Adtran Networks SE

XMUN:ADV

Earnings Call Transcript 2018-Q3

[Operator]

Dear ladies and gentlemen, welcome to the conference call of ADVA Optical Networking for the third quarter 2018 IFRS financial results. This call is being recorded. [Operator Instructions] May I now hand you over to Mr. Stephan Rettenberger, ADVA Optical Networking's Senior Vice President, Marketing and Investor Relations. Please go ahead, sir.

[Stephan Rettenberger]

Yes. Thank you, and welcome from my side. This earnings call builds on a presentation, which is available for download in PDF format from our homepage under www.advaoptical.com, in the About Us/Investors section. Should you not have the presentation in front of you, you may want to access it on the Conference calls page in the Financial Results section of the Investors section of our website. And before we lead you through the presentation, as always, please be informed that this presentation contains forward-looking statements with words such as believes, anticipate and expects to describe expected revenues and earnings, anticipated demand for Optical Networking solutions, internal estimates and liquidity. These factors are discussed in greater detail in the Risk Report section of our annual report 2017. 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 as substitute for historical information presented in accordance with IFRS. Pro forma operating income or loss is calculated prior to noncash charges related to the stock compensation programs and amortization and impairment of goodwill and acquisition-related intangible assets. Nonrecurring expenses related to 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. As usual, Brian will start and provide our business update and outlook. And then Uli will talk us through our Q3 2018 financials. And finally, we will have sufficient time for your questions, which we'll be happy to answer. So Brian, please go ahead with the business update.

[Brian L. Protiva, Co]

Thank you, Stephan. We will start as usual, Page 4, Q3 2018 in review. So Q3 revenues reached EUR 126.2 million, up sequentially from EUR 123.8 million in Q2 2018, and nicely up year-over-year from EUR 111.2 million in Q3 2017. This is near the midpoint of our guidance corridor provided on July 19, 2018, of between EUR 123 million and EUR 133 million. Moving to the next bullet. Our Q3 pro forma operating income was at EUR 6.8 million or 5.4% of revenues and was at the upper end of guidance of between 2% and 6% of revenue. As forecasted, we actually amortized more R&D cost than we capitalized, which demonstrates the strength of our results. For the first time in many quarters, we have not only shown sequential growth, but also annual growth. We continued our solid performance and further expanded our gross margins. We were able to once again demonstrate continuity, good execution and focus. Notably, our strategic investments are delivering returns. This is our fourth consecutive quarter with growth whereby strong margins and good profitability are building a foundation for driving greater shareholder returns. The optical market continues to consolidate but remains competitive while the packet edge and synchronization solutions portfolio are delivering according to plan and are helping us to secure our stable and long-term growth plans. Moving to Page #5, Prospects for Q4 2018. We will continue to strengthen our balance sheet by tightly managing our costs and driving greater growth in some of our highly differentiated products in both our packet edge solutions area and our edge NFV portfolio. The forecast for the current fourth quarter continues to point to sequential growth and, again, year-on-year increases. At the beginning of the year, we had communicated the objective of achieving moderate sales growth in 2018, also on an annualized basis. As already described in the previous earnings call, this target has become a real challenge due to the weaker-than-expected revenues in the first half of the year. Annualized, we will still have to replace strong ICP revenue numbers from one of our larger ICP customers who made large revenue contributions to the first half of 2017. Only in the case of an exceptionally strong fourth quarter, well beyond our financial guidance, will it still be possible to reach or surpass the full year revenues of 2017. Nevertheless, the positive order intake and the overall positive mood among numerous important customers provide a solid backdrop for a good fourth quarter. In terms of profitability, we remain committed to the outlook for the year as a whole. Measured in terms of pro forma operating income as a percentage of sales, the profitability of the group is expected to rise to mid-single-digit levels. Every revenue euro means more to us into 2018 than 2017 due to our increasing gross margins. As I mentioned in the previous slide, the optical market continues to consolidate. Coriant, one of the most price-aggressive competitors, has been acquired by Infinera. Our profile as the European-headquartered leading innovator with global reach and footprint continues to support revenue growth and differentiation within this market context. On the next 3 slides, I will outline my view on our position in our 3 technology segments. Page 6, Open optical networking. More than 2/3 of our revenue are driven by our flagship product, the FSP 3000. Our focus will be to leverage the metro core upgrade cycle at our carrier customers to drive additional optical revenues by expanding the use cases at both our existing and new customers. We're also aggressively pursuing DCI opportunities with open line systems, and we are introducing a number of new products for this market segment in the coming months. In addition, we're going to win new footprint for flexible and programmable 5G infrastructure, where we can leverage all 3 core technologies and our software expertise. We believe, for the first time, there will be opportunity for networking equipment manufacturers other than the big 3 mobile network providers to win real share due to the virtualization of certain parts of the network and the differentiated technology needed for 5G. The investments are too big and the lock-in too great for carriers to solely rely on the big mobile network equipment vendors. See our latest announcements around the TIP-led disaggregated cell site gateway, being supported by Vodafone, Telefonica and Facebook earlier this month. Our Optical business is moderately positive as we continue to win an ever greater number of CloudConnect customers. With the addition of our TeraFlex features, we will be expanding our CloudConnect product architecture, making winning further footprint that much easier. Our Fiber Assurance Solutions allowed us to open the doors with one of the world's largest ICPs. So we are now serving 4 of the top ICPs with ADVA Networking Solutions. And finally, our MicroMux product is shipping with increasing volumes. We continue to invest in open and disaggregated optical solutions as well as our software-defined strategy in order to support our customers looking at flexible capacity in the network in order to support cloud-like flexibility in carrier networks. Moving further to Page #7, physical and virtual packet edge. With respect to our second technology segment, we have a number of opportunities to grow our ADVA packet edge market share. The first and primary goal for 2018 has been to protect our MRV customer base and drive cross-selling initiatives with our NFV solution or other ADVA products. We have been very successful here. Next, we plan on extending the customer base for cloud access solutions by offering both physical and virtual packet edge solutions for complete flexibility and secure access. They can choose to use our all-in-one hardware solutions, which lead with price performance or to use our software solutions over their cloud infrastructure on white boxes to build secure, high bandwidth and software-defined on-ramps to data centers or cloud infrastructure. These are cloud-native solutions that can be run on any public cloud, container-based solutions, in fact. Furthermore, we plan on accelerating revenue contribution from our Ensemble software solutions as we see a lot of activity from the carrier landscape, and our win rate is increasing. This is based on our comprehensive product strategy, ease of use, secure platform and some of our latest features such as zero-touch service delivery or provisioning for both carriers and enterprises. We've also introduced a number of new Layer 3 features, increasing our total available market for our packet edge solutions. The list of potential customers is growing and our reach is at a never-before-seen scale. We have positive revenue and margin growth in this area, and we are close to signing significant new contracts in addition to the wins we've already published such as Masergy, cloud in Verizon, Colt, who all selected our Ensemble software universal CPE solution. Synchronization, Page 8. We are winning multiple footprints and growing rapidly with our synchronization strategy. So far, we are leveraging our large footprint in the carrier space, but there are a number of other customer segments, which we will successfully expand into. We are utilizing our technology leadership in synchronization to further improve overall corporate margins and win new footprint, where we then can cross-sell our other technologies. With the decision for 5G infrastructure builds being made now, we have all the pieces in order to offer a comprehensive portfolio with core, access and sync software assurance solutions, which far exceed our competitors. Our recently introduced new products put us well ahead of the competition. We are also developing pure software solutions for sync and timing to address the new segments. Accurate and scalable time and frequency synchronization will continue to grow. This enhances our ability to leverage optical, packet and timing technologies for next-gen networks. My final slide, Page #9, the investment focus moves to the edge. It is important to reiterate that our industry is pivotal to the long-term success of the digital revolution. Digitization is progressing rapidly across all ecosystems. Applications like the smart workspace, connected homes, smart robots, autonomous driving, augmented reality, artificial intelligence, the Internet of Things, all drive the transformation of the network; a transformation that is built an openness, virtualization and security, and the transformation that moves the investment focus to the edge of the network. The market is coming to our sweet spot. The edge is where ADVA performs better than all competitors. As a company, we have aligned ourselves strongly and invested inclusively in strategically important future technologies, technologies that enable new digital business models. Optical transition technology delivers the required bandwidth, physical and virtual edge technologies bring the cloud and related services closer to the customer and our synchronization technologies guarantee the level of timing needed in high-performance networking. All of these things make the difference between success and failure in the digital world. With our innovation, specifically, we are well positioned for the future. And with that, I hand over to Uli for more details on our financials.

[Ulrich Dopfer, President, CFO & Member of Management Board]

Thank you, Brian, and hello, everybody. Let's move to Slide 11. As already stated, we ended Q3 2018 with revenues of EUR 126.2 million. This result is within our revenue guidance range of EUR 123 million to EUR 133 million and represents an increase of 2% compared to Q2 2018 and 13.5% year-over-year. And more favorable customer and product mix combined with cost reductions resulted in a further increase in gross margin to 37.5%. This compares to 36.7% in Q2 2018 and 35.2% in the year-ago quarter. These effects are also reflected in the strong pro forma operating income of EUR 6.8 million or 5.4% of revenues, which compares to EUR 6.1 million in Q2 2018 and the pro forma operating loss of EUR 0.8 million in the same period the previous year. Also, this result is at the upper end -- it's within our guidance and, in fact, at the upper end of our guidance, which was between 2% and 6% of revenues. Let's move to the next slide, Quarterly IFRS profitability. In Q3 2018, IFRS operating income came in at EUR 5 million or 4% of revenues. Net income was at EUR 3.9 million or 3.1% of revenues, slightly down from the EUR 4.6 million in Q2, but this was caused by FX effects and slightly higher taxes. As the number of weighted average shares outstanding has not changed significantly, diluted EPS developed in proportion with IFRS net income to $0.08 per share. Slide 13, please, quarterly revenues per region. In Q3 2018, Asia Pacific contributed 15% of total revenues, representing a total growth of 133% compared to Q3 2017. Americas, after a strong Q2, the region contributed 37% of total revenues. This is EUR 4.9 million less than in Q2 2018 but is EUR 3.9 million up compared to the year-ago quarter. EMEA continues to be our strongest region and contributed 48% of total revenues. Next slide, please, IFRS balance sheet. Compared to Q2, overall net working capital is up by EUR 10 million and ended at EUR 131 million. Inventory increased slightly to EUR 80.1 million and is up from the EUR 76.3 million seen in the previous quarter. Due to a back-end loaded quarter, both accounts receivables and accounts payables increased compared to the end of Q2 2018. In Q3, we refinanced the EUR 55 million bridge loan used for the acquisition of MRV with a syndicated loan, providing us additional financing power for further growth. The equity ratio increased from 49.1% to 49.7%. Next slide, please. Slide 15, guidance for Q2 2018 (sic) [ Q4 2018 ]. We project Q4 2018 revenues of between EUR 126 million and EUR 136 million, with the pro forma operating income to range between 3% and 7% of revenues. This guidance includes expected adverse effects from increased import duties to the U.S. We continue with our upward trajectory and remain committed to a flexible cost and operating model that allows us to quickly adapt to changing market conditions. We will continue to perform detailed reviews of the expected business development in respect of all intangible assets, including capitalized development projects. In case of highly adverse business prospects, such a review may result in noncash impairment charges in Q4 2018 and beyond. The pro forma operating income guidance we have provided today excludes any such potential impairment charges. With that, I'd like to summarize today's call, Slide 16. We have good execution and focus. Our strategic investments are delivering returns. Q3 2018 was the fourth consecutive quarter with top line growth. Solid profitability confirms that we are on the right track to further scale the business. The forecast for Q4 continues to point to more sequential growth as well as the year-over-year increase compared to Q4 2017, which makes 2018 the year of solid revenues and profitability, providing us with the foundation to accelerate in 2019. The global growth drivers, cloud and mobility, the preparation of the network infrastructure for 5G and the digitization of all ecosystems, drive the investment to focus -- that investment focus to the network edge, creating new opportunities for us within -- with multiple ways to win. Our open programmable optical transmission technology offers significant value in terms of capacity, flexibility and automation to network operators, large enterprises and Internet content providers, delivering the unlimited bandwidth to interconnect the cloud. Physical and virtual packet edge technologies transform the speed and flexibility for service creation, delivery assurance, bringing the cloud and related services closer to the customer. Our traction with our cloud access solution is growing, and we are winning more and more designs. And last but not least, our technological advantage in network synchronization is growing. We are developing a strategic presence with Tier 1 network operators and have the most comprehensive and advanced technology portfolio to deliver the precision needed in high-performance networks. Our new technologies help our differentiation and drive additional growth. I thank you for your participation in today's call. And with that, I'd like to turn the call over to the operator to begin the Q&A portion of the call.

[Operator]

[Operator Instructions] We received the first question. She -- it's from Steven Savageaux (sic) [ Timothy Savageaux ], Northland Securities.

[Greg Gibas]

This is Greg on for Tim Savageaux today. First, was just wondering if you're seeing any disruptions or opportunities from the Infinera-Coriant merger?

[Brian L. Protiva, Co]

I think it's a little bit early to see. Definitely have heard from some customers that they're wary just because of commitment to which products. Therefore, there should be some opportunities for us and for all competitors in the marketplace because of that acquisition. And clearly, I think the period is going to go for 1 to 2 years of opportunity.

[Greg Gibas]

Okay, understood. And then second, was just wondering if you could provide some color on the timing of 600G ramping?

[Brian L. Protiva, Co]

So what we have said is we're demonstrating products this quarter to customers. We would have initial shipments next quarter. And then Q2 moving into Q3, we will start to have volume shipments of the 600-gig per wavelength capability. Everything looks really good, and the data shows that we're -- have specs that are superior -- far superior to anything else on market presently.

[Greg Gibas]

Got it. And then just finally, could you provide some detail on the extent to which the synchronization business can continue to improve your gross margins moving forward?

[Brian L. Protiva, Co]

It's a much smaller market than the optical market and the packet edge, so clearly fewer competitors. And therefore, it is higher gross margin because it is also much smaller deals. So that will continue. And I think as of now, all carriers are making decisions. Presently, they have been doing it for about 1.5 years depending on which country you're in. Pretty much we'll be through all these new service provider decisions within the next 6 to 18 months -- 6 to 12 months. And everything that we're winning is solid gross margin and then we're going to go after other verticals efficiently, I think, because our technology allows us to expand into utilities, finance markets, all sorts of things, autonomous driving, all sorts of different verticals including the ICP space. So we like it, but it is a small niche market. We want to build this business to be a EUR 100 million business. But it's step by step, and it's not potential to grow to $500 million. So it's going to be nice growth for us. It's going to be nice leg to stand on. It's going to be higher gross margins and nicely profitable for us.

[Operator]

We have no further questions for the moment. [Operator Instructions] Next question we received is from Mirko Maier, LBBW.

[Mirko Maier, Investment Analyst]

First of all, let's start with some for Uli. And income from capitalization for R&D was negative in Q3. So something we have also to assume for Q4 and perhaps also for whole year 2019? And the second question on margin in Q3. Could you split the effect between your change in the customer product mix as well as the cost reductions on the margin improvement, please?

[Ulrich Dopfer, President, CFO & Member of Management Board]

Mirko, nice to have you on the call. So first question, I would assume for Q4, it may be for your modeling for the next year, 0 income from capitalization. It's -- for the year, of course, it's a little bit early to say. But just for the modeling, I guess, you're on the safe side.

[Brian L. Protiva, Co]

So the second one is margins. I think margins have been increasing over the last 4 quarters. Product and customer mix is a big influencer, clearly. So we can have quarters that goes down. But in general, the cost reduction piece of it is one important piece, coupled with innovation. We're in a very competitive industry so we need all pieces, both innovation and new products with much higher bandwidth or highly differentiated products, coupled with cost reductions to increase gross margins. Right now, we're thinking, we've said our average of the second half of 2018 will probably be similar to our average going into 2019, and that probably margins will be a little bit lower in Q4. But that's still to be seen in the same ballpark. So I think we were stabilizing and you can expect to continue to increase those gross margins quickly as we have had over the last 4 quarters.

[Mirko Maier, Investment Analyst]

Okay. But the customer product mix has the bigger share of margin development than the cost reductions until now?

[Brian L. Protiva, Co]

I think -- I'd like to say it differently is that over the last 4 quarters, new product introductions and cost reductions have helped us to secure steadily increasing gross margins. But product and customer mix can mean that any given quarter, our margins do decrease or increase based on that mix. So I can't really weigh it like you're asking it because they're 2 different models.

[Mirko Maier, Investment Analyst]

Okay. Great. I was on the call from Nokia just a few minutes ago, and they were very bullish on their Q4 when it comes to 5G network rollouts. How this is playing at ADVA? Perhaps this is also a bigger part from your revenue improvement in the fourth quarter? Or is it something we have to wait for next year 2019?

[Brian L. Protiva, Co]

So if I'm Nokia and I'm not bullish, I'm in trouble. I think they better be bullish. I think ADVA is much more stable. And the reason is because of exposure to many different -- you know, the network layers as well as different use cases. 5G is one of our growth parameters. It's now starting to be rolled out depending on the region, step-by-step. But it's something that's going to take 5, 6, 7, 8, 9 years from a volume perspective. So it's a good growth vehicle for ADVA starting, yes, a little bit in Q4, but it's an evolving issue. I mean, it goes -- it becomes a lot higher into 2020 clearly, or 2021, than in end of 2018. So, like it, opportunities there. And as I indicated in my presentation is it's going to be much harder for the Nokias and Ericssons and Huaweis to go into carriers and have end-to-end solution sets. It all comes to me. And that's because people -- the carriers themselves have to take cost out. They have to have densification of their networks, the amount of small cells or remote radioheads increases radically. Investment dollars are going up unless they save money on the network investments. So what it means is new structures, new technologies, open RAN, virtual RAN, lots of opportunities for third parties to come into that market segment and take market share. We believe that it's a huge opportunity, much bigger for some of the others outside of the business looking on in that it is for the large OEM suppliers. I think they're going to fight very hard to keep their market share moving forward. And you might have seen our announcement move forward with the Vodafones, Telefonicas, and Facebook for a distributed cell site gateway where it's going to be commoditizing pieces of the network with the support of large carriers giving us more opportunities, new market segments to grow into. So very interesting area. We're not as dependent as Nokia is on this space. It is starting to evolve. I don't see a major uptick or a big step-up in Q4, specifically in 5G, but it's slowly evolving.

[Mirko Maier, Investment Analyst]

Okay. Great. And they have also met with some components shortage in optics and routings. That's nothing you have to deal though?

[Brian L. Protiva, Co]

I think that we're doing a lot better. I think we told you from a supply chain issue that things -- standard passive components and various other things were short in supply. We feel much better about that moving forward in the rest of this year. So I think our strategy was the right one on how to manage it, and we're nicely in control. And the delivery schedules and dates are decreasing again for ADVA.

[Mirko Maier, Investment Analyst]

Okay. Great. And then the last question to your ICP customer segment in United States. In your report, you have mentioned your investments in direct sales. So has anything happened in the recent months, as example that you have been some new customers and this specific area that you could share with us?

[Brian L. Protiva, Co]

Specifically, ICP, we won the fourth -- one of the big ones in a direct contract for fiber assurance, our first step into that account, as an example. We won a major insurance company. We're winning multiple different enterprise accounts. So yes, we're winning deals as we speak, and we believe we're in the middle of a nice pipeline build in North America. So we see North America as one of our regions of strength through our direct sales organization in Q4 and moving into 2019.

[Mirko Maier, Investment Analyst]

Yes. But the plan is not revenue. So when it -- how is the revenue timeline when you feel playing out?

[Brian L. Protiva, Co]

As I said, Q4 and 2019. We believe that order flow, order entry in North America is increasing nicely for us in this quarter and into next year.

[Operator]

Next question we received is from Robin Brass, Hauck & Aufhäuser.

[Robin Brass, Equity Analyst]

I have two questions, one, again on ICP. What is the current share of revenues in ICP? And what is your, let's say, outlook going forward? Would you think that it is slightly growing as a percentage of revenue? Or what would you say your gut feeling for 2019? And the second question if I didn't hear something wrong, I think when Uli gave the Q4 outlook, you mentioned also U.S. trade tariffs. Was that correct? And how exactly would you be affected by any trade tariffs at the moment?

[Brian L. Protiva, Co]

So the first one, we said high-single digits to maybe 10% on any given quarter. I think we're staying consistent in that range. We do have something that, I think, the fiber assurance opportunity is not going to fundamentally change that. It just adds. We have a direct contract, and we're now starting to work for cross-selling into some of the areas where we have larger revenue sales, which is good. So we have 4 direct contracts and then we're bringing latest technology like the TeraFlex to market. We hope to complete very effectively with that product to win further share there. If we win with the TeraFlex, we will grow that percentage and share. If not, I think we will stay in the high single digits, 10% range. But like I said, there is an opportunity for us if we perform well to increase that in 2019. That's the one point, and the second is the tariffs.

[Ulrich Dopfer, President, CFO & Member of Management Board]

So the tariffs, I guess, everybody, Robin, who is importing components from China into the U.S. is impacted by the tariffs. So for us, it's probably 0.5 percentage point in gross margin or so in the quarter depending how it falls, but in this range.

[Brian L. Protiva, Co]

So that's a very mitigated number. We were able to -- so only a portion of our products are manufactured in China, we also have in Europe and distributed on a global supply chain strategy, always have had that. So we're able to move things around quite nicely, point one. Point two, we are mitigating as we speak and the products that would hurt us the most, the volumes get shifted. And then we have a long-term platform. If it gets worse, next year, with 25%, to make sure that our exposure actually decreases from the 0.5% in this quarter by 50% in Q1 and continues to decrease throughout next year. So it will not have a major impact, but a smallish impact in our numbers. But that's part of our guidance. That's been included.

[Operator]

We have no further questions for the moment. [Operator Instructions] We have received a further question from Andrew Smith.

[Andrew Smith]

I had a question about the 5G opportunity. And you talked about selling in the TIP-based product. Do you see that as primarily a hardware opportunity where you would couple that with software from, let's say, Cumulus? Or do you see that as an opportunity to also put in some of your Layer 2, Layer 3 software on top of that commodity hardware?

[Brian L. Protiva, Co]

So we have our own software platform. And in this case, it is ours. We do work with Cumulus, though, for the Voyager, and have first projects. And the way you would vision the model is that we can source. It's a white -- let's say, it's essentially kind of a white box. We can source that product from Edgecore or others that can build the product because it's all public open source-type of specs, pop our software architecture on top of that and offer it in around a service wrap about just all the logistics, the support, the services, et cetera. So a carrier could buy it from us like they buy ADVA products in thousands or even 10,000 of units. So it will be very professional, very competitive, very price-competitive because also the hardware costs will be driven down annually and there's no tie-in. So there is independence of that. And then there will be a number of different software platforms on top of that, I imagine. Again, were -- we were announced as the partner first to market, et cetera. And why the carriers are doing it, but they're spending far too much money on cell site gateways. When they look at build of the 5G infrastructure, they want a very specific product and they want to spend half of what they're spending today because the volume is going to double or triple. So there is incentive from an industry to drive more efficient models. And ADVA is going to be -- it's not eating our lunch in any way or form. We're moving from the Layer 2 market and the NFV edge universal CPE market into that cell site gateway, so it's a very natural progression for us.

[Andrew Smith]

And also you talked about North America being an area of strength going into Q4 and into 2019. Is that specifically from the large ICP sector? Or is that coming from some of your more traditional, large enterprises and small and medium enterprises, when you're talking about these direct sales?

[Brian L. Protiva, Co]

Broad-based. It's broad-based across the board and we wonder we'll have a joker, you know. We're not planning for that. We think we can grow nicely as an organization. But the joker would be that we do go expand the percentage of revenues into ICPs.

[Operator]

There are no further questions at the moment. [Operator Instructions] There are no further questions. I hand back to the speakers.

[Brian L. Protiva, Co]

So thank you very much for your participation. I look forward to talking to you as individuals through IR, CFO or with me directly. And we will talk latest, end of February. So it's our largest break from a financial call perspective. So please reach out to us. Thank you very much.

[Operator]

Ladies and gentlemen, thank you for your attendance. This call has been concluded. You may disconnect.