ADTRAN, Inc. (NASDAQ: ADTN): A Possible Fraud

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ADTRAN, Inc. (NASDAQ: ADTN): A Possible Fraud


Frank Voisin is the author of the popular value focused website Frankly Speaking, found at

The market likes consistency in operations, but intelligent investors should also consider consistency in disclosures. The more consistent a corporation’s disclosures, the easier it is to make comparisons and determine the true state of the company’s performance. When companies suddenly change their disclosures without providing a concrete rationale for the change, investors should be worried that there is some bad news being covered up. Indeed, many of the accounting gimmicks covered in the excellent Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports (read my multi-part review here), are identifiable by those who watch for inconsistencies in disclosures, definitions and assumptions.

Consider the case of ADTRAN, Inc. (NASDAQ: ADTN) a provider of equipment and services for communications networks. I am always concerned when looking at companies in this niches because they tend to be overly reliant on a small number of major mobile network operators. Consequently, I pay close attention to disclosures about major customers and revenue concentration. I was quite concerned by what I found at ADTN.

The company’s 2010 10-k includes this statement:

Single customers comprising more than 10% of our revenue in 2010 include Qwest Communications International, Inc. at 20%, AT&T Inc. (NYSE:T) at 18%, and Verizon Communications Inc. (NYSE:VZ) at 11%. The revenues from all of these customers are reported in both the Carrier Networks and Enterprise Networks segments. No other customer accounted for 10% or more of our sales in 2010.

This is exactly the kind of disclosure I look for: a clear and concise discussion of who its major customers are and what percentage of sales each accounts for. I usually track these figures over time, so when I checked the recently filed 2011 10-K, imagine my surprise when I found that this year, investors received this:

Single customers comprising more than 10% of our revenue in 2011 include AT&T Inc. and CenturyLink, Inc. The revenues from both of these customers are reported in both the Carrier Networks and Enterprise Networks segments. No other customer accounted for 10% or more of our sales in 2011.

How much of the company’s sales were attributable to AT&T? How about CenturyLink, Inc. (NYSE:CTL)? From this statement only, there is no way to guess. The answers are elsewhere. I checked and the company has provided this information for each of its major customers in each of the previous eleven years. Suddenly there is a break in the consistency, and this should invite investor scrutiny.

The information is provided (indeed, it has to be), but rather than being up front, it is buried down in Note 11 “Segment Information and Major Customers” near the end of the 10-K. The company even made the odd choice to bury the data under the heading “Sales by Geographic Region” when this information has nothing to do with geography. Here’s what they say (emphasis mine):

Single customers comprising more than 10% of our revenue in 2011 included two customers at 25% and 10%, respectively. Single customers comprising more than 10% of our revenue in 2010 included three customers at 20%, 18%, and 11%, respectively. Single customers comprising more than 10% of our revenue in 2009 included three customers at 22%, 19%, and 11%, respectively. No other customer accounted for 10% or more of our sales in 2011, 2010 or 2009.

Here we see that the company doesn’t provide information about which of its two major customers is the larger purchaser. Again, they’ve done this for every year since 1999, so why stop now? Perhaps because sales to one of these customers has plummeted.

In 2010, Qwest (now CenturyLink) and AT&T comprised 38% of sales which were closely split between the two. In 2011, while the aggregate concentration of these two dropped to 35%, the gap between the two expanded from 3% to 15%. In 2010, sales to the second largest customer accounted for 18% of total revenues, or $109 million. In 2011, sales to the second largest customer accounted for 10% of total revenues or $71.7 million, for a decline of 34%. This is a dramatic decline in sales to its largest customer, but only those investors who found the strange lack of disclosure up front and hunted to the end of the 10-K could find this information. Otherwise, the offset in sales to the largest customer masked much of the decline.

I decided to check out the company’s 2011 conference call transcripts to see what happened. First, in Q1, the company said this:

Sanjiv Wadhwani – Stifel, Nicolaus & Co., Inc.

Jim, could you talk about the 10% customers for the quarter?

James Matthews

Sanjiv, Yes. As you know in the past, historically, we have given a 10% breakout customers on the quarterly calls. We have recently received letters from certain customers requesting that we not do that any longer. Therefore, that’s the practice that we’re going to take going forward. However, we did see three 10% customers in the quarter. And that’s the extent that we can talk about it at this point, Sanjiv, because of customer request.

Note that the customer request covers quarterly calls, not 10-K. The information is still in the 10-K, just buried and no longer specific to the customer. The company should stick to its track record of providing this important information up front. Later in the same call, the company said this (emphasis added):

Ehud Gelblum – Morgan Stanley (NYSE:MS)

Okay, that’s cool. Now when you look at some big customers. And I know certainly after you got these letters, you don’t want to talk about customers all that closely. But again, we have CenturyLink, Qwest, and we have a slightly different merger going on with AT&T and T-Mobile, which sort of really have nothing to do with you. But there’s been some thought out there that possibly AT&T may be slowing down expenses, or slowing down spending deployments, based on that. Are you seeing any, at either of these two mergers, are you seeing any difference in spending patterns? And if you feel like generalizing to a more general comment, that’s fine as well.

Thomas Stanton

Yes, I mean that — and I will tell you that the tone of, from customers, around talking about their business is probably as loud as it’s ever been, so we really don’t want to talk too much. If I must set the market in general, and if I talk about it from a product-line basis, maybe that’s a better way to look at it, our Broadband piece did very well. That included performances pretty much across the customer base that we would expect to see at this point in time. And so really, no surprises there. I’m not sure of much more I can tell you.

Ehud Gelblum – Morgan Stanley

So it doesn’t sound like you’re seeing any change in buying behavior from your customers.

Thomas Stanton

Well, I’ve heard the same thing that you were talking about with one of the largest carriers, and I’m not sure if we really commented about that in Q4, but I know there was a lot of talk about kind of delayed purchases and things like that. And we didn’t disagree with those comments. And we fully kind of understood what they were doing and how they’re doing things, and fully expected them to — those things happen from time to time when you see a slowdown and then a pickup.

Ehud Gelblum – Morgan Stanley

And have you seen slowdowns?

Thomas Stanton

Here again, I’ve probably delved too much into a specific customer. I would say that the comments that are out there, we haven’t commented or deemed necessarily incorrect.

Ehud Gelblum – Morgan Stanley

Interesting. Helpful.

We get a vague discussion about not disagreeing with comments about a slowdown at a customer. There isn’t much here to raise an alarm that sales might be plummeting to one of the biggest customers. It wasn’t until Q4that an analyst asked another question related to the 10% customers:

Nikos Theodosopoulos – UBS Investment Bank, Research Division

Just a couple of questions here. Maybe you guys can comment on, now that the year is done, what was — how many customers you actually had that that were 10% customers and who they were, I mean, given the growth in international and Tier 1, Tier 2? Just trying to get a sense of how customer diversification has changed over the course of the year. …

James E. Matthews

Sure, Nikos. Diversification has certainly, we believe, had a positive impact during the year. For the year, we see two 10% customers. And again, our policy is to comment only on those in the 10-K when we publish that.

Nikos Theodosopoulos – UBS Investment Bank, Research Division

Two 10% customers. Do you have like — okay, so in terms of how big they were, are you going to wait for the K or can you give any color on that?

James E. Matthews

We’ll wait for the K.

Nikos Theodosopoulos – UBS Investment Bank, Research Division

All right.

Again, management was evasive, forcing investors to wait until the 10-K. Strangely, management says diversification has had a positive impact when in fact sales became less diversified (the top customer’s sales become more concentrated than in past years). I had hoped that in Q1 of 2012, there would be some follow up questions about what happened, and this is the closest we got:

Nikos Theodosopoulos – UBS Investment Bank, Research Division

Just a couple of quick questions. Can you comment on 10% customers in the quarter? …

James E. Matthews

Nikos, this is Jim. We had one.

Did you catch that? Their second largest customer officially dropped below the 10% threshold, meaning that sales to that customer are continuing to deteriorate. Keep in mind that in Q1 2012, revenues declined from $165 million in Q1 2011 to $135 million in Q1 2012, so this is not the case of sales to that party relative to other parties growing more slowly. This was a decline in an absolute sense. Note also that in Q1 of last year, the company had three customers over 10%.

While the company’s explanation for no longer providing the 10% customer details by quarter could be accepted on face value, the subsequent change in disclosure presentation in the 10-K should be a warning. Upon further investigation (far more than would have been needed over the last eleven years!), we learn the true story. By moving key information from its traditional spot, management has made a key risk less noticeable to investors, namely that the company is becoming more reliant on its top customer and that sales to its second largest customer have collapsed.

So what should management have done? While it evidently received requests to not disclose the percentage of sales to each major customer, it could have still provided this information without naming the customer (similar to what it ultimately did in the 10-K). Furthermore, the company should have been proactively discussing this in either its press release, 10-Q or opening statements to its conference calls, rather than waiting for analysts to ask the right questions. Once analysts asked the questions, they should have been far more forthcoming about the problems with its #2 customer and what it was doing about it. Finally, under no circumstances should management have changed the location of this key information.

Here’s my takeaway: it is always worth an investor’s time to consider changes in presentation, assumptions or definitions when reading corporate filings. Any change in priority or wording from a long-standing tradition should demand greater scrutiny. More often than not, I think you will find that the change was motivated by a desire to lessen the blow of something negative. Whenever I find shenanigans like this, I assume there are more lurking in the background and so I stay away.

What do you think of consistency in disclosures?


Author Disclosure: None

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