By Stephen D. Simpson, CFA
Such is the state of business for companies that supply equipment to carriers like Verizon (NYSE:VZ) like AT&T (NYSE:T) that not missing numbers is greeted with the enthusiasm usually reserved for beat-and-raise stories. Certainly these are challenging times for last-mile equipment vendor Adtran (NASDAQ:ADTN), but increased home and business demand for broadband and ongoing wireless backhaul buildout could spell better times ahead.
Q4 Results - Good Enough Will Do
Adtran's results weren't great, but the performance at other carrier equipment vendors like Alcatel-Lucent (NYSE:ALU) and Acme Packet (NASDAQ:APKT) wouldn't give any reason to expect them to be so. Nevertheless, a sequential revenue drop of 9% (and a 6% gain from last year) was good enough to meet expectations.
Adtran saw year-on-year growth in both broadband access (up 49%) and internetworking (up 37%), but sequential comparisons were not so exciting (down almost 15% and up about 2%, respectively). Optical access was outright bad, though, as sales dropped 17% from last year and 25% from the third quarter.
Margin preservation is proving to be quite challenging, as operating leverage cuts both ways. Gross margin contracted 40 basis points sequentially, while operating income fell more than three full points on a 20% sequential drop in operating income.
Waiting For Carriers To Pick Up
It's clear that major carriers like Verizon and AT&T have cut back on their capital spending, and analysts and Adtran longs are all hoping this reverses relatively early in 2012. In the case of AT&T, which has been a sizable Adtran customer in the past, the dissolution of the merger with T-Mobile should be a positive once the dust settles. In the meantime, though, Adtran has to prove it can hold and build the business it has built with the likes of CenturyLink (NYSE:CTL) and Frontier (NASDAQ:FTR), while also hoping that Congress doesn't completely kill ongoing funding support for broadband upgrades.
Is Nokia-Siemens A Boon Or Bane?
Adtran has had its challenges in penetrating markets outside the U.S. While Adtran does well enough against companies like Alcatel, Cisco (NASDAQ:CSCO), Ericsson (NASDAQ:ERIC) and Calix (NYSE:CALX) in the U.S, it has had a harder time competing overseas. Given the growth potential in overseas broadband, not to mention the emergence of Huawei as a player in the U.S. equipment market, this is no minor issue.
Adtran recently announced a deal to acquire Nokia Siemens' broadband access business for an "undisclosed" amount believed to be $20 million or less. Given expectations of upwards of $140 million in revenue from this business, it seems like a bargain and a great way for Adtran to expand its overseas operations. The problem, though, is that Nokia Siemens has been struggling (and under-investing) for years now, and there is the not-inconsiderable risk that Adtran is going to bog itself down trying to resuscitate a dying goldfish.
The Bottom Line
Apparent bargains in tech hardware are always a reason to pause and re-consider. More often than not, success in tech hardware investing is about "buying high, selling even higher" with high-growth, high-multiple stories like F5 (NASDAQ:FFIV) as opposed to finding value-priced plays.
In the case of Adtran, these shares at least worth a second look. This company is something of a back-door play on both the growth of IP demand (especially from video) and wireless backhaul during the 4G build-out. Although Europe (and the Nokia Siemens deal) is definitely a challenge that has to go the right way, the company should be in place to benefit from a "when, not if" spending recovery from the major carriers.
Even with a fairly modest forward estimate of roughly 7% free cash flow growth over the next decade, Adtran looks cheap enough to consider. I wish the stock were a little less popular with analysts, but the combination of good returns on capital, strong free cash flow conversion, and solid product opportunities are worth a closer look.