ADTRAN Holdings, Inc. Q2 FY2024 Earnings Call

Ladies and gentlemen, thank you for being here, and welcome to the ADTRAN Holdings, Inc. Second Quarter 2024 Earnings Release Conference Call. All lines have been muted to minimize background noise. After the speaker finishes, there will be a question-and-answer session. As a reminder, this call is being recorded. During the call, ADTRAN representatives will likely make forward-looking statements based on management's best judgment with currently known factors. However, these statements involve risks and uncertainties, which are outlined in our earnings release, annual report on Form 10-K, and SEC filings. These risks could lead to actual results differing significantly from the forward-looking statements made during the call. We do not have any obligation to update these statements to reflect events that occur after this call. Throughout today’s call, we will mention certain non-GAAP financial measures. Reconciliations of non-GAAP to GAAP measures and additional information can be found in our investor presentation and earnings release. The updated investor presentation is available for download on the ADTRAN Investor Relations website. Now, I am pleased to turn the call over to Tom Stanton, Chief Executive Officer of ADTRAN Holdings. Please proceed, Tom.

Thank you, John. Good morning, everyone. We appreciate you joining us for our second 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. While the quarter came in largely as expected, financially, we realized a non-GAAP operating profit driven by gross margin improvements and substantially lower operating expenses. Working capital was significantly reduced as we continue to decrease our inventory levels. Our non-GAAP free cash flow was positive for the second straight quarter, and we grew our customer base across the U.S. and Europe, as customers continue to adopt our latest fiber networking solutions. We achieved all of these despite the headwinds that we are all feeling. Taking a closer look at the results in the second quarter, we had a strong quarter in the U.S. with revenue up across all three categories in this region. On the product mix, we were well balanced in revenue across our three categories, with 36% of our revenues coming from Subscriber Solutions; 31% of revenues coming from Access and Aggregation solutions; and 33% of our revenues coming from Optical networking solutions. Our Subscriber Solutions category was up 18% quarter-over-quarter with growth led by our residential solutions that were up 47% quarter-over-quarter. In our Access and Aggregation solutions category, growth in the U.S. broadband revenue was offset by declines in shipments to our large European customers following a strong first quarter of shipments to these customers. Optical networking solutions was essentially flat relative to the prior quarter. Taking a closer look at the regional mix, we saw sequential growth in the U.S. across all major customer segments, with these customers purchasing a diverse set of in-home broadband access and Optical Networking Solutions. From an investment perspective, we remained focused on our two key strategic initiatives, maximizing our opportunity in the U.S. broadband investment cycle, and taking advantage of the shift away from high-risk vendors in Europe. In the U.S., our highest growth opportunities remain with small to mid-size operators. Our results this past quarter reflected our continued strength with these customers. In Europe, the biggest opportunity remains with large operators, where we are well positioned with our fiber networking infrastructure solutions. Diving deeper into these two markets, I'll start with the U.S. market, where we are seeing signs of stability after the past couple of years have been more volatile due to the supply chain crisis, followed by inventory corrections. As noted earlier, our biggest opportunity in the U.S. is with the small to mid-size operators that really see value in trusted partners that can meet their fiber networking needs from the Optical core to the customer premise. This more comprehensive portfolio continues to pick up momentum. To give you a few highlights, we added 12 new Fiber-to-the-Prem customers in Q2, most of this being U.S. regional service providers adopting our latest SDX fiber access platforms. We also had 16 new customers adopt our SDG in-home platforms this past quarter, bringing the total number of customers adopting our latest WiFi platforms to well over 200. This success in our SDG platforms helped drive revenue growth in our Subscriber Solutions category this past quarter and is closely aligned with our investment in our latest WiFi 6 and WiFi 7 platforms, along with our Intellifi cloud-managed WiFi solutions. For both our new Fiber-to-the-Prem wins and the in-home platform wins this quarter, a material percentage of those were actually competitive takeaways. In our Optical transport and networking solutions this past quarter, we had 11 existing customers in the U.S. expand their purchases to include this equipment that were previously broadband-only customers with ADTRAN. This highlights our continued success in cross-selling our Optical solutions into our existing broadband access customer base and the advancements we have made in this portfolio. In addition to cross-selling success with our Optical solutions into the service provider market, we continue to grow our enterprise and ICP customers this past quarter. With the recent launch of our 800-gig transport platforms, 100 ZR pluggables, and several key enhancements to our Optical network automation capabilities, we're well positioned to continue this momentum going forward. And finally, our long-term differentiation in portfolio synergies are driven by our software platforms. Mosaic One, our flagship software platform provides a suite of SaaS applications to provide actionable insights and proactive optimization tools to reduce network operational costs while improving the Subscriber experience. We now have more than 400 customers, with the majority of those in the U.S., that have adopted our Mosaic One platform, including more than 200 customers that have adopted multiple applications within this platform. Moving forward, we expect to continue to grow the base of Mosaic One customers while also significantly increasing the adoption of additional applications by existing operators using the platform. Moving on to Europe, as mentioned earlier, we remained well positioned in fiber access and Optical transport infrastructure to take advantage of the ongoing build-out of fiber networks in the region, as well as the shift away from high-risk vendors. We continue to make progress towards volume deployments late this year and early next year with multiple large European operators for both our fiber access and Optical transport portfolios. In the fiber access space, the global market has been rapidly shifting to 10 gig PON platforms. In this technology segment, which is a key indicator for new platform deployments, ADTRAN is already a top two supplier in Europe in terms of port shipments. We have more than doubled our market share in this segment over the last year and given our funnel of activity and existing awards, we are strategically positioned to continue to grow in this market as we move forward. In the Optical transport space in Europe, we have maintained solid market share positioning while the overall service provider spending on Optical transport has been down for the past year as operators deplete inventory. With further consolidation in this market segment, particularly in Europe, the ongoing shift away from high-risk vendors, a significantly enhanced portfolio, and our strong regional presence, we feel confident in our ability to become a top two supplier in Optical transport equipment to service providers across Europe in the years ahead. In shifting to our operational performance, as you all know, we announced a program last year focused on improving our profitability and cash flow. The results of this past quarter highlight the success that we are having with this program. Moving forward, we'll continue to execute against this program and we look forward to additional improvements in the quarters ahead. In summary, we continue to make great progress on our operational efficiency and our competitive positioning has put us in a great situation to take advantage of the market opportunities we see in the U.S. and Europe. While we have streamlined our operations, we continue to invest in our strategic platforms and these investments are paying off as we see strong adoption of these platforms across the growing customer base. Having a more competitive portfolio, a growing customer base, key market tailwinds still ahead of us, and non-GAAP operational profitability despite the near-term market headwinds has us well positioned for success moving forward. While we remain confident in our long-term outlook and expect growth in the quarters ahead, we see cautious spending from some of our service provider customers driving us to continue to be cautious in our approach to forecasting and our operating model. As a result, we will continue to focus on becoming a leaner, more efficient, and more profitable company with a best-in-class fiber networking portfolio. With that, I will now turn things over to Uli to go over our financial results and then we'll open it up to any questions you may have.

Thank you, Tom, and hello, everybody. I will walk you through our financials for our last quarter and provide our expectations for the third 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. Additionally, I will discuss certain revenue information by segment and category, which is available on our Investor Relations webpage at investors.adtran.com. We've also updated the investor presentation on this site, which is available for download. Unless stated otherwise, all financials are presented in U.S. dollars. With that, let's dive into our financial performance for Q2 2024. Q2 2024 revenues of $226 million were similar to Q1 2024 revenues and slightly above the midpoint of our guidance, but were down 31% year over year. Our network solutions segment accounted for 79.3% of revenues in Q2 2024 compared to 86.4% in Q2 2023 and 80.1% in Q1 2024. Our services and support segment contributed 20.7% of revenues in Q2 2024 compared to 13.6% in the year-ago quarter and 19.9% in the previous quarter. Access & Aggregation contributed 30.9% of revenues and was down 31.9% compared to the year-ago quarter, also down 14% sequentially. Our Optical networking solutions category contributed 32.6% of revenues and was down 48.5% year over year, and down slightly by 1.9% quarter-over-quarter. Subscriber Solutions contributed 36.5% and was up 0.9% year-over-year, and up 18.1% quarter-over-quarter. International revenues made up 52.4% of total revenues and domestic revenues contributed 47.6%. Domestic revenues were sequentially up in all three product categories. Q2 non-GAAP gross margin was 41.9%, an increase of 334 basis points year over year and 37 basis points sequentially. The improved gross margin is reflective of our ongoing efforts to optimize our supply chain and supply related processes. Q2 non-GAAP operating expenses were $93.2 million, down 24% year over year and down 9.3% quarter-over-quarter. The decline in operating expenses is attributable to the impact of our business efficiency program. Year over year, we reduced non-GAAP R&D spend by 26% and SG&A expenses by 22%. For the second quarter of 2024, our non-GAAP operating profit was $1.5 million or 0.7% of revenues. This compares to a non-GAAP operating profit of $3.6 million or 1.1% of revenues in the year-ago quarter and an operating loss of $8.8 million or negative 3.9% of revenues in the prior quarter. Our Q2 2024 operating margin was at the upper end of our guidance range of between negative 3% and positive 2% of revenues. The increase in operating margin and return to profitability was attributable to improved gross margins and lower operating expenses. The company's non-GAAP tax expense for the second quarter of 2024 was $10 million. Total non-GAAP net loss was $18.8 million after adjusting for minority shareholder interest in ADTRAN Networks SE. This resulted in non-GAAP diluted loss per share attributable to the company of $0.24 per share compared to a loss of $0.02 per share in Q1 2024 and a loss of $0.00 per share in Q2 2023. Turning to the balance sheet and cash flow statement. In Q2 2024, we continued to improve our working capital. Trade accounts receivable were $186.2 million at quarter end, resulting in a DSO of 75 days, the same as in the previous quarter. We reduced our inventories by $34.2 million compared to Q1 2024. We improved working capital resulted in an operating cash flow of almost $20 million compared to $36 million in Q1 2024. Consequently, we generated $3.9 million of free cash flow. At the end of the quarter, cash and cash equivalents were $111.2 million, a quarter-over-quarter increase of $4.4 million or 4%. In summary, we made significant strides in operational efficiency, positioning ourselves well to capitalize on market opportunities in the U.S. and Europe. Despite near-term market challenges, our competitive portfolio and growing customer base positions us well for future success. While we remain confident in our long-term outlook, we remain cautious due to spending trends from service providers. Our focus remains on becoming a leaner, more efficient, and more profitable company with a top-tier fiber networking portfolio. For the third quarter of 2024, we expect revenues to range between $215 million and $235 million, with a further improved non-GAAP operating margin range between negative 1% and positive 3%. Once again, additional information is available at ADTRAN Investor Relations webpage at investor.adtran.com. We appreciate your time and attention and we are now ready to address any questions you may have. I will turn now the call back over to the operator to begin the Q&A session.

Hi John. At this point, we'd like to open up for any questions people may have.

Your first question comes from the line of Ryan Koontz from Needham & Company.

On the access weakness here, it sounds like a lot of that's coming from Europe, but maybe you can unpack a little bit what's going on there in terms of the domestic transition to the SDX, and where we are in that transition. Then in Europe, you talked about a very strong Q1, probably some inventory remaining to be deployed there, but any other color you can give on the European side of things and what might be behind the macro caution in Europe? Thank you.

Yes, sure. I would say that's exactly it. In the U.S., we had access actually grow. In the U.S., all three product segments grew, which is the first time we've seen that in a while. That was good to see. In Europe, specifically, we had two customers that bought, and they tend to buy in chunks. So it's not uncommon for them to come in one quarter and then not buy in the next quarter and then buy again in the quarter after that. That's just typical. And it was specifically, we actually had two that hit in Q1, and so those were sequentially down, but that's not indicative of anything other than just the way that they bought it. All the other business, the alternative business, and all of that was very solid in Europe for access and aggregation.

You mentioned that the two customers acquired in Q1 were not your major clients. These are newer customers who may have placed initial orders.

No. Those were existing customers.

And in terms of your outlook there in terms of getting Europe back on track, you've had a number of contract wins that you've talked about for a long time. How are those new wins kind of progressing through lab approvals and moving forward with deployments broadly?

Let me share a bit about Europe. The Fiber-to-the-Prem and Subscriber markets, including RGs and ONTs, are fairly solid. We experienced some fluctuations, but that doesn't suggest any lasting issues; customers will buy, pause, and then buy again. So, overall, the market is performing quite well, and we actually saw an increase in subscribers. If they weren't investing in infrastructure, they were purchasing something to connect customers, which is a positive development. However, the biggest concern lies in the Optical segment, where we didn't observe significant changes. I anticipate good performance in Subscribers and access in Q3. The uncertainty remains with Optical, where expectations are for flat performance, leading to some concern. Regarding SDX, it is relatively new, having been launched earlier this year along with a comprehensive software suite for both Optical and SDX, which is now being introduced. I wouldn’t categorize this as conversions for some customers; typically, Greenfield customers opt for SDX, while others continue to purchase the 5000 series alongside the SDX. This quarter, it just appears that all new customers buying the system were SDX customers.

And just a quick housekeeping question for Uli, on the tax swing. Any color you can share there in terms of how we should think about that going forward? Seemed like it had a pretty big effect on your non-GAAP income.

That's the usual you see throughout the quarter. I would, on a non-GAAP basis, expect a tax rate of about 15 to 20%. If you do your modeling on a GAAP basis, then I would expect a tax rate of about 3% to 5% for the year.

Your next question comes from the line of George Notter from Jefferies.

I guess I just wanted to level set on the inventory. Can you just kind of go through the different pieces of the business and give us a sense for where there's still excess inventory and how long you think it'll take to kind of work that off? And then conversely, where are we done with the inventory?

Let me provide a general overview first, and then you can ask me specific questions later. Regarding Subscriber, it appears that inventory levels are quite low at this moment. We observed a sequential increase of 47% in shipments to that customer base, and we anticipate a strong third quarter as well. It seems the inventory situation has resolved itself. It’s worth noting that this was the first area to experience issues, so it's not surprising it would be the first to recover. On Fiber-to-the-Prem, the situation is quite similar. There are still some areas with inventory, but it's limited. Going forward, I believe most inventory fluctuations will mirror what we have just experienced, where some customers make purchases six months in advance, deploy their supplies, and then place new orders. This is standard practice in business buying. Regarding Optical, there is still some inventory accumulation in the U.S. as well as in Europe. We expect these inventories to be depleted by the end of the year.

That's great. I'm sorry. So you said by the end of this year?

Right. That's correct.

And then just shifting gears a bit. Anything on the real estate side of things? I know you guys were looking at rationalizing a portion of the headquarters. Could you give us an update there?

Yes. We still have interested buyers. I think there are three or four, depending on the level of interest, but we are still moving forward with that process. Some of them have hired architects to come in, so that’s still on the plate. It’s a difficult thing to forecast when something like that will close, but there’s still a lot of interest. We’re moving forward in the real estate selling process. There are some other assets that we’ve talked about in the past that are kind of nonstrategic assets that we are also looking at selling, and those are moving forward as well.

Your next question comes from the line of Bill Dezellem from Teiton Capital.

I actually have a couple of questions. Relative to the inventory adjustments that are taking place, what do you believe has hurt your revenue this quarter? So if you were to normalize customer consumption from reported revenue, what was the delta?

That's a tough question. I'll give it a try, but it might be tricky. The best way to think about it is to consider normalized revenue adjusted for any market share changes, as well as customer fluctuations over time based on their individual circumstances. I'm working on giving you a specific figure. To put it simply, it's in the tens of millions of dollars, primarily related to Optical. That's the main impact. The subscriber situation has mostly stabilized, and there's not much effect from Fiber-to-the-Prem. I hope that provides some clarity, Bill.

No, Tom, I think it does. So go ahead.

No, no. That was it. That was it. Just in the two customers, the two large customers that we have that still have inventories on Optical, they typically buy in the tens of million dollars a quarter, and those are substantially down right now because they're depleting inventory.

So essentially, we are looking at tens of millions, effectively times two, since each of those customers would be purchasing tens of millions more each quarter.

I would be a little careful with that because it's not like they're not buying anything. But I think in combination, it would be tens of millions, yes. And it depends quarter-to-quarter, but yes. They're not the only inventory situation out there; they're just the most notable.

Right. And then, do you see any correlation between what's happening in the U.S. where we now have all three segments showing growth as a leading indicator for Europe? Or is Europe really a dynamic of these two large customers and their very specific excess inventory in the Optical arena?

In the Optical sector, we have one major customer in Europe and another in the U.S. that are negatively impacting our Optical business. Despite this, we experienced a sequential increase in Optical, though it wasn't our strongest quarter. Nonetheless, the U.S. Optical business managed to overcome the challenges posed by the lack of purchases from that customer. I wouldn't necessarily label this as a precursor, but it's worth noting that the U.S. and Europe have similar situations regarding Fiber-to-the-Prem and Subscriber perspectives. The difference is that we had two customers who made significant purchases in the first quarter, while others increased their purchasing in the second quarter. However, those two major customers are now depleting. I believe the Subscriber and Fiber-to-the-Prem metrics are quite comparable in both Europe and the U.S. I hope that clarifies things rather than causing confusion.

I found that helpful. I'm going to switch to one additional question, and this is really coming from a point of ignorance. Your SaaS business is showing some signs of strength in the U.S. Is that an opportunity that you have in Europe, or is the SaaS business really more centered on the U.S.?

Our current focus is primarily on the U.S. This is because we see it as a key strategic advantage in gaining market share with large customers. Therefore, most of our development efforts are concentrated on U.S. customers. While we have some interest in Europe, our feature set development is heavily aimed at the U.S. at this time.

And are there development challenges besides language to taking that offering to the European continent?

No, it relates more to the connections with existing back-office systems. Some of these connections are cross-border, but we are prioritizing based on the needs of the majority of U.S. Tier 2 and Tier 3 customers.

Your next question comes from the line of Tim Savageaux from Northland Capital Markets.

A couple of questions here. First, you mentioned kind of the buying patterns among your big European guys, one big quarter and then maybe one or two off. But as you look into your Q3 guide, what are your expectations there? What are you modeling with regard to what you're going to see out of your big European guys?

We're not expecting a huge uptick. I think we'll see that later in the year. Now there's two different ones, and they don't necessarily buy in the same cycle. So it wouldn't be that surprising to see one of them come in stronger in Q3. But at this point in time, that's not in our expectation. Needless to say, based off of the environment, we're trying to continue to make our guidance numbers. So there's a little bit of conservatism in that.

Well, got it. And that's kind of where I was heading next, which is you're looking for three flat quarters here around the $225 million level. Composed quite differently, I think, from a geographic and product standpoint. My question was going to be, is there any reason to think there could be an uplift here into year-end as you stand here now? And you kind of spoke to that there, and I think I may have said maybe, but please go ahead and expand upon that if you could.

Well, I think what we're trying to do, and maybe it's a nuance that's too nuanced. You see us continuing to try to tighten the range of the numbers. We had a very broad range coming into the year because it was so difficult to see how the customers were reacting on a kind of a monthly basis, right? That has gotten better. Visibility has gotten better. The surety within our forecast has gotten better. The biggest unknown for us right now is really kind of the Optical space and has that bottomed out? Or where is the bottom of that and when does that actually start adding on the Subscriber Fiber-to-the-Prem space? We feel very good right now. So the direct answer to your question is, we're hopeful that we'll see an uptick this quarter, and we’re probably even more confident about the fourth quarter than third quarter. That's where we sit today.

I understand. Your answers are leading me into more questions. Regarding the Optical side, I'm quite interested in your comments and your goal to rank in the top two in Europe. I have a few questions about that and also about the cross-selling you mentioned in the U.S. There's a lot happening with Lumen right now, which has historically been a significant customer for you on the Access side. This leads me to your remarks about the changes in the market landscape. I'm curious about the opportunities you're seeing, particularly in relation to the planned merger of Nokia and Infinera. Lumen is a major player at Infinera, so I’m wondering if this may introduce opportunities as they work on building their large data center network. More generally, is this merger influencing your ambition to secure that top two position in Europe, which would be quite significant? My questions cover various aspects, but I believe you understand my direction.

I believe our perspective is that in the current bidding landscape for Optical gear in Europe, we are competing with Nokia, Siena, and ourselves. With one less competitor, I think our technology remains highly competitive in the metro and regional markets we operate in, and we are capturing our fair share of the business, which is likely to increase. We have strong relationships with many large customers in Europe, so I feel optimistic about our position there. As for the U.S., it's uncertain whether new opportunities will emerge from the merger. Such mergers can lead to disruptions, and we will have to monitor how things develop. It seems we have no more questions at this moment. Thank you all for joining our conference call. We look forward to speaking with you next quarter.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.