2023-09-25 21:18:16 ET
Summary
- ADTRAN Holdings, Inc. acquired 65.3% of ADVA Optical Networking SE in 2022, boosting revenue by 82.2% YoY.
- The merger has led to structural unprofitability and operational inefficiencies, with expenses exceeding reasonable levels.
- ADTN's valuation metrics suggest untapped potential, but concerns over financial health warrant caution and a focus on operational efficiency.
- The company's valuation metrics suggest undervaluation, but its return to profitability remains uncertain.
ADTRAN Holdings, Inc. ( ADTN ) undertook an ambitious merger with ADVA Optical Networking SE in 2022, acquiring 65.3% of ADVA's revenue and boosting ADTN’s revenue by 82.2% YoY to $1,026 million. While this merger was strategically promising, it has ushered in structural unprofitability and operational inefficiencies, with expenses like R&D and SG&A exceeding reasonable levels. ADTN’s valuation metrics highlight the untapped potential of its assets. Still, I believe the market's ambivalent valuation of ADTRAN underscores concerns over its financial health, emphasizing the need for a renewed focus on operational efficiency. I think ADTN has potential, but given its current trajectory, it’s too risky to commit capital. Hence, I give it a neutral rating.
The M&A Landscape - More Than Just Numbers
ADTRAN Holdings, Inc. embarked on a transformative merger with ADVA Optical Networking SE two years ago. Announced on August 30, 2021, this merger was strategically designed to create a global, scaled provider of end-to-end fiber networking solutions catering to diverse customers, from communications service providers to governments. The financial implications were evident, with the combined entity reporting revenue of $1.2B (at the time). Also, the merger represented a strategic alignment of two seemingly complementary businesses. ADTRAN, which had fiber access, fiber extension, and subscriber connectivity, found a theoretically good fit in ADVA, a global leader in metro wavelength division multiplexing, data center interconnect, business ethernet, and network synchronization solutions. Together, they aimed to provide scalable, secure, and assured fiber connectivity, further enhanced by cloud-managed Wi-Fi connectivity and SaaS applications. The M&A rationale was to benefit from the burgeoning investment cycle in fiber connectivity in regions like the U.S. and Europe.
ADTN's M&A presentation slides
Interestingly enough, this particular merger aimed to synergize its revenues and actually projected over $50 million in annual run-rate cost synergies. At the time, the rationale was that supply chain efficiencies and an optimized operating model could deliver these cost savings. But, as I'll explain in this article, I doubt these efficiencies materialized.
This is why ADTN grappled with structural unprofitability following the merger, starkly contrasting the anticipated M&A benefits. The expected cost efficiencies remained elusive, exacerbating the company's financial position. By June 2023 , operational expenses, including SG&A and R&D, had risen sharply to 40.11% from 31.61% the previous year . This shift saw ADTN's EBIT plummet from a positive 4.73% of total revenues to a concerning -11.84%. The merger's challenges weren't confined to numbers alone. Integrating ADVA into ADTRAN appears to have been challenging, given the need to harmonize different corporate cultures, streamline operational processes, and consolidate diverse product offerings. Unfortunately, the numbers don’t lie, and the merger only deepened ADTN’s losses.
Before ADVA, ADTRAN was already dealing with the risks of its broad global operations. I believe this was magnified post-merger, with a heightened revenue focus on the U.S., U.K., and Germany. While these regions presented lucrative opportunities for revenue growth, they were not without their inherent risks. The uncertainties of the U.K.’s post-Brexit landscape and the evolving telecommunications regulations in Germany might have amplified ADTN’s costs. Managing such extensive operations relative to ADTN's size could usher in inefficiencies. These inefficiencies might manifest as overlapping processes, potential communication barriers, and the inability to streamline operations across diverse jurisdictions. I think this lack of streamlined efficiency could escalate operational costs, as the company might struggle to implement uniform best practices and cost-saving measures across its varied regional bases. And this could explain its current negative EBIT.
Operational and R&D Inefficiencies Challenge Profitability
Moreover, it's worth noting that the communications equipment industry is fiercely competitive, and often, cumulative marginal efficiencies determine a company's profitability. But for this, operational efficiency is paramount. As noted, ADTN’s operating expenses are markedly higher than its industry peers. Specifically, ADTRAN's SG&A and R&D expenses account for 19.9% and 20.2% of its total revenues, respectively, culminating in 40.1% of total operational expenses. To illustrate this point, I’ve used two similar peers in size operating in the same industry: CommScope Holding Company, Inc. ( COMM ) and Ituran Location and Control Ltd. ( ITRN ). These peers ( COMM and ITRN ) report operational expenses as 26.01% and 26.97% of total revenues, respectively, which shows how incredibly inefficient ADNT’s expenses are.
The disparity becomes even more pronounced when we delve deeper into the numbers. ITRN's SG&A and R&D expenses are 21.7% and 5.2% of total revenues, respectively. In comparison, COMM's figures are 12.7% for SG&A and 8.0% for R&D. So, the question is clear: Why does ADTRAN, a company operating in the same industry and of comparable market capitalization, have such inflated operational costs? In my view, judging by its peers, a reasonable level for operational expenses should be around 20% to 25%. So, looking at ADTN’s cost structure, I’d say there’s a lot of fat to cut.
In fact, I suspect management’s decisions regarding ADTN’s structure and global operations strategy might have inadvertently introduced these inefficiencies. ADTRAN's extensive worldwide footprint, juxtaposed with its relatively modest scale, might contribute to these operational challenges. The complexities of managing a global operation, especially for a company of ADTRAN's size, cannot be understated. The logistical, regulatory, and managerial challenges can quickly escalate operational costs if not adeptly managed.
Valuation - Is ADTN Cheap or Expensive?
Under the right circumstances, companies like ADTN, facing structural challenges, can be viable investment opportunities. Yet, pinpointing ADTRAN's exact fair value is challenging. A reliable DCF model is impossible due to its recent M&A activities and prevailing negative FCFs. However, a glance at its valuation multiples offers some clarity.
When gauged through revenue multiples and P/B ratio, ADTRAN's valuation suggests significant undervaluation. Its TTM EV/Sales ratio is a mere 0.89, a stark deviation from the sector median of 2.65, indicating a discount of roughly 66.46% compared to its counterparts. Its forward EV/Sales ratio remains at a low of 0.97, well below the sector's median of 2.64. The TTM P/B ratio of 0.83 further underscores this, as ADTRAN trades at a notable 70.73% discount to the sector median of 2.83.
Given ADTRAN's unprofitability, we can’t directly compare P/E or EV/EBIT ratios without assumptions. Yet, we can tackle this through an EBIT multiple for argument's sake. For this, let’s assume ADTN achieves half the profitability of its peers, COMM and ITRN , which boast EBIT margins of 6.17% and 20.39%, respectively. This averages to a 13.28% EBIT margin. If ADTN were to reach half of this, it would equate to an EBIT margin of 6.64%. Based on its TTM revenues, this translates to a potential yearly EBIT of $89.64 million. Applying the sector's median EV/EBIT ratio of 19.09 suggests an enterprise value of $1.71 billion. After accounting for cash and debt, the equity valuation could be around $1.60 billion. Given its current market cap of $650 million, ADTN is a potentially attractive stock. This valuation, however, hinges on ADTN's potential return to profitability, which currently seems distant.
Hypothetical Path to Profitability
ADTN’s IP portfolio is undeniably valuable, with its repository of over 1,000 patents. Yet, there's a disconnect because there’s negligible revenue from patent licensing. Many tech companies often leverage their patents, monetizing their innovations through licensing . So, considering ADTN’s distressed situation, why isn't it capitalizing on this? While assessing the exact value of each patent is intricate, the overarching narrative is evident: ADTRAN is missing out on its assets. By proactively licensing its technologies or considering strategic patent sales, ADTRAN could bolster its financial position and potentially position it for better M&A transactions.
There must be a decisive cost-cutting strategy to rectify ADTN’s structural unprofitability. This could entail re-evaluating certain operational units, leading to potential spinoffs or asset sales, streamlining operations, and bolstering liquidity. Furthermore, a focused approach emphasizing core regions, especially the U.S., is crucial given ADTRAN's expansive global presence. Essentially, ADTN’s path to profitability is riddled with challenges, but a turnaround is theoretically plausible with the right strategic moves.
Conclusion
ADTN's merger with ADVA Optical Networking SE in 2022 has undeniably brought opportunities and challenges. While the merger has significantly bolstered ADTN's revenue, the ensuing structural unprofitability and operational inefficiencies cannot be overlooked. The company's expenses, particularly in R&D and SG&A, have exceeded industry norms, raising concerns about its financial sustainability. Despite the potential highlighted by ADTN's valuation metrics and assets, the market's mixed valuation signals caution. While ADTRAN possesses potential, its current trajectory suggests inherent risks investors should be wary of. Balancing these factors, I decided to give ADTN a neutral rating. But I think it’s worth closely monitoring its strategic moves in the coming quarters.
For further details see:
Adtran: Untapped Potential, Return To Profitability Uncertain