ADTRAN - 10-Q quarterly report FY

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C.  20549

FORM 10-Q

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.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock, as of the latest practicable date:

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ADTRAN, INC.

Quarterly Report on Form 10-Q
For the Quarter Ended March 31, 2003

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PART I.  FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

ADTRAN, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

See notes to condensed consolidated financial statements

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ADTRAN, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)

(1) Assumes exercise of dilutive stock options calculated under the treasury stock method

See notes to condensed consolidated financial statements

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ADTRAN, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

See notes to condensed consolidated financial statements

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ADTRAN, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.          BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of 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. Operating results for the three months ended March 31, 2003 are not necessarily indicative of the results that may be expected to occur for the year ending December 31, 2003. The interim statements should be read in conjunction with the financial statements and notes thereto included in ADTRAN’s latest Annual Report on Form 10-K.

2.           INVENTORY

At March 31, 2003 and December 31, 2002, inventory consisted of the following:

3.          COMPREHENSIVE INCOME

Comprehensive income consists of net income, unrealized gains and losses on marketable securities, net of deferred taxes, and unrealized foreign currency translation adjustments, net of deferred taxes. Comprehensive income of $9,245,296 for the three months ended March 31, 2003, consists of net income of $10,538,895, unrealized losses on marketable securities of $1,311,733 (net of deferred tax) and unrealized foreign currency translation gains of $18,134 (net of deferred taxes). Comprehensive income of $18,498,243 for the year ended December 31, 2002, consists of net income of $24,775,962 and unrealized losses on marketable securities of $6,277,719 (net of deferred tax).

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4.          EARNINGS PER SHARE

A summary of the calculation of basic and diluted earnings per share (EPS) for the three months ended March 31, 2003 and 2002 is as follows:

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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 costs, as well as research and development, interest 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 months ended March 31, 2003 and 2002.  Asset information by reportable segment is not reported, since ADTRAN does not produce such information internally.

The tables below present sales information by product and geographic region for the three months ended March 31, 2003 and 2002.

Sales by Product

Sales by Geographic Region

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

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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.

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 (Loss) & Earnings (Loss) Per Share

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:

Weighted Average Assumptions

8.          RECENTLY ISSUED ACCOUNTING STANDARDS

In May 2002, the Financial Accounting Standards Board issued SFAS No. 145, Rescission of FAS Nos. 4, 44, and 64, Amendment of FAS 13, and Technical Corrections as of April 2002. This statement rescinds FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt, and FASB Statement No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. The statement also rescinds FASB Statement No. 44, Accounting for Intangible Assets of Motor Carriers, and amends FASB Statement No. 13, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have

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economic effects that are similar to sale-leaseback transactions. This statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. SFAS No. 145 does not currently impact ADTRAN.

In July 2002, the Financial Accounting Standards Board issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which is effective for disposal or exit activities that are initiated after December 31, 2002. This statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring). The statement requires that a liability for a cost associated with an exit or disposal activity shall be recognized and measured initially at its fair value in the period in which the liability is incurred, except for liabilities for one-time termination benefits that are incurred over time. In the unusual circumstance in which fair value cannot be reasonably estimated, the liability shall be recognized initially in the period in which fair value can be reasonably estimated. SFAS No. 146 was implemented in the three months ended March 31, 2003 and had no impact on ADTRAN’s financial statements.

In 2002, ADTRAN adopted the requirements of FASB Interpretation No. 45, issued in November 2002, entitled “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”. The Interpretation requires increased disclosure regarding the nature of the guarantee, including the approximate term of the guarantee, the events or circumstances that would require the guarantor to perform under the guarantee, and the maximum potential amount of payments that the guarantor could be required to make. Effective with 2003, a liability for the fair value of certain guarantees must be recorded. The adoption of the complete 2003 requirements of FASB Interpretation No. 45 is not expected to have a material impact on the consolidated financial statements of ADTRAN.

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), the primary objective of which is to provide guidance on the identification of entities for which control is achieved through means other than voting rights (“variable interest entities” or “VIEs”) and to determine when and which business enterprise should consolidate the VIE (the “primary beneficiary”). The adoption of FASB Interpretation No. 46 is not expected to have a material impact on the consolidated financial statements of the ADTRAN.

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

ADTRAN designs, develops, manufactures, markets, and services a broad range of high-speed network access products utilized by providers of telecommunications services (serviced by our Carrier Networks Division) and corporate end-users (serviced by our Enterprise Networks Division). 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 increased this year compared to last year due to our strategy of increasing unit volume and market share through the introduction of 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

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competitors. An important part of ADTRAN’s strategy is to engineer the reduction of the product 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 in most instances 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 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 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.

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RESULTS OF OPERATIONS – THREE MONTHS ENDED MARCH 31, 2003 COMPARED TO THREE MONTHS ENDED MARCH 31, 2002

SALES
ADTRAN’s sales increased 3.5% from $83,341,983 in the three months ended March 31, 2002 to $86,222,501 in the three months ended March 31, 2003. The increase is primarily the result of increasing unit volume and market share gains in the Carrier Networks Division.  In particular, the increase in overall sales is attributable to an increase in sales of our Systems products, partially offset by decreased sales of our Digital Business Transport (DBT)/Total Reach®‚ and High-bit-rate Digital Subscriber Line (HDSL)/T1 products. The increase in Systems revenue is attributable to increasing sales of our Total Access 3000 broadband platform and sales of new products comprising access routers, DSLAMs and optical access products. Carrier Networks sales increased from $53,333,390 in the three months ended March 31, 2002 to $57,806,017 in the three months ended March 31, 2003.  Carrier Networks sales as a percentage of total sales increased from 64.0% in the three months ended March 31, 2002 to 67.0% in the three months ended March 31, 2003. Enterprise Networks sales decreased from $30,008,593 in the three months ended March 31, 2002 to $28,416,484 for the three months ended March 31, 2003. The decrease in Enterprise Networks sales is attributable to a decrease in CSU/ DSU sales. The CSU/DSU is a hardware unit that terminates T1 services at the enterprise location.  The industry has integrated the functionality of CSU/ DSU’s in integrated access devices and access routers thereby reducing the requirement for a standalone CSU/DSU.  Enterprise Networks sales as a percentage of total sales decreased from 36.0% for the three months ended March 31, 2002 to 33.0% for the three months ended March 31, 2003. Foreign sales decreased 28.1% from $4,573,684 in the three months ended March 31, 2002 to $3,290,161 in the three months ended March 31, 2003.  The decrease in foreign sales is attributable to market challenges in the Asia/ Pacific region.

COST OF SALES
Cost of sales decreased 11.0% from $43,983,153 in the three months ended March 31, 2002 to $39,149,105 in the three months ended March 31, 2003. The decrease in cost of sales quarter over quarter is primarily related to manufacturing efficiencies and the timing differences between the recognition of cost reductions and the lowering of product selling prices.  As a percentage of sales, cost of sales decreased from 52.8% in the three months ended March 31, 2002 to 45.4% in the three months ended March 31, 2003 and is primarily attributable to product cost reductions, in excess of sales price reductions, in the Carrier Networks Division. Carrier Networks cost of sales, as a percent of division sales, decreased from 55.4% in the three months ended March 31, 2002 to 46.1% in the three months

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ended March 31, 2003. Enterprise Networks cost of sales, as a percent of division sales, decreased from 48.1% in the three months ended March 31, 2002 to 43.9% in the three months ended March 31, 2003.

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 decreased 3.1% from $20,789,822 in the three months ended March 31, 2002 to $20,152,444 in the three months ended March 31, 2003. This decrease is primarily related to a reduction of bad debt expense. Selling, general and administrative expenses as a percentage of sales decreased from 24.9% in the three months ended March 31, 2002 to 23.4% in the three months ended March 31, 2003.

RESEARCH AND DEVELOPMENT EXPENSES
Research and development expenses increased 3.2% from $13,834,261 in the three months ended March 31, 2002 to $14,270,491 in the three months ended March 31, 2003. ADTRAN continually evaluates new product opportunities and engages in intensive research and product development efforts.  To date, ADTRAN has expensed 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. As a percentage of sales, research and development expenses remained relatively constant at 16.6% in each of the three months ended March 31, 2002 and 2003. ADTRAN will continue to incur research and development expenses in connection with its new products and its expansion into international markets.  Research and development expenses as a percent of sales will fluctuate whenever there is a significant fluctuation in revenues during the periods being compared.   

INTEREST INCOME
Interest income increased 20.5% from $2,048,132 in the three months ended March 31, 2002 to $2,467,929 in the three months ended March 31, 2003.  This increase is primarily related to an increase in fixed income investments and related investment income. 

INTEREST EXPENSE
Interest expense decreased 4.4% from $690,283 in the three months ended March 31, 2002 to $659,722 in the three months ended March 31, 2003. This decrease is primarily related to a decrease in the interest rate on our $50,000,000 revenue bond.

NET REALIZED INVESTMENT GAINS
Net realized investment gains increased from $891 in the three months ended March 31, 2002 to $1,777 in the three months ended March 31, 2003.

OTHER INCOME (EXPENSE)
Other income (expense) increased $448,983 from ($64,767) in the three months ended March 31, 2002 to $384,216 in the three months ended March 31, 2003. This increase is primarily related to an increase in realized foreign currency gains and scrap material sales.

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INCOME TAXES
Our effective tax rate increased slightly from 28.0% for the three months ended March 31, 2002 to 29.0% for the three months ended March 31, 2003. During the quarter ADTRAN resolved certain tax contingencies resulting in the reduction of the effective tax rate from 32% to 29%. 

NET INCOME
As a result of the above factors, net income increased 142.8% from $4,340,678 in the three months ended March 31, 2002 to $10,538,895 in the three months ended March 31, 2003. As a percentage of sales, net income increased from 5.2% in the three months ended March 31, 2002 to 12.2% in the three months ended March 31, 2003.

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”). 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, 2003, the Authority had issued $50,000,000 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 $50,000,000. The bond matures on January 1, 2020, and bears interest at the rate of 5%. Included in long-term investments is $50,000,000 of restricted funds, which is a collateral deposit against the principal of this bond.

ADTRAN’s working capital, which consists of current assets less current liabilities, increased 17.3% from $203,511,000 as of December 31, 2002 to $238,654,000 as of March 31, 2003. The quick ratio, defined as cash, cash equivalents, short-term investments, and net accounts receivable, divided by current liabilities, increased from 5.73 as of December 31, 2002 to 6.17 as of March 31, 2003. The current ratio, which is current assets divided by current liabilities, increased from 7.35 as of December 31, 2002 to 7.47 as of March 31, 2003. The increase in working capital and related ratios is primarily a result of shifting investments from long-term to short-term and ADTRAN’s ability to generate cash from operations.

ADTRAN has used, and expects to continue to use, the cash generated from operations for working capital and other general corporate purposes, including (i) product development activities to enhance its existing products and develop new products and (ii) expansion of sales and marketing activities.

Accounts receivable increased 26.6% from December 31, 2002 to March 31, 2003. Quarterly accounts receivable days sales outstanding increased 10 days from 41 days as of December 31, 2002 to 51 days as of March 31, 2003. This increase in accounts receivable and quarterly accounts receivable days sales outstanding is caused by seasonality. Inventory decreased 6.4% from $39,926,000 as of December 31, 2002 to $37,382,000 as of March 31, 2003. Quarterly inventory turnover increased from 3.93 turns as of December 31, 2002 to 4.05 turns as of March 31, 2003. The decrease in inventory is attributable to our continued efforts to streamline our production process, work closely and efficiently with our subcontractors, and increase manufacturing velocity. 

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Accounts payable increased 12.1% from December 31, 2002 to March 31, 2003. Accrued expenses increased 27.7% from December 31, 2002 to March 31, 2003. These increases are primarily related to the variations of timing of payments. Capital expenditures totaled approximately $984,000 and $294,000 for the three months ended March 31, 2003 and 2002, respectively. These expenditures were primarily used to purchase equipment.

In July 2001, the board of directors approved the repurchase of 2,000,000 shares of ADTRAN common stock. As of March 31, 2003, we had repurchased 1,676,552 shares of our common stock at a total cost of $31,747,000. No shares were purchased during the three months ended March 31, 2003.  During the three months ended March 31, 2003, ADTRAN issued 314,403 shares of treasury stock for $6,490,000 to accommodate employee stock option exercises.  During 2002 and 2001, ADTRAN issued 187,750 shares, and 36,670 shares, respectively, of treasury stock to accommodate employee stock option exercises. 

At March 31, 2003, ADTRAN’s cash on hand of $138,678,000 and short-term investments of $39,566,000 placed our short-term liquidity in cash, cash equivalents and short-term investments at $178,244,000. At December 31, 2002, cash on hand was $125,092,000 and short-term investments were $19,747,000, which placed our short-term liquidity at $144,839,000.  This increase is attributable to shortening the maturity of ADTRAN’s investment portfolio and ADTRAN’s ability to generate cash from operations.

At March 31, 2003, ADTRAN’s long-term investments decreased by 9.9% to $158,865,000 from $176,331,000 at December 31, 2002. This decrease is attributable to shortening the maturity of ADTRAN’s investment portfolio by selling our longer-term fixed income investments and buying fixed income investments with shorter maturities. Long-term investments at March 31, 2003 and December 31, 2002 include a restricted balance of $50,000,000 related to the revenue bonds as discussed above. Additionally, ADTRAN has committed to invest an aggregate of $8,000,000 in two private equity funds, of which $962,459 has been invested to date. The duration of each of these commitments is five years with $3,000,000 expiring in 2005 and $5,000,000 expiring in 2007.

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.

FORWARD LOOKING STATEMENTS

The Private Securities Litigation Reform Act of 1995 (the “Reform Act”) 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, our other filings with the Securities and Exchange Commission 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 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 20, 2003 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. 

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You are further cautioned not to place undue reliance on those 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.

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

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the Securities Exchange Act of 1934 Rules 13a-14(c) and 15d-14(c)) for the company.  Our disclosure controls and procedures include our “internal controls,” as that term is used in Section 302 of the Sarbanes-Oxley Act of 2002 and described in the Securities and Exchange Commission’s Release No. 34-46427 (August 29, 2002).  Our chief executive officer and chief financial officer, after evaluating the effectiveness of our disclosure controls and procedures as of a date within 90 days before the filing date of 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 controls.  There were no significant changes in our internal controls or in other factors that could significantly affect those controls subsequent to the date of the evaluation.  As a result, there were no corrective actions to be taken. 

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PART II. OTHER INFORMATION

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

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.

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CERTIFICATIONS

I, Mark C. Smith, Chairman of the Board and Chief Executive Officer, certify that:

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I, James E. Matthews, Senior Vice President – Finance and Chief Financial Officer, certify that:

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