Description

One area that I find to be fertile hunting ground for new long opportunities is in tech hardware companies that are currently seeing cyclical downturns in their business/industry and the resulting stock price corrections that go along with those downturns. At the moment, broadband/optical telecom equipment vendors are seeing a severe cyclical downturn that’s been ongoing and generally getting worse over the last year or so. I’m pitching buying one of the most beaten down names in the group, ADTN, that I believe has 2.5x-5x upside from the current $5.60 based on $1-$1.50 of EPS power showing up over the next two years. While not without risk, I believe the company can manage through their tight liquidity situation without diluting shareholders, and can return to posting the kind of earnings that would justify substantial upside in the stock. I'd note that I'd been sitting on this pitch for the last week waiting for ADTN's delayed 10-K to be filed; it has now been filed (on 3/15) as they expected within the 15 day grace period, and provides further evidence that the company should be able to manage through its admittedly tight liquidity situation.

Key points

• The telecom equipment sector is currently experiencing a severe cyclical downturn on inventory corrections and project pushouts at carriers, but the situation will eventually improve

  • Telecom carriers over-ordered during the COVID era when component lead times were extremely long – now they have too much inventory – macro concerns have also caused projects delays

  • As telecom customers work down inventory, the impact can be seen broadly across public equipment companies, and related companies in the supply chain

  • ADTN’s consolidated revenue has fallen from $1.4B to a $900M run-rate over the span of just a few quarters - this current revenue run-rate is now lower than ADTN has seen on an annual basis in at least a decade, highlighting the severity of the current downturn

  • While inventory corrections like this tend to naturally work themselves out over time as customers use up excess product and return to more normal levels of buying, there are also specific catalysts here that should help supercharge the recovery – the environment should be significantly better a year from now

• ADTN’s acquisition of German optical networking company ADVA two years ago has resulted in a large cash obligation and, when coupled with lower revenue due the current industry downturn, has caused market concerns about ADTN’s liquidity situation

  • ADTN is obligated to acquire the remaining 35% of ADVA that it doesn’t already own for $350M-$400M in cash within the next 2-3 years

  • With cost reductions, monetization of real estate, and reduced working capital, coupled with an expected rebound in their business, liquidity should prove manageable 

    • The severe revenue downturn has caused ADTN to get more aggressive on cost reductions – initially targeted $52M in annual cost synergies post ADVA acquisition, now planning to do $90M+

    • ~$70M can be generated from normalization of working capital in CY24

    • ~$50M from monetizing real estate is expected in 2H24, with potential for another $100M+, which I assume can happen in CY25

    • ADTN’s current operating losses are minimal (-1.4% NG EBIT in Q423), and they should return to significant profitability in 2025 as industry conditions improve 

    • In my base case scenario, ADTN can exit 2025 at ~2x net debt/EBITDA inclusive of the ADVA minority interest obligation

• Positive multi-year outlook based on fiber deployments, subsidies, and regulations

  • $42.5M in US BEAD subsidies for fiber rollouts start flowing in late 2024-2025

  • Huawei equipment replacements in Europe concentrated in 2025-2026

• In a more normalized environment, ADTN could do $1.2B-$1.4B in revenue, $140M-$220M EBITDA,  $80M-$120M in FCFE, and $1+ of GAAP EPS, which makes the current sub-$500M market cap & sub-$6 stock price look extremely cheap 

ADVA Merger

ADTN announced an exchange offer to acquire Germany-listed ADVA Optical (ADV GR) in 2021, and closed on a tender for 65% of ADVA shares in Q322. The two companies were of a similar ~$600M revenue scale when the deal was announced. Had ADTN successfully acquired all of the outstanding shares of ADVA in 2022, ADTN shareholders would have owned 54% of the combined company, and ADVA shareholders 46%. However, 35% of ADVA shareholders did not tender their shares, and those shares still trade in Germany. ADTN has consolidated ADVA’s results since Q322. In order to have the power to enact cost savings measures at ADVA, ADNT had to enter into a DPLTA (Domination and Profit and Loss Transfer Agreement) with the remaining 35% minority holders of ADVA, under which they had to agree to both guaranteed annual dividend payments, and a guaranteed cash Exit Compensation for the remaining ADVA shares. I discuss under ‘Liquidity’ below how I see this playing out, but needless to say, this situation turned into a mess when ADTN did not acquire a more sizable percentage of outstanding ADVA shares, and had to agree to a substantial $360M+ cash obligation to ADVA minority holders. Given the current severe downturn in the business, it has caused liquidity concerns with investors, which helps explain ADTN’s sub-$500M market cap today. 

In 2021, when the deal was announced, ADTN had forecast $200M+ of combined EBITDA after an assumed $52M in cost synergies. 

Given the severity of the current downturn, ADTN has now targeted $90M+ of operating expense by year end 2024 vs 2023 levels, of which they’ve already achieved a majority by Q423. If/when revenue rebounds, these additional cost cuts should aid them in achieving the company’s targeted low double-digit EBIT margins. 

Business Overview

Overall, ADTN addresses a $10B+ TAM across broadband access equipment, customer premise equipment (CPE), and optical transport, and primarily sells to service providers/telecoms. 

ADTN reports in 3 revenue line items: 

• Access & aggregation (28% of Q423 revenue) – broadband access equipment mostly to US Tier 2/3 service providers; Optical Line Terminals (OLT) is major product here

• Subscriber solutions (33%) – residential gateways & Optical Network Terminals (ONT)

• Optical networking (38%) – came from ADVA acquisition – Metro WDMs

ADTN’s strongest market share position is in Tier 2/3 broadband access in N.A., and optical transport in Europe:

• In broadband access in N.A., ADTN had about 30% share with Tier 2/3 N.A. service providers ($1B-$2B TAM, CALX has #1 share), with much lower but growing market share in Europe, aided by Huawei replacements (discussed more below)

  • LUMN has historically been a big Tier 2 customer in the US, and slowed fiber deployments in 2023, which has been a drag

  • British Telecom and Deutsche Telecom are access customers in Europe

• In Europe Metro optical transport WDMs (wavelength division multiplexer), ADTN (ADVA) has about 1/3 market share of an estimated ~$1.0B-$1.5B market

Each of the three revenue lines has seen substantial declines from peak quarterly levels, ranging from 37%-44% as of Q423. The recent weakness in ADTN’s business has been broad-based across products and geographies. 

In Q423, the US was 38% of revenue, and international (mostly Europe) was 62%, with that mix having been relatively constant in recent quarters. 

In 2023, ADTN had one international customer that was 11% of revenue - I believe this is British Telecom, but could also be Deutsche Telecom.

Telecom Equipment Downturn is Broad-based

ADTN’s quarterly revenue (including ADVA) is down -39% from the peak level in Q322. Revenue declines of 20%-40%+ can also be seen widely across a range of public companies in the space. Just within the last week, INFN, CIEN, and MRVL (carrier infrastructure) reported weak numbers/guidance in the space. Given the industry-wide declines, I believe the declines seen by ADTN are primarily caused by broader market conditions and not due to company-specific or competitive issues. 

Investors have been burned here

In March 2023, before the industry slowdown became readily apparent, Jefferies had assumed that in a downside scenario, ADTN would do $1.575B in 2024 Revenue. A year later, 2024 estimates are for <$1B. Analysts and investors were, in hindsight, applying growth rates to inflated “bubble” (per ADTN CEO) levels of spending by service providers during the period when lead times for ADTN’s products were very extended. When ADTN’s revenue was running at $1.4B+ in 2022, it reflected a lot of excess buying by customers. 

In looking back at 10+ years of historicals for the combined ADTN/ADVA, it’s clear that recent revenue levels have now overshot in the opposite direction: 

The current -39% multi-quarter revenue decline is now more severe than either ADTN or ADVA had seen at any point in at least the last decade. And as a result, ADTN’s stock is down from $25 in mid-2022, and $16 a year ago, to the current $6.

I believe normalized revenue here is in the range of +/- $1.2B/year. I assume ADTN can get back to doing ~$1.2B in 2H25, and $1.3B in CY26 in my base case ($1.4B bull case CY26), aided by US federal incentives (BEAD) & tailwinds in Europe. If the company can get to the $1.5B-$1.7B revenue level that analysts had forecasted not too long ago, then that would represent upside to all of my numbers. 

Positive Industry Catalysts Ahead

BEAD 

As part the infrastructure bill passed in 2021, $42B in federal funding was allocated in the BEAD program to bring high speed broadband to 7m+ unserved/underserved homes in the US. Funding from the program will be allocated at the state level in late 2024 and 2025. Service providers will then have 4 years to spend those funds and deliver service. Industry analysts at Dell-Oro Group estimate that this funding will approximately double the number of new FTTH homes passed in the US over this period versus baseline/trailing.

Europe / Huawei Replacement

For geopolitical reasons, Huawei is broadly being replaced in Europe’s networks. UK, Denmark, Sweden, Estonia, Latvia, and Lithuania have put in outright bans requiring ripping and replacing Huawei, while other countries like France, and Italy have blocked individual deals, or put in other restrictions that serve to discourage or block use of Huawei equipment going forward. Germany has at this point just proposed a ban, but not implemented anything yet. ADTN sees an incremental $1.4B opportunity ($1B optical, $400M broadband access) from Huawei replacement, with spending concentrated in 2025-2026. Huawei historically has had 50%+ market share in broadband access in Europe; this share should fall dramatically going forward, to the benefit of NOK (#2 behind Huawei in Europe), and secondarily ADTN. 

The Huawei replacement opportunity would be incremental to the opportunity in large FTTH rollouts at major ADTN customers BT and DT – each aim to go from ~2M homes passed as of 2022 to 20M+ by 2026-2027. 

Liquidity

As of Q423, ADTN had $87M of cash and $195M of borrowings on their $400M Wells Fargo credit facility. They also had a ~$345M (and growing) Exit Compensation obligation to the remaining holders of 35% of ADVA (ADV GR). ADTN must also make ~$12M in guaranteed dividend payments per year to those ADVA holders. The exit compensation obligation accrues at a rate of ~8% less dividends paid, so assuming payment of dividends, the exit compensation guarantee accrues at ~5%. There is an ongoing legal case in Germany where the minority holders are challenging their compensation arrangement, with ADTN expecting it not to be resolved for another 24-32 months (as of March '24 10-K). Given the guaranteed dividends and increasing value of their guaranteed put option to ADTN of a combined 8%, these minority holders are financially disincentivized from putting their shares to ADTN until they’re forced to. There will be an eventual end date for the exit compensation put right, which will be determined after resolution of the German court case, at which point the expectation would be that ADTN pays out the cash for the exit compensation. For modeling purposes, I assume ADTN would pay this out at 1/1/26.   

Currently, ADTN’s cash of $87M + availability under their credit line would not be sufficient to pay out the $360M+ obligation that would be due should all ADVA minority holders put their shares to ADTN. For the reasons stated above (minority holders are effectively getting 8% interest), I do not believe this will be a near term cash obligation for ADTN until we approach the expiry of the minority holders’ put right.

The minority shareholders are asking for a higher compensation in the German courts, and I don’t know how that will play out. What I can point out is 1) since the ADTN acquisition, ADVA’s business has declined roughly inline with ADTN’s core business, i.e. significantly; ADVA’s business today looks worse overall than when the original share exchange deal was agreed to, so the German listed stock would likely be trading significantly lower today than the current €20/share, if not for the ADTN put, and 2) the 65% of former ADVA holders who took the exchange offer for 0.8244 share of ADTN for each ADVA share in 2022 now have ADTN shares currently valued at less than €5 per former ADVA share – the 35% of holders who did not accept the exchange offer are already getting a dramatically better deal than those holders who did exchange. 

In hindsight, management handled this situation poorly. Once they had an idea on the magnitude of the future cash liability to the minority holders back in 2022, they should have sold ADTN equity to fund it. This would have effectively gotten them to the same place as if they had successfully acquired all 100% of ADVA shares with ADTN shares in the exchange offer, and avoided the current messy liquidity situation.   

As I show below in my base case, I believe that ADTN can improve their net debt position from $100M+ of net debt at Q423 to closer to net cash neutral by the end of 2024, in both cases excluding the ADVA obligation. The primary levers here are a reduction of ~$70M in working capital, and ~$50M from real estate sales, offset by modest ongoing losses concentrated in 1H24. 

Given assumptions around cash generation, and some rebound in the business over the next two years, ADTN should be able to fund the ADVA obligation from available cash + credit line at the end of 2025, while leaving them at a manageable ~2x net debt/EBITDA at YE25.

I should note that ADTN needed to get covenants on their WF credit line relaxed in January. They are tight on their total leverage ratio covenant of 5x net debt/EBITDA, and will remain tight through 1H24 before, I believe, improving substantially in 2H24 aided by monetizing real estate of $50M.

Per the 10-K just filed, ADTN was in compliance with covenants at the end of Q423, and they had $38.8M of availability under the WF facility, with that amount being lower than the maximum of $205M, due to covenant constraints. Also per the 10-K, the company believes that their current available liquidity will be adequate to meet their obligations and “continue to comply with our debt covenants under the Second Amendment for at least the next twelve months, from the issuance of these financial statements.”

Model/Valuation

I show an annual summary, as well as quarterly detailed income statement/cash flow items below, and the main assumptions here are:

• Revenue rebounds over the course of 2024-2025 to ~$1.3B in 2026 in base case, $1.4B in bull case

  • Pro forma revenue had been running $1.2B +/- $100M for a number of years before jumping to $1.4B+ in 2022 on over-ordering by service providers

  • A revenue rebound modestly above the historical $1.2B revenue run-rate is based on BEAD & Huawei/Europe tailwinds benefitting 2025-2026, on top of a return to more normalized spending post inventory correction at customers

• GMs move up towards 43% from 41% in 2H23 (ADTN target model is mid-40%s) 

• Non-GAAP EBIT margins reach 11.4% in 2026 in base case, 13.3% in bull case (ADTN target model is low teens)

  • ADTN had been running at around 10% EBIT margins a decade ago, but had been running low-mid single digits in recent years
  • ADVA has consistently been running in mid-high single digit EBIT margin range
  • With higher revenue and $90M in cost cuts, low double digit EBIT margins look achievable

• Working capital benefit of $70M in 2024 as DSO and inventory days return to more normal levels

• Real estate sales generate $50M in 2H24, and I assume another $100M in Q325

  • The company has communicated that they believe there’s up to $180M in potential monetization of excess RE and potential sale-leasebacks

  • Only $40M-$60M of RE sales in 2H24 has been communicated as being expected expected at this point, with the potential for another $100M+ should they need to move forward with an additional sale-leaseback 

• Factoring in the ADVA obligation, which I assume gets paid at the start of the Q126 quarter, ADTN can exit 2025 at ~2x net debt/EBITDA, and ~1x exiting 2026

Annual Summary

Quarterly Income statement 

Cash flow items

Price targets

8x EV/Q425 RR adjusted EBITDA = $13

15x base case 2026 GAAP EPS = $16

17x bull case 2026 non-GAAP EPS (19x GAAP) = $26

Risks

• Absent a reasonable rebound in the business in the next two years, ADTN would likely need to seek financing

  • As it stands today, and assuming limited ability to access incremental borrowing on their WF credit line in the event of continued business weakness, ADTN could be looking at needing ~$300M in financing to satisfy the ADVA obligation

    • If ADVA holders became particularly concerned about ADTN’s liquidity situation, there would be the theoretical possibility that some holders may decide to forego the guaranteed 8% yield in order to cash out early with their put right, and there’s a “run on the bank” situation

  • Because I view current revenue levels as being well below normal, coupled with positive catalysts ahead, I don’t see the business remaining at these depressed levels for that long 

• Given minimal EBITDA generation right now, ADTN is tight on their WF credit facility net leverage ratio covenant of 5x net debt/EBITDA, and had to get a relaxation of covenants in January ‘24

  • This should be back to comfortably within range by 2H24 given working capital cash generation and real estate monetization, but they may need another covenant adjustment/waiver during 1H24

• Current downturn could be longer and more severe than expected & the expected positive industry catalysts in US & Europe may not result in the expected uplift in ADTN's business

• German courts could award ADVA minority holders a larger Exit Compensation amount 

Catalyst

- Revenue recovery

- Return to profitability

- Real estate sales, improving liquidity