Adtran And Its Peers Are Back To "Show Me" Status

By Stephen D. Simpson, CFA | July 12, 2012 AAA

I'll often get emails from readers that ask me "if you think this stock is cheap, why don't you own it?" Adtran (Nasdaq:ADTN) is a great example of why I often wait to pull the trigger - while I do like the company's management and I think there's potential for the business to grow, no single boat can fight the tide and I'd rather wait to see signs of stabilization (or recovery) in the carrier spending market before stepping up with my own money.

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Disappointing Q2 Results
Adtran seemed cautiously optimistic about a carrier spending recovery coming out of the first quarter, but it looks like that rebound really didn't materialize.

Revenue fell very slightly on a year-on-year basis, while rising nearly 37% sequentially. That translated into about a 3% miss relative to sell-side estimates. On an organic basis, though, growth was not quite as good - revenue fell about 2% from last year and rose 20% from the first quarter.

SEE: How To Decode A Company's Earnings Reports

Within revenue, carrier spending jumped 13% due in part to the acquisition of Nokia Siemens Networks' broadband assets. Broadband access (which is nearly half of the company's revenue base) saw 8% annual growth and 69% growth from the first quarter, as the company enjoyed a good rebound at customers like CenturyLink (NYSE:CTL) and Telmex. Legacy product sales (like HDSL) were weaker though, as it seems that major Tier 1 customers like Verizon (NYSE:VZ) are de-prioritizing spending here.

Adtran is also struggling to show solid operating leverage. Gross margin fell more than six points from last year and more than three points from the prior quarter. Management continues to support its sales efforts, though, and devote considerable resources to research and development. As a result, operating income fell sharply from last year's level.

SEE: Zooming In On Operating Income

A Disappointing Outlook Looks Like an Industry Problem
As is often the case, investors were more concerned with Adtran's guidance than the actual reported results. Whereas the Street had been hoping for 16% sequential revenue growth in the third quarter, management is now looking for flat to slightly positive performance.

That's a pretty sharp revision. If there's good news, it's that companies like Acme Packet (Nasdaq:APKT) and Calix (Nasdaq:CALX) have also disappointed investors quite recently - suggesting that it's an industry problem, as top carriers still haven't increased their spending as hoped. Still, knowing that it's a widespread problem is pretty cold comfort, and investors can't be feeling too optimistic about other players like Alcatel Lucent (NYSE:ALU), Ciena (Nasdaq:CIEN), Tellabs (Nasdaq:TLAB) and Juniper (Nasdaq:JNPR) right now.

The Bottom Line
In my mind, the biggest long-term risk in the Adtran story is the company's strategic focus on being a low-cost supplier to mature markets and largely giving a pass to new emerging growth markets (until they mature). That sounds a lot like the slower-growth cash farming that lures many value-oriented investors into stocks that stagnate for long stretches because they can't feed the Street's lust for tech growth.

SEE: How To Make A Winning Long-Term Stock Pick

Still, I like the last-mile business at Adtran, as well as the prospects for the BlueSocket WiFi access business and the longer-term derivative plays on video-driven IP growth. However, aggressive competition from companies such as Huawei or rejuvenated efforts at Ciena or Tellabs could seriously crimp the growth.

I'm slashing back my forward growth assumptions pretty significantly; estimating future revenue growth in the mid-single digits and a free cash flow conversion margin well below past levels. That translates into low single-digit free cash flow growth over the next 5-10 years, but even with that low growth rate, these shares seem to have a fair value above $30. As I said in the first paragraph, I'd be seriously tempted to wait before buying these shares, but it's hard to ignore the potential value that may be emerging here.

Disclosure: Telmex is a subsidiary of America Movil (AMX), a stock the author has owned since December of 2004.

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