Adtran Looks Cheap … But Is It Safe?

By Stephen D. Simpson, CFA | April 13, 2012 AAA

Using a 36-year old movie reference to introduce a tech stock ("Is it safe?" from "Marathon Man") may not be the best approach, but it's a worthwhile question to ask with Adtran (Nasdaq:ADTN). Adtran is an unusually high-quality company with solid share and good growth potential in "last mile access," but the company is critically dependent on carrier spending and that makes the timing of any recovery much harder to forecast.
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First Quarter Results Bad ... As Expected
Adtran made it pretty clear a month ago that carrier spending wasn't rebounding sharply in the first quarter, as the company preannounced a very disappointing quarter. Revenue fell 23% sequentially (and 19% from the prior year) and came in almost one-quarter below original expectations.

Revenue was pretty weak across the board - broadband access, Internetworking and optical access were all down sequentially, with broadband access down 33% sequentially. Management previously mentioned delayed buying activity from a major Tier 1 customer, which could mean CenturyLink (NYSE:CTL) or Frontier (Nasdaq:FTR), though it seems unlikely that AT&T (NYSE:T) was a big spender either.

With weak sales came negative operating leverage. Gross margin dropped almost five points from last year, while operating income fell by nearly two-thirds. Adtran management runs this business for the long-haul, and the company didn't cut sales or research and development spending in response to the weaker sales environment.

Are Things Finally Getting Better?
Management comments seem to indicate that carrier spending was getting better as the first quarter went on. Only time will tell. I think Adtran has a credible management team, but investors should certainly want to hear from companies like Juniper (NYSE:JNPR), Ciena (Nasdaq:CIEN), Acme Packet (Nasdaq:APKT) and Alcatel Lucent (NYSE:ALU) to get a fuller sense of the carrier demand environment. Of course, that takes time.

All in all, I think investors have reason to be guardedly optimistic. Carriers like AT&T, Verizon (NYSE:VZ) and Sprint (NYSE:S) really do have to spend on their networks eventually. The trouble is with the word "eventually" and how quickly that spending will pick up. Now, chip companies like ON Semiconductor (Nasdaq:ONNN) and Texas Instruments (Nasdaq:TXN) have sounded more optimistic about second-half communications demand, but it's not as though they really have a better insight on the markets than Adtran.

SEE: How To Pick The Best Telecom Stocks

How to Play the Rebound
Investors have a lot of different options for playing the carrier spending rebound. Investors who want big-risk/big-reward ideas could look at names like Ciena or even Powerwave (Nasdaq:PWAV), while names like Acme Packet and Juniper should also offer pretty good returns.

I do continue to like the Adtran story, though. I think the company's angles on last mile access, IP telephony and videos are legitimate and offer good growth potential. Moreover, the company seems to be getting traction overseas. Better still, the company has maintained reasonably good cash flow and returns despite some major declines in revenue.

The Bottom Line
Adtran's end market is cyclical and that has translated into cyclical free cash flow production as well. Consequently, 6 to 7% free cash flow growth over the next decade may sound ambitious and it's almost certainly not going to go in a straight line.

Nevertheless, I do believe these shares are undervalued and could climb well into the $30s on sustained evidence that carrier spending has resumed. There's still some downside risk to the story, but investors may finally have a relatively safe entry point.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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