ADVA Q407

We summarize ADVA’s quarterly call and shed light on the issues surrounding a decline in revenue from channel partners as well as the threats they face in 2008.

ADVA Q407 results of EUR 53.8M met the lowered guidance relayed in December and the company provided Q108 revenue guidance that was roughly flat. The prepared remarks offered little new information but the Q&A was particularly interesting and shed light on the investor concerns that have driven the stock to exceptionally low valuations.

Q108 guidance of EUR 51M – 55M was below expectations, primarily because the poor results of Q407 were thought to be temporary. CEO Brian Protiva indicated that Q208 is expected to be better but refrained from offering any 2008 revenue guidance beyond that citing market uncertainty. The company has failed to meet provided guidance in the last three consecutive quarters and needs to restore trust with the investment community.

A quick snapshot of 2007 quarterly revenue highlights the trend that has driven the company to a market capitalization of EUR 70M today from EUR 360M a year ago (note the company has no significant net cash/debt balance).

Some trends underlying these numbers are worth highlighting.

• If the acquired Movaz (Metro WDM) business is removed from the above results, the original ADVA core business has grown 5% from Q107 to Q108 (using provided guidance).
• The company has reduced revenue through distribution partners from 50% to 24% of revenue. Nokia-Siemens (NSM) and Alcatel-Lucent were the primary channels.

In short, the revenue decline at ADVA is attributable to less shipments of Movaz equipment through ALU, and less reseller business through Nokia Siemens (NSM).

The Movaz revenue, originally sold through Lucent, took a hit following the merger merger with ALU. Given ALU has a competitive product it isn’t expected that this product will see incremental wins through the ALU channel though some incremental or end-of-life revenue is possible.

The Loss of revenue through Nokia is more puzzling and investors continue to view this with suspicion. CEO Protiva indicated ADVA is still the exclusive partner of NSM for Metro WDM though they do compete with internal Nokia solutions. Investors on previous calls raised concerns that NSM’s acquisition of Atrica (Israeli Carrier Ethernet Switch) would be a competitive threat. We do not believe Atrica is a material threat.

The most likely reason is Nokia is placing greater emphasis on selling in-house equipment, something we have heard other vendors that resell through Nokia express frustration about. Quote from Protiva:

I think the NFN relationship is just as good today as it was three months and 12 months ago. There is overlap between our product opportunity. We’ve got to drive our own business going forward, and they are committed to the customers that they’ve won with ADVA technology, and often we are strategic for them in certain accounts.
So there’s a — it’s not black and white, but the business has deteriorated with NFN. Yes, we haven’t won many new accounts lately. You could say, well, that may be indicative that they’re not really pushing us, but again, when strategic, they will push us.

The other possibility is spending weakness in Europe where most NSM customers reside. There was significant discussion on this – with CEO Protiva indicating that regulatory issues are hampering the rollout of upgraded broadband services in Europe – something that resonates with our negative view of EU telco regulation trends.

The company re-iterated its plans to spend more on SG&A in an effort to accelerate towards a direct sales model. R&D expenses will be reduced as the company assumes one-time charges to shut down Swedish R&D operations (Nothing more expensive than cutting headcount in Europe).

The company indicated 45% gross margins were a long term target though we would expect to see a greater rise from current levels. Revenue obtained through channel sales has significantly lower gross margins than direct sales as the distribution premium is reflected in a lower ASP. Moving to direct sales should result in higher ASP’s and revenues, albeit with higher associated SG&A. What appears to be taking place customers are being moved to a direct model and given the extra savings that a move away from the channel yields. A follow up question has been posed to the company on this issue.

While the company did not indicate any offers have been received, they did indicate that significant strategic interest existed in the company and that they were pursuing their fiduciary duty. One shareholder highlighted that World Wide Packets was sold for several times the current value of ADVA – a price that CEO Protiva believed reflected the value of their supply relationship with AT&T, a major Ciena customer. Ciena continues to be primary competitor of ADVA in the US market but ADVA indicates they do not see them often. Huawei was named as the primary threat in previous calls.

We feel one the major risks to ADVA continues to be Nokia-Siemens acquiring a major WDM vendor. A potential sale of Tellabs to NSM is something we would view negatively as it would place a decent WDM product (Tellabs 7100) in the European market and close the door on future progress in America. The second risk is Ciena making inroads in Europe, particularly at BT, where the strong PBT capabilities of the World Wide Packets product make them a compelling choice.

Protiva points out that while Ciena is larger in terms of revenue, the majority of this revenue is derived from businesses that are adjacent to ADVA. However given the importance ADVA places on the direct sales model they should take heed of the benefit that Ciena’s larger critical mass brings.

Link to ADVA investor presentation

Author holds a position in ADVA