ADTRAN Holdings, Inc. Q1 FY2024 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to ADTRAN Holdings, Inc. First Quarter 2024 Earnings Release Conference Call. As a reminder, today's call is being recorded. 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 risks detailed in our earnings release, our annual report on Form 10-K and our filings with the SEC. 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. We undertake no obligation to update any statements to reflect the events that occur after this call. During the course of today's call, we will refer to certain non-GAAP financial measures. Reconciliations of non-GAAP to GAAP measures and certain additional information are also included in our investor presentation and our earnings release. The investor presentation found on ADTRAN Investor Relations website has been updated and is available for download. 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, Julianna. Good morning, everyone. We appreciate you joining us for our first quarter 2024 earnings conference call. With me today is ADTRAN Holdings CFO, Uli Dopfer. Following my opening remarks, Uli will review the quarterly financial performance in detail, and then we will take any questions you may have. Our first quarter revenue came in as expected with revenue just above the midpoint of our guidance range and non-GAAP operating margin within guidance. Our focus on managing expenses and reducing inventory levels helped us achieve positive free cash flow during the quarter despite the near-term headwinds that continue to impact service provider spending. While we do see signs that the market will improve as we move through the year, we will continue to focus on managing our expenses and further reducing our inventory levels. Taking a closer look at the results in the first quarter, the overall revenue and geographical mix was very close to the results from the previous quarter, with 63% of our revenues coming from outside the U.S. On the product mix, we were well balanced in revenue across the three categories, with 31% of our revenue coming from subscriber solutions, 36% from access and aggregation solutions, and 33% from optical networking solutions. Our subscriber solutions category was down 7% quarter-over-quarter after posting a strong quarter in Q4. The Access and Aggregation solutions category was up 27% quarter-over-quarter, driven by an increase in shipments of our fiber access platforms for both European and U.S. customers. Optical Networking Solutions continued to be impacted by inventory reduction initiatives with customers. We had two primary areas of sequential growth in the quarter. In the U.S. market, we had a strong quarter with our small to midsized service provider customers purchasing our fiber access platforms and residential fiber CPE. This customer segment was up sequentially for both direct purchases and indirect purchases through our distribution partners. The second area of strength was our large customers in Europe. This customer segment had a strong quarter with purchases of our fiber access platforms and Ethernet CPE. These two customer segments, the small to midsized service providers in the U.S. and the larger service providers in Europe, are where we continue to see the highest growth potential moving forward, given their close alignment with our strategic initiatives and portfolio investments. These two key strategic initiatives to maximize the investment opportunity in fiber-based broadband networks in the U.S. and high-risk vendor replacements in Europe continue to drive our corporate focus. Taking a closer look at these market segments, I will start with the U.S. market. This past week, we hosted our Broadband Business Solutions Summit at our corporate headquarters here in Huntsville. This is a multi-day event that we host twice per year, with attendees primarily being small to midsized U.S. broadband service providers. These are the customers that are leading the charge in building out fiber across the U.S. The energy there was as high as it's ever been, and we had a record attendance with over 180 customers and partners at the event. That excitement really comes from two areas. For one, despite some recent challenges, it is still a good time to be in the market. Nearly half of the U.S. households still lack a fiber connection, and the government stimulus programs funding further investment in these networks are still in their early stages. During our event last week, a quick poll of the audience showed that more than 80% of customers in attendance were participating in broadband stimulus programs. The second driver for this excitement comes from the broader set of needs that we can meet with this customer segment. We have been very intentional in creating a more comprehensive fiber networking portfolio that is optimized for the needs of these small and midsized U.S. service providers. These customers ideally want to buy in-home networking solutions, business networking solutions, fiber access platforms, optical transport platforms, network automation software, and cloud-based monitoring tools from a single vendor that they can trust to deliver reliable solutions and support them throughout their deployments. On top of that, the solutions need to integrate seamlessly with their existing systems without a lot of custom IT integration activities. There is only one vendor that can check all of these boxes, and that's ADTRAN. You can go through each segment of our portfolio and see where our investment, more comprehensive and integrated portfolio is paying off. In our residential portfolio, we have launched Intellifi, along with our latest SDG series of WiFi 7. We have already signed up dozens of customers for Intellifi, making it the highest growth application in our Mosaic SaaS application suite, aiming to push the total number of service providers adopting Mosaic 1 to 400. We have added 36 new Mosaic 1 customers this past quarter. On the network infrastructure side, we have taken the best fiber access platform in the industry, our SDX Series, and integrated it into the leading billing systems targeting the U.S. regional service providers. These efforts have led to a surge of deployments over the last six months, helping us add nine new fiber-to-the-home operators just this past quarter. These customers were a mix of new operators and vendor swap-outs. As operators build out these higher-capacity fiber access networks, they need to upgrade their transport networks as well. We have spent the past two years developing an optical network solution that is optimized for the needs of regional networks. Regional middle mile and backhaul networks need the capacity and reach enabled by technologies like Coherent, DWDM, widely deployed in core networks, but they need this technology to be optimized for regional network deployments. This network optimization means integrated temperature-hardened pluggables, enabling up to 800 gig speeds instead of traditional large overlay systems. That also means you need end-to-end service automation and precision monitoring of the fiber infrastructure. After a sizable and well-thought-out investment, we have launched an optical portfolio that is tailored to address all these needs and is the perfect complement to our fiber access and subscriber solutions portfolio. Reinforcing that progress over the past two quarters, we have had over 20 U.S. broadband service providers start to purchase our Ethernet and optical portfolio that were previously broadband-only customers for ADTRAN. We see this segment continue to accelerate as these customers increase their builds with stimulus funding. Our fiber networking solution set, covering everything a small and midsized operator needs to deploy fiber to every home, business, and 5G site, is paired with an increasingly integrated management suite that simplifies the deployment and operation of these networks. We believe the progress in selling our complete portfolio offering paired with our strong regional capabilities, which include local manufacturing, has us well positioned to succeed in the upcoming BEAD project in the U.S. One notable milestone with our local manufacturing is that we have now shipped over 1 million OLT ports that comply with the latest Build America by America rules that are part of BEAD, highlighting our long history of U.S.-based manufacturing. Moving to Europe, the theme around investments in our portfolio beginning to pay off is consistent with what we are seeing in the U.S. market. But that customer segmentation and market drivers are a bit different. In Europe, many of these service providers are migrating away from high-risk vendors and they are making the shift as they upgrade their fiber network infrastructure. Also, while we are very successful with smaller alt nets in Europe, the bulk of the investment is still coming from larger service providers in the region. These customers value a trusted secure partner with a broad portfolio and scale deployment in the region. It is also just as important to have in-region R&D, sales, installation, support services, and supply chain capabilities as well. ADTRAN is one of only two vendors that can address these needs. As I mentioned earlier, this past quarter was very successful with our large European customers deploying our fiber access platforms. For our two largest customers in the U.K. and Germany, we continue to ramp deployments of our latest high-density 10-gigabit fiber access platform, the SDX 6330, which was the key catalyst for this growth this quarter. We were also selected as a vendor in the latest Ethernet aggregation service offering at one of these customers. The technical superiority of the SDX 6330, which has better power efficiency and density than competitive solutions, while also building on a more modern architecture, has us well positioned for sustainable success with these customers and other operators in the region. One of these operators is a multinational Tier 1 operator where we have already been deployed in three countries. We have recently launched customer trials in a fourth and larger country that they operate in, opening new growth opportunities for us later this year. In another Tier 1 fiber access operator that we won last year with the SDX 6330, we continue to make great progress through the lab and remain on track for scale deployments next year. In addition to these projects, we have recently awarded a strategic software contract for MPLS Edge routers with a multinational Tier 1 operator. This MPLS software suite for our packet aggregation platforms has experienced high demand in the past six months, providing another growth opportunity for us moving forward. On the optical transport side, where we have traditionally been very strong in Europe, we remain on track to start deployments late this year with our recent Tier 1 optical wins. With the recent launch of the M-Flex 800 and our latest 800-gig optical platform, we are still well positioned to benefit from the next upgrade cycle from 400 gig to 800 gig across our broad optical customer base in that region. In summary, we have introduced key enhancements across our portfolio, enabling us to be more competitive in landing new customers and expanding our business with existing customers. These portfolio enhancements paired with our strong regional presence and progress in selling our complete portfolio offering have us well positioned for success in the ongoing investment cycle in fiber networks across both the U.S. and Europe. While we remain confident in our long-term outlook, we see a path to growth in the quarters ahead. We continue to see cautious spending from service provider customers, driving us to keep a cautious approach to our forecast and operating model. As a result, we will continue our focus on becoming a leaner, more efficient, and more profitable company with a best-in-class fiber networking portfolio. With that, I will turn things over to Uli to provide a review of our financial results. And following Uli's remarks, we will answer any questions you may have.

Thank you, Tom, and hello, everybody. I will cover our Q1 2024 results and provide our expectations for the second quarter of 2024. 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 web page at investors.adtran.com. In addition, we have updated the investor presentation to the site, which is available for download. Unless stated otherwise, all financials are presented in U.S. dollars. Q1 2024 revenue came in slightly above the midpoint of our guidance at $226.2 million and was down 30% year-over-year but slightly up sequentially. Our Network Solutions segment accounted for 80.1% of revenues in Q1 2024 compared to 87.2% in Q1 2023 and 80% in Q4 2023. Our Services & Support segment contributed 19.9% of revenues in Q1 compared to 12.8% in the year-ago quarter and 20% in the previous quarter. Access and Aggregation contributed 36% of revenue and was down 16% compared to the year-ago quarter but grew 26.6% sequentially. Our optical networking solutions category contributed 33.2% of revenues and was down 49% year-over-year and down 12.7% quarter-over-quarter. Subscriber Solutions contributed 30.8% and was down 12.1% year-over-year and down 7.3% quarter-over-quarter. International revenue made up 63.2% of total revenue and domestic revenue contributed 36.8%. We had two customers contributing 10% or more of revenue in Q1 2024. Q1 non-GAAP gross margin was 41.6% and increased by 429 basis points year-over-year and was slightly below Q4 2023. The year-over-year improvement is mainly driven by lower manufacturing and transportation costs and a more favorable customer product mix. Q1 non-GAAP operating expenses were $102.7 million, 8% down year-over-year and slightly up quarter-over-quarter. The sequential increase was mainly due to unfavorable currency exchange rates as well as two seasonal effects. Year-over-year, we reduced non-GAAP R&D spend by 20% and SG&A expenses by 16%. Non-GAAP operating loss was $8.8 million, which translates into a non-GAAP operating margin of negative 3.9% compared to negative 1.4% in Q4 2023. Our operating margin was within our guidance range of between negative 7% and 0% of revenues. The sequential decline in operating margin was attributable to higher OpEx and slightly lower gross margins. The year-over-year decrease in operating profitability was due to lower sales volume, partially offset by improved gross margins and operating expense reductions. The company's non-GAAP tax benefit for the first quarter of 2024 was $13 million. Total non-GAAP loss was $1.7 million, and after adjusting for minority shareholder interest in Adtran Networks SE, this resulted in a non-GAAP diluted loss per share attributable to the company of $0.02 per share compared to $1.09 in Q4 2023 and $0.14 in Q1 2023. Turning to the balance sheet and cash flow statement. In Q1 2024, we made significant improvements to our working capital. Trade accounts receivable were $187.6 million at quarter end, resulting in DSO of 75 days compared to 88 days in the prior quarter. We reduced our inventories by $40.1 million compared to Q4 2023. The improved working capital resulted in positive operating cash flow of $36.6 million compared to a negative operating cash flow of $16.3 million, an increase of $52.9 million quarter-over-quarter. Consequently, we generated $23.2 million of free cash flow. This resulted in a noticeable increase in cash and cash equivalents which came in at $106.8 million, a quarter-over-quarter increase of $19.6 million or 22%. In summary, near-term headwinds continued to impact service provider spending throughout the quarter. We continue to focus on the execution of our business efficiency program and as a result, managed to significantly increase our cash flow quarter-over-quarter, resulting in positive free cash flow. Even as we continue to see cautious spending from our service provider customers, we remain confident in our long-term outlook as we see a path to growth in the quarters ahead. We are convinced that the long-term growth drivers for our business are fully intact. We expect that investment in data-driven infrastructure and the fiber everywhere future will continue, supported by stimulus funding and the desire to reduce exposure to high-risk vendors. We continue on capturing fiber footprints with our upgraded fiber access and optical transport platforms while driving the adoption of our latest subscriber platforms, software solutions, and high-value services. We maintain our focus on becoming a leaner, more efficient, and more profitable company with a best-in-class fiber networking and software portfolio. Consequently, for the second quarter of 2024, we are narrowing our guidance range to between $215 million and $235 million, and we expect a non-GAAP operating margin between negative 3% and positive 2% of revenues. Once again, additional information is available at Adtran's investor web page at investors.adtran.com. I will now turn it back over to the operator, and we will take your questions.

Our first question comes from George Notter from Jefferies.

I guess I would like to just step back and kind of, I guess, better understand the bigger narrative here on the business. Obviously, over the last year, one and a half years, we've been talking a lot about excess inventories at customers. I know that your CPE business kind of went through that excess inventory and digestion phase. I think we're out of it now, but I'd love to hear your comments there. And it seems like we're still in that phase with optical, but just give us the picture on excess customer inventories? What do you see? What parts of the business are getting better? What parts of the business are still going through it? What's the picture?

Yes, let me begin by highlighting that the area with the least inventory is our access and aggregation, particularly the fiber-to-the-prem OLT product line, which currently has minimal stock available. This segment has been the least affected, as reflected in the numbers and growth we observed. In terms of subscribers, many customers have resolved their inventory issues, but some still have excess stock due to overordering. Overall, the situation is improving month by month. Regarding optics, you are correct; this area is still facing inventory challenges. While some larger customers may have surplus, which can skew the overall numbers, that situation is also improving, although it will take more time to fully resolve. Does that address your question?

Any expectation on when you would get through that inventory on the optical side of the business?

I believe it will resemble the previous three cases. We will see some improvement, although it will be limited due to the current inventory levels. We anticipate enhancements in the second half of the year, and we may navigate most of the challenges by then. Looking at the inventory situation with our larger customers today, we expect to address that in the latter half. However, some will show stronger performance. I expect improved numbers moving forward. That said, I want to temper expectations a bit. While we feel we are at the lowest point right now, there could be surprises. At this moment, we believe the positives and negatives balance out historically. For the other two areas, we expect continued strength through the second half.

Okay. Great. And then you also made some comments about just softer service provider spending, cautious service provider spending. I guess I want to delineate between what is a byproduct of excess inventory versus what is just genuinely softer consumption rates by customers. Do you have a perspective on that?

It depends. There are many different ways to analyze that. In Europe, particularly with larger customers on the access side, they are proceeding with their plans, which contributed to a strong quarter there. In the U.S., there is some caution, but it varies. It depends on the customer; some are advancing while others are equity-backed and pursuing aggressive strategies. Some customers are waiting to see how the stimulus measures will unfold, while others are taking steps forward even as they watch the situation. Overall, it's a mixed scenario. Demand is present, but the current environment has undoubtedly affected it, making it challenging to determine how much is due to inventory issues. I would say that inventory remains the primary concern.

Our next question comes from Michael Genovese from Rosenblatt Securities.

I understand the situation with access and aggregation. It seems we need a few more quarters of inventory reduction for optical platforms before we see improvement there. Can you provide more details about subscriber solutions and experiences? Specifically, what’s the status of inventory versus demand in that area? Additionally, could you clarify how much of that category relates to access versus optical, and if there's any distinction between optical and access in subscriber solutions? That would be interesting to know.

Let me share a few thoughts that come to mind that could clarify the situation. First, our subscriber numbers showed solid performance last quarter, especially in the residential segment. While there was a slight decline, it wasn't significant, indicating that the issues with inventory are resolving. Most customers seem to view this as a past concern rather than an ongoing one. However, looking at the year-over-year trends, Subscriber Solutions did see a decline overall. It's worth noting that the residential segment actually increased, while shipments of ONT and CPE Ethernet also rose. The only decline occurred with some legacy products sold to a major carrier in Europe and another in the U.S., both of which are experiencing inventory challenges. Excluding those two customers, the entire category would reflect growth both sequentially and year-over-year. We are definitely making progress in navigating through that inventory situation.

Could you help us understand the breakdown of subscriber solutions, specifically how much is related to the access business versus the optical business?

On the optical side, it's the Ethernet piece is kind of the traditional, I'll call it, Adva piece that we're talking about here. And that business is actually doing pretty good. And then the other pieces of that are the subscriber piece is broken up multiple areas, right? One is residential, and that's kind of the ONTs, RG, the things that are driven by fiber to the print shipments. That business is up on a year-over-year basis. The piece that is down is we have, if you remember, traditional switches and routers, but those typically go through carriers, and they go along with service offerings from those carriers. And we have two big customers that drive that business, and both of those customers were down. That's the whole totality of subscriber solutions.

Got it. That's helpful. And then my other question is, you are clearly making significant progress on the management front, aiming to enhance profitability even if revenues are lower for a certain period. I can see that, but I want to ensure I'm not overlooking anything. There's restructuring and managing working capital, including reducing inventory. My main question is, am I missing anything that I should be paying attention to? Also, could you provide an update on any developments related to the real estate portfolio transactions?

Yes, we have some real estate in Huntsville that is currently for sale. We have two distinct properties. One is a tower that is currently 90% unoccupied, and we expect to fill the remaining space by the end of this quarter. That property is on the market now, and we have received some interest, although nothing has been finalized yet. The other property in Huntsville has potential for a sale leaseback, which we are considering carefully to ensure we make the right decision at the right time. Therefore, we may or may not proceed with that transaction.

And were there any other categories of kind of like the OpEx restructuring, working capital management? Any other kind of big categories of what you're thinking about to improve the market?

These are the main categories, Mike. Our business efficiency program includes getting more efficient as a company, optimizing costs, and optimizing physical footprint. And then, of course, the working capital measures you mentioned, the big piece here is the management of inventory.

We did also announce the closure of a site in Germany earlier in the quarter.

Our next question comes from Ryan Koontz from Needham & Company.

We would like to hear your thoughts on the customer summit you held. We've noticed that some of your counterparts in the U.S. have mentioned that BEAD is causing a slowdown in customer activities and planning. Additionally, there seems to be significant concern among smaller customers regarding the regulatory requirements related to BEAD, which may lead to some resistance. Could you share any insights on these matters from your summit?

Yes, we discussed this extensively. BEAD has not yet begun to flow significantly, and it's evident that some states are more effective at implementation than others. There is considerable interest, with around 80% of participants utilizing stimulus dollars and receiving ARPA funds. Various funding sources are available, and most entities are engaged in some capacity. During our recent event, a quick survey indicated that over 80% of attendees were involved in broadband stimulus programs. The second source of excitement stems from the wider array of needs we can address for this customer segment. We have intentionally developed a more comprehensive fiber networking portfolio tailored to the requirements of small and mid-sized service providers in the U.S.

Got it. Helpful, Tom. Regarding OpEx efficiency, I understand there were some one-time impacts from foreign exchange and likely seasonal payroll factors that affected Q1. What is our outlook for OpEx efficiency moving forward? Can you provide more insight into how you view this line for the remainder of the year?

We haven't reached our target yet, but we outlined a plan where Q2 would be the point at which we achieve our ultimate objective, which is actually below the Q1 level, and that’s our goal for this quarter. I'm not sure if you have any additional detailed questions.

We said not the last earnings call, the earnings call before, if you recall it, Ryan, we said our target is to reduce our 2024 expenses by $90 million compared to 2023, and this is still our target.

All right. Thanks. I think we have any more industry regards.

We do have one more question from Tim Savageaux from Northland Capital.

We had a couple of questions. The first one is about the outlook, which seems to be relatively flat. Could you share more details on your expectations by segment? It appears that after a strong quarter in access and aggregation, growth might continue, possibly even in subscribers, though this could be countered by ongoing inventory challenges in optics. Can you confirm if this is a correct interpretation or if there are other factors at play?

Yes, I believe that is directionally accurate. The way you described it is correct.

Great. And I assume you had some pretty sharp moves sequentially in Q1, would you expect those movements by segment to be a little more modest in Q2?

I guess I don't know what you mean in my sharp moves.

I mean, access and aggregation was up 30% sequential almost in Q1. I mean those type movements.

Yes. We're not expecting that kind of sequential increase on a quarterly basis. We would anticipate them to reach the numbers we discussed. We are expecting a modest increase sequentially, while optical is expected to see a modest decrease.

Great. I was wondering if you could comment on whether you had any customers in the U.S. for the 10% increase, or should we assume they are both international?

They're both international.

Great. And last question on the Q2 guide. Obviously, your gross margins were up pretty sharply. And you mentioned the drivers there, OpEx just reiterated the target there was certainly higher than I was looking for. I mean, to some degree, as you look at the Q2 guide for modestly negative operating margins, should we expect that to reverse a little bit maybe with gross margins backing off and along with OpEx coming down pretty solidly?

Gross margin is influenced by customer and product mix, particularly in the last month of the quarter, and there are many variables at play. If you consider your model, as Tom mentioned, we anticipate that operating expenses will decrease in the second quarter. This would suggest that if you adjust for the midpoint of the guidance, gross margin might also see a slight decline.

Well, I think we're through the call queue. So thank you very much for joining us on our conference call this quarter, and we look forward to talking to you next quarter. Thank you.

This concludes today's conference call. Thank you for your participation. You may now disconnect.