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Dear, ladies and gentlemen, welcome to the Conference Call of ADVA Optical Networking for the Third Quarter 2019 IFRS Financial Results. This call is being recorded. [Operator Instructions] I now hand you over to Mr. Stephan Rettenberger, ADVA Optical Network's Senior Vice President, Marketing and Investor Relations. Please go ahead, sir.
Yes. Thank you and welcome from my side. This earnings call builds on a presentation, which is available for download in PDF format from our home page under www.adva.com in the about-us/investors section. If you do not have the presentation in front of you, you may want to access it on the conference call page in the Financial Results section of the Investors section of our website. Before we will lead you through the presentation, as always, please be informed that this presentation contains forward-looking statements with words such as believes, anticipates and expects to describe expected revenues and earnings, anticipated demand for optical networking solution, internal estimates and liquidity. These factors are discussed in greater detail in the Risk Report section of our Annual Report 2018. Please also be reminded that we provide consolidated pro forma financial results in this presentation solely as supplemental financial information to help the financial community make meaningful comparisons of our operating results from one financial period to another. This pro forma information is not prepared in accordance with IFRS and should not be considered a substitute for historical information presented in accordance with IFRS. Pro forma operating income or loss is calculated prior to noncash charges related to the stock compensation programs and amortization and impairment of goodwill and acquisition-related intangible assets. Nonrecurring expenses related to the restructuring measures are not included. Unless stated otherwise, all numbers are presented in euro. We will target to limit this conference call to 60 minutes. As usual, Brian will start and provide a business update and outlook, and then Uli will talk us through our Q3 2019 financials. And finally, we will have sufficient time for your questions, which we'll be happy to answer. So, Brian, please go ahead with the business update.
Thank you, Stephan. Let's move to Page 4, Q3 2019 in review. Q3 revenues reached EUR 144.3 million, up nicely by 14.4% year-over-year from EUR 126.2 million in Q3 2018. Our Q3 pro forma operating income was at EUR 7.4 million or 5.1% of revenues. Both key performance indicators are at the top end of our guidance corridor provided on July 25, 2019. We continue to see solid demand and are pleased with the level of order entry. While the demand for our solutions is very healthy, the challenges around a strengthening U.S. dollar and the U.S.-China trade tensions with related costs continued to put pressure on our margins. We have taken measures to counteract these effects, which we will explain later in this presentation. Nevertheless, most importantly, our win rate with recent technology investments is very high, allowing us to realize higher margins in our new market segments. Our achievements here further underscore our momentum and the confidence in the market. Slide 5, industry macro environment. The industry growth drivers, which we have described in the previous earnings call, continue to be fully intact. Digitization is changing networks and bringing the investment focus to the edge of the network. The edge is where you need to combine infrastructure knowledge with end customer application knowhow. As a reminder, it is where ADVA performs best. We've started to see 5G gaining momentum. Slowly but surely, it will become a reality. Several mobile operators have announced the start of their 5G services, and the new network buildouts are in process. We have already benefited from a number of strategic synch and timing wins in 2019. A substantial part of the 5G infrastructure will be served in a wholesale model, where our portfolio fit is perfect. In addition, the need for tighter synchronization and compute resources at the edge of the network play well into our technological concepts for both the transport and packet edge infrastructure. As a company, we've aligned ourselves well with the upcoming network requirements by having all of the key technology pieces to address edge networking for 5G infrastructure. Beyond 5G, open networking disaggregation, the virtualization of the edge and edge computing are all fundamental for the digital transformation, which we have all been tracking and discussing as an industry over the last few years. Our technology builds the foundation for this transformation, a foundation that is driving automation, supporting the move to the cloud and ultimately increasing productivity within all verticals and all customers. This positive backdrop around the demand for our networking solutions is, unfortunately, overshadowed by geopolitical tensions. Even within this context, I want to reiterate, our industry growth drivers are fully intact and our strategy and portfolio are well aligned. Our 3 core competencies are strategically relevant and important. On the next 3 slides, I will highlight some of the key accomplishments we have made over the past few months. Moving to Slide 6, cloud interconnect. Our cloud interconnect solutions built around the FSP 3000 product line are designed to deliver the most effective terabit transport with great levels of security and ease of use. The solution architecture is leading in terms of its openness and doing well in a world that is moving to a disaggregated networking approach. We have possibly the most versatile open line system and leading-edge open terminals. This is not only about building right hardware solutions, but having the flexible, open software with the right APIs and the ability to support agile development requirements from our customers. Speed and flexibility is key. In more detail, last month, industry analysts from Ovum confirmed our market leadership in the enterprise DCI, the data center interconnect where our native protocol support and certified encryption technology make a big difference. With global share of 30% and 47% in EMEA, we continue to expand our success as a trusted partner for security-sensitive, mission-critical infrastructures. With our new TeraFlex terminal, we have further proof points of unparalleled spectral efficiency, boosting the capacity of existing optical networks, so-called brownfield applications. The performance of the product is compelling, and the market introduction is proceeding according to plan. We are in the process of scaling our volumes of the TeraFlex. As a reminder, we have the best and most flexible architecture on the market, enabling us to offer up to 1,200-gig, 1.2-terabit, super channels today. In addition, we have the ability to adapt to any optical line sight infrastructure and map the most efficient modulation scheme with our fractional modulation capabilities and any bit rate to optimize for the highest bandwidth over the longest distance. We are years ahead of the competition, although they will not admit to this presently and are trying to use fear and uncertainty to slow our market penetration. Moving to Slide 7, cloud access, our second area of competency. Our FSP 150 family of packet edge solutions, together with our Ensemble software products, provide flexible and fast delivery of NFV-based services at the network edge. Since the beginning of the year, we have seen a phenomenal acceptance rate of our Ensemble Connector software the network operating system that converts a bare metal server into a universal customer premise equipment, or short universal CPE. The majority of carriers requests for proposals. Short RFP are explicitly asking for NFV-based universal CPE solutions. We see proof points that Ensemble Connector is the market winner. It is the right product at the right point in the cycle. Besides the publicly announced wins you see on this curve, we also have won a significant number of additional accounts that still have to be named or made public. In addition to the success of our software solutions, I want to highlight that our FSP 150 Pro Series, our programmable packet edge devices, receives a significant amount of interest in the context of a wholesale network infrastructure for 5G. The products provide very good solutions where operators seek to deploy edge compute facilities for latency-sensitive IoT applications. In general, our FSP 150 IP and carrier Ethernet products are very competitive based on having introduced new aggregation and CPE/MID architectures over the last 12 months. All in all, we are expanding the differentiation of our market-leading hardware portfolio, and we are moving to higher margins with our technologically advanced software solutions. Slide 8, network synchronization. For network synchronization solutions, the third area of competency, our success rate for tenders have been very high for several quarters. The Oscilloquartz portfolio is technologically leading and supports the transition of radio access networks to 5G. In addition to the use case in the network infrastructure for mobile network operators, the portfolio's now ready to expand into other industry verticals. Our synchronization technology is enabling the rollout of the so-called fiber deep architectures in digital cable networks as we distribute precision timing to the remote fiber devices more efficiently than ever before. The financial services industry is migrating from Network Time Protocol, known as NTP, for time stamping to PTP, where our Oscilloquartz solutions are technologically superior. The server farms in geographically separated data centers need to be tightly synchronized independently of GNSS signals, driving the demand for our atomic clocks. And most recently, in Q3, we added functionality to support the requirements of power utilities and broadcasting networks. With our investments in synchronization technology, we expand our total addressable market, increase ADVA's value proposition and relevance in the networking industry while ultimately further accelerating our growth in higher-margin markets. And with that, my summary Slide 9, portfolio growth opportunities summarized. Edge computing solutions, IoT and 5G require a robust and scalable telecommunications infrastructure with more optical transmission capacity, new models providing communication services and more precise network synchronization. Our technology investments address precisely these aspects. Our FSP 3000 platforms sets new standards in open optical transmission technology. The platform efficiently delivered automated, scalable data transmission that further reduces the cost of terabit transport. Our market leadership in enterprise DCI and the compelling feature set of our new TeraFlex open terminal allow us to drive success in the segment. Our packet edge solutions with Ensemble software provide flexible and fast delivery of NFV-based services at the network edge. The market acceptance of our mature enterprise edge compute solutions has dramatically accelerated in 2019, laying a solid foundation for software revenue growth. The need for edge compute solutions in the 5G framework to address low-latency applications fuels additional growth potential. In addition, we have enhanced the end-to-end packet edge solutions, our FSP 150 product family, with aggregation, higher layer protocols, timing and temperature hardening. We are prepared for 5G transport and IP solutions. Our synchronization solutions portfolio is technologically ahead of any competitor and is actively used by many of the world's leading network operators. We have made further investments in the portfolio to expand our addressable market and enter new industry verticals. We will continue our growth trajectory and profitable business development. Throughout 2019, our technology tripod has gotten stronger. And many of the technology investments of the last few years have been transformed into highly competitive product offerings, enabling us to grow high single digits in the fiscal year and providing us with a solid foundation for 2020. And with that, I'd like to pass off to Uli.
Thank you, Brian. Welcome, everybody, and thank you for joining us on our Q3 2019 conference call. I will review our Q3 results and also our view for Q4. As Brian stated in the beginning of this call, revenues amounted to EUR 144.3 million and were 14.4% up from EUR 126.2 million in Q3 2018. This result was at the upper end of our guidance of between EUR 135 million and EUR 145 million. Gross profit contribution increased to EUR 49.1 million, up from EUR 47.3 million in the year-ago quarter. Our pro forma operating income margin was 5.1% of revenues, down from 5.4% in Q3 2018. This result came in towards the upper end of our guidance of between 3% and 6% of revenues. Net income was EUR 2.2 million compared to a net income of EUR 3.9 million in the year-ago quarter. Consequently, earnings per share decreased from EUR 0.08 to EUR 0.04. Q3 2019 net debt without the adoption of IFRS 16 was EUR 38.7 million, at the same level we have seen in Q3 2018. Including the IFRS 16 adjustment, our net debt was EUR 74.9 million. Except of revenues, all our key financials are significantly impacted by the U.S. trade dispute, on which I will elaborate further on the next slides. Next slide, please. Our revenues grew sequentially by 8.3% to EUR 144.3 million. We are pleased that the strong pipeline we saw at the beginning of the quarter materialized, driven by solid demand from all customer segments and technology groups. The effects of the U.S. trade dispute, however, had an increasing negative impact on our business. A significant portion of our products are manufactured in China and are denominated in U.S. dollar. Thus, the increase in tariffs as well as the strong U.S. dollar negatively impacted our business, resulting in a gross margin of only 34% in Q3 2019 versus 37.5% in the year-ago quarter or 37.9% (sic) [ 34.9% ] in Q2 2019. With EUR 7.4 million or 5.1% of revenues, our pro forma operating income improved strongly versus the EUR 4.3 million in Q2 2019. Compared to the year-ago quarter, pro forma operating income increased by EUR 0.6 million. Excluding the U.S. tariffs impact, our pro forma operating income would have been EUR 2 million higher and 6.5% of revenues. In the third quarter of the financial year, our revenues continued to develop well. However, since the profitability remains below our expectations, we initiated several actions to streamline our supply chain and to limit our overall spend. Let's move to the next slide, please. First off, we are moving significant portions of our production out of China to limit our exposure to U.S. tariffs. Secondly, throughout Q3, we expedited the transfer of materials and components to U.S. locations to reduce the negative impact of further increasing import duties. This shift resulted in increased freight costs and higher inventory levels, but would help us -- will help our profitability going forward. Finally, we are strictly controlling our operating costs. We have aggressively invested in innovation and technology in recent years and quarters and developed many important products. We are now in a position to consolidate some of our R&D efforts without jeopardizing our competitiveness. We are streamlining our footprint. We are reducing headcount selectively, and we're managing discretionary spending aggressively in order to optimize our cost base and to improve our profitability. These measures will save us approximately EUR 26 million to EUR 30 million until the end of 2020. Some of these measures led and will lead to one-off costs. Next slide please, quarterly revenues per region. EMEA revenues increased significantly by 27.9% year-over-year, now representing 53.9% of total revenues. Based on stronger demand from a number of customers in North America, especially from the communication service providers, revenues increased nicely by 18.3% compared to Q3 2018 now contributing 38.5% of total revenues. Asia Pacific continues to be dominated by project-based business, leading to quarterly fluctuations. This region now represents 7.6% of total revenues. Turning to the balance sheet now, next slide, please. Q3 2018 -- Q3 2019 credit metrics remains solid with an equity ratio of 48.1%. Gross leverage at 1.2 indicates a solid investment-grade profile. Liabilities to banks of EUR 77 million and IFRS lease liabilities of EUR 36.2 million add up to our total financial debt of EUR 113.2 million. Year-to-date ROCE was at 2.4%. We invested more in our working capital mainly to mitigate the effects of the higher U.S. tariffs. This impacted our cash position in Q3, but will benefit us in the quarters to come. Our gross cash came in at EUR 38.4 million, and our net working capital was at 24.1% of sales at the end of Q3 2019. Next slide, please. As already mentioned in the past, our operating cash flow is subject to a certain seasonality due to recurring events, in particular employee-related costs in Q1 and Q3. Special effects impacted our Q3 cash flow negatively by EUR 3.5 million, but reached a similar level compared to the year-ago quarter. Next slide, please. While changes in the global economy currently impact our profitability, revenues continued to develop in a positive manner. Growth and profitability are our key objectives, and we took initiatives to keep our business on track. Despite several countermeasures taken, the uncertainties about the U.S. trade disputes as well as the final outcome on the Brexit remain challenging and might have further impact on our future numbers. However, for the current quarter, Q4 2019, we project revenues of between EUR 142 million and EUR 152 million and pro forma operating income margin of between 5% and 7% of revenues. We remain committed to the positive outlook for the current fiscal year and continue to invest all our energy and creativity in innovative solutions for the benefit of our customers, shareholders and employees. With that, operator, please open the Q&A.
[Operator Instructions] The first question is from Simon Scholes, First Berlin.
I have 2 questions, if I may. The first is on your cost development, where -- I mean, cost development -- cost discipline is clearly, clearly evident in sales and marketing, general and admin and R&D. And they're respectively below 11%, below 6% and below 20% of sales in Q3, which is some way below what they've been in recent quarters. So I was wondering if you can maintain these cost items at this percentage of sales providing revenues remain buoyant over the next quarters.And then the second question is, you mentioned that your pipeline was very positive at the beginning of Q3, and the promise of that pipeline was fulfilled. Can I assume that the pipeline remains -- or is similarly promising at the beginning of Q4 and that, that promise is being fulfilled?
So I'd take the first question regarding the cost development. Yes, I mean, we try to maintain that metrics even though -- maybe even improve it with increasing revenues. I guess, last -- during the last earnings call, we made the statement that we try to keep our operating costs, excluding any effect from the R&D capitalization, as flat as possible. And this is we are committed to and to do everything to be there. And as you said, if revenues increase, then the metrics should become even better.
I think we've said our goal is to keep that flat over 6 quarters at least and allow things to catch up, compensating for some of the challenges on our gross margin due to the effects of the dollar and China trade war, et cetera. I'll take the second one, and that is pipeline. Q3 was good going in. I think when you talk to our operations and teams, we feel secure also and moving into Q4. Otherwise, we wouldn't be guiding EUR 142 million to EUR 152 million, which would indicate that business is strengthening into Q4. So we feel good about the environment. It's day-by-day in our industry, as we all know, but we like what we see, and we've got to keep pushing.
The next question is from Felix Lutz, Frankfurt Main Research.
On the projects you expect in China, or you say there's project business, do you have a timeline when these projects will come?And you have a cost position for restructuring costs of EUR 2.4 million in your pro forma EBITDA. Where does this come from? And what could we expect in Q4 and maybe in 2020 for one-off costs related to restructuring of the operational business?
All right. Felix, we don't have any projects in China. I guess what I said, we have project businesses in Asia Pacific. I guess you may have misheard it. So this was -- is that clear now or you...
Okay, that's clear.
The second one regarding the restructuring -- or the one-off expenses in Q3 was about close to EUR 2.5 million. The majority was related to severances and partially to facilities. The -- for Q4, I would expect a similar amount most likely at the same range, and no further plans for now for -- as far as it comes to one-offs for 2020.
And maybe I have a follow-up. The -- can you give a picture of the client concentration in the U.S. with your -- with the new products? Where is it going, more to the ICPs or -- and maybe you have a higher capitalization rate in the R&D. Maybe you can give some information on this as well.
With the U.S. business, I think we sell into all 3 segments efficiently and effectively. And that is we have ICP business, we have the service providers and we have enterprise business, and all of them are doing quite well. Specifically, some of our larger customers have continued to build out business with us. And therefore, United -- America is growing and we believe actually going into a good phase, especially with our competitive new products.
Regarding the capitalization, actually, the capitalization rates are down slightly. And also, in absolute numbers, the net effect of the capitalization went down compared to the previous quarter. So I don't know where you are looking at.
I have to check it, okay?
Please start to check and then come back.
So there are no changes expected from the capitalization rate?
So the capitalization rate will go down or will be around that range. However, amortization will increase over the next quarters. I mean, I guess we always said that the impact on our pro forma EBIT will be close to 0 towards the end of the year. And I guess this is how it looks. So it's the way how we are trending right now.
The next question is from Tim Savageaux, Northland Capital Markets.
I think that was me. A couple of questions. And, first, overall, congratulations on some very solid results in a pretty -- depending on where you look, a pretty volatile looking environment. My first question is on, you mentioned, Brian, the 1,200, 1.2 terabit capabilities or 600-gig per wavelength. I wonder if you're seeing any material revenues for those solutions that can describe the pipeline that you see heading into Q4 and into next year, and kind of as a side note to that, whether you're seeing any impact in the market competitively from any emerging 800-gig solutions.
So I mean, we have some pretty cool stuff in our TeraFlex being able to support the concept of super channels. Whether you use 1 or 2 wavelengths, it's less dependent. We can use wavelengths that are right next to each other or pick wavelengths with any kind of a frequency range accordingly to build those super channels. So I think it's available today. We're moving forward with it as a company, and a number of our customers really like what we offer there, point one. Point two, we do not see any competitive threat in any of the RFPs or the projects that we're working on from any 800-gig-based solutions today. I am sure that there are pricing exercising in existing customers and market share, where our competitors are trying to push 800-gig technology and pricing, let's say, modeling that's not based on their existing technology, but on future ware. That clearly is happening, but I think we're very well positioned in order to compete effectively. So I really like our offering. Things are doing really well in the field trials and some of the PoCs, and I think it's an area where we're going to win market share over the next 12 months.
Great. And if I might follow up. For Q3 overall, really solid double-digit growth there, but pretty volatile underneath the hood, right, some pretty nice strong growth in EMEA, in particular North America, and declines in Asia Pacific. I wonder if you could maybe get -- dig a little bit deeper in terms of what the growth drivers were in those regions, in EMEA in particular, focusing on overall market growth versus share gain potentially. And then as you look at your Q4 guidance, are there any similar dynamics in terms of regional or geographic growth or declines that you can call out either sequentially or year-over-year?
I guess, high level. First of all, we're doing these numbers in this growth even though 2 of our top customers definitely have taken a break due to some of the things that are going on internally within their organizations. One of those customers is in Asia Pacific. It was -- a large customer of ours. I think we're very well positioned at that customer. But volumes aren't strong, and, therefore, it is infecting along with the project basically and project dependency in APAC our numbers some. It starts to recover. Asia Pacific should be growing into next year, and we should start getting quarter steps forward in Asia Pacific. Having said that, strong EMEA and strong U.S. I think bandwidth growth in general, investment dollars into clearly beginnings of 5G, all important. And maybe more fundamentally is we're winning market share. We're winning market share with our new products, which is helping for growth. We're winning new customers. Our win rate at new customers is really strong. We're not losing many. Yes, it's a very -- there's price competition out there, but I think ADVA probably hasn't ever been better positioned with our product portfolio than we are today. So you asked how that evolves in Q4. I'm looking forward to the competitive environment. I believe ADVA's never been better positioned. So let us go compete for our building infrastructure needs of our customer base. And what we're hoping clearly is that the industry-relevant issues like investing in bandwidth growth, like investing in 5G, just it seems like all segments are investing aggressively because the network's at the heart of productivity gains, automation and all the things we're talking about in the digital transformation that, that outweighs some of the economic challenges that the world seems to be facing. So far so good. Fingers crossed that, again, industry-specific issues, service providers have to continue to invest, enterprises are selectively investing in areas that make a difference and allow them to drive digital transformation that they continue to move forward. And of course, the ICPs are the ICPs, big dollars and most likely getting bigger over the next years. And, therefore, we're confident and also hopeful that our industry as a whole doesn't get influenced like many other industries are being influenced right now.
If I could maybe follow up on that just briefly, and then I'll hand it over. You mentioned a couple of carriers sitting on the sidelines in Asia Pacific. We've also -- I don't know if that's a specific reference to Deutsche Telekom, but, certainly, they have slowed down a lot, at least in terms of access spending, and have historically been a pretty big customer for you guys, which is, I think, even more impressive to grow through. But my question is, do you see any kind of recurring themes or kind of rhyme or reason with regard to carriers? And seemingly a decent number of them, I don't know whether it's looking at post spectrum purchases or auctions, or looking at architecting fiber aspects of 5G networks and just kind of taking some time in the back half of '19 to evaluate that before moving into '20 or would you look at some of this sitting on the sidelines just kind of random and uncorrelated.
So I guess my view is optical networking is a different animal than broadband access. You go through major upgrades in the access networks and they come to an end at a carrier. If you're exposed to a number of carriers, and they are in sync, you can have highs and lows, more, let's say, volatility in that -- in this segment. Having said that, there are fewer competitors. So our challenge is if there are more competitors, there's always the pricing velocity is very high in our industry, but getting better. The consolidation is happening. We still have 9 competitors out there, but there are very few that are profitable and healthy essentially. But, in general, I think the optical networking space is a little bit better right. At the end, it's growing every day. Yes, you have some rollouts where it starts and it ends at a carrier. Very rarely are they in sync across an industry or even a region or even within a country. So it's much more staggered. I think the second carrier that we mentioned, one in APAC, is not in EMEA. So that answers your question. And I believe that, again, we are in an industry that shouldn't have huge ups and huge downs. Having said that, we are in a very competitive industry, but what we need for that is innovation and the ability to price competitively. And I think, again, we have those things to do well in our industry.
We have no further questions for the moment. [Operator Instructions] And there are no further questions. Ladies and gentlemen, thank you for your attendance. This call has been concluded.
Okay, then. Thank you, everybody, for joining today's earnings call. We will be back with our Q4 earnings then in February 2020. Thank you, and bye-bye.
Thank you. Bye-bye.
Ladies and gentlemen, thank you for your attendance. This call has been concluded. You may disconnect.