 4,846,649 shares.
We issued 24,167 shares of treasury stock for $265 thousand during the three months ended March 31, 2005, to accommodate employee stock option exercises. During 2004, we issued 84,794 shares of treasury stock and 357,601 newly issued shares of common stock for an aggregate of $5.6 million to accommodate employee stock option exercises.
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.
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During the three months ended March 31, 2005, 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 11, 2005. 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 $7.2 million in two private equity funds, of which $2.3 million has been invested to date. The duration of each of these commitments is five years with $1.3 million expiring in 2005 and $3.6 million expiring in 2007.
EFFECT OF RECENT ACCOUNTING PRONOUNCEMENTS
In November 2004, the FASB issued SFAS No. 151, Inventory Costs – An Amendment of ARB No. 43, Chapter 4. SFAS No. 151 amends the guidance in Accounting Research Bulletin (ARB) No. 43, Chapter 4, Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Among other provisions, the new rule requires that items such as idle facility expense, excessive spoilage, double freight, and rehandling costs be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal” as stated in ARB No. 43. Additionally, SFAS No. 151 requires that the allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005, and is required to be adopted by ADTRAN effective January 1, 2006. We do not expect SFAS No. 151 to have a material impact on our consolidated results of operations or financial condition.
In December 2004, the FASB issued SFAS No. 123R, Accounting for Stock Based Compensation. SFAS No. 123R revises the guidance in SFAS No. 123 and supercedes APB 25, and its related implementation guidance. SFAS No. 123R focuses primarily on the accounting for share-based payments to employees in exchange for services, and it requires a public entity to measure and recognize compensation cost for these payments. SFAS No. 123R is effective for fiscal years beginning after June 15, 2005 (fiscal year 2006 for ADTRAN). SFAS No. 123R requires ADTRAN to recognize the cost of employee services received in exchange for its equity instruments. Currently, in accordance with APB 25, we record the intrinsic value of stock-based compensation as expense. Accordingly, no compensation expense is currently recognized for fixed stock option plans as the exercise price equals the stock price on the date of grant. Under SFAS No. 123R, ADTRAN will be required to measure compensation expense over the options’ vesting period based on the stock options’ fair value at the date the options are granted. SFAS No. 123R allows for the use of the Black-Scholes or a lattice option-pricing model to value such options.
ADTRAN has determined that it will use the Black-Scholes option-pricing model to calculate the fair value of its options. As allowed by SFAS No. 123R, ADTRAN can elect the Modified Prospective Application, which applies the Statement to new awards and modified awards after the effective date, and to any unvested awards as service is rendered on or after the effective date, or the Modified Retrospective Application, which can apply the statement to all prior years for which SFAS No. 123 was effective. ADTRAN is currently evaluating which method of application will be used. For a discussion of our stock-based compensation plans and agreements, see Note 7 to the Notes to Consolidated Financial Statements included in this report.
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In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets – An Amendment of APB Opinion No. 29. SFAS No. 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, Accounting for Nonmonetary Transactions, and replaces it with an exception for exchanges that do not have commercial substance. SFAS No. 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is effective for periods beginning after June 15, 2005, and is required to be adopted by ADTRAN effective July 1, 2005. We do not expect SFAS No. 153 to have a material impact on our consolidated results of operations or financial condition.
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 effective.
(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.
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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
(a) Total
Number of
Purchased
(b)
Average
Price
Paid per
Share
(c) Total
Purchased as
Part of Publicly
Announced
Plans or
Programs (1)
(d) Maximum
Shares that May
Yet Be
Under the Plans
or Programs
January 1, 2005
January 1, 2005 – January 31, 2005
February 1, 2005 – February 28, 2005
March 1, 2005 – March 31, 2005
ITEM 6. 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.
/s/ James E. Matthews
Senior Vice President - Finance and
Chief Financial Officer
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EXHIBIT INDEX
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