Earnings Call Transcript - ADTN Q4 2023

Operator, Operator

Ladies and gentlemen, thank you for being here. Welcome to the ADTRAN Holdings Incorporated Fourth Quarter 2023 Earnings Release Conference Call. During this call, ADTRAN representatives will discuss forward-looking statements that reflect management's current best judgment based on known factors. However, these statements are subject to risks and uncertainties, which are explained in our earnings release, annual report on form 10-K, and SEC filings. These risks and uncertainties could result in actual outcomes differing significantly from those stated in the forward-looking statements made during this call. We are not obligated to update any statements to reflect events that occur after this call. Today, we will also mention certain non-GAAP financial measures. Reconciliations of non-GAAP to GAAP measures and additional information can be found in our investment presentation and earnings release. The investor presentation on the ADTRAN Investor Relations website has been updated and is available for download. It is now my pleasure to hand the call over to Tom Stanton, Chief Executive Officer of ADTRAN Holdings. Please go ahead, Sir.

Tom Stanton, CEO

Thank you, Krista. Good morning, everyone. We appreciate you joining us for our fourth quarter 2023 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'll take any questions you may have. Our fourth quarter revenue came in as expected with operating profitability on the upper end of our guidance range, helped by lower operating expenses and improving gross margins. Revenue, of course, continued to be impacted by macroeconomic factors and elevated inventory levels. Given the environment, we continue to focus on managing our operational expenses and reducing our inventory levels. Taking a closer look at the results in the fourth quarter, 62% of our revenues came from outside of the US, which is similar to the geographical revenue mix in the first three quarters of the year. On product mix, subscriber solutions were up quarter-over-quarter due to an improving inventory situation with both RGs, residential gateways and ONTs. The access and aggregation solution category was down quarter-over-quarter due to timing of orders with a couple of our larger customers. Optical networking solutions continued to be impacted by inventory reduction initiatives with large customers. Coming into 2024, we remain focused on two strategic initiatives, the investment in fiber-based broadband networks in the US and the high-risk vendor replacements centered in Europe. These two initiatives have driven us to broaden our presence and strategic relevance in Europe and substantially increase our product portfolio breadth for customers here in the US. And while 2023 presented headwinds to equipment suppliers, operators continue to invest in deployment of fiber networks across most regions of the world. According to the Fiber Broadband Association, fiber broadband deployments in the US set a record in 2023, passing 9 million homes, up 13% year-over-year from the previous year's record of 8.3 million homes passed. These results brought the total homes US passed to 77.9 million. Even with this impressive growth number, nearly half of the US homes are still not passed with fiber. Similar trends are happening in Europe. In the UK, full fiber coverage increased by 4.6 million premises in 2023 according to Ofcom, now covering 17.1 million premises. As more homes are connected with fiber-based broadband enabling multi-gigabit speeds per household, upgrades to in-home connectivity solutions and middle-mile transport are following. These investments underscore the importance of fiber as critical infrastructure in the modern digital economy and reinforce the continued push by service providers to connect more customers with fiber and upgrade the capacity of their networks. With several large broadband stimulus programs still ahead of us in the US and Europe, including the $42.5 billion in funding from BEAD in the US that is still on track to begin allocations later this year. We still have an optimistic outlook on the growth for fiber networks over the next few years. For the US market opportunity, we see real differentiation in being able to provide a complete fiber networking portfolio that spans from optical core to the customer premise and is paired with software applications that simplify and lower the cost to deploy and operate. The value of our offering was reinforced by the 15 additional fiber to the home operators we added during the quarter, increasing the total for the year up to 66 fiber to the home operators. These operators are primarily from the US regional service provider segment. In addition to providing fiber access platforms to these customers, we are having increasing success in ongoing software and in-home platforms for this customer segment. We added 50 new operators this past quarter and more than 225 in the past year. Our current total is approximately 380 independent operators. A lot of the interest in our SaaS applications is driven by Intellifi, our latest cloud-managed Wi-Fi offering that is supported by our latest generation of Wi-Fi 6, Wi-Fi 6E and Wi-Fi 7 platforms in our SDG series. The enhancements that we have made to our SDG series along with the launch of Intellifi helped drive strong growth with our residential gateways in this past quarter. To complete our fiber networking offering in the US, we have our packet optical portfolio. As we have educated our customers on our full portfolio of solutions, including our latest FSP 3000 solutions, tailored towards the needs of regional service providers, we have been able to secure dozens of new packet optical wins over the past six months that were from customers that had traditionally been broadband-only customers for ADTRAN. We see this packet optical segment as offering meaningful upside for the US market. And as I mentioned, it is the key component of our strategy to offer broader fiber networking portfolio solutions to our customers. In addition to our portfolio offering, I want to highlight the value US customers see in a US-based vendor that not only has R&D support and services teams in the country but also has a long history of manufacturing solutions at volume locally. When looking at the Build America, Buy America requirements that are part of the BEAD program, we are already well positioned to address these needs with minimal changes to our supply chain. Considering the breadth of our fiber networking portfolio and the full suite of onshore capabilities, you can see why the value proposition is unique in the industry and why we are excited about the ongoing investment cycle in fiber networks for the US market. I mentioned there was a second key initiative for us and that is the high-risk vendor replacement opportunity that is centered out of Europe. Given the current geopolitical environment, we see the high-risk vendor replacement gaining momentum and it is really a question of timing of the phase-out in Europe rather than a question of whether it will happen or not. Similar to our situation in the US, we now have a very strong regional presence in Europe, including a broad support staff and regional R&D resources. We have also greatly enhanced our local supply chain capabilities with the recent opening of our Terafactory in Germany, which was supported by significant backing from the state government in the region. The power of our new combined portfolio is most notably highlighted by our recent win in Europe with a Tier 1 carrier who selected ADTRAN specifically for its combined portfolio for meeting the challenges of a new service rollout they are planning later this year. We continue to make progress with multiple Tier 1s in Europe that have previously selected ADTRAN. Q4 marked the beginning of volume shipments to our largest customer in Germany of the 6330, our flagship product. And our largest customer in the UK continues to pass millions of homes per year with fiber utilizing our platform. And with another carrier in Northern Europe, we have begun fiber access deployments in three countries while being qualified for four. We are in the lab for certification with yet another large multinational Tier 1 operator and we were selected for large-scale deployments a couple of quarters ago. On the optical transport side, we continue to progress our Tier 1 opportunities in Europe, with one of our recent new customer wins set to begin deployment late this year. We are also investing in significant upgrades to our line systems, pluggable transceivers, muxponders and software platforms to stay on the leading edge of innovation in the metro optical and enterprise optical segments. One example of our optical innovation is our pioneering effort to introduce coherent transceiver technology at the edge of the network with our 100 ZR pluggable. We have successfully completed customer trials with our 100ZR coherent optical pluggable optic and we will ramp production of these modules this year. The 100ZR lowers the cost by up to 50% or more to provide 100-gigabit backhaul over DWDM to fiber access nodes, a key need as service providers continue to deploy higher volumes of multi-gigabit residential access services, while also delivering higher speed services for enterprise and 5G site connectivity. These edge-optimized optical solutions reinforce the portfolio synergies between our packet optical and fiber access solution sets and they drive more value to our customers adopting these combined solutions under a common suite of software tools. In summary, we continue to focus on capturing fiber footprint with our upgraded fiber access and optical transport platforms, while driving the adoption of our latest subscriber platforms, software solutions and high-value services. While we remain confident in our long-term outlook, we continue to see cautious spending from our service provider customers, driving us to take a more cautious approach with our forecasted operating model. As a result, we will continue our focus on becoming an even more efficient and more profitable company with our 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 open it up for questions.

Uli Dopfer, CFO

Thank you, Tom, and hello everybody. I will cover our Q4 2023 preliminary results and provide our expectations for the first 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 webpage 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 US dollars. Q4 2023 revenue came in at the midpoint of our guidance at $225.5 million but down 37% year-over-year and down 17% quarter-over-quarter. Our Network Solution segment accounted for 80% of revenues in Q4 2023 compared to 88.6% in Q4 2022 and 83.9% in Q3 2023. Our Services and Support segment contributed 20% of revenues in Q4 2023 compared to 11.4% in the year-ago quarter and 16.1% in the previous quarter. Access and aggregation contributed 28.5% of revenue and was down 32.9% compared to the year-ago quarter and down 32.1% compared to the previous quarter. Our optical networking solution category contributed 38.2% of revenues and was down 39.5% year-over-year and 26% quarter-over-quarter. Subscriber solutions were down 37.5% year-over-year but grew 22.3% quarter-over-quarter and contributed 33.4% of revenues. As Tom mentioned earlier, we continued to face a decline in service provider spending driven by macroeconomic challenges and ongoing inventory adjustments. International revenue made up 62% and domestic revenue contributed 38% of total Q4 revenue. We had one customer that contributed 10% or more of revenue in Q4. Q4 non-GAAP gross margin was 41.9% and increased by 277 basis points year-over-year and 155 basis points sequentially. The year-over-year and quarter-over-quarter increase is due to reductions in manufacturing and transportation costs and a more favorable customer and product mix. In the fourth quarter of 2023, we successfully achieved our target with a 15% sequential reduction in non-GAAP operating expenses. Q4 non-GAAP operating expenses were $97.6 million, decreasing by 15% quarter-over-quarter and 18% year-over-year. We reduced non-GAAP R&D spend by 18% and SG&A expenses by 11% quarter-over-quarter. Non-GAAP operating loss was $3.2 million, which translates into a non-GAAP operating margin of negative 1.4% compared to negative 1.9% in Q3 2023. Our operating margin was at the upper end of our guidance range of between minus 7% and 0% of revenues. The sequential improvement in operating margin was attributable to higher gross margin and the successful implementation of our cost initiatives. The year-over-year decrease in operating profitability was due to lower sales volume, partially offset by improved gross margins and operating expense reduction. The company's GAAP and non-GAAP tax expenses for the fourth quarter of 2023 were $64.4 million and $73.1 million respectively. Given the current environment, the company decided to establish a valuation allowance related to our domestic deferred tax assets during the quarter. Of course, the company will be able to release this valuation allowance as we return to profitability. Including the $81.6 million tax valuation adjustment, total non-GAAP loss was $82.9 million and the net loss of $85.9 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 $1.09 per share. Turning to the balance sheet and cash flow statement. Cash and cash equivalents totaled $87.2 million at quarter end. Cash flow used for operations was $23.6 million compared to $6.8 million of operating cash flow generated in the previous quarter. The increased usage in cash flow from operations quarter-over-quarter was primarily driven by lower revenue inflows, partially offset by reduced expenses. Trade accounts receivable were $216.4 million at quarter end, resulting in DSO of 88 days compared to 77 days in the prior quarter. Inventories were $362.3 million at the end of the fourth quarter, down $11.7 million compared to Q3 2023 and down $65.2 million compared to Q4 2022. Q4 inventory included a $3.3 million write-off as we accelerated the end of life of certain products to streamline our product offerings. As Tom mentioned earlier, we remain focused on reducing our inventory levels moving forward. Accounts payable were $163 million, resulting in DPO of 67 days compared to 60 in the previous quarter. In summary, we are still experiencing cautious service provider spending due to economic uncertainty and continued customer inventory adjustments. Given these uncertainties, we will continue to focus on aspects of our business that we can influence, such as managing our operational expenses and reducing our own inventory levels. We are convinced that the long-term growth drivers for our business are fully intact. We expect that the investment in data-driven infrastructure and the fiber everywhere future will continue to be supported by stimulus funding and the desire to reduce exposure to high-risk vendors. We continue to focus 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. Consequently, for the first quarter of 2024, we expect revenue to range between $210 million and $240 million, and we expect a non-GAAP operating margin between negative 7% and 0% of revenues. Once again, additional information is available at ADTRAN's Investor Relations webpage at investors.adtran.com. Thank you for attending our call. I will now turn back over to the operator and we will take your questions.

Operator, Operator

George Notter from Jefferies.

George Notter, Analyst

I wanted to just ask some more questions about what you're seeing in the marketplace. You referenced inventory digestion, you referenced the macro economy. But I know one of your competitors was also talking about BEAD acting as an overhang on current demand. But could you tell us more about what you're seeing? Is there a BEAD effect in your business, or what can you tell us that gives us more detail on demand trends?

Tom Stanton, CEO

So I think when you were talking about BEAD, we're typically talking about the Tier 3, the smaller carrier space. If I look at OLT shipments specifically into that space in the quarter, they were actually pretty flat, maybe slightly down. I would expect it to pick up this quarter, so I don't know. I guess you could say, yes, there's an impact because that's a segment that had been growing 30% year-over-year for some period of time. But as to how much of that, I don't get a sense there's a lot of inventory in that Tier 3 space. I think what we're seeing is real demand. So I would say, for us, anyways, it's flat at this point in time. There are without a doubt some customers that are waiting for BEAD and then some customers that are moving forward. So I would say, yes, I see the impact. But for us, that kind of points back to a flat number. Does that answer your question?

George Notter, Analyst

And then, I know there was an effort to look at the real estate portfolio in Huntsville and maybe elsewhere. Any update on where you guys are in rationalizing real estate?

Tom Stanton, CEO

We have three separate buildings here, and we consolidated everyone because we had too much space, especially post-pandemic and even a bit before that due to hiring and acquisitions. We had a lot of resources in Europe, particularly in Poland, and also in India. As a result, we are clearing out two of the towers, which should be completed by the end of this quarter. We have begun showing those properties, and that process is moving forward. We still expect to see an impact from this in the second half of the year.

George Notter, Analyst

Any update on what kind of proceeds you might be able to get from that process?

Tom Stanton, CEO

There are two different paths we can take, and while we discussed one option that is relatively straightforward to implement, we haven't made a definitive decision to proceed with it. This option involves the East Tower, which we could sell and lease back. Regarding the North South Tower we just mentioned, I'm estimating that it could generate proceeds in the range of $40 million to $60 million.

Operator, Operator

Your next question comes from the line of Michael Genovese from Rosenblatt Securities.

Michael Genovese, Analyst

So is the CPE subscriber solutions inventory correction over? Is that the right way to think about it?

Tom Stanton, CEO

Well, that's how I prefer to view it. The truth is, I can't provide a definitive answer. I hesitate to say yes because we cater to a diverse range of customers. We have noticed an increase and expect it to remain in a similar range this quarter. For our specific inventory, I believe we've moved past the most challenging part. I'll just leave it at that.

Michael Genovese, Analyst

And can you talk about access and aggregation, just some of the timing issues some more? And I mean, we've got your first quarter guide sequentially flat. What should we be looking at as we move through further quarters given the timing on access and aggregation?

Tom Stanton, CEO

So we had a couple of customers and it really was to one in Europe, which you can probably guess who that one is, and then an MSO here in the US that had bought previous to that. I would expect the MSO probably to come back this quarter. The other customers are going to have a decent quarter this quarter; it will be stronger than last quarter. And then Tier 3s I already talked about, they're kind of flattish.

Michael Genovese, Analyst

And then finally for me, I mean, just when we look at the overall guide, the midpoint of the guide at 225 flat sequentially. I mean, you've already mentioned subscriber solutions being about flat sequentially. I mean, should we look at the other two, optical and access aggregation roughly flat as well?

Tom Stanton, CEO

Let me just try to add some clarity there. Subscriber solutions, flattish is probably a good guess. It's probably a little conservative, but it's a good guess. You would expect access to be up just based off of the very specific customer thing I talked about. Optical is what we would expect to be down as I specifically mentioned. So I talked about inventory in optical; I really didn't talk about inventory corrections impacting subscriber and our fiber to the premise business that much, and that was on purpose. So we still think there's inventory in the optical space. We think the other two are easing up. And if I had to look at the mix between optical and the other two, I would expect the other two to be up on a sequential basis and optical to be down.

Michael Genovese, Analyst

And just for gross margins, does that mix make a difference for gross margins? I mean, I have a hard time thinking that gross margin will be quite as high in Q1 as in Q4. Could you just help out with that?

Tom Stanton, CEO

The main change will involve the infrastructure aspect of fiber to the premise, which actually has quite good gross margins compared to the subscriber aspect in both app and premise. Yes, there is some variability we need to navigate. I'm uncertain about the final outcome until we reach the end of the quarter. We're also seeing some easement in our inventory costs and are performing better than we anticipated with gross margins. This trend is supportive in our calculations.

Operator, Operator

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

Ryan Koontz, Analyst

I wanted to unpack gross margins in the fourth quarter a little bit there, really nice improvement along with a higher mix in CPE, which usually is a headwind on that line. So can you maybe unpack the kind of puts and takes there? You talked about transportation costs being down, and I haven't heard that elsewhere too much. So any color there would be helpful.

Uli Dopfer, CFO

The transportation cost comment was mainly related to the comparison for Q4 2022 where transportation costs were still extremely high.

Ryan Koontz, Analyst

But I talked about transportation cost specifically just kind of the positive. So any other color you want to give on Q4?

Tom Stanton, CEO

I’m thinking on the sequential improvement, Uli.

Uli Dopfer, CFO

The sequential improvement is mainly driven by customer and product mix.

Ryan Koontz, Analyst

And that includes a higher mix of CPE. So I guess that implies stronger shipments to smaller customers that maybe have better margins?

Tom Stanton, CEO

Well, the CPE is made up of several different things, and some of it depends on the actual customer itself. 10 gig CPE versus 1 gig CPE, for instance, makes a difference. And I will tell you this, the infrastructure business, in general, has been tending upwards, I think, just because of the nature of the competitive environment right now. So I think that has actually benefited. And then we continue to work down kind of higher price bill of material parts into lower price bill of material parts without expedite fees, and those have all just been positive attributes coming into really over the last couple of quarters.

Ryan Koontz, Analyst

And one kind of broader question, maybe stepping back from the European opportunity with Huawei displacements. How would you characterize Huawei's position in the European continent today outside of your specific projects you've talked about winning? Like where are they still competing and how would you kind of characterize the competitive environment relative to the Chinese supply?

Tom Stanton, CEO

Honestly, you don't see them very often. When they do appear, it usually involves pricing rather than actual awards. Year over year, more carriers are recognizing that this isn't just a short-term issue but a longer-term concern, especially when they work with high-risk vendors. They have to think about when to phase out that equipment and when to stop receiving software updates from those companies, and the momentum of this situation is only getting stronger.

Ryan Koontz, Analyst

And so in terms of new bids, they're not competitive. But in kind of run rate business, they're still seeing a fair amount, I would think, of sales into the legacy footprint?

Tom Stanton, CEO

What you're seeing happen is in the legacy footprint, if somebody has open slots in shelves then they are liable to fill those open slots right now until they get through an award process or until they have an alternative. But open slots are still being filled in a large part of Europe, but new shelves coming in you just don't see an awful lot of that. And we have some very specific opportunities where they're literally talking about taking equipment out.

Operator, Operator

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

Tim Savageaux, Analyst

I had a question, I guess, about the access and aggregation market. In Q4, your segment was down pretty good sequentially. And you talked about Tier 3s being flat. It sounds like that's a reference more to Q1, or could I get some clarification on that? And I know that Tier 3 also includes subscriber. So as you look at that decline in Q4, would you attribute that more to a couple of large customers and is that flattish comment also hold in Q4 versus Q1?

Tom Stanton, CEO

There's a nuance that needs to be understood for everything to make sense. The primary issue was two specific customers to whom we had previously shipped a significant amount. I don't see that as an inventory problem; it's just their purchasing pattern, which typically spans six-month periods. This impacted us. In terms of access and aggregation, while there was a decline, it's composed of various elements, including switching components sold into fiber to the premise and sometimes outside of hybrid to the premise, along with pluggable optics that accompany the product. Looking at OLT shipments into the Tier 3s, they remained relatively flat in Q4. For Q1, I expect a similar trend or perhaps a slight increase. However, optics can vary significantly from quarter to quarter. The optics segment, especially the pluggable aspect, declined in Q4, but I anticipate a slight recovery in Q1. This can be viewed as more inventory-related, where some optics may be available, but they don't have the necessary active hardware components in the OLT. Did that clarify things for you?

Tim Savageaux, Analyst

And just continuing on that, if you look at the competitive dynamics, and I know you discussed that regarding some of the Huawei replacement. But again, specifically in that US rural broadband market. I guess, what are you seeing there from a competitive standpoint in terms of the potential for competition to intensify here in a flat market environment or any other dynamics that you would be willing to comment on?

Tom Stanton, CEO

It's quite similar to what we experienced for most of last year. In that market, we mainly compete with Calix and, in some cases, Nokia. The competition is primarily between the three of us, with Calix being our main competitor, and the dynamics have remained constant. Software plays a significantly larger role now, which is why I mentioned Mosaic One; our adoption rate for it has been excellent. We've also introduced a strong offering with Intellifi, our managed Wi-Fi tailored for that segment. However, the competitive dynamics haven't changed; they are essentially the same. Everyone is positioning themselves, and no awards have been given out yet through the states. Louisiana appears to be the first state that has cleared all pathways for funding and is moving towards the award process. Therefore, everyone's trying to connect with potential customers, and as funds begin to flow, we will start to see who is actually securing these customers. At this point, I think we're out of questions. So I appreciate everybody joining us for the call and look forward to talking to you next quarter.

Operator, Operator

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