ADVA Optical Networking


Dec 9, 2013 - ...

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ADVA Optical Networking

Forecast revision

Coriant may act as a drag on growth in 2014

Tech hardware & equipment 9 December 2013

Although ADVA expects ‘significant growth’ from some key customers in 2014, disruption from the Coriant relationship is likely to act as a drag on this overall performance. With margins depressed, the shares trade on a 48x 2013 P/E, but on a mere 0.5x EV/sales – a considerable discount to its

Price

€3.84

closest peer. If ADVA can deliver revenue growth despite Coriant, then forecast upgrades are possible. Revenues need to increase by approximately 15% to get margins up to historic and peer levels that would justify a more in line EV/sales rating and would soon make the shares look cheap on P/E multiples.

Net cash (€m) as at September 2013

Market cap

€184m 41.4

Shares in issue

47.9m

Free float

81%

Code

ADV

Primary exchange Revenue (€m)

PBT* (€m)

EPS* (c)

DPS (c)

P/E (x)

EV/sales (x)

12/11

310.9

18.1

29.1

0.0

13.2

0.5

12/12

330.1

21.5

33.5

0.0

11.5

0.5

12/13e

308.7

5.5

8.0

0.0

48.0

0.5

12/14e

311.6

4.7

6.7

0.0

57.3

0.5

Year end

DAX

Secondary exchange

Frankfurt

Share price performance

Note: *PBT and EPS (fully diluted) are normalised, excluding amortisation of acquired intangibles, exceptional items and share-based payments.

A difficult year’s trading likely to close on same note Affected by weakness at one of its major customers, ADVA has reported four consecutive quarters of declining revenues (year-on-year) and with revenue risk from its relationship with Coriant following the announcement by its major shareholder that it plans to integrate it with Tellabs, management expects Q4 to remain subdued (Coriant accounts for approximately 15% of sales). We reduce our EPS forecasts for 2013 by 35% and 2014 by 58% to reflect weaker Q4 guidance given at the Q3 results on 24 October and the estimated impact of the likely disruption flowing from the Coriant/Tellabs merger.

Reasons to be more optimistic for 2014 While Coriant is likely to act as a drag on growth, there are reasons to be more optimistic for 2014: 1) Significant capex plans have been announced by a number of telecoms operators, including Deutsche Telecom, one of ADVA’s larger customers. 2) With LTE network coverage prioritised during 2013, attention is now likely to turn to bottlenecks in the mobile backhaul, where ADVA is well positioned. 3) With a strong pipeline of deals, management has indicated that it expects ‘significant growth’ from H214.

Valuation: Evidence of top-line recovery needed With the current depressed margins ADVA trades on a premium P/E (48x 2013). However, on 0.5x EV/sales it is the cheapest stock among its peers and it would only take a low double-digit recovery in sales over the next two years to bring

%

1m

3m

12m

Abs

(1.6)

(8.4)

(8.9)

Rel (local)

(3.0)

(17.4)

(25.1)

52-week high/low

€4.86

€3.55

Business description ADVA is a global manufacturer and supplier of nextgeneration telecommunications network equipment specialising in Metro and long-haul fibre optic WDM equipment and Ethernet access and aggregation devices.

Next event FY results

January 2014

Analysts Bridie Barrett Schmidt

+44 (0)20 3077 5700

Katherine Thompson

+44 (0)20 3077 5730

Dan Ridsdale

+44 (0)20 3077 5729

[email protected] Edison profile page

margins back up to historic and peer levels (6-8%), quickly making the share seem cheap on P/E multiples. Evidence that the pipeline of deals indicated by management is sufficient to offset revenue risk from Coriant is key to driving the valuation on the upside. The prospect of further industry consolidation and ADVA’s low sales rating should support the shares on the downside.

ADVA Optical Networking is a research client of Edison Investment Research Limited

Investment summary Company description: Pure-play optical and Ethernet ADVA is a niche player in the global telecommunications equipment market. It has no exposure to legacy technologies but focuses on next-generation optical and Ethernet transport solutions that increase bandwidth efficiency. In this competitive global market, ADVA has carved out leading market positions in global fibre Ethernet Access Devices (EADs) and EMEA metro WDM (Wave Division Multiplexer) equipment, key areas of bandwidth bottlenecks for operators and enterprises.

Financials: Earnings downgrades on weak near-term guidance Management reported its Q3 results on 24 October, with a fourth consecutive quarter of year-onyear declines in revenues (-3.9% to €79.1m). Operating profits of €4m were at the higher end of expectations on the back of tight cost management, but down 29% y-o-y as a result of operational gearing effects. An ongoing focus on the supply chain helped support solid operating cash generation, which at €80.6m for the nine months was up 15% y-o-y and the balance sheet remains strong with €41.4m of net cash at the period end. Looking ahead, repercussions are likely following the announcement that one of ADVA’s US competitors (Tellabs) is to be integrated into its second largest customer Coriant (15% of nine-month sales), and management has consequently guided to a weak Q4. However, ‘significant’ growth is expected from non-Coriant customers during 2014. We are updating our forecasts to reflect the revised Q4 guidance and an assumption that Coriant contributes only 10% to consolidated sales during 2014. We assume non-Coriant business grows by 10% from the second half of the year. Overall, this drives our 0.9% forecast revenue growth in 2014. Sales and marketing costs are likely to continue to be ramped up in 2014 as ADVA continues to focus on deepening its direct sales relationships, and mitigate the potential impact from Coriant. However, with tight cost control elsewhere, operating margins should remain positive. Exhibit 1: Changes to forecasts EPS (c) 2013e 2014e 2015e

Old 12.3 16.1 34.7

New 8.0 6.7 12.8

PBT (€m) % chg. -35% -58% -63%

Old 8.5 11.3 24.1

New 5.5 4.7 9.1

Pro-forma operating profit (€m) % chg. -35% -58% -62%

Old 10.50 12.7 25.3

New 7.8 6.1 10.4

% chg. -25% -52% -58%

Source: Edison Investment Research

Valuation: Reflects depressed margins We forecast a 2013 pro-forma operating margin of 2.5% vs peak of 6.6% over the last five years. Given the current depressed margins, earnings forecasts are sensitive to fairly small changes in our assumptions. For example, a 1pp improvement in revenues in 2014 would drive a 23% increase in operating profits and a 30% improvement in EPS. Industry forecasters are looking for mid doubledigit growth rates in the WDM and Ethernet segments over the next four years. If they are accurate, then our current forecast of a high-single-digit recovery from H2 next year could prove overly conservative. If we were to assume 15% top-line growth from H214, all else being equal, our forecast EPS would increase to 12c in 2014 and 36c in 2015 , implying a 2015 rating of only 10.7x. The strength and speed of the recovery from non-Coriant customers, and management’s ability to retain Coriant business are likely to be the key catalysts driving the valuation.

Sensitivities Key sensitivities include: 1) the pace at which network operators and enterprises invest in nextgeneration technologies; 2) management’s ability to mitigate the impact of the Coriant/Tellabs deal; 3) cost management; and 4) the success or failure of new products.

ADVA Optical Networking | 9 December 2013

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Company description: Pure-play optical and Ethernet ADVA provides optical and Ethernet solutions targeted at improving bandwidth capacity and reducing the costs of next-generation networks. Its products have been deployed in more than 10,000 enterprises and 250 carriers globally. For the nine months to September 2013, 65% of sales were from EMEA (Germany 23%), 29% the Americas and 6% Asia-Pacific. We recommend that readers new to the sector read the Appendix in our August 2012 note for an overview of the basics in network technology and architecture.

Products: Focus on optical and Ethernet solutions Telecoms operators are facing an exponential increase in demand for bandwidth by customers across all platforms. In the home, demand is driven by increasing use of rich media applications. In business, the strains are being felt as a result of increasing use of cloud computing services. Consequently, they have to handle higher volumes and more complex data, faster. Cisco forecasts that internet traffic will increase threefold over the next four years. Despite this demand, with flat pricing models for data and falling voice revenues, operators’ average revenues per user (ARPU) are under pressure. With this pressure on the bottom line, operators are seeking to reduce the cost per bit of data transported. Optical and Ethernet solutions play key roles in achieving this.

ADVA’s solutions ADVA has two key product ranges: scalable optical transport solutions, based on Wave Division Multiplexing technology (FSP 3000), and carrier Ethernet solutions for access and backhaul (FSP 150). 

Ethernet Access Device (EAD) (30% sales) – the FSP 150: Ethernet, the most common LAN protocol, is also becoming the predominant protocol in the wide area network. It is faster, cheaper, simpler and more flexible than legacy technologies (SONET/SDH, ATM). An EAD connects the LAN to the transport network and allows the information to remain in the Ethernet protocol. This helps customers eliminate equipment costs and complexity while increasing throughput and speed from existing networks. During 2012, ADVA expanded into the Ethernet Aggregation segment with the FSP 150 EG-X Gateway. This equipment enables numerous Ethernet signals to be scaled and consolidated into a single network. The EAD segment is one of the most competitive parts of the Ethernet market. ADVA was the first company to produce EADs and has led the market for the last five years. It has a 21% market share in fibre based EADs and its products are seen as best in class.



Wave Division Multiplexer (WDM) (70% sales) – the FSP 3000: A multiplexer is a device that combines several input information signals into one output signal, creating a signal stream with higher data throughput (bandwidth). ADVA has traditionally focused on Metro transport solutions using TDM (time division multiplexing) and WDM (wavelength division multiplexing). technology. While WDM was quickly established in long-haul networks, ADVA was one of the first companies to introduce a commercially-viable WDM solution for the Metro space. The company has expanded its product range into the long haul via its collaboration with Juniper Networks (FSP 3000 Agile Core Express, PTX products). ADVA competes with the industry giants including Huawei, Alcatel-Lucent, Cisco and Fujitsu. In this highly competitive market, products are fairly homogenous over time and any product advantage tends to be temporary.



Software and services (13% sales, across EAD and WDM): Hardware is pre-installed with proprietary software to enable service features such as remote automated network management (FSP Network Manager), encryption, service level assurance (FSP Service Manager) and synchronisation (Syncjack), etc.

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Competitive position: Pure play in growth niches ADVA is in the fairly unique position of having no exposure to legacy technologies; it is exposed only to the growth niches of Ethernet Access and optical WDMs where it has carved out leading positions (number one globally in fibre EADs). Exhibit 2: Divisional summary Products Share of revenues Addressable market Market position Growth rates: Pricing Sales channel

Ethernet Access FSP 150 30% $0.6bn Aggregation: $10bn Global number two after Ciena with c 15% share. Global number one with 21% share in fibre EADs 13.6% CAGR forecast 2012-16 (Technavio). Infonetics forecast 81% growth over the four years to 2016. Access devices: €1,000/box Aggregation devices: €3,000/box 100% of sales direct to carriers. Carriers deploy equipment in customers’ premises (eg corporate user or mobile base station) and then sell the service of maintaining the line and guaranteeing QoS. Customers include BT, Colt, Belgacom.

Enterprise networks FSP 3000 30% $1bn

Carrier infrastructure FSP 3000 40% METRO WDM: $2bn Long haul WDM: $2bn 8% global (number four), 10% EMEA (number two) for Metro WDM Optical transport and switching market is forecast by Infonetics to grow at a 17% CAGR from 2011 to 2016, outpacing the 5.5% CAGR of the overall optical equipment market (WDM, SONET/SDH). €50k and over €10k to €1m depending on application and speed Sales both direct and via VARs, which can offer an entire Enterprise solution, not just access (eg storage, security, carrier contract, etc). Customers include Morgan Stanley.

Sales via OEMs (with no competing product) with access to large incumbents, eg Coriant (supplies to DT, TI). Remainder is via VARs and direct sales.

Source: Edison Investment Research

Management estimates ADVA’s addressable market at $5.2bn (2.6% of the $200bn telecoms infrastructure market). ADVA (2013e revenues $417m) is a niche player compared to the likes of Huawei (FY12 revenues $35bn), ZTE (FY12 $13bn), Cisco (FY13 $49bn), Alcatel Lucent (FY13e $15bn) and Ciena (FY13e $2bn). It does not compete across the entire product suite, but focuses on the transport segment of the network, and within this, the niche segments of Metro WDM and Ethernet Access Devices. Strategic positioning: ADVA is the only vendor to offer exclusively optical and Ethernet solutions. Unlike its main competitors, it only operates in high-growth niches, having no exposure to legacy technologies. Formed in 1994, ADVA has grown via acquisition (most recent Movaz Networks and Covaro in 2006) and by carving out strong positions as an ‘innovation leader’ in niche segments of the market. ADVA prides itself on its lack of bureaucracy and is reputed to be quick to market with the latest features and innovations. For example: 

EADs: ADVA was first to develop Ethernet Access technology in 1999; first to offer 10Gbps demarcation devices; the first to offer timing synchronisation functionality for mobile backhaul solutions (Syncjack launched in 2012); and its FSP 150 solutions deliver the most precise timing accuracy on the market (with sub micro-second timing accuracy). As a leader in this field, ADVA frequently hosts seminars and attends industry conferences.



WDMs: It was the first to market with the software driven ‘add-drop’ wavelength function for bandwidth management in 2007, and first to market in 2011 with the 100Gbps (4x 28G) Metro card, which is enjoying considerable success in the enterprise segment.

ADVA expands its customer base by working with a network of global partners. The sales channels it uses vary depending on the size or complexity of the network solution required. For larger, more geographically dispersed and complex customers, it partners with OEMs that have no competing product (on an exclusive basis) or with VARs (on a non-exclusive basis). Under these arrangements, the equipment is branded as ‘powered by ADVA’. Across the group 50% of sales are direct to carriers; 25% via OEM; 25% via VARs. It has particularly important relationships with BT (approximately 20% sales) and Coriant (approximately 15% sales).

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Growth drivers: Data volume ADVA should benefit from the need to address bandwidth bottlenecks across many parts of the network as a result of the explosion in data volume being transported across fixed, mobile and enterprise networks. However, with networks prioritising LTE roll-outs during 2012/13, and customer specific issues for ADVA, growth has faltered over the last 18 months. Looking ahead, ADVA’s second largest customer Coriant poses specific revenue risks for ADVA. However, significant growth is expected in 2014 from other major customers in 2014, in particular for mobile backhaul and 100G enterprise solutions.

Carrier infrastructure: Growth in data straining networks With pressure on ARPU and cash flows, operators and enterprises are compelled to get more out of their existing network infrastructure and reduce the overall cost per bit transported. WDMs have a key role to play in relieving bandwidth shortages quickly and cost effectively as they: 

Avoid the cost and inconvenience of provisioning or leasing new fibre; DWDM technology is the fastest available. It can increase the available bandwidth by up to 40 times by passing more data down existing fibres. ADVA’s latest generation offers speeds up to 100GBps, with distances up to 2,500km.



Help operators to streamline their networks; WDMs can transport data over thousands of kilometres, bypassing smaller access nodes, and eliminating the expense of operating these locations. They can combine various traffic streams from different access media (copper, co-ax, fibre) on to a single transport platform, avoiding the need for parallel networks.

Enterprise networks: Cloud computing and private networks The growth of cloud-based computing and remote data centres is straining capacity and fuelling demand for high-speed connectivity. Enterprise networks need to be scalable to accommodate growth and they need to be secure, robust and resource efficient (minimum rack space, power and heat management). With WDM, bandwidth can be provisioned in a matter of days and can be increased on an ‘as you use’ basis. ADVA operates across all verticals and enterprise sizes. ADVA’s DWDM solution has the lowest latency on the market, offers integrated security (key for trading infrastructure) and has one of the highest density DWDM systems (ie highest bandwidth possibilities). With these features, it has a particular strength in the financial sector where speed and security are paramount. More recently, it has reported consistent success with ISPs. It also performs well within healthcare, research and education verticals, often overlooked by the larger players, which tend to focus on carrier networks. ADVA’s product is reputed for innovation and ease of use; it was first to market with the 100Gbps metro card in 2012, which is enjoying considerable success as a cost efficient alternative to existing 100G solutions for distances up to 500km. For example JSC Fortex (Russia) chose ADVA’s 100G Metro to upgrade its services during 2013 citing its plug-and-play simplicity. Similarly, Hetzner Online (German web-hosting providers and data centre operators) recently deployed the 100G metro solution to respond to fierce growth in video traffic quoting the plug and play functionality and the compatibility with legacy infrastructure as decisive factors in its selection. Enterprise business tends to be higher margin than carrier infrastructure business, and ADVA, building on its current success, is investing more sales resources into this segment.

Carrier Ethernet replacing legacy technologies Traditionally Ethernet was a LAN-only technology as it could not offer the required reliability, information or speed for long-haul transport. However, Ethernet speeds and service levels have improved significantly in recent years and it is now ‘Carrier grade’. Furthermore, it is significantly

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cheaper, simpler, more flexible and a more scalable technology than the legacy technologies (SONET/SDH and ATM). We estimate that Ethernet is now used in between 20% and 30% of network transport outside the LAN and is steadily replacing SONET/SDH and ATM (legacy layer 1 and 2 transport technologies).

Mobile backhaul should be a significant new market for EADs Demand for mobile bandwidth is expanding significantly as consumers increasingly expect the same service outside the home as they receive within it. Operators are looking to increase network speeds by building out 4G/LTE networks to cope with the shift in usage patterns. However, these higher network speeds can only be experienced when supported by an adequate mobile backhaul network. During mobile communication, connectivity from the mobile base station to the central office occurs over the mobile backhaul. Current mobile backhaul networks are based on legacy technologies optimised for voice transport and present a bottleneck to 4G mobile communications. To cope with the higher speeds, backhauls will have to be upgraded. ADVA is well positioned to benefit from this market transition. It has developed an EAD specifically for the mobile backhaul market that offers key quality of service information (via its Etherjack software). Its timing synchronisation software (Syncjack) has the lowest failure rate on the market, which is critical for effective backhaul in mobile networks.

Potential from other new markets In 2010, Juniper and ADVA engaged in a marketing and distribution partnership. First joint contract wins were reported during 2011 and in 2012, they jointly developed the FSP 3000 Agile Core Express Layer, an ‘add on’ transport product designed for Juniper’s core routers. ADVA was hopeful that its Juniper relationship could be developed into a significant new revenue driver for the group and taking the product a step further, it has designed a state of the art product that integrates the agile core transponder functionality into Juniper’s PTX router platform. The router market is significant (addressable market $2.5bn) and Juniper is a strong partner. A moderate success could have a meaningful impact on ADVA’s results. However, while development work on this project has been completed and prototypes have been on major carriers' test shelves for some time, the timing and likelihood of a commercial launch (originally planned for 2013) of this product is now unclear. Revenues from the Juniper partnership are expected to be approximately €10m in 2013. During 2012, ADVA expanded into the Ethernet aggregation segment with its FSP 150 EG-X Gateway, a device that enables numerous Ethernet services to be scaled and consolidated onto a single network. The aggregation segment is significant ($10bn), and a small market share could have a meaningful impact on results. The growth drivers and competitors for these devices mirror those for EADs.

The industry has had a difficult 18 months While the structural growth drivers are clearly in place for ADVA’s products, the growth outlook must be seen in the overall context of the market environment for telecom infrastructure capital expenditure budgets and telecoms service providers’ immediate priorities. After a retrenchment in network investment in 2009 and 2010, there has been a return to modest growth in global telecoms network capex over the last three years (+3% in 2011, +4% in 2012 and with +4% forecast by Infonetics for 2013). However, over the last 18 months, much of this increased investment has been channelled into building out LTE coverage rather than addressing the bottlenecks in the backhaul that will occur as customers start subscribing to these services in greater numbers. 

OTN (optical transport network growth) was down 10% in 2012, compared to +9% in 2011, dragged down by a 30% decrease in legacy SONET/SDH technologies. While the WDM

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market continued to show single-digit growth overall, most of this was in the US and China – markets where ADVA is under exposed. For the first year on record, sales of WDMs across EMEA were down in 2012. 

Growth in the EADs market also slowed considerably during 2012. According to Infonetics, the global EAD market grew at only 3.5% in 2012 to $860m, following 17% growth in 2011 and 43% in 2010.

Industry returned to growth in 2013, but customer specific issues impact ADVA During 2013 the optical and Ethernet segments have started to show signs of recovery. Infonetics reports 7% average quarterly growth in the optical segment growth for the nine months to September 2013, with average WDM growth of up 12% (SONET/SDH -30%), driven in particular by 100G deployments, and a solid recovery in the US. Across the industry, growth rates have picked up (Exhibit 3), particularly for companies with large US exposures (notably Ciena: 63% sales are from the US). Despite this more favourable industry backdrop during 2013, ADVA has not reported year-on-year growth for four consecutive quarters. This is largely due to the significant decrease in mobile backhauling order volume from its (previously) third largest customer (accounting for c 10% of revenues in H112) and the fact that much of the recovery has come from tier 1 customers in the US, where ADVA is underexposed, has not helped. Exhibit 3: Peer growth rates Company ADVA Juniper Ciena Finisar Oclaro JDS Uniphase Alcatel-Lucent

Q1 11% 21% 65% 26% 14% 37% 13%

2011 Q2 Q3 13% -2% 15% 9% 12% 9% 10% 0% -3% -13% 21% 3% 0% -9%

Q4 5% -6% -4% -8% -28% -14% -20%

Q1 16% -6% 14% 1% -23% -10% -12%

2012 Q2 Q3 10% 4% -4% 1% 9% 2% -3% -4% -4% 41% -7% 1% -7% -3%

Q4 -4% 2% 8% -2% 84% 5% 5%

Q1 -6% 3% 6% 1% 60% -1% 1%

2013 Q2 -9% 7% 14% 21% 30% -4% 2%

Q3 -4% 6%

Source: Bloomberg, Edison Investment Research, company reports. Note: Calendar years.

2014 outlook encouraging, but Coriant relationship will act as a drag on growth With ambitious investment plans announced by AT&T (non ADVA customer), Deutsch Telecom (ADVA customer) and China mobile (non ADVA customer), the outlook for capex spending overall in 2014 and 2015 appears quite strong. This is consistent with management’s observations; it guides to ongoing weakness in Q4, but has indicated that there are signs that operators are now ready to start to invest in the backhaul, and it has a strong pipeline that is expected to materialise in 2014. However, the recent announcement that Coriant’s major shareholder plans to integrate it with one of ADVA’s US-based competitors (Tellabs) is likely to affect its relationship with Coriant and is one of the reasons for ADVA’s guidance for ongoing revenue declines for Q413. Coriant accounts for approximately 15% of ADVA’s revenues and sells ADVA products into key accounts such as Deutsche Telecom, Telecom Italia, Telekom Austria and Telstra Australia. Management is seeking to mitigate the potential impact of this deal by trying to take on some of the business generated by Coriant direct, and to secure a non-exclusive distribution agreement for the remaining Coriant business. However, it is likely to act as a drag on the ‘significant growth’ expected from other customers over the coming year. Of the 15% contribution to revenues currently made by Coriant, we estimate that two thirds is recurring business, which ADVA is likely to retain. The remaining is new business which poses the greater risk of being lost in the near term.

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Sensitivities We outline here the key risks and sensitivities to our assumptions. 

The pace at which networks are upgraded is unpredictable: The rate at which operators upgrade networks is a balancing act between necessity, profitability and regulatory forces. Structural changes in the industry are putting pressure on profitability and telecoms operators often turn to network capex as a way to manage cash flows in the short term. While mediumterm industry forecasts for the optical and Ethernet segments are for strong growth, network investment can be lumpy.



The competitive landscape could intensify: To date, Chinese manufacturers have focused on the carrier infrastructure markets and are under-represented in the enterprise segment outside Asia. We expect Chinese firms to become more active in this segment and consequently margins could come under pressure. The addressable market size for EADs is only $0.6bn and so far is serviced by niche players. However, with double-digit growth rates forecast for the next five years, the segment is unlikely to remain off the radar of the ‘all service’ manufacturers.



New segments offer new opportunities: ADVA is expanding into Ethernet aggregation and the long-haul WDM markets. These markets together have an estimated spend of $12bn – almost triple the addressable market of EADs and Metro WDMs. Any significant developments in these segments could change the profile and profitability of the group significantly.



Dependence on key customers: Major customers are BT (20% of group sales) and Coriant (circa 15% of group sales, selling on to DT, TI, Telekom Austria, Telstra Australia). Below this level, no one customer represents more than 5% of sales. ADVA’s relationship with BT is nonexclusive. Although no orders have been placed with it to date, BT does have another contracted equipment supplier. Coriant accounts for c 15% of revenues and as discussed the proposed merger with Tellabs is likely to affect future revenues from this customer.



Revenues are mainly derived from two product lines, which can lead to volatile trading.



One of ADVA’s unique selling points is as a technology innovator. However, the time taken to replicate cutting-edge technology is shrinking and patents in hardware markets serve little purpose. The industry is dominated by large companies with deep pockets. If they decide to increase investment in R&D in these areas, ADVA would struggle to compete.



Currency: ADVA is a global player, with over 50% of revenues derived outside the eurozone. While ADVA employs hedging policies, it is exposed to currency gains and losses.

Financials We are downgrading our EPS forecasts for the current year by 35%, and by 58% for 2014 to reflect the weaker than expected guidance for Q4 given at the Q3 results on 24 October, and to take account of the likely disruption to sales flowing from the Coriant/Tellabs deal.

Review of Q3 results to September 2013 ADVA reported Q3 revenues of €79.1m (-3.9% y-o-y, +0.9% q-o-q) and operating profits of €4m (prior year: €5.6m), in line with forecasts and guidance. This performance leaves year-to-date revenues down 6% at €234.5m. Although there has been general weakness in carrier infrastructure demand in EMEA, that region was reported up 3% for the nine months to September helped by stronger demand from enterprise networks for 100G technology. However, US business was down 22% flowing in particular from weaker demand for EADs from one of ADVA’s largest customers. Tight cost management supported an increase in the operating margin to 5% in Q3 (vs 1.5% in H113), at the upper end of guidance. Year-to-date pro-forma operating profits of €6.3m are down

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63% y-o-y, affected by the operational gearing effect of lower revenues, but also by the cost of increased efforts in establishing direct links with customers in order to drive a deeper long-term understanding of their requirements. An ongoing focus on the supply chain helped support solid operating cash generation, which at €80.6m for the nine months was up 15% y-o-y. Net cash at the period end was €41.4m.

Changes to forecasts We had forecast a gradual recovery of revenues from Q413, however following the announcement of the proposed Coriant/Tellabs deal, Q4 guidance is now for further year-on-year revenue declines to €71-76m, with operating margins in the range of 1% to 5%. Management remains optimistic about the prospects of stronger growth in 2014. In its Q3 release its states: “ADVA Optical Networking’s pipeline is expanding, and there are clear signs that we will return to significant growth in our market for Optical+Ethernet solutions”. Management has indicated that there are many projects with customers other than Coriant that are in the pipeline, especially for Cloud data storage and LTE Advanced, with many projects close to finalisation. We reduce our revenue estimates to reflect 1) Q4 guidance, 2) the contribution from Coriant falling to 10% of consolidated revenues in 2014 (this equates to a €4m revenue reduction each quarter) and 3) an assumption of 10% growth from non-Coriant customers from H214. Overall this drives our forecasts of 0.9% revenue growth in 2014. ADVA has been increasing its investment in its direct sales channels over the last year (particularly for enterprise solutions and in Asia). Consequently, while tight cost management has seen other costs decline, total operating expenses have continued to grow (nine month op ex +3.7%, Q3 op ex +1.5%). Given mitigation efforts required to secure Coriant business, we forecast a continuation of recent cost trends in 2014 (2014 opex forecast +1.4%). Exhibit 4: Summary forecast changes

Revenues (€m) Revenue growth Pro forma operating margin Pro forma operating profits (€m) Reported operating profits (€m) PBT (normalised) (€m) PBT (reported) (€m) Net profit (normalised) (€m) Net profit (reported) (€m) Normalised EPS (c)

Old 319.5 -3.2% 3.3% 10,5 8.7 8.5 6.8 6.1 5.6 12.3

2013e New 308.7 -6.5% 2.5% 7.8 6.1 5.5 3.8 3.9 3.6 8.0

Change -3.4%

-25.2% -30.0% -35.1% -43.8% -35.1% -36.0% -34.9%

Old 338.7 6.0% 3.7% 12.7 10.9 11.3 9.6 7.9 6.8 16.1

2014e New 311.6 0.9% 1.9% 6.1 4.3 4.7 3.0 3.3 2.1 6.7

Change -8.0%

-52.2% -60.4% -58.4% -68.9% -58.4% -68.9% -58.4%

Source: Edison Investment Research

Valuation On our forecasts, ADVA trades on a premium 48x 2013 P/E. However, on an EV/sales multiple of just 0.5x, it is one of the cheapest stocks among peers. If it can deliver top-line growth despite the drag from Coriant, then forecast upgrades are possible. All else being equal, revenues need to increase by approximately 15% to get margins up to historic and peer levels, which would justify a more in line EV/sales rating.

Peer comparison Based on our normalised earnings forecasts (which adjust for amortisation of acquired assets and share-based payments), ADVA is trading on a premium P/E of 48x 2013 earnings. However, on

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EV/sales of 0.5x, it is the cheapest stock among its peers. Given the relatively lower historic operating margins, a degree of discount on an EV/sales basis is to be expected. However, the 62% sales discount to Ciena, its closest peer (65% revenues from WDM and ADVA’s closest competitor in the EAD market, with a similar market share), is more anomalous and gives an indication of the possible valuation upside possible if ADVA can improve its growth and margins towards the 6% to 7% range delivered in the past and at peers. The EAD industry remains crowded and is ripe for consolidation. Given its niche focus, ADVA could be a neat fit into a number of larger vendors, although its 18% long-term shareholder, investment company EGORA Holdings, does complicate the situation somewhat. Recent sector deals include the proposed integration of Tellabs into Coriant, Overture’s merger with Hatteras (2011) and Telco Systems’ (BATM) acquisition of ANDA (2011). On an EV/sales multiple of 0.5x, ADVA is trading broadly in line with the price received for Nortel’s MEN business in 2010. The prospect of industry consolidation may provide some support to the valuation on the downside.

Scenarios: Earnings forecasts sensitive to small changes in assumptions 

Pick up in top-line growth: A 1pp improvement in revenues in 2014 would drive a 23% increase in operating profits and a 30% improvement in EPS. All else being equal, to get the operating margin back to the 6% level needed to justify a sales rating comparable to peers, revenues need to increase by around 15% on 2013 forecasts.



Cost savings: Management has been focused on driving efficiencies from the business over the last few years, and has made significant strides in improving the efficiency of the supply chain. ADVA is now ranked in external surveys as one of the most efficient in the industry. Given the amount of work that has already been done, we are not forecasting further cost savings. However, should further efficiencies be found, for each $1m of cost savings, we estimate a 16% improvement in operating profits and a 21% improvement in EPS.

Exhibit 5: Peer comparison

ADVA Ciena Corp Tellabs Inc Alcatel-Lucent Infinera Corp BATM Advanced Communications Allot Coms. Cisco Systems Juniper Network Ericsson Finisar Corp JDS Uniphase Corp Oclaro

Market cap (local m)

Current EV/sales

Next EV/sales

Current EV/ EBITDA

Next EV/ EBITDA

Current P/E

Next P/E

Sales growth next year

57.3x 21.5x 81.3x 95.8x 66.2x

Sales growth current year -6.5% 12.7% -20.5% 1.3% 23.5%

184 2,308 868 9,071 1,117

0.5x 1.5x 0.3x 0.6x 1.7x

0.5x 1.3x 0.3x 0.6x 1.6x

4.0x 16.3x 19.5x 11.8x 30.3x

4.2x 13.3x 10.3x 7.4x 18.2x

48.6x 36.0x N/A N/A 549.4x

75 425 113,535 10,342 243,159 1,936 2,779 204

0.8x 2.9x 1.7x 1.8x 0.9x 1.5x N/A 0.6x

0.7x 2.4x 1.6x 1.7x 0.8x 1.3x N/A 0.5x

19.8x 31.6x 5.1x 7.9x 7.5x 7.8x N/A N/A

10.5x 17.5x 4.8x 6.8x 6.2x 6.7x N/A 20.2x

50.6x 123.9x 10.7x 16.7x 19.3x 14.2x 20.9x N/A

Current Next EBIT EBIT margin margin

0.9% 11.4% -3.9% 2.6% 11.2%

2.5% 6.3% N/A 1.5% 1.3%

1.9% 7.8% N/A 3.8% 6.3%

20.2x 30.3x 10.1x 14.9x 15.0x 12.3x 14.5x N/A

3.5% -7.8% -4.4% 5.8% -0.6% 20.6% 4.2% -30.3%

5.8% 19.2% 4.3% 5.7% 3.3% 11.0% 8.3% 7.6%

2.1% 3.1% 29.5% 19.1% 7.6% N/A 9.2% N/A

5.2% 12.2% 29.3% 20.9% 9.7% N/A 10.8% N/A

Source: Edison Investment Research, Bloomberg. Note: Priced at 4 December 2013.

ADVA Optical Networking | 9 December 2013

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Exhibit 6: Financial summary 2011 IFRS

2012 IFRS

2013e IFRS

2014e IFRS

2015e IFRS

310,945 (177,429) 133,516 37,568 17,283 (2,493) (1,583) 0 13,207 797 18,080 14,004 2,935 14,197 16,939

330,069 (196,820) 133,249 45,116 21,798 (1,620) (1,344) 0 18,834 (329) 21,469 18,505 (1,783) 16,338 16,722

308,713 (186,128) 122,585 35,266 7,835 (682) (1,040) 0 6,113 (2,301) 5,534 3,812 (247) 3,929 3,565

311,644 (189,209) 122,435 33,302 7,354 (503) (1,226) 0 4,330 (1,337) 4,722 2,993 (898) 3,305 2,095

330,343 (197,927) 132,416 38,236 6,058 0 (1,263) 0 9,088 (1,296) 9,054 7,792 (2,338) 6,338 5,454

Average Number of Shares Outstanding (m) EPS - normalised (c) EPS - normalised and fully diluted (c) EPS - (IFRS) (c) Dividend per share (c)

47.3 30.0 29.1 35.8 0.0

47.6 34.3 33.5 35.1 0.0

47.9

0.0

48.2 13.1 6.7 11.3 0.0

48.4 13.1 12.8 11.3 0.0

Gross Margin (%) EBITDA Margin (%) Operating Margin (before GW and except.) (%)

42.9 12.1 5.6

40.4 13.7 6.6

39.7 11.4 2.5

39.3 10.7 1.9

40.1 11.6 3.1

BALANCE SHEET Fixed Assets Intangible Assets Tangible Assets Investments Current Assets Stocks Debtors Cash Other Current Liabilities Creditors Short term borrowings Long Term Liabilities Long term borrowings Other long term liabilities Net Assets

99,386 61,930 37,455 1 160,510 36,536 54,874 59,110 9,990 (85,391) (75,058) (10,333) (38,519) (17,614) (20,905) 135,986

109,797 69,774 39,240 783 174,298 41,339 55,464 70,625 6,870 (91,684) (76,928) (14,756) (38,502) (14,269) (24,233) 153,909

115,094 75,010 39,301 783 170,006 38,664 51,875 72,597 6,870 (75,080) (73,907) (1,173) (51,357) (27,124) (24,233) 158,664

118,880 78,482 39,615 783 168,811 39,031 52,368 70,542 6,870 (75,495) (74,322) (1,173) (50,211) (25,978) (24,233) 161,985

124,456 83,165 40,508 783 170,180 41,373 55,510 66,426 6,870 (102,957) (76,967) (25,990) (24,248) (15) (24,233) 167,431

CASH FLOW Operating Cash Flow Net Interest Tax Capex Acquisitions/disposals Financing Dividends Net Cash Flow Opening net debt/(cash) HP finance leases initiated Other Closing net debt/(cash)

40,871 (1,535) (1,135) (33,027) 32 1,307 0 6,513 (24,650) 0 0 (31,163)

46,158 (1,348) (1,002) (34,167) (782) 1,578 0 10,437 (31,163) 0 0 (41,600)

39,699 (2,301) (247) (34,450) 0 0 0 2,701 (41,600) 0 0 (44,301)

34,083 (1,337) (898) (32,758) 0 0 0 (910) (44,301) 0 0 (43,391)

36,659 (1,296) (2,338) (34,724) 0 0 (1,271) (2,969) (43,391) 0 (0) (40,422)

Year end 31 December PROFIT & LOSS Revenue Cost of Sales Gross Profit (pro-forma) EBITDA Operating profit (pro-forma/normalised) Intangible Amortisation Stock compensation expense Other exceptionals Operating Profit Net Interest Profit Before Tax (norm) Profit Before Tax (FRS 3) Tax - reported Profit After Tax (norm) Profit After Tax (FRS 3)

€'000s

6.9

8.0

4.3

Source: Company accounts, Edison Investment Research

ADVA Optical Networking | 9 December 2013

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Contact details

Revenue by geography

ADVA Optical Networking Campus Martinsried, Fraunhoferstrasse 9a 82152 Martinsried/Munich, Germany +49 89 89 06 65 0 www.advaoptical.com CAGR metrics EPS 10-14e EPS 12-14e EBITDA 10-14e EBITDA 12-14e Sales 10-14e Sales 12-14e

% EMEA

Profitability metrics -23.3% -49.5% 3.6% -12.4% 2.3% -1.6%

ROCE 13e Avg ROCE 10-14e ROE 13e Gross margin 13e Operating margin 13e Gr mgn / Op mgn 13e

59%

36% Americas

Balance sheet metrics 6.6% 8.8% 2.5% 39.7% 2.5% 15.6x

Gearing 13e Interest cover 13e CA/CL 13e Stock days 13e Debtor days 13e Creditor days 13e

5%

Asia-Pacific

Sensitivities evaluation N/A 3.4x 2.3x 46 61 82

Litigation/regulatory Pensions Currency Stock overhang Interest rates Oil/commodity prices

     

Management team CEO: Brian Protiva

CFO: Jaswir Singh

Brian Protiva co-founded ADVA in 1994 and has been CEO since 2001. Prior to ADVA he worked at EGORA group (18% shareholder of ADVA).

Jaswir Singh joined in 2007 and has a solid background in technology manufacturing and finance. Prior to ADVA, he was regional FD for Nokia North America.

CTO: Christoph Glingener, PhD

Chief of sales and marketing: Christoph Unterberger

Christoph Glingener joined ADVA in 2006 and was appointed CTO in 2007. His prior roles were both academic and corporate, including at Marconi and NSN.

Christoph Unterberger has been with ADVA since 2007 after a long career at Nokia Siemens Networks.

Principal shareholders

(%)

EGORA Ventures Deutsche Bank AG DWS Investment GmbH Fidelity Management & Research Company ING International DNB Asset Management AS ING Investment Management (Netherlands) DEKA bank Deutsche

18.0 7.9 7.9 3.5 1.9 1.8 1.1 0.9

Companies named in this report Alcatel Lucent (ALU FP), Allot Communications (ALLT US), BATM Advanced Communications (BATM LN), Cisco (CISCO US), Ciena (CIEN US), Finisar Corp. (FNSR US), Huawei (SHE 002502), Infinera (INFN US), JDS Uniphase Corp (JDSU US), Juniper Networks (JNPR US), Sycamore Networks (SCMR US), Tellabs (TLAB US), Telefonaktiebolaget LM Ericsson (ERICB SS)

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