It's almost cliché to talk about how bad of a year 2012 was for communications equipment vendors dependent on American and European carrier spending. With core broadband access product sales down 13% in 2012, ADTRAN (Nasdaq:ADTN) definitely found itself among the laggards, with shares down more than 30% over the past year and well below the S&P 500.
But 2013 is a new year, and hope springs eternal in the hearts of tech investors. While investors should not discount the competitive risks from rivals like Calix (NYSE:CALX) and Alcatel Lucent (NYSE:ALU), there is reason for at least cautious optimism that carrier infrastructure deployments will lead to better results for ADTRAN. At a minimum, it certainly doesn't seem like the Street has priced this stock for particularly breathtaking performance.
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2013 Off To A Good Start
Particularly in the wake of F5's (Nasdaq:FFIV) gruesome warning on telco spending, ADTRAN needed to deliver some optimism and it looks like the company came through.
Revenue rose 6% from the year-ago period and 2% sequentially, topping both the average and highest sell-side estimate. Profits were also better than expected. While gross margin did fall sharply from the year-ago level, the company's first quarter number was better than expected and up sequentially on a non-GAAP basis. Likewise, while operating income was down sharply from the first quarter of 2012, there was sequential improvement and the reported number was considerably higher than analysts expected.
Arguably just as important, management's commentary was relatively positive. It looks like carrier spending is improving, and management expects spending trends to improve as the year goes on. Time will tell of course, but it clearly beats the alternative of another negative revision.
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Can AT&T Come Back As a Major Customer?
One of the concerns I've had about ADTRAN is the company's customer mix. Verizon (NYSE:VZ) and AT&T (NYSE:T) have both declined in terms of their revenue contributions, and I've been worried that ADTRAN has lost wallet share to rivals like the aforementioned Calix and Alcatel, as well as others like Ericsson (Nasdaq:ERIC) and Huawei (overseas). At the same time, CenturyLink (NYSE:CTL) has been a relatively good customer for ADTRAN, but its increasing importance as a percentage of revenue could make the company vulnerable to pushbacks on pricing and/or loss of spending share to Calix.
Ultimately I still believe that there's a real opportunity here. Fiber to the X (FTTx) is real, and I believe that carrier spending will be a “when, not if” question. Said differently, while upgrading to 4G is clearly important to carriers, FTTx (especially fiber to the home) is an important growth opportunity for carriers, as I believe they can grab revenue from rivals like cable companies with stiffer competition on bundled services.
The Operating Philosophy Is Still A Risk Factor
While I've mentioned it before and don't wish to harp on it, I do believe tech investors need to appreciate that ADTRAN's operating model is different than the normal tech company. ADTRAN doesn't try to be first to market or at the cutting edge of new technology. Instead, the company looks to provide low-cost equipment for more established markets, letting others take the risk of innovative product development (but also reaping the benefits of better pricing and margins). While it's true that carriers are always looking to save a buck, it does leave the company vulnerable to rivals like Alcatel if/when they take a meaningful step forward and can offer better technology with more compelling long term economics (cost-benefit).
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The Bottom Line
I was relatively positive on ADTRAN's valuation early in 2012, and clearly that proved to be a big mistake (at least in terms of the one-year results). So it is with more than a little trepidation that I say that ADTRAN shares do still look undervalued on a long-term basis.
If ADTRAN can grow its revenue at a long-term rate of 4% and its free cash flow (FCF) at a 5% rate, fair value comes out to around $25 per share – not a bad surplus to today's price. As this company has amply demonstrated, though, it cannot and does not control the demand for its products, and investors who think they may see value here need to keep those risks in mind.