ADC Telecommunications (ADCT)

 

Business Impact of Next Generation Networks and Competitive Environment

 

The evolution to next generation networks is impacting our industry significantly. The evolution is providing increased opportunities to sell infrastructure products that allow networks to provide more robust services at increasing speeds. For instance, overall spending on central office fiber equipment, wireless coverage and capacity equipment and equipment to aid the deployment of fiber based networks closer to the ultimate consumer (i.e., fiber to the node, curb, residence or business, which we refer to as our “FTTX” products) has increased significantly in recent years. We expect these spending trends for FTTX and wireless coverage and capacity solutions to continue. Sales of these next generation products also tend to be project-based, causing our sales to fluctuate from period to period and making the timing of our sales harder to predict.

 

Spending trends on these next generation initiatives in which we participate has not resulted in significant overall spending increases on all categories of infrastructure equipment. In fact, overall spending on all categories of equipment has increased only modestly in recent years, and projections suggest that in the next two to three years overall spending globally will be relatively flat. Our continued ability to compete with other manufacturers of communications equipment depends in part on whether we can continue to develop and effectively market next-generation network infrastructure products.

 

Competitive pressures to win and retain customers have caused many of our service provider customers to consolidate with one another. We expect this trend to continue. Our customers engage in consolidation in order to gain greater scale and increase their ability to offer a wider range of wireline and wireless services. Consolidation results in larger customers who have fewer competitors and increased buying power. This places pressure on the prices at which we and other vendors can sell products and services. Additionally, consolidation among our customers has caused short-term spending deferrals while the combined companies focus on integration activities. As customers complete integration activities, we generally expect increased sales demand from these customers due to their prior spending deferrals. Ultimately, the rate at which our customers respond to each other’s competitive threats, the buying power they may gain from consolidation and the products they elect to purchase will impact our sales growth and profit margins and those of other equipment vendors.

 

Recently, a number of our competitors have engaged in business combination transactions, and we expect to see continued consolidation among communication equipment vendors. These business combinations may result in our competitors becoming financially stronger and obtaining broader product portfolios than us. As a result, consolidation could increase the resources of our competitors and negatively impact our product sales.

 

We believe we need to do three things to compete in this market environment. First, we need to make market share gains in areas where spending is increasing. The acceptance of such products as our fiber connectivity for central offices and FTTX, our TrueNet^® CopperTen^® structured cabling solutions, our Digivance^® and FlexWave^tm wireless coverage solutions and our recently acquired Fusion^tm and Unison^tm in-building wireless coverage and capacity solutions will determine our ability to gain market share. Second, we need to continue to expand our product portfolio and the geographic footprint where we sell. Expanding our product portfolio and geographic reach provides us with more opportunities to complete sales and grow revenues. Third, we need to continue to transform our business model so that we operate more efficiently while continuing to provide superior service to our customers. Finding ways to contain costs, while efficiently servicing the needs of our customers, contributes to our profitability.

 

gain from consolidation and the products they elect to purchase will impact the sales growth and profit margins of equipment vendors.

 

In both fiscal 2005 and fiscal 2006, the impact of the changes in our industry resulted in increased revenues and lower profit margins for our business. We believe that to succeed in this type of business environment it is imperative that we not only find ways to increase revenues but also to become more cost efficient.

 

In fiscal 2005, the growth of our sales outpaced that of our industry. In fiscal 2006, however, our sales increased at a slower rate that was within the range of sales growth experienced by our peers. We believe there are several reasons for this slowed rate of growth. For instance, our fiber-to-the-X (i.e., the deployment of fiber-based networks closer to the ultimate consumer, which is sometimes referred to as “FTTX”) customers generally became more efficient in their use of FTTX products in fiscal 2006 such that they required less of our products to pass the same number of subscribers versus what was needed in fiscal 2005. We also believe customer consolidations resulted in the deferral of certain spending decisions while the combining companies focused on integration activities. Further, spending increases on FTTX and related fiber initiatives in recent years appear to have impacted spending adversely on other wireline initiatives. Finally, as many of our products are utilized in emerging next-generation networks, deployment rates can vary significantly from customer to customer. Among other things, these deployment rates can depend upon how quickly the customer constructs these networks, the degree to which a customer’s network architecture requires the use of a product and regulatory decisions regarding competitive access to the networks.

 

Despite slower sales growth in fiscal 2006, we continue to expect our sales to grow over time, primarily as a result of broadband initiatives as well as enterprise projects. Our ability to take advantage of any spending increases will depend on the acceptance of such products as our fiber connectivity for central offices and FTTX, our TrueNet^® and CopperTen^tm structured cabling solutions, our Digivance wireless coverage and our WiFi and WiMax solutions.

 

In addition to the need for revenue growth, we believe we must become more cost efficient in order to increase profitability on a more consistent basis. We therefore are focusing aggressively on ways to conduct our operations more efficiently. For instance, we continue to move more of our manufacturing capabilities to lower-cost locations. We also are taking steps to redesign our products so that we have more common parts across different types of products. Other steps we are taking to rationalize costs are described below in the strategy discussion.

 

As has been the case for many years, our business remains dependent largely on sales to communications service providers and for the year ended October 31, 2006, our top five customers in that industry accounted for 35.7% of our revenue. Our entry into enterprise markets in recent years, however, has mitigated this dependence to some degree.

 

gain from consolidation and the products they elect to purchase will impact the sales growth and profit margins of equipment vendors.

 

In both fiscal 2005 and fiscal 2006, the impact of the changes in our industry resulted in increased revenues and lower profit margins for our business. We believe that to succeed in this type of business environment it is imperative that we not only find ways to increase revenues but also to become more cost efficient.

 

In fiscal 2005, the growth of our sales outpaced that of our industry. In fiscal 2006, however, our sales increased at a slower rate that was within the range of sales growth experienced by our peers. We believe there are several reasons for this slowed rate of growth. For instance, our fiber-to-the-X (i.e., the deployment of fiber-based networks closer to the ultimate consumer, which is sometimes referred to as “FTTX”) customers generally became more efficient in their use of FTTX products in fiscal 2006 such that they required less of our products to pass the same number of subscribers versus what was needed in fiscal 2005. We also believe customer consolidations resulted in the deferral of certain spending decisions while the combining companies focused on integration activities. Further, spending increases on FTTX and related fiber initiatives in recent years appear to have impacted spending adversely on other wireline initiatives. Finally, as many of our products are utilized in emerging next-generation networks, deployment rates can vary significantly from customer to customer. Among other things, these deployment rates can depend upon how quickly the customer constructs these networks, the degree to which a customer’s network architecture requires the use of a product and regulatory decisions regarding competitive access to the networks.

 

Despite slower sales growth in fiscal 2006, we continue to expect our sales to grow over time, primarily as a result of broadband initiatives as well as enterprise projects. Our ability to take advantage of any spending increases will depend on the acceptance of such products as our fiber connectivity for central offices and FTTX, our TrueNet^® and CopperTen^tm structured cabling solutions, our Digivance wireless coverage and our WiFi and WiMax solutions.

 

In addition to the need for revenue growth, we believe we must become more cost efficient in order to increase profitability on a more consistent basis. We therefore are focusing aggressively on ways to conduct our operations more efficiently. For instance, we continue to move more of our manufacturing capabilities to lower-cost locations. We also are taking steps to redesign our products so that we have more common parts across different types of products. Other steps we are taking to rationalize costs are described below in the strategy discussion.

 

As has been the case for many years, our business remains dependent largely on sales to communications service providers and for the year ended October 31, 2006, our top five customers in that industry accounted for 35.7% of our revenue. Our entry into enterprise markets in recent years, however, has mitigated this dependence to some degree.