ITEM 1.         BUSINESS

Introduction

ADTRAN, Inc. develops products and services that simplify access to today’s telecommunications networks. Our high-speed, digital transmission products improve the operation of, and reduce the costs associated with, building and using communications networks. Small and large telephone companies, long-distance carriers, and other network service providers use our products to deliver high-speed data, voice, video, and Internet services to their customers in a cost-efficient manner. Businesses, schools, and government agencies use our products to connect facilities, remote offices and mobile workers, enabling corporate information services, Internet access, telecommuting, and videoconferencing within their organizations.

We were incorporated under the laws of Delaware in November 1985, and commenced operations in January 1986. We are headquartered in Cummings Research Park in Huntsville, Alabama. The mailing address at our headquarters is 901 Explorer Boulevard, Huntsville, Alabama, 35806. The telephone number at that location is (256) 963-8000.

Products and Services

We maintain two operating divisions based on our product and service offerings: the Carrier Networks Division and the Enterprise Networks Division. While many of the technologies we develop can be used to build products for both divisions, the divisions serve two distinct markets. These divisions support sales in the United States and in other countries around the world and operate as two reportable segments. In 2002, sales of Carrier Networks products accounted for 63.3% of revenue, while sales of Enterprise Networks products accounted for 36.7%. Sales to countries outside of North America are included in these aggregate divisional figures, but when accounted for separately, comprise 5.9% of total revenue. For more financial information about these divisions, see note 9 to the consolidated financial statements included in this report.

Our product portfolio consists of approximately 1,000 different high-speed telecommunications devices. In both carrier and enterprise networks, these products are used primarily in the “last mile,” or local loop, of the telecommunications network. The last mile is that segment of the network that connects end-user subscribers to a service provider’s closest facility. Our products typically connect two ends of a telecommunications circuit, and serve to transmit data, voice, and video over that circuit. The bandwidth of the circuit, along with the type of transmission format being used, determines the type of equipment needed.

We develop, market, and support high-speed digital transmission products, including those used to upgrade slower, established networks, or those used to deploy new broadband networks. Our products may be used in copper, fiber, or wireless networks both in the United States and abroad.

Carrier Networks

Our Carrier Networks Division specializes in system-based solutions that domestic and global service providers use to meet demand for a variety of data, voice, and Internet services, while reducing the cost of initial deployment and ongoing operations. These products are typically installed throughout the service provider’s network in locations such as central offices or network operations centers, remote terminals or pole-mounted cabinets, and the customers’ premises.

In the past few years, carriers have concentrated their capital expenditures on expanding and updating core switching facilities. Originally built to handle primarily voice applications, these facilities have been modified to accommodate large volumes of Internet and other high-speed, bandwidth-intensive data. The high-volume switching and transmission products used in a carrier’s core network are typically supplied by larger, integrated systems equipment suppliers, such as Lucent, Nortel, and Alcatel. With the core network in place, carriers are now trying to connect customers by offering broadband digital services. Our Carrier Networks Division supplies the network access products carriers require to connect their customers to core transmission and switching networks.

The flagship product line produced by our Carrier Networks Division is the Total Access® System. This multi-function access system offers service providers a single platform that can accommodate demand for a variety of high-speed Internet, voice, data and video services for business and some residential applications. Total Access consists of many different products that can be used separately or in tandem to reach more customers, offer a greater number of services, offer higher speed services, and make better use of network resources. Total Access connects to copper and fiber optic network backbones, making it suitable for installation in many parts of the network, and enabling deployment of a wide range of voice and data services around the world.

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Total Access features a distributed architecture that fits the decentralized networking model most carriers are using today both in the United States and abroad. This modular, scalable, and geographically distributed system offers advantages such as lower start-up costs, more flexible service deployment, greater network interface options, increased bandwidth, grow-as-you-go modularity, and centralized network management.

T1/HDSLx Access

The transmission technologies behind dedicated, leased line voice and data services to businesses are T1, which transmits data and voice at 1.544 megabits per second, or Mbps, and E1, the European equivalent, which transmits at 2.048 Mbps. T1 and E1 are the most widely deployed network technologies in business today. High bit-rate Digital Subscriber Line, or HDSLx, is a signaling technology that simplifies the provisioning of T1/E1 services over these circuits. We are the industry’s leading supplier of T1/HDSLx technology in the United States, with equipment in use by every incumbent local exchange carrier, or ILEC, and many independents and competitive service providers.

Our HDSL/HDSL2/HDSL4 products implement two-wire or four-wire transport of voice and data over T1/E1 facilities at extended distances, with less engineering investment. Our T1/HDSLx and E1/HDSLx products are available in form factors to fit our Total Access System, as well as other equipment shelves commonly deployed by ILECs and other service providers.

Packet-Based DSL Access

To meet residential demand for high-speed Internet access, and to meet the corresponding business demand to deliver high-speed Internet content, service providers must deploy packet-based varieties of DSL transport technologies. Our Total Access DSL Access Multiplexer, or DSLAM, helps ILECs, competitive service providers, local and regional independent telephone companies, and post telephone and telegraph (PTT) companies deliver Asymmetric DSL, or ADSL, a technology that permits faster downloads and slower uploads to accommodate Internet usage for residential and small business environments; and Symmetrical HDSL, or SHDSL, a technology that offers businesses high-speed network access at potentially lower monthly cost than leased line networks.

In 2002, we expanded our Total Access DSLAM portfolio to include models for low- to medium-density markets. These lower density models complement our Total Access 3000 DSLAM, which has been available since 2000. Because major carriers are deploying high volumes of new DSL accounts each day, and because packet-based technologies often fall outside the scope of the carriers’ legacy operating systems, carriers require a separate automated provisioning and management tool for these deployments. To satisfy this need, we offer the Total Access Element Management System, a high-performance network management system supporting our Total Access DSLAM platforms.

In countries outside of North America, our Total Access SHDSL is being adopted as an economical way to meet strong demand for E1 business services over a single pair of copper wires. SHDSL has a capacity of up to 2.3 Mbps per pair, making it a global symmetrical standard that accommodates E1 signaling rates. ADTRAN was a primary contributor to the international SHDSL standardization effort concluded in 2001, and the first to introduce an SHDSL product.

Fiber Access Multiplexing

Multiplexers are products that combine individual communications channels into a common band or stream for transmission. Our Total Access OPTI-3 is a multiplexer that aggregates three copper DS3 channels onto a fiber OC-3 feed. DS3 is a digital signal level which supports transmission of 672 individual digital signals at 45 Mbps, and OC3 is an optical carrier level which transmits at 155 Mbps. The Total Access OPTI-3 offers service providers a smaller, more cost-effective alternative to traditional devices used for this purpose. It is a non-proprietary device that complies with the SONET optical interface standard governing the interworking of optical transmission products. As a result, the Total Access OPTI-3 works with other SONET multiplexers in existing installations, and supplies environmental alarms and other network management information to the operations center or central office.

M13/STS-1 Multiplexing

The MX2800 is an M13 multiplexer, a device that aggregates multiple T1 or E1 channels into a single larger channel, such as DS3 in copper applications, or STS-1, or synchronous transport signal level one, in fiber optic applications. The MX2800 offers service providers a smaller, more cost-effective alternative to traditional devices used for this purpose. It includes a redundant power supply and the capacity to minimize network disruptions.

IMA Aggregation

Inverse Multiplexing over ATM (Asynchronous Transfer Mode), or IMA, is a method of aggregating DSL traffic from multiple subscribers onto a single circuit for transport to the central office switch. By moving the consolidation point closer to the subscriber, the service provider reduces the cost of backhauling this traffic. By consolidating ATM traffic into fewer, more efficiently utilized interfaces, the service provider conserves valuable switch ports. This capability is available in our Total Access 3000 DSLAM.

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POTS/DLC Services

Our Total Access System includes solutions for deploying narrowband (from 64 Kilobytes per second, or Kbps, to 1.544 Mbps) services, including Plain Old Telephone Services (POTS) for voice, and special services, such as analog data or foreign exchange. Service providers use Digital Loop Carriers (DLCs), or remote cabinets, to consolidate large volumes of voice lines as close as possible to the customer origin. Our high-density platforms for POTS deployment through a DLC increase the number of customers that can be served through the same facilities.

An important part of the distributed DLC concept is the ability to move voice traffic from narrow-bandwidth circuits, originating at the customer’s site, onto broader bandwidth circuits traveling back to the central office. Our products provide the concentration and multiplexing technologies needed to consolidate narrowband signals, where most of the carriers’ demand resides, into higher level bandwidth signals for backhaul to the switching facilities.

Loop Deployment

We offer a comprehensive line of plug-in transmission, repeater, extension, and termination devices for T1, E1, Frame Relay, Integrated Services Digital Network (ISDN) and Digital Data Service (DDS) services in a variety of form factors to fit our customers’ needs. Our Total Reach ISDN and DDS products extend digital services over one twisted pair of copper wires instead of the traditional two pair, and resolve deployment issues related to extensive repeater engineering, bridged tap determination and removal, and power requirements.

Wireless DS1/DS3 Access

Our TRACER series of license-free radios support voice and data over broadband DS3; dual, quad, and octal T1; and E1 wireless links. These products are also sold by our Enterprise Networks Division, as described below.

Network Management

We develop and support sophisticated systems to centralize the configuration, provisioning and management of our network access products. The Total Access Element Management System is a web-based, Java application used to configure, monitor and control Total Access equipment installed on local loop circuits. This high-performance system ensures smooth communication with the carrier’s central management system to minimize truck rolls and reduce operating costs.

Technical Services and Support

Carrier Network products sold in the United States carry up to a 10-year return-to-factory warranty, pre- and post-sales telephone technical support, and certain training options. Warranty and support options vary in countries outside of the U.S. Customers seeking additional support, or a complete turnkey solution, may choose to contract our professional services group for configuration, pre-assembly, and installation of their system.

Enterprise Networks

Our Enterprise Networks Division specializes in wide area connectivity and internetworking products. Businesses, academic organizations, and government agencies use these products to implement reliable, high-speed data, voice, Internet, and video communications between geographically dispersed locations or employees. These products are typically installed in equipment rooms or on desktops at both ends of a wide area circuit, connecting headquarters, branch offices, telecommuters, and mobile users to corporate information resources.

Our enterprise network products physically connect the user’s equipment – telephones, PBX’s, routers, computers, local area network equipment, and videoconferencing gear – to the wide area circuit. We address all of the commonly used networking technologies, at speeds ranging from 56/64 Kbps to 45 Mbps over wireline, fiber, and wireless facilities. Products range from simple, single-circuit termination units to more complex integrated access devices, access routers, multiplexers, firewalls, and license-free radios. Functionality ranges from low-cost, unmanaged devices to modular, remotely-manageable devices. Emergency service restoral is offered for a number of platforms.

Our broad range of equipment permits customers to satisfy their applications (data, voice, videoconferencing, or combined data/voice) using the most cost-efficient service offerings. In a wide area network that uses multiple transmission technologies in different geographic locations, the customer can usually obtain all the necessary equipment from us. Many of the products available from the Enterprise Networks Division have applications in carrier networks as well, especially carriers outside of North America. These products are typically installed by the carrier at the customer premises as part of a bundled service package.

IP Access Routing

In 2002, we introduced the NetVanta 3000 Series of Internet Protocol, or IP, access routers. These routers serve the purpose of providing Internet access or interconnecting corporate locations over private IP or leased line infrastructures, then routing data to its

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destination computer. These devices include features to secure the network against cyber attacks, to secure the privacy of data as it is transported across the Internet, and to restore communications in the event of equipment failure. These devices may be used by businesses or service providers in both domestic and global installations.

Internet Security

Our NetVanta 2000 Series is a family of products that combines firewall and Virtual Private Networking, or VPN, technologies to secure the transport of data over the Internet and private IP networks. The product line includes models to connect mobile workers, remote offices, and regional office/corporate headquarters, without the security concerns normally associated with shared networks. VPN is a service that provides customers with the attributes of a private network and is a cost-effective replacement for private leased line networks.

Frame Relay, Performance Monitoring, and Traffic Shaping

We offer a comprehensive line of Frame Relay connectivity products. Frame Relay is the most popular networking technology used by businesses today. Basic connectivity products support data, converged voice and data, routing, and disaster recovery at speeds ranging from 56 Kbps to 2.3 Mbps. In the IQ™ series, more advanced functionality lets network operators or service providers identify and classify traffic types, including e-mail, file transfer, and music downloads, allocate bandwidth to certain applications, and quantify the quality of service delivered on these Frame Relay circuits.

Integrated Access

Integrated access devices are a product class commonly used to reduce telecommunications costs by collapsing multiple voice and data circuits into a more streamlined and less expensive topology. Convergence also simplifies network administration and enables new features and services. We offer the ATLAS, Total Access 600 Series, Total Access 750/850, and TSU series of integrated access devices to accommodate both enterprise and carrier applications. Product architectures are scalable, and various models offer a wide range of features and capacities.

Fiber Connectivity

Our optical transport products for the enterprise support (1) point-to-point dark fiber termination, where the customer seeks to connect intra-campus buildings over a fiber optic cable; and (2) copper-to-fiber conversion, where the customer seeks to connect existing copper-wired buildings to fiber optic cable.

Leased Line Connectivity

Leased line networks, which provide dedicated point-to-point circuits leased from the service provider, are widely deployed in business. Circuits are available for DDS at speeds of 56 Kbps, ISDN at 128 Kbps, T1 at 1.544 Mbps, E1 at 2.048 Mbps, and T3 at 45 Mbps. ADTRAN supplies equipment in each of these technology categories for data, voice, and video applications. Models range from economy to full-featured with options for routing, network management, and emergency service restoral.

Broadband Fixed Wireless

We compete in a portion of the wireless communications market known as license-free fixed wireless. License-free fixed wireless installations are permanent or temporary point-to-point microwave radio links classified as unlicensed by the FCC. Our TRACER Series radios support voice and data over broadband DS3; dual, quad, and octal T1; and E1. Installed by a carrier or a business, fixed wireless links serve to overcome geographic barriers, establish emergency communications, or improve the efficiency of wireless carriers’ backhaul operations.

Network Management

We develop and support sophisticated systems to centralize the configuration and management of our wide area connectivity and internetworking products. Our N-Form Network Management Software Suite, a web-enabled product, allows network operators to monitor network activity, modify equipment settings, and isolate problems from a remote location using a variety of popular management interfaces.

Technical Services and Support

Each enterprise network product sold in the United States carries a five-year return-to-factory warranty, pre- and post-sales telephone technical support, and certain training options. Warranty and support options vary in countries outside of the U.S. Customers seeking additional support may choose to purchase our extended installation and maintenance service plans and/or fee-based training classes.

Customers

Customers of our Carrier Networks Division in the United States include all of the major regional telephone companies, also known as ILECs or RBOCs (Regional Bell Operating Companies); large and small independent telephone companies; competitive service

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providers; Internet service providers or ISPs; long distance carriers (known as Interexchange Carriers or IXCs); and wireless service providers. Worldwide, this division also serves PTT companies and competitive service providers in selected regions.

ILECs and most other service providers require product approval prior to adopting a vendor’s products for use in their networks. Therefore, we are involved in a constant process of submitting new and succeeding generations of products for approval. In the past, we have been successful in obtaining such approvals, and our products are widely deployed in service provider networks. However, we cannot be certain that we will obtain such approvals in the future, or that sales of such products will continue to occur. Further, any attempt by an ILEC or other service provider to seek out additional or alternative suppliers, or to undertake, as permitted under applicable regulations, the production of such products internally, could have a material adverse effect on our operating results.

End users of our Enterprise Networks Division include a large number of private and public organizations in numerous vertical markets, including finance, retail, food service, government, education, health care, manufacturing, military, transportation, hospitality, and energy/utility. However, because the majority of the products from this division are sold through a distribution channel, our major customers consist of several large technology distributors and an extensive network of value added resellers as described in “Distribution, Sales and Marketing” below.

The major customers of ADTRAN include the following:

Single customers comprising more than 10% of our revenue include SBC Communications, Inc. at 21%, Verizon Communications, Inc. at 14%, and Sprint Corporation at 10%. No other customer accounted for 10% or more of our sales in 2002.

Distribution, Sales and Marketing

We sell our Carrier Networks products in the United States to our major customers through a combination of a direct sales organization and a non-exclusive distribution network. The direct sales organization supports ILEC customers, and has offices located throughout the country. Sales to most competitive service providers and independent telephone companies are fulfilled through several major technology distribution companies.

Sales to service providers involve lengthy product qualification and standardization processes that can extend for several months or years. Subsequent orders, if any, are typically placed under single or multi-year supply agreements that are generally not subject to minimum volume commitments. Carriers generally prefer having two or more suppliers for most products, so individual orders are generally subject to competition based on some combination of total value, service, price, delivery, and other terms.

The majority of Enterprise Networks products are sold in the United States through a non-exclusive distribution network which consists, at the top level, of several major technology distributors and system integrators, such as Tech Data, Ingram Micro, and Sprint North Supply. These large distribution houses then sell to an extensive network of value-added resellers or system integrators.

Value added resellers and system integrators may be affiliated with us as a channel partner, or they may purchase from the distributor as an unaffiliated company. Affiliated partners participate with us at one of three levels based on sales volume and other factors to receive benefits such as product discounts, co-op funds, technical support, and training. We maintain field offices nationwide to support both distributors and value added resellers and system integrators. The Enterprise Networks Division also maintains a direct sales organization to generate demand within large, national accounts.

Outside of the United States, both carrier and enterprise products are sold through distribution arrangements customized for each region. Each region is supported by an ADTRAN field office that offers sales and support functions, and in some cases, warehousing and manufacturing support.

Our field sales organizations and distributors receive support from headquarters-based marketing, sales, and customer support groups. Under certain circumstances, other headquarters personnel may become involved in sales and other activities.

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Research and Development

Rapidly changing technologies, evolving industry standards, changing customer requirements, and continuing developments in telecommunications service offerings characterize the markets for our products. Our continuing ability to adapt to these changes, and to develop new and enhanced products, is a significant factor in maintaining or improving our competitive position and our prospects for growth. Therefore, we continue to make significant investments in product development.

During 2002, 2001 and 2000, product development expenditures totaled $56,295,000, $58,935,000, and $50,628,000, respectively. Because our product development activities are an important part of our strategy and because of rapidly changing technology and evolving industry standards, we expect to sustain, and possibly increase, product development activities in 2003. To date, all product development expenses have been charged to operations as incurred.

We strive to deliver innovative digital network access solutions that lower the cost of deploying services, increase the level of performance achievable with established infrastructures, reduce expense for our customers, increase network bandwidth and functionality, and extend network reach. Our development process is conducted in accordance with ISO 9001 and TL 9000, which are the international standards for quality management systems for design, manufacturing, and service.

We develop most of our products internally, although we sometimes license intellectual property rights for use in certain products. Internal development gives us more control over design and manufacturing issues related to our products, and therefore, closer control over product cost. Our ability to continually reduce product costs is an important part of our overall business strategy. Our product development efforts are often centered around entering a market with improved technology, offered at a price point lower than established market price. We then compete for market share. We continually re-engineer successive generations of the product to improve margin. In the extremely competitive markets characteristic of 2000, 2001 and 2002, this strategy has allowed us to meet customers’ stringent price requirements, while remaining profitable.

To maintain or increase our revenues and margins while continuing this strategy, we must continue, in some combination, to increase unit sales volumes of existing products, introduce and sell new products, or reduce our per unit costs. Per unit costs must be reduced at rates sufficient to compensate for the reduced revenue effect of continuing reductions in average sales prices. While we cannot be certain that we will be able to maintain or increase revenues or margins by increasing unit sales volumes of our products, introducing and selling new products, or reducing our per unit costs, our approach has been generally successful in the past.

Product development activities center around products to support both existing and emerging technologies in the telecommunications industry in segments of our markets that we consider to be viable revenue opportunities. We are actively engaged in developing and refining technologies to support data, voice, and video transport over Time Division Multiplex, ATM, and IP network architectures. Our work includes fiber optic transport, edge routing, integrated access, ADSL, SHDSL, HDSL4, Ethernet, network security, and network management and services.

A centralized research function supports product development efforts company-wide. This group provides guidance to our various product design and engineering teams in digital signal processing technologies, computer simulation and modeling, CAD/CAM tool sets, custom semiconductor design, industry standards, and technological forecasting.

Many telecommunications issues, processes and technologies are governed by standards boards. These boards consist of scientists, engineers, and other industry specialists working to establish specifications and compliance guidelines for emerging telecommunications technologies. We are an active participant on numerous standards boards, and have been instrumental in driving worldwide standards development in many technologies, especially DSL. A significant contributor to both HDSL2 and SHDSL standards, we developed many of the sophisticated coding algorithms incorporated into these standards. Currently, we are participating in the Federal Communications Commission’s efforts to define guidelines for spectral compatibility on local loops where multiple services are simultaneously deployed. We are also involved in the committee reviewing various techniques for deploying Ethernet in the local loop.

Manufacturing

The principal steps in the manufacturing process are the purchase and management of materials, assembly, testing, final inspection, packing, and shipping. In 2002, we continued to purchase parts and components for the assembly of some products from a large number of suppliers through a worldwide sourcing program. In addition, we have begun to shift to a process of allowing contract manufacturers to purchase the materials that they use in the assembly of our products. Certain key components used in our products are currently available from only one source, and other key components are available from only a limited number of sources. In the past, we have experienced delays in the receipt of certain key components, which has resulted in delays in related product deliveries.

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We attempt to manage such risks through developing alternative sources, through engineering efforts designed to obviate the necessity of certain components, and by maintaining close personal contact and building long-term relationships with each of our suppliers.

We rely on subcontractors in Mexico and China for assembly of printed circuit board assemblies, sub-assemblies, chassis, enclosures and equipment shelves, and, more recently, also to purchase the raw materials used in and for such assembly. Beginning in 2001, we transitioned our manufacturing of low-volume, high-mix, or complex printed circuit board assemblies to our manufacturing site in Huntsville, Alabama. We continue to build and test all new product prototypes and initial production units for all products in Huntsville, then later transfer the production of high-volume, low-mix printed circuit board assemblies to our subcontractors. We plan to continue to transition the purchasing of materials for assembly and final testing of a significant portion of our lower-priced products to subcontractors in Mexico or China. Such assembly typically can be done by subcontractors at an equal or lower cost than if we assembled such items internally, which furthers our goal of being a low-cost, high-quality provider in the industry. Subcontract assembly operations can contribute significantly to production cycle times, but we believe we can respond more rapidly to uncertainties in incoming order rates by selecting assembly subcontractors having significant reserve capacity and flexibility. We have consolidated our subcontractors to a few whose proven flexibility and quality meet our requirements.

The reliance on third-party subcontractors for the assembly of our products involves several risks, including the unavailability of, or interruptions in access to, certain process technologies and reduced control over product quality, delivery schedules, manufacturing yields, and costs. These risks may be exacerbated by economic or political uncertainties, terrorist actions, or by natural disasters in foreign countries in which our subcontractors may be located. We currently have limited foreign exchange risks, as we conduct the majority of all transactions with foreign vendors or customers in United States dollars.

Shipment of products to customers occurs from our facilities in Huntsville, Alabama. Our facilities are certified pursuant to ISO 9001, TL 9000, and certain other telephone company standards, including those relating to emission of electromagnetic energy and safety specifications.

Competition

We compete in markets for networking and communications equipment for service providers and businesses, government agencies, and other commercial enterprises worldwide. Our products and services support the transfer of data, voice, and video across service providers’ copper, fiber, and wireless infrastructures, and across wide area networks, local area networks, and the Internet.

The markets for our products are intensely competitive. Numerous competitors exist in each of our product segments. New manufacturers have entered the markets in recent years offering products that compete with ours. Under the intensely competitive conditions of the past two years, some of our competitors have consolidated or ceased operation. In addition, certain companies have, in recent years, increased consumer acceptance of alternative communications technologies, such as coaxial cable and cellular-based services. Competition might further increase if new companies enter the market, or existing competitors expand their product lines.

For our Carrier Networks Division, factors influencing the markets in which we currently compete or may compete in the future include:

•          The ability to help the customer solve networking problems within the confines of restrained capital budgets;

•          The ability to deliver solutions that fit the distributed networking model being deployed by most carriers;

•          The ability to deliver solutions at attractive price points;

•          The ability to deliver reliability and redundancy, especially for higher bandwidth products;

•          The ability to adapt to new network technologies as they evolve;

•          The ability to compete effectively with large firms with greater resources;

•          The ability to deliver products when needed by the customer;

•          The ability to deliver responsive customer service, technical support, and training; and

•          The ability to assist customers requiring pre-assembled, turnkey systems.

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Competitors in the carrier networks arena include large, established firms such as Fujitsu Limited, Nortel Networks, Alcatel, Siemens, and Cisco Systems, Inc., as well as a number of smaller, specialized firms such as Carrier Access Corporation and ADC Telecommunications.

For our Enterprise Networks Division, factors influencing the markets in which we currently compete or may compete in the future include:

•          The ability to satisfy the customer’s need to deploy a combination of transmission technologies within a single network;

•          The ability to increase the performance and lower the costs of the customer’s telecommunications network;

•          The ability to add capacity and migrate to new or different technologies without a major system upgrade;

•          The ability to continue to develop and support established platforms, and to offer products to address new networking technologies in a timely manner;

•          The ability to deliver reliability and system backup, especially for higher bandwidth products;

•          The ability to adapt to new network technologies as they evolve;

•          The ability to deliver products when needed by the customer;

•          The ability to deliver responsive customer service, technical support, and training; and

•          The ability to assist customers requiring hands-on installation and maintenance.

Competitors in the enterprise networks area include Nortel Networks, Netopia, Inc., Siemens, Enterasys Networks, Kentrox, Paradyne, Quick Eagle Networks, VINA Technologies, Carrier Access Corporation, Larscom, Visual Networks, Inc., Cisco Systems, Inc., SonicWALL, Inc., WatchGuard, and NetScreen Technologies, Inc. Some of these companies compete in a single product segment, while others compete across product lines.

Our company has been able to achieve leading market share positions in wide area connectivity solutions for integrated access devices, and for T1 and DDS DSU/CSU (Data Service Units/Channel Service Units).

Backlog and Inventory

A substantial portion of our shipments in any fiscal period relate to orders received in that fiscal period and firm purchase orders released in that fiscal period by customers under agreements containing non-binding purchase commitments. Further, a significant percentage of orders require delivery within 48 hours. These factors result in very little order backlog. We believe that because we fill a substantial portion of customer orders within the fiscal quarter of receipt, our backlog is not a meaningful indicator of actual sales for any succeeding period.

To meet this type of demand, we maintain a substantial finished goods inventory. We have implemented sophisticated supply chain management systems to manage the production process. Our practice of maintaining sufficient inventory levels to assure prompt delivery of our products increases the amount of inventory that may become obsolete. The obsolescence of such inventory may cause us to have to write down the value of the obsolete inventory, which may have an adverse effect on our operating results.

Employees

As of December 31, 2002, we had 1,522 full-time employees in the United States and 27 full-time employees in our international subsidiaries, located in Canada, China, Europe, and Australia. Of our total employees, 254 were in sales, marketing and service; 374 were in research and development; 819 were in manufacturing operations and quality assurance; and 102 were in administration. None of our employees are represented by a collective bargaining agreement, nor have we ever experienced any work stoppage. We believe that our relationship with our employees is good.

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Proprietary Rights

The ADTRAN corporate logo is a registered trademark of ADTRAN. The name “ADTRAN” is a trademark of ADTRAN. A number of our product identifiers and names are also registered. We also claim rights to a number of unregistered trademarks.

We have ownership of at least 89 patents related to our products and have additional patents pending. We will continue to seek additional patents from time to time related to our research and development activities. We do not derive any material amount of revenue from the licensing of our patents.

We protect our intellectual property and proprietary rights in accordance with good legal and business practices. We believe, however, that our competitive success will not depend on the ownership of intellectual property, but instead primarily on the innovative skills, technical competence, and marketing abilities of our personnel.

The telecommunications industry is characterized by the existence of an ever-increasing number of patent litigation and licensing activities. While there are currently no intellectual property lawsuits existing or pending by or against ADTRAN, it is possible that third parties may initiate litigation against us in the future, resulting in costly litigation and/or judgments. Any intellectual property infringement claims, or related litigation against or by us, could have a material adverse effect on our business and operating results.

Available Information

A copy of this Annual Report on Form 10-K, as well as our Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to these reports, are available free of charge on the Internet at our website, www.adtran.com, as soon as reasonably practicable (generally, within 1 day) after we electronically file these reports with, or furnish these reports to, the Securities and Exchange Commission. The reference to our website address does not constitute incorporation by reference of the information contained on the website and should not be considered part of this document.

Risk Factors

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 verbal forward-looking statements, including statements contained in this report and our other filings with the 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 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 (many of which we have discussed in prior SEC filings). 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 those forward-looking statements because they speak only of our views as of the date 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:

We must continue to update and improve our products and develop new products in order to compete and to keep pace with improvements in telecommunications technology.

The markets for our products are characterized by rapidly changing technology, evolving industry standards, and continuing improvements in the telecommunications service offerings of common carriers. If technologies or standards applicable to our products, or common carrier service offerings based on our products, become obsolete or fail to gain widespread commercial acceptance, our existing products or products under development may become obsolete or unmarketable.

Moreover, the introduction of products embodying new technologies, the emergence of new industry standards, or changes in common carrier service offerings could adversely affect our ability to sell our products. For instance, we offer a large number of products that apply primarily to the delivery of high-speed digital communications over the local loop over copper wire. We compete favorably with our competitors by developing a high-performance line of these products. Recently, we have begun marketing products that apply to fiber optic transport in the local loop. We expect, however, that deployment of coaxial cable and cellular transport in the local loop

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will increase. Also, non-traditional providers, such as cable television companies, are increasing their presence in the local loop. To meet the requirements of these new delivery systems and to maintain our market position, we may have to develop new products or modify existing products.

Our sales and profitability in the past have resulted to a significant extent from our ability to anticipate changes in technology, industry standards and common carrier service offerings, and to develop and introduce new and enhanced products. Our continued ability to adapt will be a significant factor in maintaining or improving our competitive position and our prospects for growth. We cannot assure you that we will be able to respond effectively to changes in technology, industry standards, common carrier service offerings or new product announcements by our competitors. We also cannot assure you that we will be able to successfully develop and market new products or product enhancements, or that such products or enhancements will achieve market acceptance. Any failure by us to continue to anticipate or respond in a cost-effective and timely manner to changes in technology, industry standards, common carrier service offerings, or new product announcements by our competitors, or any significant delays in product development or introduction, could have a materially adverse effect on our future profitability and our ability to market our products on a timely and competitive basis.

We do not engage in long-term research and development processes, and as a consequence may miss certain market opportunities enjoyed by larger companies with substantially greater research and development efforts.

Our research and development efforts are focused primarily on the refinement and redefinition of transmission technologies, which are currently accepted and commonly practiced. Most of our research and development efforts result in improved applications of technologies for which demand already exists or is latent. We do not, for the most part, engage in long-term speculative research projects, which represent a vast departure from the current business practices of our key customers. This includes pioneering new services and participating in advance field trials or demonstration projects for new technologies. Our strategy, while producing a more predictable revenue stream, could result in lost opportunity should a new technology achieve rapid and widespread customer acceptance.

Our dependence on a limited number of suppliers may prevent us from delivering our products on a timely basis, which could have a materially adverse effect on customer relations and operating results.

Certain raw materials and key components used in our products are currently available from only one source, and others are available from only a limited number of sources. The availability of these raw materials and supplies is subject to market forces beyond our control. From time to time, there may not be sufficient quantities of raw materials and supplies in the marketplace to meet customer demand. Many companies utilize the same raw materials and supplies as we do in the production of their products. Companies with more resources than our own may have a competitive advantage in obtaining raw materials and supplies due to greater buying power. These factors can result in reduced supply, higher prices of raw materials, and delays in the receipt of certain of our key components, which in turn may generate increased costs, lower margins, and delays in product delivery, with a corresponding adverse effect on sales, customer relationships, and revenue. Furthermore, due to general economic conditions in the U.S. and globally, our suppliers may experience financial difficulties, which could result in increased delays, additional costs, or loss of a supplier. We attempt to manage these risks through developing alternative sources, through engineering efforts designed to obviate the necessity of certain components, and by building long-term relationships and close personal contact with each of our suppliers. However, we cannot assure you that delays in or failures of deliveries of key components, either to us or to our contract manufacturers, and consequent delays in product deliveries, will not occur in the future.

Our dependence on subcontractors may result in reduced control over product quality, delayed delivery of products and/or increased manufacturing costs, each of which could negatively effect customer relations and operating results.

We rely on subcontractors in Mexico and China for the assembly of printed circuit board assemblies, subassemblies, chassis, enclosures and equipment shelves, and, more recently, also to purchase the raw materials used in and for such assembly. We are heavily dependent on two of these subcontractors. This reliance on third-party subcontractors for the assembly of our products involves several risks, including the unavailability of or interruptions in access to certain process technologies and reduced control over product quality, delivery schedules, transportation interruptions, manufacturing yields, and costs. These risks may be exacerbated by economic or political uncertainties or by natural disasters in foreign countries in which our subcontractors may be located. To date, we believe that we have successfully managed the risks of our dependence on these subcontractors through a variety of efforts, which include seeking and developing alternative subcontractors while maintaining existing relationships. However, we cannot assure you that delays in product deliveries will not occur in the future because of shortages resulting from this limited number of subcontractors or from the financial or other difficulties of such parties. The inability to develop alternative subcontractors if and as required in the future, or the need to undertake required retraining and other activities related to establishing and developing a new subcontractor relationship, could result in delays or reductions in product shipments which, in turn, could have a negative effect on our customer relationships and operating results.

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We compete in markets that have become increasingly competitive, which may result in reduced gross profit margins and market share.

The markets for our products are intensely competitive. Additional manufacturers have entered the markets in recent years to offer products in competition with us. Additionally, certain companies have, in recent years, developed the ability to deliver coaxial cable and cellular transmission, especially in high-density metropolitan areas. Competition would further increase if new companies enter the market or existing competitors expand their product lines. Some of these potential competitors may have greater financial, technological, manufacturing, sales and marketing, and personnel resources than we have. As a result, these competitors may be able to respond more rapidly or effectively to new or emerging technologies and changes in customer requirements, withstand significant price decreases, or devote greater resources to the development, promotion, and sale of their products than we can. In addition, our present and future competitors may be able to enter our existing or future markets with products or technologies comparable or superior to those that we offer. An increase in competition could cause us to reduce prices, decrease our market share, require increased spending by us on product development and sales and marketing, or cause delays or cancellations in customer orders, any one of which could reduce our gross profit margins and adversely affect our business and results of operations.

We depend heavily on sales to certain customers; the loss of any of these customers would significantly reduce our revenues and net income.

Historically, a large percentage of our sales have been made to ILECs (also formerly known as RBOCs) and major independent telecommunications companies. In 2002, these customers continued to comprise a large percentage (approximately 57%) of our revenue. As long as the ILECs and other service providers represent such a substantial percentage of our total sales, our future success will significantly depend upon certain factors which are not within our control, including:

•          the timing and size of future purchase orders, if any, from these customers;

•          the product requirements of these customers;

•          the financial and operational success of these customers;

•          the impact of legislative and regulatory changes on these customers; and

•          the success of these customers’ services deployed using our products.

Sales to our large customers have, in the past, fluctuated and may fluctuate significantly from quarter to quarter and year to year. The loss of, or a significant reduction or delay in, sales to any such customer or the occurrence of any such sales fluctuations could have a materially adverse effect on our business and results of operations. Further, any attempt by an ILEC or other service provider to seek out additional or alternative suppliers or to undertake, as permitted under applicable regulations, the production of such products internally, could have a materially adverse effect on our operating results.

The lengthy approval process required by the ILECs and other carriers could result in fluctuations in our revenues.

In the industry in which we compete, a supplier must first obtain product approval from an ILEC or other carrier to sell its products to them. This process can last from six to 18 months depending on the technology, the service provider, and the demand for the product from the service provider’s subscribers. Consequently, we are involved in a constant process of submitting for approval succeeding generations of products, as well as products that deploy new technology or respond to new technology demand from an ILEC or other carrier. We have been successful in the past in obtaining such approvals. However, we cannot be certain that we will obtain such approvals in the future or that sales of such products will continue to occur. Furthermore, the delay in sales until the completion of the approval process, the length of which is difficult to predict, could result in fluctuations of revenue and uneven operating results from quarter to quarter or year to year.

Consolidation and deterioration in the competitive service provider market could result in a significant decrease in our revenue.

We sell a moderate volume of products to competitive service providers, relative newcomers to the telecom industry, who compete with the established ILECs. The competitive service provider market is overbuilt, and is experiencing a process of consolidation and closure. Many of our competitive service provider customers do not have a strong financial position and have limited ability to access the public financial markets for additional funding for growth and operations. If one or more of these competitive service providers fail, we could face a loss in revenue and an increased bad debt expense, due to their inability to pay outstanding invoices, as well as the corresponding decrease in customer base and future revenue. Furthermore, a significant portion of our sales to competitive service

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providers are made through independent distributors. The failure of one or more competitive service providers could also damage a distributor to the point that the distributor could also experience business failure and/or default on payments to us.

Increased sales volume in international markets could result in increased costs or loss of revenue due to factors inherent in these markets.

We are in the process of expanding into international markets, which currently represent 5.9% of our net sales, and we anticipate increased sales from these markets. We currently maintain regional offices outside of North America in Melbourne, Australia; Beijing and Hong Kong, China; and Bad Homburg, Germany. A number of factors inherent to these markets expose us to significantly more risk than domestic business, including:

•          local economic and market conditions;

•          exposure to unknown customs and practices;

•          potential political unrest;

•          foreign exchange exposure;

•          unexpected changes in or impositions of legislative or regulatory requirements;

•          less regulation of patents or other safeguards of intellectual property; and

•          difficulties in collecting receivables and inability to rely on local government aid to enforce standard business practices.

Any of these factors, or others, of which we are not currently aware, could result in increased costs of operation or loss of revenue to us.

Our success depends on our ability to reduce the selling prices of succeeding generations of our products.

Our strategy is to attempt to increase unit sales volumes and market share each year by introducing succeeding generations of products having lower selling prices and increased functionality as compared to prior generations of products. To maintain or increase our revenues and margins while continuing this strategy, we must continue, in some combination, to increase sales volumes of existing products, introduce and sell new products, or reduce our per unit costs at rates sufficient to compensate for the reduced revenue effect of continuing reductions in the average sales prices of our products. We cannot assure you that we will be able to maintain or increase revenues or margins by increasing unit sales volumes of our products, introducing and selling new products, or reducing our per unit costs.

Our failure to adequately protect our intellectual property rights could adversely affect the development and commercialization of our products.

Our future success depends in part upon our proprietary technology. Although we attempt to protect our proprietary technology by contract, trademark, copyright and patent registration, and internal security, these protections may not be adequate. Furthermore, our competitors can develop similar technology independently without violating our proprietary rights. From time to time we receive and may continue to receive notices from third parties, including some of our competitors, claiming that we are infringing upon third-party patents or other proprietary rights. We cannot predict whether we will prevail in any litigation over third-party claims, or whether we will be able to license any valid and infringed patents on commercially reasonable terms. Any of these claims, whether with or without merit, could result in costly litigation; divert our management’s time, attention, and resources; delay our product shipments; or require us to enter into royalty or licensing agreements. A third party may not be willing to enter into a royalty or licensing agreement on acceptable terms, if at all. If a claim of product infringement against us is successful and we fail to obtain a license or develop or license non-infringing technology, our business, financial condition, and operating results could be affected adversely.

Our success depends on attracting and retaining key personnel.

Our business has grown significantly since its inception. Our success is dependent in large part on the continued employment of our executive officers, including Mark C. Smith, our Chairman of the Board and Chief Executive Officer, Howard A. Thrailkill, our President, Chief Operating Officer and a director, Thomas R. Stanton, our Senior Vice President and General Manager, Carrier Networks, Danny Windham, our Senior Vice President and General Manager, Enterprise Networks, and other key management

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personnel. The unplanned departure of one or more of these individuals could adversely affect our business. In addition, for ADTRAN to continue as a successful entity, we must also be able to attract and retain key engineers and technicians whose expertise helps us maintain competitive advantages. We do not have employment contracts or non-compete agreements with any of our employees. We believe that our future success will depend, in large part, upon our ability to continue to attract, retain, train, and motivate highly-skilled employees who are in great demand. Properly managing our continued growth, avoiding the problems often resulting from such growth and expansion, and continuing to operate in the manner which has proven successful to us to date will be critical to the future success of our business.

Two stockholders own or may influence a significant amount of our common stock and may continue to have significant influence on our affairs.

Mark C. Smith, our Chief Executive Officer and Chairman of the Board of Directors, and Lonnie S. McMillian, our Director Emeritus, who along with Mr. Smith is a co-founder of ADTRAN, together with certain of their family members and family trusts, currently beneficially own approximately 45.9% of our common stock. As a result, these individuals and the family trusts may be able to control the election of our Board of Directors and in all likelihood will continue to have significant influence over all matters requiring approval by our stockholders.

The price of our common stock has been volatile and may continue to fluctuate substantially.

Our common stock is traded on the Nasdaq National Market under the symbol ADTN. Since our initial public offering in August 1994, there has been and may continue to be significant volatility in the market for our common stock, based on a variety of factors, some of which are beyond our control, including the following:

•          actual or anticipated fluctuations in our quarterly or annual operating results;

•          the gain or loss of significant contracts by us or our competitors;

•          the entry of new competitors (potentially including the ILECs) into our markets;

•          changes in management or additions or departures of key personnel;

•          announcements of technological innovations, new products, changes in product pricing, acquisitions, strategic partnerships, joint ventures or capital commitments by us or our competitors;

•          changes in financial estimates or investment recommendations by securities analysts or our failure to perform in line with analysts’ expectations;

•          legislative or regulatory changes; and

•          other events and circumstances beyond our control.

In addition, the stock market has recently experienced significant price and volume fluctuations, which have particularly affected the share price of many high technology companies like ADTRAN. These fluctuations may be unrelated to the operating performance of these companies.