ADTRAN Holdings, Inc. Q4 FY2022 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to the ADTRAN Holdings, Inc. Fourth Quarter 2022 Preliminary Earnings Release Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer period. During the course of the conference call, ADTRAN representatives expect to make forward-looking statements that reflect management's best judgment based on factors currently known. However, these statements involve risks and uncertainties, including the continued spread and the extent of the impact of the COVID-19 pandemic, the ability of component supplies to align with customer demand, the successful development and market acceptance of our products, competition in the market for such products, the product and channel mix, component cost, freight and logistics costs, manufacturing efficiencies, our ability to effectively integrate mergers and acquisitions and other risks detailed in our annual report on Form 10-K for the year ending in December 31, 2022, and our quarterly report on Form 10-Q for the quarter ending September 30, 2022. These risks and uncertainties could cause actual results to differ materially from those in the forward-looking statements, which may be made during the call. It is now my pleasure to turn the call over to Tom Stanton, Chief Executive Officer of ADTRAN Holdings. Sir, please go ahead.

Thank you, Lisa. Good morning, everyone. We appreciate you joining us for our fourth quarter 2022 earnings conference call. With me today is ADTRAN Holdings CFO, Mike Foliano. Following my opening remarks, Mike will detail the quarterly financial performance, and then we will take any questions. I want to start by highlighting the significance of the milestone reported last month regarding our combination with ADVA Optical Networking SE. The Domination and Profit and Loss Transfer Agreement was registered, marking the final step in our operations as a single company. We can now focus on integrating our operations to enhance synergies and shareholder value. Moving forward, I will refer to ADTRAN as a unified entity rather than as two distinct companies. Our initial reason for merging with ADVA was our belief that it would strengthen and diversify both organizations. The main aspects of our combined value proposition include a more diverse and differentiated portfolio, a wider customer base in terms of type and region, and a stronger foothold in our focus markets, particularly in the US and Europe, to take advantage of growth opportunities in fiber networking. The Q4 results illustrate the enhanced product and customer diversity of the combined company. I will share quarter-over-quarter growth statistics on a pro forma basis to show the performance in Q4 compared to Q3, factoring in ADVA’s financials for all of Q3. The financials Mike will discuss will compare Q4 totals quarter-over-quarter, with a partial contribution from ADVA starting July 15, 2022, and year-over-year without ADVA contributions from last year. To clarify, I want to start with optical networking solutions, which saw a 7% quarter-over-quarter increase on a full quarter basis. Growth in this area was particularly strong in Europe, resulting in a 10% rise in non-US optical networking revenue quarter-over-quarter, contributing to an overall 15% increase in non-US revenues. This quarter set a revenue record for optical networking solutions, both for ADVA alone and as part of ADTRAN. We continue to experience robust demand for bookings this quarter, aided by our combined company's initiatives to reduce backlog. Revenue from access and aggregation solutions grew 7% quarter-over-quarter on a full quarter basis, driven by an increase in fiber access platforms. However, performance was partially hindered by operational delays owing to the introduction of redesigned products aimed at resolving supply chain challenges. Overall, subscriber solutions revenue decreased quarter-over-quarter after a record performance in Q3. Revenue from outside the US accounted for 60% of total company revenue this quarter, buoyed by our strong position in Europe. Our success in Europe coincided with sustained demand for fiber broadband solutions from U.S. regional service providers. We experienced record demand from these providers in Q4. We continue to invest in innovation across all segments of our portfolio and are witnessing broad-based demand resulting from these investments. I will now highlight some of the factors driving excitement in our solutions, starting with Optical Networking Solutions, which fueled our growth last quarter. Unlike many other vendors in this field whose success relies on specific customer segments or regions, our solutions are utilized by a diverse range of large service providers, regional providers, internet content providers, government agencies, and major enterprises. Our offerings include multi-terabit transport systems, internally developed optical modules, and infrastructure monitoring solutions. We stand out through operational simplicity, security, and customized solutions that are tailored for our primary applications in metro edge and private Optical Networking sectors. This diversity in solutions, customers, and differentiation places us in a strong position for sustained growth ahead. Our success is underscored by ADTRAN being recognized as the fastest-growing optical network vendor in Europe according to Omdia's latest market share report. We also received the layer one, two, and three networking transformation award in the sustainability category for our Coherent 100ZR transceiver. In our access and aggregation solutions, we officially launched the SDX 6330, our leading open disaggregated fiber access platform. This launch is among the most anticipated in our portfolio in recent years, as the SDX 6330 sets new industry standards for density, scalability, and power efficiency, driving extensive demand from a diverse array of national and regional service providers. The timing of this release aligns well with ongoing investments in next-generation fiber access networks and the emphasis on energy-efficient network infrastructure. We expect the SDX 6330 to contribute significantly to our growth this year, following orders and project awards from several large national operators and numerous regional operators. According to the latest Omdia market share reports, ADTRAN is already the second-largest vendor of 10-gig fiber access platforms across North America and EMEA combined, and this product launch is expected to bolster our position in this market. In our subscriber solutions category, we provide varied offerings that serve residential, business, and wholesale markets. On the residential front, we are seeing continued success from growth in 100-gig fiber CPE and multi-gigabit mesh Wi-Fi solutions. These in-home offerings contributed significantly to our revenue in Q4, and we anticipate that demand will remain robust as service providers expand fiber connections to homes and upgrade in-home connectivity to multi-gigabit speeds. Similar trends are present in the enterprise and wholesale sectors, where there is strong demand for our business-class routers, virtualized edge platforms, multi-gig enterprise switches, and 10-gig Carrier Ethernet termination devices. In the virtual edge cloud arena, we recently signed the largest software contract in our company's history for this segment, highlighting the growth opportunities we have ahead in this space. Our subscriber solutions portfolio is the most comprehensive in the industry for connecting users to fiber networks of all kinds. Our offerings are supported by an extensive software and services portfolio that streamlines engineering deployments and the ongoing operations associated with these fiber networks. On the software side, we are witnessing sustained interest in our SaaS applications, with over 150 service providers already adopting our latest Mosaic One offering, and many more expected to start utilizing this platform this year. As we unify our broader fiber networking portfolio under a cohesive set of software applications, we anticipate this will further drive growth in our software and networking platforms. This highly differentiated portfolio positions us well for ongoing success in our key growth markets, responding to increasing demands from operators, especially our existing customers, in deploying our complete range of fiber networking solutions. With our significantly expanded customer base, this greatly increases our immediate addressable market for these solutions. Long-term public and private investments in fiber networks remain strong, with key funding sources like the $42.5 billion broadband project in the US still slated for the coming years. Efforts to reduce reliance on high-risk vendors, particularly in Europe, remain robust, and we foresee this being a further catalyst for growth in the years to come. As a scaled Western supplier with a diverse technology lineup, we expect to gain from these long-term trends. On the supply chain front, conditions have improved considerably compared to the previous year. The outlook continues to brighten, and we foresee supply chain issues being less of a hurdle for our growth in the near future. Given these elements, we are optimistic about our growth potential and our ability to enhance shareholder value. With that background, I'll turn things over to Mike for a review of our financials. After Mike's remarks, we will address any questions you may have.

Thank you, Tom, and good day to all. I will cover the fourth quarter 2022 preliminary and unaudited results and provide our expectations for the first quarter 2023. Please note that Q4 2022 results include a full quarter consolidation of the ADVA financials, which affects year-over-year and quarter-over-quarter comparisons. Please be reminded that Q3 2022 incorporated only a partial quarter with ADVA beginning July 15, 2022. Since this is the case, I will refrain from repeating the consolidation effects when discussing the year-over-year comparisons of our results. I will be referencing non-GAAP information, with reconciliations to the most directly comparable GAAP financial measures presented in our press release and also certain revenue information by segment and category which is available on our Investor Relations webpage. In addition, we've uploaded and updated investor presentations to this site, which is available for download. Unless stated otherwise, all financials are presented in U.S. dollars. ADTRAN's fourth quarter 2022 revenue came in at $358.3 million, up 132% year-over-year, and up 5% quarter-over-quarter within the lower half of our guidance range of $355 to $375 million. Our Network Solution segment accounted for 89% of revenues in Q4 2022, compared to 90% in Q4 2021, and also 90% in Q3 of 2022. Our Services and Support segment contributed 11% of revenues in Q4 2022, compared to 10% in the year-ago quarter and in the previous quarter as well. Year-over-year and quarter-over-quarter revenue increases were driven by our optical Networking Solutions category, which comprises 40% of revenues, compared to 35% in the previous quarter. Subscriber Solutions & Experience contributed 34% of revenues, compared to 35% in the year-ago quarter and 39% in the previous quarter. Access & Aggregation revenue share was 27%, compared to 65% in Q4, 2021, and 26% in Q3 2022. On a regional basis, for year over year, fourth quarter domestic revenue grew by 41% and international revenue increased by 310%. International revenues make up 60% of our revenue and domestic revenue contributed 40% of Q4 2022 revenues. Customer diversity continues to be a focus with one 10% of revenue customer for the company during the quarter. Q4 non-GAAP gross margin was 39.1%, improving by 3.7 percentage points year-over-year and one percentage point sequentially. Gross margin was positively impacted by higher software sales, product mix, and improvement in supply chain expenses, with the year-over-year, partially offset by unfavorable currency developments. While supply chain constraints lessened during the fourth quarter, we do anticipate challenges and remain focused on managing higher component costs, freight expenses, and expedite fees in the near term. Our non-GAAP operating expenses were $118.6 million, increasing by 123% year-over-year and 9% quarter-over-quarter, which were primarily driven by increased labor costs related to the first full quarter of expenses, partially offset by lower contract services. Operating expenses were 33% of revenue, compared to 34% of revenue in Q4 2021 and 32% of revenue in Q3 2022. We remain on track with our synergy plans and expect total savings of $52 million, which will be realized with 43% in 2023 and 57% during 2024. Non-GAAP operating profitability was $21.5 million, which translates into a non-GAAP operating margin of 6%, compared to 1% in Q4 of 2021 and 6% in the previous quarter. The year-over-year improvement in operating profitability was driven by higher revenue volume at more favorable gross margins. The quarter-over-quarter remained flat with improvements in gross margins being offset by higher operating expense. Other income on a non-GAAP basis significantly increased year-over-year and quarter-over-quarter, primarily due to unrealized gains on foreign exchange forward contracts. We entered into a Euro, US dollar hedge arrangement to provide payment security of future Euro denominated payment obligations. The company's non-GAAP tax provision for the fourth quarter of 2022 is currently expected to be an expense of $15.9 million, or 50%. The company's GAAP tax is expected to be a benefit of $57.5 million or 255%. The difference between the GAAP and non-GAAP tax rates is primarily driven by changes in our valuation allowance as the company released the majority of its valuation allowance against its domestic deferred tax assets during the fourth quarter. Closing out our income statement results, the non-GAAP net income was $15.7 million $9.9 million after adjusting for minority shareholder interest in ADVA. This results in diluted earnings per share attributable to the company of $0.12 per share. Following the DPLTA on January 16, 2023 and beyond, ADTRAN will absorb all of ADVA's profits and losses. However, the net income attributable to common shareholders of ADTRAN will be reduced by the recurring cash compensation paid to the minority shareholders as part of the DPLTA agreement. This recurring annual compensation for the minority shares outstanding amounts to €0.59 per share. Turning to the balance sheet and cash flow statement, cash and cash equivalents totaled $108.6 million at quarter's end. For the quarter, operating cash flow was $812,000 mainly due to the higher inventory levels and business combination expenses. Net trade accounts receivable were $279.4 million at quarter's end, resulting in a DSO of 72 days, compared to 82 days in the prior quarter. Net inventories were $427.5 million at the end of the fourth quarter resulting in terms of 2.4, compared to 3.1 in the third quarter of 2022. The company continues to carry a higher level of inventory and raw materials to minimize further disruptions, given the challenging electronic component market and continued extended lead times. Trade accounts payable were $237.7 million resulting in DPO of 67 compared to 71 days in the previous quarter. Looking ahead to the first quarter of this year, the continuing effects of the COVID-19 pandemic, the ability of component supplies to align with customer demand, the book and shift nature of our business, the timing of revenue associated with large projects, the variability of ordering patterns from our customer base, as well as fluctuation in currency rates, and any potential additional required purchase accounting adjustments related to the ADVA merger may cause material differences between our expectations and the actual results. We continue to focus on the supply side, related cost challenges, and our merger integration. We see signs of normalization in the semiconductor supply chain and expect our backlog to moderate and decrease inventories over the upcoming quarters. We will continue to focus on cost management and operational efficiency while investing in key areas to drive growth. We're confident that our strategic plans and disciplined execution will enable us to deliver strong financial performance and create value for our shareholders. With that in mind, we expect that our first quarter 2023 revenues will be between $355 million and $375 million and we expect a non-GAAP operating margin between 5% and 6.5%. Once again, additional financial information is available at ADTRAN's Investor Relations webpage. I'll turn it back over to Tom and we'll take your questions.

Super. Thanks Mike. At this point, we'd like to open up to any questions people may have.

Thank you. The question-and-answer session will be conducted electronically. We'll take our first question from Michael Genovese with Rosenblatt Securities.

Hey guys, this is Andrew King standing in for Genovese. Thanks for taking my question. First off, can you break out the revenue contribution from ADVA versus ADTRAN organic?

Yes, so the ADVA contribution on a US dollar basis was $202 million.

Got it? And then I'm not sure if I missed this detail this quarter, but I know last quarter you had mentioned that on the gross margin side, you've seen approximately 350 basis points of impact from supply chain. If you could update that number for this quarter? And then if you continue to see the supply chain improvements that you saw through this quarter, how much of that would you expect to gain back through the year of FY 2023?

Yes, the first part is a little easier than the second part on that question. So, let's start with the easy one. Compared to the 350 basis points for this past quarter, it was 260. So, roughly 2.6 percentage points of impact is still out there. So, you see it's going in the right direction. We expect it will continue to move in that direction, but it's not going away over the near-term quarters. So, I think there will be a hangover for a while there just of extra purchase price variation and cost that we have paid to secure components that some of that is remaining on the balance sheet. I think we've said before that we're starting to see freight and logistics costs dropping as more capacity has come online and rates have reduced a bit, but it's still a bit elevated from where it has been in the past. So I can't tell you exactly what's going to happen in the future, but we do expect it to continue to move in the right direction.

Got it. And if I can just sneak in one more quick one here. You saw a trend that started to defy the industry this quarter, which is your book to bill remained around 1% and your backlog came up about 2% sequentially. So I mean, what do we have to see in the improvement in supply chain to see that backlog start to get released and come back down to historical levels, and how much do you expect to be released over this next year and this next quarter?

You're right about the book to bill ratio, and we continue to see strong order entry. Over the next three quarters, we are hopeful for improvements, though we can't say for certain. Some issues stem from missing one or two components out of a total of around 200, but those situations are improving. Unfortunately, the missing component issues remain the most challenging. I expect significant improvement throughout this year, as we are focused on managing the longest lead times in our backlog and clearing those out, including anything that may impact customers. I believe conditions will notably improve by the third quarter.

Understood. Thanks for taking my questions.

Okay.

Thank you for the questions. Tom, could you elaborate on the strong performance in Europe? It seems ADVA had an excellent quarter there. What specific applications are contributing to their success with service provider customers? Additionally, could you provide an update on ADTRAN's progress regarding core fiber wins in Europe? That would be appreciated. Thank you.

In Europe, the optical solutions segment showed strong performance across metro and private networks. There was a general trend of companies upgrading their networks to support increased speeds, driven by the significant growth in data flow. There wasn't a specific highlight; instead, the strength was widespread. Regarding the ADTRAN fiber access segment, we have several awards in progress that we expect to finalize this quarter. Currently, all the projects we discussed are through lab trials and ready to proceed. The main factor affecting this is our ability to deliver products. I noted that the 6330 has been delayed until this quarter, and many customers are awaiting this model. It’s our latest, most differentiated platform, and several awards were based on it, so we need to get it shipped out and anticipate distributing it towards the end of this quarter.

Super helpful. Thanks. And just as a follow-up, you mentioned your large software run, do you have any color on that you can share what type of customer or what type application?

Yeah. That was the largest. So we have NFV solutions, which are kind of by feature solution that was our largest NFV to date. So that was using the ensemble platform.

Got it. That's like business demark, like a universal CPE type model?

Yes. That's correct.

Got it. That's it, Tom. Thanks so much.

And NFV is finally shipping after being in development for a while.

Thank you for taking my question. I was wondering if you could discuss the Huawei replacement cycle and where you are seeing the most activity. I assume it's in the UK. Also, how much of that contributed to your revenues for the quarter? Thank you.

That's a good question. I should have mentioned what’s happening in Europe with our optical solutions as much of this activity stems from carriers and enterprises needing to remove non-trusted vendors from their networks. The situation can be approached in various ways. If I consider just the basic borders, the UK is indeed the strongest, having made early decisions a couple of years ago to migrate away. Almost all major carriers, if not all of them, are currently engaged in these changes. We added five additional carriers in Europe, with most being affected by the need to adjust their vendor choices. In fact, I would argue that all of them have been influenced by this necessity, leading to either new contracts or expedited projects. This trend is also reflected in the optical solutions space. That's why we are starting to see this activity increase, as companies are compelled to make decisions.

Thank you for that.

Thank you for taking my question. My first question is about residential SAS. Could you provide us with an update on that? Additionally, with the availability of the Wi-Fi 6 chip, do you have an estimate of how quickly this can grow in 2023?

Yes. So it is a hot area. I mentioned that our subscriber solutions were down on a quarter-over-quarter basis, but we had a really kind of super focused on trying to clean up some of that backlog in Q3. Demand hasn't lightened a bit in that product area, both for RDS and RNTs. In fact, I think RNTs made actually set a record this quarter. They were very, very strong. On the SAS front, I'd also mentioned, we've crossed 150 customers. I will tell you, carrier customers. All of those, of course, have subscribers that are tethered to them. We are working through the backlog of onboarding these customers. So my guess is we're probably of that 150. We're probably about 50% of those are online now or very close to being online. That backlog continues to grow. Our SAS customer kind of continues to grow at over 30% year-over-year rate, and I was actually at that rate again this year. So, a very good uptake on that. And I would say software in general was a positive note. I mentioned the ensemble piece, but just from a revenue perspective, all of that's coming in line and we're very happy with what we did this quarter.

Okay. As you had 2 million end subscribers, not service providers, but end subscribers at the end of September. Do you have an idea where you were at the end of December?

We're currently over 2 million subscribers and that number continues to increase. We haven't decided to break out that figure yet, but I can assure you it is significantly above 2 million.

Okay. Another question on the middle-mile, can you talk a little bit about what your strategy is in the States and what you're seeing out there and what we might expect this year and next as far as new orders?

Yes, the reception in the US has been very positive. We have already secured deals and begun shipping them. The introduction of the combined company's assets has influenced carriers' buying decisions, either continuing ongoing projects or initiating new ones, particularly in the RSP space in the US, where we are seeing a strong response, indicating we are just in the beginning stages. In Europe, things are progressing as planned. We have received introductions from the ADVA customer base using ADTRAN equipment and are effectively collaborating in our approach to customers. This unified strategy is clearly impacting how we present to large carriers and their requirements. Overall, from the customer perspective, I can't identify any negatives.

Okay. If I could ask one more question. What business does your German security company encompass, and what is your strategy for pursuing new business? Who is your target market, and what kind of revenue can we anticipate from it? Additionally, will this be reported separately in the future?

Mike, would you like to discuss the breakout of the ANS revenue?

Yes. We don't break it out today. If it grows larger, we would actually break it out, but it's not reported separately today. The customers that we're focused on mostly there are government customers who have high security requirements, mostly in Europe. But they can actually sell elsewhere as well. The products, I think, Paul, that are in there are all around high-level encryption and security technologies. So its things that governments are using for their own private networks to ensure secure communications.

You can estimate it to be less than $50 million, likely in the multi tens-of-millions range. We fully anticipate growth, but it is very targeted in focus.

Hey, good morning. I wanted to get a quick one in on the tax rate. It's been pretty volatile. So, Mike, I wonder if you have any expectations for Q1 or the year. And then, on to a more substantive question. Tom, you mentioned you couldn't think of any negatives on the customer side, maybe we can explore that a little further. Seems like one of your US based competitors is seeing a pretty good-size win at Deutsche which given the strength that you saw in the quarter with ADVA, I assume that's your largest customer for the quarter or at least in competition. I wonder if you could talk about that competitive environment more broadly. And if I have time for a follow-up I'll jump in there. Thanks.

Yeah. Let me start with the tax.

Well, I will tell you know everybody has to have two vendors and well I should say most companies have to have two vendors. I would say with our position within that account both from a relationship side, but really more specifically from the technology side where giving the possible scenarios of what could have happened, we're happy with where we are. I think we're in a good position there. So as you know, that used to be a three-vendor account, with us Huawei and Nokia and that is materially changing. And we think we're in a really good position. So hopefully, that answered that question.

Sure. I think you're right that we've had some pretty big volatility on our tax rate, the 50% that we ended with in the quarter there is driven just by a lot of the International taxes that are coming from the business combination. And then with the global intangible low tax income rolling across that we've had some increases there. Now our non-GAAP rate for the year was 21.7, so maybe just slightly higher than we had expected. The last quarter was really making up for some benefits that we saw earlier in the year because of the changes that happened in the tax code. Looking ahead, at what we're expecting for 2023, I would say our non-GAAP rate should be in the low to mid-20s percentage rate, and we should have a lot less volatility going forward. Now that the valuation allowance has been mostly eliminated, I think it changes in the valuation allowance caused some swings in that non-GAAP rate as well. So I think it should settle out a bit into that low-20s percentage rate.

Tim, did that answer your question?

It certainly does. If I may follow up briefly, I'm referring to the standalone ADTRAN performance this quarter, which saw a double-digit decline sequentially and was relatively flat year-over-year. You mentioned the subscriber solutions possibly contributing to this trend, and you highlighted the strengthening in US rural areas. Is there anything specific outside of that, perhaps related to new product offerings, that is influencing the ADTRAN standalone numbers?

The biggest unexpected impact was the launch of the 6330, which was initially set to ship in Q4 but is now aimed for the end of this quarter. We faced some challenges with supply and the necessary approvals, which affected us a bit. Additionally, we encountered issues redesigning many of the predecessor model, the 6320, which delayed its release. This had the most significant effect on our performance. However, the 6320 is now shipping, so that issue is behind us, while we still have some work to complete on the 6330.

Okay. Thanks very much.

Okay. All right. I think that's the end of our questions session. So I appreciate everybody joining us today and we look forward to talking to you next quarter. Thanks very much, everyone.

Thank you. That does conclude today's presentation. Thank you for your participation and you may now disconnect.