Description

Adtran (ADTN) is a smallcap networking and communications equipment manufacturer recently making high 52 week lows. Even though the company has a solid balance sheet, many years of profitability and pays a dividend, Mr. Market is concerned with decreasing revenues and gross margins as well as a lack of business visibility. We think patient investors stand to make very good money from a host of positive surprises over the next 12-18 months as well as a possible takeout candidate. (What Dad thinks his child is ugly?)

Industry & Business Description

“ADTRAN is a communications equipment provider that predominantly sells to carriers for broadband services, optical services; I'll say access services worldwide. We're headquartered in Huntsville, Alabama. About 60% of our revenue is in the US, 40% is outside of the US. We do business with all of the Tier 1s, all of the Tier 2s and many of the Tier 3s here in the US. We have been growing our presence outside of the US over about the last three and a half to four years after our acquisition of Broadband Access from Nokia Siemens.” –Adtran CEO Tom Stanton

The Access Services market pertains to the last mile or edge of the network, providing the connection from the operator to the customer. According to Infonetics, the Access Services market is roughly $26B, which consists of cable, copper and fiber connections.

Adtran maintains two operating divisions: the Carrier Networks Division and the Enterprise Networks Division.

• Carrier Networks 80% of Revenue

Carrier Networks Division offers broadband and optical infrastructure products and services used by service providers to aggregate, transport, and deliver voice, data, and video services to their customers’ premises and mobile network cell sites. These products are typically located in central office exchanges or outside plant cabinets, infrastructure locations for business services and mobile backhaul networks, and residential and business premises.

Competitors of the Carrier Networks Division include large, established companies such as Alcatel-Lucent, Ciena, Fujitsu, Huawei, Coriant, and ZTE as well as a number of smaller, specialized companies such as Actelis Networks, Calix Networks, Cyan, Overture Networks, Zhone Technologies, and other privately held firms.

• Enterprise Networks 20% of Revenue

Enterprise Networks Division provides cloud connectivity solutions, such as IP business gateways and access routers, which provide business access to service provider networks, and enterprise communications solutions, which enable businesses to construct voice, data and video networks at a single customer premises or among a distributed enterprise’s multiple sites.

Competitors of the Enterprise Networks Division include: Aruba Networks, Avaya, Cisco Systems, Extreme Networks, Hewlett Packard, Juniper Networks, and other smaller companies which include Aerohive, Ruckus, and ShoreTel. Some of these companies compete in a single product segment, while others compete across multiple product lines.

Two customers, CenturyLink, Inc. and Deutsche Telekom (DT), individually comprised more than 10 percent of revenue in 2014. In 2015, this hasn’t changed much.

Investment Opportunity

For the last few years, Adtran has been shunned by investors since revenues topped out in 2012 at the same time as gross margins have been decreasing from over 50% to a low of 42%. Decreasing revenue is never a good thing and in telecom, without excitement from a visible new product(s) or a significant upgrade cycle on the horizon, the market doesn’t care to stick around.  For the past 3.5 years, there has been a lack of investment in wireline networks as carriers have been allocating more capex dollars towards their wireless networks.

Currently, 60% of the US is serviced by broadband speeds less than 10mps, which is bottom of the range of “reasonable” connectivity dictated by the FCC.  From the Consumer Reports website, “The FCC considers 10Mbps to 25Mbps reasonable for households that stream video, but heavy data users might want even more robust connections of up to 50Mbps or more.” With the thirst for ever increasing bandwidth, carriers find themselves competing to provide faster internet connections.  In the US, a major headwind for Adtran has been the debate of fiber to the home (FTTH) versus upgrading existing copper wireline infrastructure. Late in 2012, Google began disrupting the industry by announcing a plan to experiment with FTTH in Kansas City. Since then, Google has been investing billions of dollars into FTTH with the announcement of additional cities (even though it is not economical at this time). With the tier-1 carriers caught between investing in wireline and wireless infrastructure, some carriers have had to follow Google in their fiber investment.  It’s also important to note that Adtran also has a significant exposure to FTTH but a majority of its revenue is on the copper side.

Adtran has benefited as European carriers have decided to pursue a different patch (i.e. Deutsche Telekom), which is upgrading the current copper infrastructure for faster speeds. US carriers have been neglecting wireline capex so a pick up in spending could arise to be a bright spot going forward in a lackluster telecom capex outlook.  We think ADTN should greatly benefit as these headwinds of the last couple years turn into tailwinds.  With $6.65 in cash and no debt, the market will soon rerate Adtran for profitable sales growth and years of returning excess cash to investors via dividends and stock buybacks.

Investment Points

• Multiyear Demand from CAF 2 funding and AT&T

After rarely 3 years of a wireline capex hiatus from major carriers, Adtran stands to benefit from recently awarded CAF 2 spending.  For some background, in 2011 the FCC created the Connect America Fund “CAF” to subsidize the buildout of broadband in rural communities. The first phase of the CAF program gave $300M to carriers to expand their broadband networks in these uneconomic areas. The second phase of the program (CAF 2) was announced this past summer and will provide $1.5B over 6 years to carriers. The great thing about this funding is once the carriers take the funding, they are committed to spending it. Further, carriers accepting the funds are required to buildout at least 40% of the qualified locations by the year of 2017. According to JP Morgan Analyst Rod Hall, ADTN current customer base represents 67% or $1B.  Assuming hardware costs are 15-20% of the stimulus spending and Adtran has 50% market (Calex CALX has the other 50%), we are anticipating additional $75M-$100M in revenue annually.  We think the stock has been slow to react to the story since management has cautioned investors it is still unknown how much of this revenue will be “incremental” to the company’s current business with these carriers.

In addition, part of AT&T’s acquisition of Direct TV is AT&T committed to build and “enhance” high-speed broadband service to cover a further 15 million customers within four years, through a combination of fiber and copper networks, mainly in rural areas where AT&T does not provide high-speed broadband today.   

It’s important to note that Adtran’s domestic business is much higher margin, currently in the low 50%’s versus mid 30%’s for its International business.  Therefore, with growth expected from the domestic business and flat to low growth in the international business, Adtran should benefit from gross margin expansion.  The company is already starting to see new demand from CAF2 as domestic revenues should be up 8% in 2015 after  years of declining revenues.

“Alright. So let me cover the last piece first. So the US business has been down for -- down, declining and then flat for 3.5 years. There's been very little capital spending going on in the US, and we started seeing a pickup, CAF-related pickup, earlier towards the tail end of last year, and without a doubt, that continued to do well, and we've seen that pickup kind of broaden, and we are expecting CAFII to come into full force next year, which would -- without a doubt -- every single carrier that has received CAFII we have been in talks with about what their plans are, and we expect the US to do well next year.” - Mike Foliano - ADTRAN, Inc. - Interim CFO, Secretary, Treasurer & SVP, Operations

• End of the U.S. Dollar rally

Over the last few years, the company has experienced rapid growth in its international business thanks to two acquisitions in 2011 and 2012. Adtran acquired Bluesocket in 2011 and the NSN BBA business from Nokia Siemens in 2012. Shortly after it won a large project from DT, making the European carrier the company’s largest customer (currently making up 21-24% of revenues). In Germany, Adtran prices its products in Euros making the results very sensitive to the Euro/Dollar exchange rate.  Since 2011, the US dollar has appreciated over 40% against the Euro, which has put tremendous pressure on the international revenue since the company reports in US $. Further, since manufacturing mostly occurs in the US, the Euro depreciation also has put downward pressure on gross margins.

Smart minds like Ray Dalio and Jim Grant have been making predictions the Fed is going to cut rates, not raise rates. Dalio makes the argument that the collapse in commodities is sighting the risk of deflation, not inflation. The Fed has been vocal about its plan to raise rates in 2016 but Mr Market has some doubt.  If Ray is correct, the dollar’s rally should be close to being over and appreciation against the Euro would no longer be a substantial headwind in 2016 and beyond.

• Temporary European Inventory Glut

Adtran’s Q3’15 International Revenue was down 40%, partially due to the Euro depreciation but also from an inventory glut from very ambitious plans.  Currently, the project is only 15% complete and equipment purchases has been curtailed through the Q4’15, which pushed some orders in Q1’16.  The International segment should be less of a drag in 2016 when the excess inventory works its way through the system.

“So we feel good about the long-term prospects and even 2016 on that. The issue that we have right now is that they just really have more inventory than they can install between now and the end of the year, so they've asked us to hold back on shipments until they can catch up. So I don't see any long-term disruption there, but without a doubt it's a disruption for the fourth quarter.” Mike Foliano - ADTRAN, Inc. - Interim CFO, Secretary, Treasurer & SVP, Operations

• Less drag from Legacy Business

The last few years the Legacy Revenue have been a major drag for revenue growth.  The Loop Access business as well as the HDSL business has decreased significantly but the decrease has begun to mitigate.  In addition, the contribution to revenues has decreased so going forward the drag on revenues will be much smaller.

• Cost cutting and Share Buybacks

Management has guided to 5% cut to run rate Q1 ’15 operating expenses. We calculate this to be roughly a $6M cut for 2016 compared to 2015.

Yes, we've been fairly specific on our target there. We are trying to get to 5% below the Q1 run rate by the exit of Q4 this year. We are well on track to do that. So I think the Q4 number will actually be higher than our Q1 number. And if you think about that I think we said mid-single digits down, which is roughly 5%, is where we expect our Q1 numbers to be. They were not -- at this point we feel we are very much staffed properly. Let me put it this way. We don't need to add any additional staff. So I would say that that's a good baseline, and it may move up just because of revenues

moving up or down but in sales expense associated with that. But not -- we're not expecting any big variations from that really through the year. Q3 2015

Management has been consistently repurchasing shares since the middle of 2011 spending over $330M and reducing shares outstanding by over 15M shares or 24%.  Unfortunately, revenue has been decreasing and gross margins have been under pressure, mitigating the affects from the stock buybacks.  

• Industry Consolidation

2015 marked some interesting consolidation in the Access Services industry. In April, Nokia acquired Alcatel Lucent. In August, Ciena acquired Cyan for $400M or $2.7x EV/Revenues.  We think Adtran could be an interesting take out candidate, given its IP portfolio of over 520 patents worldwide and over 170 additional patent applications pending, low valuation (ex-cash), market share position and a multi-year revenue tailwinds from CAF 2 and DT’s network buildout.

Valuation

Currently, the shares are trading for .9x EV/Revenue, near its cheapest valuation in many years. Historically the share have traded as high as 2.4x EV/Revenue.  On an EBIT basis, the stock is trading for 11x our estimate for 2016 EBIT of $48M. We think our estimate is very conservative and will look to make adjustments as we see continued growth in domestic revenue and strength in the Euro/USD exchange rate.

Catalyst

Incremental revenue growth from CAF 2 stimulus 

Appreciation of the Euro/US$ exchange rate

Increased broadband investment

Taken out