Note 3 – Stock Incentive Plans

Stock Incentive Program Descriptions

Our Board of Directors adopted the 1996 Employee Incentive Stock Option Plan (1996 Plan) effective February 14, 1996, as amended, under which 17.0 million shares of common stock were authorized for issuance to certain employees and officers through incentive stock options and non-qualified stock options. Options granted under the 1996 Plan typically become exercisable beginning after one year of continued employment, normally pursuant to a four or five-year vesting schedule beginning on the first anniversary of the grant date, and have a ten-year contractual term. The 1996 Plan expired February 14, 2006, and expiration dates of options outstanding at December 31, 2012 under the 1996 Plan range from 2013 to 2015.

On January 23, 2006, the Board of Directors adopted the 2006 Employee Stock Incentive Plan (2006 Plan), which authorizes 13.0 million shares of common stock for issuance to certain employees and officers through incentive stock options and non-qualified stock options, stock appreciation rights, restricted stock and restricted stock units. The 2006 Plan was adopted by stockholder approval at our annual meeting of stockholders held on May 9, 2006. Options granted under the 2006 Plan typically become exercisable beginning after one year of continued employment, normally pursuant to a four-year vesting schedule beginning on the first anniversary of the grant date, and have a ten-year contractual term. Expiration dates of options outstanding at December 31, 2012 under the 2006 Plan range from 2016 to 2022.

Our stockholders approved the 2010 Directors Stock Plan (2010 Directors Plan) on May 5, 2010, under which 0.5 million shares of common stock have been reserved. This plan replaces the 2005 Directors Stock Option Plan. The 2010 Directors Plan provides that the Company may issue stock options, restricted stock and restricted stock units to our non-employee directors. Stock awards issued under the 2010 Directors Plan normally become vested in full on the first anniversary of the grant date. Options issued under the 2010 Directors Plan have a ten-year contractual term. We currently also have options outstanding under the 1995 Directors Plan, as amended, and the 2005 Directors Plan. Expiration dates of options outstanding under both plans at December 31, 2012 range from 2013 to 2019.

The following table is a summary of our stock options outstanding as of December 31, 2011 and 2012 and the changes that occurred during 2012:


*(In thousands, except per share amounts)*	Number of Options			Weighted Average Exercise Price		Weighted Avg. Remaining Contractual Life in Years		Aggregate Intrinsic Value
Options outstanding, December 31, 2011		5,400		$	25.66		6.78	$	27,270

Options granted		1,104		$	17.93
Options cancelled/forfeited		(106	)	$	25.73
Options exercised		(370	)	$	16.36

Options outstanding, December 31, 2012		6,028		$	24.82		6.71	$	5,138

Options exercisable, December 31, 2012		3,552		$	24.83		5.20	$	2,566

All of the options above were issued at exercise prices that approximate fair market value at the date of grant. At December 31, 2012, 7.2 million options were available for grant under the shareholder approved plans.

The aggregate intrinsic values in the table above represent the total pre-tax intrinsic value (the difference between ADTRAN’s closing stock price on the last trading day of 2012 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on December 31, 2012. The amount of aggregate intrinsic value will change based on the fair market value of ADTRAN’s stock.

The total pre-tax intrinsic value of options exercised during 2012, 2011 and 2010 was $4.5 million, $39.8 million and $20.3 million, respectively. The fair value of options fully vesting during 2012, 2011 and 2010 was $7.7 million, $7.3 million and $6.9 million, respectively.

The following table further describes our stock options outstanding as of December 31, 2012:


	Options Outstanding						Options Exercisable
Range of Exercise Prices	Options Outstanding at 12/31/12 *(In thousands)*		Weighted Avg. Remaining Contractual Life in Years		Weighted Average Exercise Price		Options Exercisable at 12/31/12 *(In thousands)*		Weighted Average Exercise Price
$14.88 – 16.96		601		5.86	$	15.27		598	$	15.27
$16.97 – 20.46		1,026		9.65	$	17.03		30	$	19.19
$20.47 – 23.02		1,040		4.07	$	22.67		1,037	$	22.67
$23.03 – 27.90		935		6.96	$	24.09		618	$	23.72
$27.91 – 30.36		1,327		7.19	$	30.24		587	$	30.14
$30.37 – 41.92		1,099		6.15	$	33.40		682	$	33.16

		6,028						3,552

Restricted Stock Program Description

On November 6, 2008, the Compensation Committee of the Board of Directors approved the Performance Shares Agreement under the 2006 Plan which sets forth the terms and conditions of awards of performance-based restricted stock units (RSUs). Of the 13.0 million shares of common stock authorized for issuance under the 2006 Plan, we may grant up to 5.0 million shares of common stock for issuance to certain employees and officers for awards other than stock options, which would include RSUs. Under a proposal that was approved by the Board of Directors and shareholders at the 2010 annual meeting, the number of shares available for awards other than stock options under all stock plans was reduced to 3.3 million. The number of shares of common stock earned by a recipient pursuant to the RSUs is subject to a market condition based on ADTRAN’s relative total shareholder return against all companies in the NASDAQ Telecommunications Index at the end of a three-year performance period. Depending on the relative total shareholder return over the performance period, the recipient may earn from 0% to 150% of the shares underlying the RSUs, with the shares earned distributed upon the vesting of the RSUs at the end of the three-year performance period. The fair value of the award is based on the market price of our common stock on the date of grant, adjusted for the expected outcome of the impact of market conditions using a Monte Carlo Simulation valuation method. A portion of the granted RSUs also vest and the underlying shares become deliverable upon the death or disability of the recipient or upon a change of control of ADTRAN, as defined by the 2006 Plan. The recipients of the RSUs receive dividend credits based on the shares of common stock underlying the RSUs. The dividend credits are vested and earned in the same manner as the RSUs and will be paid in cash upon the issuance of common stock for the RSUs.

The following table is a summary of our RSUs and restricted stock outstanding as of December 31, 2011 and 2012 and the changes that occurred during 2012:


*(In thousands, except per share amounts)*	Number of shares			Weighted Average Grant Date Fair Value
Unvested RSUs and restricted stock outstanding, December 31, 2011		90		$	34.21

RSUs and restricted stock granted		51		$	19.50
RSUs and restricted stock vested		(21	)	$	27.75
RSUs and restricted stock cancelled/forfeited		—		$	—
Adjustments to shares granted due to shares earned at vesting		(17	)	$	26.65

Unvested RSUs and restricted stock outstanding, December 31, 2012		103		$	29.25

At December 31, 2012, total compensation cost related to the non-vested portion of RSUs and restricted stock not yet recognized was approximately $1.9 million, which is expected to be recognized over an average remaining recognition period of 1.7 years.

Valuation and Expense Information

We use the Black-Scholes option pricing model (Black-Scholes Model) for the purpose of determining the estimated fair value of stock option awards on the date of grant. The Black-Scholes Model requires the input of certain assumptions that involve judgment. Because our stock options have characteristics significantly different from those of traded options, and because changes in the input assumptions can materially affect the fair value estimate, existing models may not provide reliable measures of fair value of our stock options. We use a Monte Carlo Simulation valuation method to value our performance-based RSUs. The fair value of restricted stock issued is equal to the closing price of our stock on the date of grant. We will continue to assess the assumptions and methodologies used to calculate the estimated fair value of stock-based compensation. If circumstances change, and additional data becomes available over time, we may change our assumptions and methodologies, which may materially impact our fair value determination.

The following table summarizes stock-based compensation expense related to stock options, RSUs and restricted stock for the years ended December 31, 2012, 2011 and 2010, which was recognized as follows:


*(In thousands)*	2012			2011			2010
Stock-based compensation expense included in cost of sales	$	422		$	412		$	317

Selling, general and administrative expense		4,351			4,316			3,575
Research and development expense		4,491			4,441			3,825

Stock-based compensation expense included in operating expenses		8,842			8,757			7,400

Total stock-based compensation expense		9,264			9,169			7,717
Tax benefit for expense associated with non-qualified options		(1,234	)		(1,321	)		(650	)

Total stock-based compensation expense, net of tax	$	8,030		$	7,848		$	7,067

At December 31, 2012, total compensation cost related to non-vested stock options not yet recognized was approximately $17.4 million, which is expected to be recognized over an average remaining recognition period of 2.6 years.

The stock option pricing model requires the use of several significant assumptions that impact the fair value estimate. These variables include, but are not limited to, the volatility of our stock price and employee exercise behaviors. There were no material changes made during 2012 to the methodology used to determine our assumptions.

The weighted-average estimated fair value of stock options granted to employees and directors during the twelve months ended December 31, 2012, 2011 and 2010 was $5.60 per share, $9.53 per share and $11.69 per share, respectively, with the following weighted-average assumptions:


	2012			2011			2010
Expected volatility		39.46	%		38.32	%		39.57	%
Risk-free interest rate		0.96	%		1.01	%		1.35	%
Expected dividend yield		2.05	%		1.19	%		1.08	%
Expected life (in years)		6.18			5.15			5.78

We based our estimate of expected volatility for the 12 months ended December 31, 2012, 2011 and 2010 on the sequential historical daily trading data of our common stock for a period equal to the expected life of the options granted. The selection of the historical volatility method was based on available data indicating our historical volatility is as equally representative of our future stock price trends as is our implied volatility. We have no reason to believe the future volatility of our stock price is likely to differ from its past volatility.

The risk-free interest rate assumption is based upon implied yields of U.S. Treasury zero-coupon bonds on the date of grant having a remaining term equal to the expected life of the options granted. The dividend yield is based on our historical and expected dividend payouts.

The expected life of our stock options is based upon historical exercise and cancellation activity of our previous stock-based grants with a ten-year contractual term.

The RSU pricing model also requires the use of several significant assumptions that impact the fair value estimate. The estimated fair value of the RSUs granted to employees in 2012, 2011 and 2010 was $19.46 per share, $38.73 per share and $39.21 per share, respectively, with the following assumptions:


	2012			2011			2010
Expected volatility		37.75	%		39.32	%		40.82	%
Risk-free interest rate		0.38	%		0.37	%		0.51	%
Expected dividend yield		2.12	%		1.08	%		1.07	%

Stock-based compensation expense recognized in our Consolidated Statements of Income for the 12 months ended December 31, 2012, 2011 and 2010 is based on RSUs and options ultimately expected to vest, and has been reduced for estimated forfeitures. Estimates for forfeiture rates are based upon historical experience and are evaluated quarterly. We expect our forfeiture rate for stock option awards to be approximately 1.6% annually. We estimated a 0% forfeiture rate for our RSUs and restricted stock due to the limited number of recipients and historical experience for these awards.