Verizon calls AFC in breach of FTTP contract

Access equipment vendor Advanced Fibre Communications reported disappointing results for the second quarter of 2004, with lower than expected revenue and complaints from one of its major customers, Verizon Communications, that AFC is in breach of its supplier contract after having missed some recent technological milestones.

After having passed earlier milestones as part of its contract to supply Verizon with fiber-to-the-premises (FTTP) equipment, AFC missed some recent milestones, including one in late June that resulted in a $1-million penalty, AFC said. That penalty is reflected in AFC’s revenue report for the second quarter.

"I certainly don’t want to sugar-coat this," AFC CEO John Schofield said in a conference call yesterday. "This is serious. And I can assure you that Verizon is not pleased that we have missed these milestones. In fact, they have said they think we are in breach [of contract]. Obviously they are able to take their business elsewhere. However, at this stage, we don’t expect them to do that. Because, despite the problems encountered thus far, we believe the project is generally proceeding as planned."

"While this seems extremely ominous on the surface, and we believe AFC takes it very serious [sic], we do not believe it puts the company in danger of losing its supply position at Verizon," Lehman Brothers analyst Steve Levy wrote in a research note this morning. "As far as [optical line terminals] go, we are still progressing under the assumption that AFC gets its act together and keeps the single-source position either all the way through 2005 or at least well into the second half of the year."

On Monday, Verizon said it would probably name a second supplier for optical line terminals in 2005. Dual-vendor sourcing is a common practice for carriers with large deployment projects. Sprint’s local division, another customer of AFC, began a request for proposals earlier this year to find a second supplier to compliment AFC’s gear, Schofield said. "This was not a surprise to us."

Three customers accounted for at least 10% of AFC’s revenues for the second quarter: BellSouth, Sprint and Verizon.

AFC’s revenue for the second quarter was $118.6 million, a 28% sequential increase from the first quarter and a 43% increase from the second quarter of 2003. Schofield called the revenue numbers "somewhat below what we have anticipated," and he attributed the disappointment to three things: a supply constraint of a key component in FTTP equipment, a "large customer workforce issue" (probably labor negotiations at SBC) that limited order flow from that customer, and the timing of some international orders. Also, Schofield said, many independent telcos interested in offering video are taking time to evaluate various technology options, which is delaying purchases.

"AFC's performance over the past few months has been clearly disappointing," Levy wrote. While AFC has fallen short of revenue expectations two quarters in a row--a fact Levy attributes largely to the company’s own execution problems--the vendor has also exceeded bookings expectations in both of those quarters, Levy wrote, which signals positive demand. "AFC wasn't prepared to deal with the demand acceleration, and it is stressing the company technologically," he wrote.

AFC’s recent disappointments shouldn’t endanger its pending acquisition by Tellabs, Levy added.

On a positive note, Levy also pointed out that operating profits from Marconi’s North American access division, which AFC acquired in February for $230 million, were slightly higher than expected: $6 million for the quarter. "At least AFC can point to its acquisition of Marconi's North American access division as something that has gone right lately," he wrote.