ADVA Optical Networking SE

XETRA:ADV

Earnings Call Transcript 2022-Q2

[Steven Williams, executive]

Welcome to ADVA's Q2 2022 Financial Results Conference Call. In addition to this call and the press release, we have posted a presentation, which is available for download from our homepage, adva.com, on the conference call page in the Financial Results section of the About Us/Investors section.

Before turning the call over to Brian, please be reminded that this presentation contains forward-looking statements with words such as believes, anticipates and expects to describe expected revenues and earnings, anticipated demand for networking solutions, internal estimates and liquidity. These factors are discussed in greater detail in the Risk and Opportunity Reports section of our annual report 2021.

Please also be reminded that we provide consolidated pro forma financial results in this presentation solely as supplemental financial information to help the financial community make meaningful comparisons of our operating results from one financial period to another. This pro forma information is not prepared in accordance with IFRS and should not be considered a substitute for historical information presented in accordance with IFRS. Pro forma operating EBIT is calculated prior to noncash charges related to stock compensation programs and amortization and impairment of goodwill and acquisition-related intangible assets. Additionally, expenses related to M&A and restructuring measures are not included. Unless stated otherwise, all numbers are presented in euro.

We will target to limit this conference call to 60 minutes. Brian will start this call providing a business update. And today, our CTO, Christoph Glingener, joins this call and will provide an important technology update. And finally, Uli will guide us through our Q2 financials, outlook and the latest progress on the ongoing business combination with ADTRAN. And finally, we will have sufficient time for your questions, which we'll be happy to answer.

And with that, I'll turn the call over to Brian. Please go ahead.

[Brian Protiva, executive]

Thank you, Steven. We will move to Page 4, please, Q2 2022 financial highlights.

The narrative of the past quarters continues. The digitization and modernization of the communication infrastructure are driving the expansion of the fiber optic industry and infrastructure and the demand for communication technology. This macroenvironment is driving an excellent order entry in all regions. On the other hand, we continue to fight challenges in our supply chains. The current bottlenecks in procuring components and in manufacturing limit our revenue growth.

The magnitude of the cost increases for procurement, production, logistics and warehousing and a further clear strengthening of the U.S. dollar are putting pressure on our margins. Nevertheless, we are proud of the results achieved in the first 6 months of this financial year and started the second half of 2022 with a record order backlog.

Q2 revenues were up 11.4% compared to the year ago quarter at EUR 166.3 million. Six months' revenues reached a record level of EUR 336.8 million. Our pro forma EBIT margin for Q2 was at 3.9%, and we report a Q2 net debt of EUR 0.9 million in IFRS, which is equivalent to a greater than EUR 20 million GAAP net liquidity. We continue our aggressive approach to procuring important components and carrying higher inventory. Most excitingly, we started Q3 with further signs of solid demand.

Moving to the next slide, Page 5, business transformation update. In connection with the strategic transformation of our business model which we've been driving forward for several quarters, I will report several positive news from the second quarter. First, in the area of customer diversification and focus on new markets, we continued our journey through higher degrees of differentiation.

Numerous investments in new technologies give us access to new markets in which we can operate in a highly differentiated and profitable manner and grow beyond our average growth rate, especially in the field of the network security. More and more industries are interested in solutions that offer additional security against eavesdropping and cyberattacks. Several press releases about successful quantum secure data transmission and protecting networks against GNSS cyberattacks manifest our technology leadership in this area.

Secondly, in terms of revenue contributions from software and services, we are on course and launched a new offering, which has real potential. The management and orchestration, MANO software, from our Ensemble portfolio is now also available as a SaaS solution, software-as-a-service. SaaS is a particularly attractive business model for network operators who want to introduce new services quickly and cautiously without major upfront investments. Once again, we expanded our portfolio of software products to further drive revenue growth in this area.

And the third pillar of our business transformation strategy is all about verticalization. The development of new markets and cost optimization of our own systems through stronger in-house capabilities in the field of optoelectronics is progressing well. In June, we announced together with II-VI, a U.S.-based global leader in optoelectronic components, the development of the new pluggable coherent transceiver for the efficient transmission of signals with data rates of up to 100 gigabits per second. The extremely compact and energy-efficient module opens new architectural possibilities at the network edge. We expect a first prototype before the end of the year and first revenues in 2023.

In the past quarter, we recognized a strong increase in revenues from our component business, resulting from modules launched in previous quarters. Overall, the verticalization of our value chain is advancing at an exciting rate.

To give you more insights on the disruptive nature and importance of the new Coherent 100-gig ZR module, I hand the presentation now over to Christoph Glingener, our CTO, and my successor as CEO. The official handover will take place within a very few weeks. Christoph?

[Christoph Glingener, executive]

Thank you, Brian, and hello, everyone. We go to Page 6, Coherent 100ZR, a paradigm shift for optical edge. As you have heard in many earnings calls, data traffic across the globe is exploding, and it's not going to slow down anytime soon. Our reliance on Internet connectivity has significantly increased with the pandemic.

At the same time, our expectations have also grown. We don't just expect to get online, we must have high-speed, secure and reliable connectivity. This is forcing network operators to evolve their optical edge infrastructure by increasing transport speeds in the last mile network. In most cases, this means an upgrade from 1 gigabit per second to 10 gigabit per second rates. That is a 10x capacity increase, which, in turn, requires the adoption of 10x higher speeds in optical edge aggregation devices. This has an impact on all last mile technologies.

For example, residential broadband with DSL and fiber-to-the-home, a market where ADTRAN has a strong play, optical line terminals are rolled out with 100-gig interfaces. Cable operators upgrade their hybrid fiber coax infrastructure with headends supporting 100-gig towards the network. Business services go to 10-gig data rates, driving 100-gig ports as a provider edge router. And last but not least, we forecast a rapid increase of 100-gig ports driven by so-called distributed units and 5G architecture for mobile broadband.

So millions of aggregation devices at the optical edge must be upgraded to support 100 gigabit per second rates as well as the DWDM links, interconnecting those devices with the optical network core. This can be a costly and overwhelming task for operators. The question is, what is the most efficient and economical way to do it? The answer is a new generation of optical transceivers that brings 100-gig coherent technologies to the optical edge.

Let's move to the next slide, Page 7, Coherent 100ZR, a new breed of coherent optics for the edge. Just to give you a bit of industry context, direct detect technology has been predominant in access networks. It works well and is cost-efficient solution for data rates up to 25 gigabit per second. However, things become more tricky at 100 gig per seconds where direct detect solutions start to show distant limitations due to transmission impairments.

Coherent technology, on the other hand, is far more robust and tolerant to line impairments. This simplifies deployment and maintenance and makes optical line system requirements much simpler. However, Coherent innovation has been largely driven by hyperscale demands, maximizing data throughput with higher board rates and more complex modulation schemes. You can see it in the bar chart that increasing the line speeds leads to an increase in port cost, but it decreases the cost per bit as we go from 100 gig to 200 gig to 400 gig and beyond.

At the edge, 100 gig is, a foreseeable future, a lot of capacity. The bigger problem is power consumption. Any existing coherent solution is well above 10 watt. So far, power consumption and cost levels of coherent detection have prevented its wider deployment at the optical edge. Well, until now.

As you may have seen in the media, we have announced a new application-specific coherent pluggable device the ADVA Coherent 100ZR. It empowers users to introduce 100G coherent links in optical edge aggregation networks at lower cost and with higher operational simplicity than other solutions that are currently commercially available. The new ADVA Coherent 100ZR features a new and purpose-built 7-nanometer DSP, co-developed by ADVA and II-VI Incorporated. The small size and low-power consumption of this DSP makes it possible to create a 100G coherent pluggable transceiver compliant with power dissipation of 5 watt.

In summary, this is a unique solution enabling a rapidly growing 100G edge aggregation market.

With that, I hand over to Uli.

[Ulrich Dopfer, executive]

Thank you, Christoph, and welcome, everybody. As Brian mentioned, revenues in Q2 reached EUR 166.3 million, up by 11.4% from EUR 149.4 million in the year ago quarter. Q2 was the most challenging quarter in recent times. Continued slips in semiconductor delivery schedules pushed production to the back end of the quarter. And on top, we had one customer who returned already delivered products after the quarter was already over, which then triggered the top notification from July 15.

On the positive note, overall demand continued to be very strong. The issue is still that demand is growing faster than supply. Last quarter, I said it's all about execution, and I think this will continue to be our model for a while. The already high purchasing costs driven by the silicon shortages were further impacted by the strong U.S. dollar. Consequently, gross profit decreased by 5.1% compared to the year ago quarter. Pro forma EBIT margin was 3.9% compared to 9.7% we have seen in Q2 2021.

Net income reached EUR 7.3 million, down from EUR 12 million in the year ago quarter. Consequently, diluted earnings per share were EUR 0.14 compared to EUR 0.23 in Q2 2021. We continue to use excess cash to secure our supply. As a result, our net cash position of EUR 3.9 million in Q2 2021 now turned into a net debt IFRS 16 position of close to EUR 1 million.

Next slide, please. IFRS versus U.S. GAAP comparison. As explained in the past, we added this slide for the purpose of transparency and to provide our analysts and investors an enhanced comparison since most of our peers report their numbers in U.S. GAAP. Please note, the U.S. GAAP numbers here have not been audited. The main differences between the 2 standards are due to the capitalization and amortization of R&D under IFRS. The R&D amortization leads to higher costs. And for Q2, the resulting difference in gross margin is 6.3 percentage points. The R&D capitalization on the other hand leads to lower OpEx. Net impact in this quarter was negative 0.4 percentage points.

Slide 11, regional revenue development Q2 2022. EMEA was once again the strongest region. Q2 revenues, however, slightly declined by 3.5% year-over-year, now representing 55.9% of revenues. Demand continued to be strong across all customer groups.

In the Americas, Q2 revenues increased substantially by 42.5% year-over-year, now representing 35.7% of revenues in Q2, and the Americas are now back to former strength. Growth was primarily driven by communication service and Internet content providers in addition to the positive impact from the U.S. dollar appreciation.

Compared to the year ago quarter, Asia-Pacific grew substantially by 23.2% and now represents 8.4% of Q2 revenues. Growth in Q2 was predominantly driven by strong demand from CSPs.

Moving to the next slide, cash flow and balance sheet. Similar to Q1, we spent a major portion of our nonoperating cash to secure our supply and thus increased our inventory levels. Hence, operating cash flow was EUR 6.5 million, down from EUR 31.7 million in Q2 2021. CapEx and R&D investments were negative EUR 12.6 million, down from negative EUR 17.1 million in the year ago quarter.

Free cash flow was negative EUR 6.1 million compared to positive EUR 14.6 million in Q2 2021. Our debt leverage ratio of 0.4x EBITDA and an equity ratio of 58% supports our very solid capital structure and investment-grade credit metrics. Q2 ROCE on a 12-month basis was 7.7% and reflects our commitment to deliver shareholder value.

Slide 13, outlook. Our revenues in the first half of 2022 were at a record level, and our order books are very strong. Despite many external factors impacting our margins, our operating results have been solid so far. The progress of digitization in all ecosystems as well as security concerns in numerous industries and network operators of the Western industrialized nations are driving the demand for our technology. On the other hand, there is still a high level of complexity with additional costs in the areas of procurement, production and logistics. This environment will continue for the foreseeable future.

Our teams work tirelessly on solutions to meet market demand, and we work closely with our customers every day to provide the best possible support for the network expansion. Against the background of a continued strong order intake and, on the other hand, a strengthening dollar in combination with persistently higher costs in our supply chain, we have decided to adjust our outlook for the full year accordingly which we announced in an Ad-hoc release on July 15. We are raising our revenue guidance to between EUR 680 million and EUR 730 million and reducing our pro forma EBIT margin guidance by 1 percentage point to between 5% and 9% of revenues.

Last and final, Slide 14, road to business combination with ADTRAN. The last few weeks have been very eventful for our company. There has been a lot of news related to the proposed business combination with ADTRAN. Although we provided the market with timely updates on recent developments, I would like to summarize the key milestones.

Firstly, the FDI approval by the German government was the final closing condition of the business combination with ADTRAN. The closing took place on July 15. Secondly, Brian has stepped down as CEO and moved to the Board of the new holding company as Vice Chairman. From the time of the resignation, our long-standing CTO, Christoph Glingener, will assume the role of CEO. And thirdly, ADTRAN'S intention to seek a domination agreement or DPLTA, was the subject of another mandatory notification that we published on July 6, 2022.

With the closing, ADTRAN Holdings became ADVA's controlling shareholder. However, both companies will continue to operate independently until a domination agreement, or DPLTA, becomes effective. The aim is to operationally integrate both companies -- both organizations as fast and complete as possible. Such an agreement requires the approval of our shareholders and will become effective upon entry into the commercial register.

In the past few weeks, we have taken significant steps forward to create a company with annual revenues well in excess of EUR 1 billion and to become one of the bigger players in our industry. There is a high investment need around the network edge, and together with ADTRAN, we will have the leading technology portfolio for this space.

And with that, I hand over to the operator to open the Q&A.

[Operator]

[Operator Instructions] Our first question comes from Hugo Paternoster with Kepler Cheuvreux.

[Hugo Paternoster, analyst]

Can you hear me?

[Ulrich Dopfer, executive]

Yes, we can.

[Hugo Paternoster, analyst]

Great. I have 3 questions, if I may. And the first one is regarding the unexpected customer request to postpone the delivery that you announced for your preliminary ad hoc publication. I wonder whether you could provide a small information on that, the reason of this delay, if you already have an idea on the potential delivery, the timing and potentially also more explanation on the profitability impact. And this is the first one.

[Ulrich Dopfer, executive]

So I think I'll take this one, Christoph and Brian. I guess, unexpected return is something -- some of our customers have the right to return equipment. And since this was significant and obviously the quarter was closed, we felt obligated to adjust this in our numbers and go out with ad hoc notification. Since then this led to us missing the consensus and also the deviation to the market expectations which was too high. And we want to be it as always open and transparent, right? So I guess this was one of the reasons or the main reason.

But the order will be there, right? So it's not that the order got cancelled. It was just that the customer asked us, since they have bottlenecks with installation, obviously, and just asked us to delay the shipment to a later quarter. So I hope that answered your question.

[Hugo Paternoster, analyst]

Yes, yes. Okay. Got it. And another question regarding your profitability guidance. So even though it seems that procurement costs have been higher than initially anticipated along with the negative FX development and some price profitability improvement in subsequent quarter, and I wonder if you could run us through your gross margin and potentially OpEx expectation for H2, which could give us more insight on the development going forward.

[Ulrich Dopfer, executive]

Sure. No problem. So as I said during my speech earlier, it's all about execution, right? So we have a full order book that is, on one hand, very satisfying; on the other hand, not so satisfying, because we have many customers who screamed at us because we can't deliver, right? But we expect that we will be able to dispatch more in the second half of the year, right? We see signs that in certain areas, supply gets better. So we should be able to scale.

Secondly, we expect slightly improved gross margins despite the stronger U.S. dollar. This is simply because I think we told you guys last time that we started to impose price increases on a broad basis, simply to -- because we cannot follow all the costs, the additional costs that a semiconductor shortage causes. So we should see some impact of this price increases already in Q3, hopefully more in Q4. And then we also see a little bit of relief on -- when it comes to freight costs. So this should overall help us to increase the gross profit slightly.

OpEx, I would assume, remains fairly stable compared to the first half of the year. So there should not be too much movement. Of course, there will be some, but I think that's neglectable. But again, it's all about execution on the top line and scale on the top line.

[Hugo Paternoster, analyst]

Okay. Got it. And maybe one last one -- last question. It's regarding your revenue guidance, which has been increased. To what extent it is linked to the dollar or potentially volume or your own pricing at this stage? I understand pricing maybe is a part.

[Ulrich Dopfer, executive]

So well, if you look at to -- it's in fact the midpoint of our guidance. We roughly have to grow 10% or a little bit more compared to the first half of the year, right? I would say a small, let's say, 3% to 4% is attributable probably to the stronger U.S. dollar. A small portion, maybe 1% is really the price increases or so, and the rest is simply the ability to execute more -- to ship more, right, or dispatch more.

[Operator]

Our next question comes from Simon Scholes with First Berlin.

[Simon Scholes, analyst]

I noticed that net R&D is at EUR 23 million in the second quarter. I think the previous time value over the last 4 quarters is about EUR 20.1 million. I was just wondering if that's to do with investment in the new transceiver and what we should expect for this item over the next few quarters. And also with regard to the 100ZR transceiver, how big a part of your module business you expect this product to be within 2 or 3 years?

[Ulrich Dopfer, executive]

So I'll definitely take the first one. Yes, R&D is up, but this basically has to do with lower income from the capitalization, and it's recapitalized based on projects and the reaching of certain milestones in these projects, and it's just a coincidence that it fell that way. So -- but we assume that this will continue to stay in that range. So we believe that the R&D cost in the next quarter will be on a similar level, maybe a little lower but a similar level than we have seen in Q2.

And then I don't know if, Brian, if you want to jump on the next one on the other question regarding the transceiver?

[Christoph Glingener, executive]

Christoph here. I'll take it. So obviously, our strategy to increase revenues from verticalization and forecasting a 10% to 15% over some years, this is an important piece in it. Also as I tried to explained earlier on the 2 slides, we see really a big opportunity with a big wave of upgrades of [ integration ] devices with this one, hopefully taking us higher.

[Operator]

[Operator Instructions] Our next question comes from Robert-Jan van der Horst with Warburg Research.

[Robert-Jan van der Horst, analyst]

I also have 3. So the first one would be on the order development which you described is pleasing, but just could you give me an idea how the order momentum developed from Q1 to Q2? Is it still stable on this almost record level that we saw during the last quarters? Or is there some normalization going on?

And my next question would be on the integration. So you just mentioned that the companies will be treated going forward until this agreement has reached at 2 separate entities. Is this affecting somehow the integration costs that you have predicted for the second half of the year? Because I still have quite some integration costs in the third quarter of about EUR 10 million, is that still accurate or if that might be postponed to the fourth quarter?

And my final question will be -- maybe an update on the shortages because I've heard in the market that the number of components that are actually in short supply go down with a few critical components being very short. But apparently, especially those where you're in competition with consumer electronics since the demand seems to be lower this year than it was last year, it's getting easier. So could you give us maybe a picture of, are there like a very limited amount of critical components, what are those components and what's your prospect for the second half of the year, especially in light of a reduced demand for the consumer electronics?

[Ulrich Dopfer, executive]

All right. Let's talk about the order book. So we have seen probably the strongest order intake in the first quarter of this year. It slowed down a little bit in the second quarter, but it remained on an extremely high level. Also, we expect it will remain on that level in the third quarter as well. So we are very pleased with this development because many of these orders are not that they are going way into the future. So basically, what customers order, they want to have as quickly as possible for the most part. So a big portion of our order book is really for Q3, Q4 and maybe Q1 of next year. But -- so I think this is very satisfying and helps us also to manage our supply chain and our suppliers, right?

Regarding the components, I guess this is what Christoph will take. I will take the integration question. So well, I think we knew that all along that from the time when the business closes and in case a domination agreement will be pursued that there might be some delays in the integration, but I don't think this is anything that we did not expect. So I would not expect any disadvantages from this situation because we basically planned for it in a way. And as a matter of fact, we also planned originally to try to find ways without a domination agreement, if this is possible, too.

And so nothing unexpected, nothing -- no impact on costs, no slowdown in integration planning. But as we said, until a domination agreement or DPLTA is registered, the companies need to work independently from each other, and this is what we're doing.

[Brian Protiva, executive]

Robert, I have a quick question. This is Brian. Is in your model, you put EUR 10 million of integration costs in the model, was that understood correctly? Or that was not a...

[Robert-Jan van der Horst, analyst]

No. I do have some costs with the deals are really -- it's all the costs that are somehow associated with the deal. And I think after we haven't seen a lot of them in the last quarter as like for the whole year, the main adjustment to the EBIT from the merger is actually in my planning in the third quarter.

[Brian Protiva, executive]

Okay. Thank you. I was just -- I just wanted to clarify there because there's not in addition integration costs coming where -- because that the integration really starts the day of the DPLTA where you start actually making decisions that are specific to integration. We're doing integration planning today, but there are other deal-related costs. So I think everything is good. You have everything under control. Christoph?

[Christoph Glingener, executive]

On the semiconductor shortage question, you had, yes, I confirm your view. It's getting a little bit less parts. We are chasing, although those lesser parts get more severe. So it's harder to get them. Basically, that's exactly what we see.

In terms of overall situation, it seems to get a little bit bigger on the larger node sizes. So like 14-nanometer parts, they seem to be easier to get now, maybe pushed a little bit by consumer electronics being less in demand. But on -- for most of our parts, we need industrial great spots. And there, we don't see that yet. We're going to see a little bit easing there, hopefully, in the next 2 quarters, but it is not yet there.

[Operator]

There are no further questions at this time. I hand back to Mr. Brian Protiva for closing comments.

[Brian Protiva, executive]

So this -- it was my last quarterly financial call. And thus, I would like to take the opportunity to thank all of you for your support for ADVA during the last 23 years and for me personally as the CEO and co-founder of the company. I'm very, very happy about the decision to pursue the business combination with ADTRAN. I think we are building a global leader.

In the meantime, my transitioning into the Board of ADTRAN, I hope to continue to contribute in the best sense and direction of shareholder value creation. And I'm very sure that Christoph and team are going to run ADVA perfectly for the next quarters. And hopefully, we will give them the opportunity to do and have a very successful integration with ADTRAN. I think that's in the best interest of all of us to go drive global leadership and then hopefully, in a few years, take the next strategic step.

So thank you very much. And next call, I think, it will be Uli, and we'll see how we bring the team together to be able to answer your questions. Thank you very much, and talk to you soon.