ADTRAN Holdings, Inc. (ADTN) Earnings Call Transcript & Summary

Good afternoon. Paul Silverstein, Senior Analyst, communications and networking equipment at Cowen. It's my pleasure to have with us Michael Foliano, CFO of ADTRAN. Hopefully, as you all are aware, we've got a very favorable view because it's easy to have a favorable view of broadband access at ADTRAN these days. A lot going on in ADTRAN market. You've got to deal about to close on ADVA. You've got a massive amount of taxpayer money coming by way of the U.S. federal government and foreign governments. You've got Huawei displacement in Europe. And there are only 4 western companies, presumably they're not going to displace Huawei with ZTE or FiberHome. It's just you, Calix, DZS and Nokia. Nokia has already got a major presence in Europe. Calix doesn't seem to be overly if at all interested in that business. And DZS has appeared a bit smaller than you, doesn't have your presence. So there's a lot of favorable trends going to the market.

Let me ask then, given all that and presumably and easing of supply chain constraints over time. Logically, before we discuss ADVA, shouldn't that translate to accelerating growth for ADTRAN?

Yes, that absolutely should. There's no reason that it shouldn't. And when you think about our markets, really the 2 biggest markets are the U.S. and EMEA. And both of those have been growing. And this is before you start to see this big government funding that's coming into play, right? So if I was going to open this up, I would have said exactly what you said. There's some huge tailwinds for us right now. The first one is the transition to fiber everywhere, right? Everybody has now recognized, I think, that fiber is the solution, right? There was some debate for a while, and is it coax, can we stretch it further. Once you put the fiber in, you can go and just change the optics, and you can continue to improve your speed. So I think that's been recognized. So now everyone is in this technology transition, and you have governments that are putting in just crazy amounts of money, not just in the U.S., right? When you look at Europe, the amount of funding that's starting to happen there is just wild. So there's really never been a better time for this to happen. And then at the same time, you have these security concerns. Now it's country-by-country, right? There are certain countries that really haven't decided that it's a security issue, but there's others that have decided there will be no Eastern suppliers in their network, and they're ready to move away from those. And with the small number of competitors in the space, I think it really positions us well. That's -- we're expecting that growth should continue. If you look at what's going on in the U.S. market, it really started with the smaller players, right? The Tier 3s and these more nontraditional-type carriers have all started to build out fiber. And then it moved to Tier 2s. And now you're starting to see some life in the Tier 1s also announcing fiber builds. So it just continues to grow there. Europe is a little bit different because you've got certain areas with high penetration, right? You got Spain and Portugal, and France and the Nordics, where there's pretty high penetration of fiber already, but yet those countries are all looking at what's the next-gen solution. How can I go from GPON to XGS-PON PON? And that's going to have...

That's been going from 1 to 10 gig PON [indiscernible]

Exactly. From 1 gigabit to 10 gig PON. And then you have the other countries like the U.K. and Germany and Poland where there's much lower penetration, and there's a lot of money that's now going into building out those networks, right? You got BT that announced, what, 25 million households passed by the end of '26. You have Deutsche Telekom said, "we're going to do 10 million households passed by the end of '24." So they're laying out these big plans, and there are some fairly significant funding that's over there. There's probably EUR 45 billion spread across those countries in Europe.

Well, by those countries in Europe, just for the benefit of those who may not be aware, you're referring to all of Europe, are you referring to the U.K. and Germany?

The EU plus the U.K.

EU plus U.K.

So the big money is in the U.K., it's in Germany. It's in -- Italy just announced about a EUR 4 billion build out. It's in Austria. And then there's a couple of other grants that cover the 27 EU countries that are a little small but...

That's EUR 45 billion, right? So in -- you're not just -- it's a big part of the story are these Huawei displacement opportunities at DT, BT and in the raft of others, and I want to come back to that in some greater detail. But before we get there, just to make a point. You also got increasing exposure to other players. And if we look at just the U.K. by example, I can think of half a dozen carriers. I'm sure it's a much greater number than that, all of which have increased substantially, have increased their planned build-outs from what they planned a year or 2 ago, in the wake of over the money being made available to what they now plan. BT is an extreme example. So it's the largest where we look at CityFibre, and a whole raft of others that went from 100,000 to multiple hundreds of thousands or millions and multiple millions, et cetera. And you've got leverage to an increasing number of these in Germany and the U.K., et cetera, correct?

Yes. That's right. When you look at those smaller what we call altnet carriers or over builders, it's actually kind of amazing to me that how many of them are out there and how much private equity funding is going into these. But when you talk to people in the U.K., there are certain areas where you can get 2, 3 and even 4 different fiber connections into the same home. Seems a bit inefficient to me, right? But that's exactly what's happened in...

And you're not complaining about it.

I'm not complaining about it. That's -- we'll support that anyway we can.

All right. Let me take a step back before I drill back down. There are concerns throughout the investment community about macro, macro deterioration in terms of recession. The thought arises that I think most people would sort of give up alcohol and calories than give up with broadband or take even a lesser broadband connection. So let me ask you any signs of attenuation in your forward-looking metrics, order book, et cetera, any signs of attenuation?

Well, I can't give up my broadband because I order all my food and my alcohol on that. I'm a guy that never leaves the [ cast ].

[ Side to the calories and the alcohol ].

But there really are no signs at this point. The order book is strong and it continues to grow. It's -- there's really no sign of slowdown. And when I think about the amount of the government funding that's out there, I think that I'm not going to say we're recession-proof because that's probably...

But you're d*** close.

I'd say we're highly recession-resistant.

So as I like to say, you're not immune, but you're very insulated. You're more insulated than virtually anybody else.

We're growing our second vaccine on our second vaccine booster.

Got it. All right. So let me ask you back on the Huawei displacement. You've announced -- well, let me just ask another question. How -- remind us how many wins have you announced? How many opportunities are out there that have not yet been awarded but that are within 6 to 12 months award? And how many more to go after that before I [ kill ] down some of that?

Okay. So in EMEA, we've announced 6, right? And there's 2 big ones that are pretty much underway. I might as well give you a little status on these 2, and one of them is the U.K. with Openreach that is now ramping pretty significantly. The next one is Deutsche Telekom that we'll be building out shortly. So we've got orders in, they're starting to go, right? Those are probably the 2 largest. There's another one that's a multinational carrier out of Spain, and they're going to be a little bit slower to get started. There's a bunch of integration work that has to happen to get into the billing systems and all the rest of that, but that work is underway. So probably expect revenue from that one in '23.

First revenue with meaningful revenue in '23 or not so '24?

Meaningful revenue.

First meaningful revenue, '24.

Yes. Sometime in '24.

And the DT and BT opportunity has been meaningful flow in '22.

Yes. The BT already is and the DT is just now beginning to ramp.

It's starting to ramp.

Yes.

And you think it will be meaningful this year.

I do. I do. So it's the whole XGS-PON experience just seems to be really taken off. And these Tier 1s are embracing it, and really started to roll with it. So...

And again, just to push the point, that's operators, even though they already have fiber to the premise, they're going from 1 gig GPON to a 10-gig XGS-PON.

In some cases, yes. So when you think of BT, there are certain cases where they already have GPON, there's a lot of new build, though, too, where it's the first fiber that's going on.

Super. Either way.

And in DT, there's very little fiber there, right? They're...

Right. They -- right. They did VDSL, VDSL2, VDSL2 vectoring, they can try and extend a little.

Yes. And then on top of those 3 big ones that I just mentioned there, 2 are underway ramping and still working their way through the build process. I'll call it, there's 3 others that are slightly smaller that will come up faster. So...

And they've already been awarded?

Already been awarded. So this is the sixth. So one of them is in the Nordics. It's a national carrier in Sweden. One of them is in Eastern Europe that we just recently announced a couple of months ago, and that's in the Czech Republic. And then the sixth one is actually in Israel. And all those guys seem to -- when you think about how long it takes to build a disaggregated network and the software integrations that happened, the toughest ones are like an Openreach, right, where they have an architecture that has to let anybody be able to ride on it. Some of the easier ones when you think about these other 3, they're going to come up much faster, right? A lot of the software is already built, and it's going to be able to not require the same depth.

All right. Opportunities that haven't yet been awarded. So Huawei displacements is around the...

Yes. So there's -- and every one of those 6 had some Huawei concern in it, where maybe in BT, it was a little bit different where Huawei was being kicked out, and it really opened up for another supplier, but the others had some type of concern or other. When you think about the additional big ones that are left, there's probably 4 others that are working in some state of planning or an RFP. And those are pretty big ones that I would expect in the next year or so, they would close.

To make awards in the next year?

Yes. Yes. And then depending on the size of and the complexity of the bill, it might take -- like a telephonic, it might take a year to get it going. If it's more like the others, it might come up much more quickly.

Two related questions. I think Tom and you have publicly stated that because of the absence of Huawei, and not just Huawei, but ZTE, FiberHome Chinese, there actually has been better pricing associated with those deals. Historically, Europe has been perhaps a good revenue opportunity, but challenging, quite some challenging margins. And you also said, it's relatively better. I don't know if that makes for good, but it's better. Let me ask the direct question. Will your investors see acceptable profitability, acceptable margins attending the revenue stream?

Yes. And I think over time, it continues to improve, but there is some amount of, what I'll call, pricing memory that's still there from how the prices have been depressed by the Huawei effect. But I think if you look at what's going on in the big ones that are already underway, it's probably a little bit better than it has been in the past for Europe. We've always said that when you look at the gross margin line and you compare the U.S. to Europe, it's probably about 10 points different. Now in the U.S., though, you have a lot of these smaller carriers as well that there is a differential in margin between a small carrier in a Tier 1 in the U.S. as well. So when you start to blend that together, you see those effects. But we do expect that over time, we're going to see some loosening of the pricing just by taking out the eastern competitor factor.

And Mike, I think both you and Tom have also said that given the competitive landscape, where once again, as you, Nokia, who already has a big presence in most of these carriers is either the #1 or #2 alongside Huawei, plus the fact that Calix isn't going after this business and DZS is not as well positioned as you. At least they don't have historical footprint than you do, and they're smaller that you all are expecting or have been awarded or expecting to be awarded a significant portion of these very sizable opportunities. You mentioned BT planning 25 million homes passed by 2025, '26. BT, the number of homes passed is what...

10 million by '24.

10 million, yes. And you're all expecting a significant portion, not a 10%, 20% award, but far greater than that, correct?

Yes. That's right. That's right. And I think a lot of it's going to depend on how the suppliers perform too because that is the reason that those big ones try to get 2 suppliers, right, especially in today's supply chain environment with the tightness that's going on there, if you've got 2 suppliers, you can substitute one for the other whenever you need to.

Sure. And keep going on this as well, I assume. On the government broadband subsidies, you and Clearfield share the same audience, you all have done a good job of really delineating and let me ask you maybe for the benefit of investors, if you could talk about the amounts and the timing under the bigger programs and the multiple programs in the U.S. but also in Europe, as you mentioned, EUR 45 billion. So that's a massive number in itself. Maybe you could share some insights since it does impact you above and beyond what you're already seeing?

Yes. And let me tell you, it's so complicated that I put my slide right here so I can make sure that I cover all these. But I think everybody knows about the rural digital opportunity fund, right? It's been rolling out for a while. There's about $9 billion in the first phase, and $20 billion total. All right. The second phase is a little bit up in the air due to mapping and where it's actually going to happen. But that $9 billion is actually started. We've seen orders for some of that start to flow, but it's not significant yet at this point. I'm expecting late this year, and into '23, you'll see a lot of that start to move. And then the way that, that is set up as far as building out, you have to build -- you have to be able to build 40% in the first 3 years, and then you go to 60% a year later, then 80%. When you get to the sixth year, they're supposed to be completed, and then they're going to go back and take another look at the actual coverage that's out there and see if anything else needs to be added. It's run by the FCC so it's a little bit different than some of these other ones. But I think you're going to see some fairly significant tailwinds start to take off here as we go into this period of late '23, probably all the way through '28 in that 6-year period. The next one is a little bit smaller, not -- people don't talk about it as much, and I know you said major programs, is a $1.2 billion program, a major program. It used to be. It's not so much anymore when you look at all this funding that's out there, but the USDA has the rural connectivity phase 3 that's going out between '23 to '27, and that's about $1.2 billion that's a mix of grants and loans. And it has a few things in it that pushes it towards tribal lands and also it has some stuff in it where it's focused on vulnerable areas.

And Mike, apologies, that's a part of what's separate from the larger rural utility services fund under the USDA, correct?

Yes. That's right. It's the third phase of a program that -- it's actually -- it's under USDA and RUS manages, and it actually can have a little bit of overlap with RDOF, too. You could be an RDOF recipient and also get this one. And then when you start getting into the really big ones. So the Rescue Plan Act has about $20 billion that they really have to be obligated by the end of '24 and extended by the end of '26. And this one is not run by the federal government. It's going to be passed out, state, local and tribal land. So you've got a bunch of money there that we're going to have to figure out how it flows.

Well, just to -- if I may, just to be clear, that actually should be a net positive, assuming you and your peers have the capacity to fulfill it with the thought being that the federal government and the FCC is usually the most inefficient, certainly historically has been. And that at the state level, they will relative not efficient in absolute since they'll be relatively more efficient than the federal government and the disbursements.

Certainly, more focused, right? Because they know at the local level, what's really needed. So I think you're right about that. And then the really big one is in the Infrastructure Act. It's the broadband equity access and deployment that is $42.45 billion. And some people are saying you'll see some of that in '23, I think it's '24 before it really gets started. And the end date is still a bit open, right? It probably goes for 4 to 5 years to be able to push that much money all the way through. So you figure it goes to '28 or so. So just putting all that together in the U.S., you have a huge spend. And then if you...

And that not includes state funds. California has allocated $3 billion of California tax care money on top of the money they're getting out of ARPA, $6 billion total for broadband build-outs. Virginia, I think the number was $900 million or thereabouts, where again, there's a portion that's coming from state tax revenue above and beyond what they're accessing through one or more of the federal funds.

And even prior to this, some of the CARES Act funds actually ended up going to broadband as well. So it wasn't significant like these numbers, but a lot of the states took that and they could -- if they had shovel-ready projects, they went ahead and pushed it in that direction. So it's really a crazy amount of money. And then when you think Europe, I said EUR 45 billion, and it's at least a dozen different programs that we've rolled up that are happening really across the U.K., Germany, Poland, France, Austria and Italy are the biggest countries. And then there's a few of them that are focused on the EU 27, so it goes across all of the different EU members.

I made the same point in earlier session with [ so in ] Calix. If those programs, Europe, U.S., whatever, they were available today, they were fully funded of -- the dollars are flowing. I trust it would have virtually 0 -- probably 0 impact on your revenue in terms of supply constraints preventing it from shipping, which is not a bad thing. It's actually going to extend the runway to the extent these funds initial disbursements, medical disbursements are down the road. You would agree with that?

I do, and I agree on the back end, there'll be some issues, too. So if you think about that, if all that was available today, and even if we had no supply constraints and we could push it out as fast as we wanted to, you're going to run into constraints to actually build the fiber, right? You get down on the ground to labor and materials and all those...

Labor [ is an issue ], absolutely.

Yes. And it will be larger when all these things start to hit.

So not unique to ADTRAN. You, along with everybody else, have been impacted by supply chain, especially on the cost side, not just your ability to ship against demand, recognize revenue, but costs are backed up for you, you went from 41, 42 to 34 overnight. About a year ago, if I recall, you have been clawing your way back. Any thoughts you can share, one on, do China lockdowns pose an incremental risk on both costs and ability to ship presumably transitory, but nonetheless. And two, what's the glide path before we talk about ADVA's potential impact, the glide path to getting back to the low 40s? And you have previously said before you got hit by the cost back up, you've been talking about getting to a mid-40s, and possibly an upper 40s model. What can you share with us?

Yes. So the whole world changed when the supply chain crashed. But when you think about -- let's start with the China lockdown. So Shanghai opened up today after, what, 65 days of being closed. We're -- even though we don't have any kind of significant production presence in China, there are a certain number of components that come from there, and we are not immune to some of the factories from our suppliers actually being shut down. Now fortunately, none of them were in Shanghai where you'd be shut down for 2 full months. Most of the way it works is you find a COVID case inside of a factory, they close the factory for 4 days. They clean everything, and then they start bringing back a few employees to ramp it back up again. So we've been hit multiple times for a couple of weeks to go by. But the problem is you just never know when or where it's going to happen. So it's much like the whole de-commit story coming from certain suppliers. So they tell you you're going to have something on a certain date, and it's something like this that's kind of out of everyone's control, just locks it up. That's the first thing. The second thing is something that a lot of people have been talking about. So now we've opened Shanghai. It's probably -- it is the largest port in China. What's going to happen in the logistics world? I was, not too long ago saying that this cost side that is roughly half of logistics and expediting, and the other half is component cost increases, the logistics piece would ease first. And it just hasn't done that. We got fuel costs going up. And now you have lockdowns like this that when this opens, there's just going to be a flood of container ships moving, and we'll be right back to where we were where Long Beach and Seattle and every port in the U.S. is backed up, and you have goods sitting offshore for 60 days before you can even move them through, which forces companies like us to move stuff in the air. And air freight is 5x or more and more expensive than putting stuff on the ocean. So that's the insidious nature of global supply chains. And as this stuff starts to get tight, it can have long-term effects. I think I saw there are 400 container vessels waiting for pickup in Shanghai, which is just a crazy amount of freight.

So what does that do -- again, ADVA is going to change these too. But before we talk about ADVA, how does that affect your thinking of getting back to that low 40s little and getting back to the mid-40s?

Yes. I think we continue to claw back through this year, but I think we might get back into the 40 range probably doesn't happen until sometime next year, right, as things really start to loosen up. I mean you see some of these companies are actually putting in extra capacity, really got to get additional fab capacity. I think the first stuff comes online early in '23, right? And then as you go through the year, we should have more of the -- and on the other side of the equation is demand has to reduce. So potentially, if there is some level of recessionary activity that happens in consumer goods, automotive, and these other big users of electronics start to slow down a little bit. That could help to alleviate it. But I think the only real solution here is more capacity.

Do you think that -- once you've been given those constraints, do you think you'll be able to drive sequential improvement, albeit not as great as...

Yes. I think this -- I've said before, I think we're near the bottom of this thing. It really can't get much worse. I think companies are learning to deal with it. And I think we're learning to deal with it as well and getting a little bit better at how we manage it. So it is possible over time, we'll drive some sequential improvement. I just don't think we're going to get back to 40 inside of this.

But I will tell you your commentary and outlook are somewhat different than most other companies than that. The cost increases were so dramatically before China lockdowns as they're talking about a sequential decline of 200 to 300 basis points, even some of the best like Arista. So your commentary -- and I recognize you got hit harder than most that 8-point decline but you are talking about improvement notwithstanding the challenges. That hasn't changed.

Yes. That's right. I think it's incremental improvement as we go.

All right. We've got 1 minute left to talk about ADVA, I know the deal hasn't closed yet. I know you don't have full insight. You don't have control of the asset, et cetera. But I introduced ADVA in the United States, 20-something years ago. So I have some insight, but they came to hear your thoughts. Anything you can share with us?

Yes. I think we're still pretty close to actually finishing the final closing condition, and that is approval by the German foreign direct investments. So that comes from the PMWK in Germany, working with other ministries over there. We've said that it would happen in Q2 to Q3. So roughly midpoint of the year. That's about 30 days, 29 days from today. So if we're right on time, it would be something like that. Could be a little bit later, but I'm fairly confident that we'll get through that, and that will get closed. And at this point, we're working on integration planning so we can try to hit the ground running.

Mike, if you don't get 100%, and you're not going to get 100%, I think that sector has a very fair statement. We're not going to get close to 100%. I don't know the arcana of European in general and especially German labor laws, but I'm vaguely familiar with the fact that if you don't get -- I think it's 100%, you've got to get agreements on virtually anything and everything you do, right, from those third-party shareholders that don't agree. How does that work practically?

Well, it's designed to protect the minority share.

Yes. No, I understand that. But how is it going to work in terms of your ability to optimize that asset?

Well, I think all we need is agreements between the 2 companies to work together as long as it doesn't hurt the target.

So you don't need agreements from each of those? You don't need those shareholders to sign off?

No. No. What we need them to sign off on is if we would decide to go to a domination profit and loss agreement. At that point, you can manage them just like your own. You can have access to all the full cash flows, all the rest of that. But if you want to work without that before that, you need intercompany agreements. So for instance, if we want to approach customers together on behalf of the 2 companies, we just need a sales agreement. We want to work together on supply chain and costs with components, we need an intercompany agreement for that. As long as what's happening doesn't hurt the ADVA side, so those shareholders would be hurt at the benefit of that.

So you're saying, you don't need or do you plan to have a domination agreement. And without the domination group, you can still consolidate ADVA's financials, it will be 1 set of financials. They'll be in your revenue and your OpEx and your gross margin blah, blah, blah, as long as it doesn't -- your different transactions do not or not to the detriment of ADVA shareholders.

That's right.

That's the key, right? And you'll have an agreement so...

Yes. And we haven't said that we won't do a domination agreement. We're still exploring would that be required and do we need to do it. But we're certainly working down the path of having agreements between the 2 companies, so we can get started on synergies as soon as possible.

All right. I'm already over the limit of [ threshold ] territory. Anything else you want to share with folks before you...

I'm just super excited that we're in the transition to fiber to 10 gig fiber. There's government funding that's out there that is crazy. We have Eastern suppliers that are being displaced, and we're in a very good position to take up a lot of that business. We're getting ready to combine with ADVA, and will be a $1.4 billion company today, both of us growing. And then the only negative side is we've got these supply issues. If those go away, I don't know what to do.

Awesome. Well, listen, I appreciate your comment. Appreciate all of you out there, if I can give any help, do let me know. Mike, thank you.

Thanks.