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Edited Transcript of ADV.DE earnings conference call or presentation 25-Jul-19 1:00pm GMT

Q2 2019 ADVA Optical Networking SE Earnings Call

Martineried Aug 3, 2019 (Thomson StreetEvents) -- Edited Transcript of Adva Optical Networking SE earnings conference call or presentation Thursday, July 25, 2019 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Brian L. Protiva

ADVA Optical Networking SE - Co-Founder, CEO & Member of Management Board

* Stephan Rettenberger

ADVA Optical Networking SE - SVP of Marketing & IR

* Ulrich Dopfer

ADVA Optical Networking SE - President, CFO & Member of Management Board

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Conference Call Participants

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* Mirko Maier

Landesbank Baden-Wurttemberg, Research Division - Investment Analyst

* Robin Brass

Hauck & Aufhäuser Privatbankiers AG, Research Division - Equity Analyst

* Simon Scholes

First Berlin Equity Research GmbH - Senior Analyst of Technology, Biotech, Medtech, and Resource

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Presentation

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Operator [1]

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Dear ladies and gentlemen, welcome to the conference call of ADVA Optical Networking for the Second Quarter 2019 IFRS Financial Results. This call is being recorded. (Operator Instructions)

I now hand over to Mr. Stephan Rettenberger, ADVA Optical Networking's Senior Vice President, Marketing and Investor Relations. Please go ahead, sir.

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Stephan Rettenberger, ADVA Optical Networking SE - SVP of Marketing & IR [2]

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Yes, thank you for the introduction, and welcome from my side. This earnings call builds on a presentation, which is available for download in PDF format from our homepage under www.advaoptical.com, in the About Us/Investors section. Should you not have the presentation in front of you, you may want to access it on the Conference Calls page in the financial results section of the Investors section of the 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, anticipate and expects to describe expected revenues and earnings, anticipated demand for optical networking solutions, 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 as 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 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 Q2 2019 financials.

And finally, we will have sufficient time for your questions, which we'll be happy to answer.

With that, I hand it over to Brian. Please go ahead with the business update.

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Brian L. Protiva, ADVA Optical Networking SE - Co-Founder, CEO & Member of Management Board [3]

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Thank you, Stephan. So as always, we start with the business update and outlook on Page #4.

Q2 revenues reached EUR 133.2 million, up nicely by 7.6% year-over-year, from EUR 123.8 million in Q2 2018. This is within our guidance corridor provided on April 18, 2019, of between EUR 130 million and EUR 140 million.

Our Q2 pro forma operating income was at EUR 4.3 million or 3.3% of revenue, and that's around the midpoint of our guidance of between 2% and 5% of revenue. Both revenues and profitability developed within our guidance, even though we had to push off revenue recognition of one large project.

We achieved some great customer success in Q2 with an impressive win rate. Our order entry was strong and we are going into Q3 with a significant backlog. While the demand for our solutions is very healthy, we see the strengthening U.S. dollar, U.S.-China trade tensions with related costs and our product customer mix putting pressure on our margins.

Most importantly, however, we are excited to report that many of our new wins come from our recent technology investments. Our win rates with new products are very high, allowing us to realize higher margins in our new market segments. Our achievements here further underscore our confidence in the market and our growth opportunities.

Moving to Page #5 of the macro environment. The industry growth drivers that we have described in the previous earnings' calls 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 applications' know-how, as we have discussed in the previous calls. It is where ADVA performs best. As a company, we've aligned ourselves accordingly and invested exclusively in strategically important future technologies, technologies that enable new digital business models.

In detail. Optical transmission technology delivers the required bandwidth. Physical and virtual edge technologies bring the cloud and related services closer to the customer and enable instant service creation with a click of a mouse, whereby packet solutions within this framework allow for secure cloud access. And our synchronization technology guarantees the level of timing needed in a high-performance network.

In addition to this positive backdrop around the demand for our networking solutions, I want to comment on 2 topics that influence the macro environment. First, Cisco announced its intentions to acquire Acacia. According to their public statements, the main intention is to drive a tighter integration of optics within their switching and routing platforms. We see this as a confirmation that the importance of pluggable transceivers in our industry is increasing and can confirm that our initiatives in this space around our MicroMux have lots of traction. I will revisit pluggable optics and our MicroMux later in today's call.

Cisco said that they will continue to support Acacia's current and new customers as well as their market model. At this point, we see no impact on our ability to innovate and bring differentiated products to market, especially since we have multiple partners for each of our key technology pieces. As a side note, it will be interesting to see if China will get its approval for this announced acquisition, which brings me to the second point.

The current political tensions and disputes between the economic superpowers are increasingly affecting our industry and our company. Some of these ramifications present us with new challenges, as there is being opportunities. For example, the trade conflict between the U.S. and China generates higher tariffs and transport costs, putting pressure on our margins. The strong dollar adds to this pressure.

On the other hand, the decision of the U.S. administration to deny access to U.S. technologies to Chinese telecommunications supplier, Huawei has changed the competitive landscape around the globe, especially in Europe. Many communication service providers have large installed base of Huawei technologies in their network. Our limited supply capability on the part of a Chinese giant would have an impact on further network expansion and supplier selection.

However, Huawei's response to this new situation and thus the opportunities for us as a trusted partner and supplier in Europe, is not yet completely clear. We will continue to monitor these events very closely in order to proactively address negative effects or capitalize on new opportunities.

Summarizing. Our industry growth drivers are fully intact and our strategy and portfolio are well aligned. Our 3 core competencies are strategically relevant to the transformation of networks, a transformation based on openness, virtualization, security and precision-timing. This creates new growth opportunities and new market segments.

On the next 3 slides, I will highlight some of the key accomplishments we have made over the past few months. Essentially, they are overviews of many of the projects and customer wins/announcements that we have made.

Moving to Slide 6, cloud interconnect. Our cloud interconnect solutions built around the FSP 3000 product line are doing well in a world which is moving to an open, disaggregated networking approach. We have possibly the best and most versatile open line system architecture, and we have just come to market with a new generation of terminals. In addition, you'll be seeing us also offering pluggable coherent optics.

Yesterday, we announced that our new TeraFlex terminal broke several industry records in a terrestrial long-haul network. The performance of the product is compelling and its market introduction is proceeding according to plan. The feedback from customers who have already tested the device is excellent, and we have already had our first orders on hand, shipped in Q2 and plan on scaling the TeraFlex in Q3.

It is a powerful tool for our network operators to expand the capacity of existing network infrastructure, not only in DCI applications but also in terrestrial brownfield scenarios.

We have announced several other interesting customer wins since our last earnings call. And the revenue contributions from our highly differentiated advanced link monitoring system, or ALM, and our MicroMux 10 x 10 small little optical plug that muxes up to 100-gig, are growing nicely, as can be seen on some of the wins on this presented slide.

Moving to Slide 7, cloud access. A big picture. Our FSP 150 family of packet edge solutions, together with our ensemble software products, our NFVi infrastructure products, provide flexible and fast delivery of NFI -- NFE-based services at the network edge. More specifically, the market response to the launch and general availability of our new 100-gig aggregation platform, the FSP 150-XG480 has been extremely positive. We start shipping this quarter and hope to ship volumes in Q4.

On the virtual side of the portfolio, our Ensemble Connector software has been certified for the Intel Select solution for universal CPE applications. Equally important, we announced a new partnership with Dell EMC also for the universal CPE application. So we are one of the largest integrators as a partner, and we are the largest technology provider for the virtualization of the edge of the network as partners today.

Our universal CPE architecture is technologically leading and not only relevant for carriers but also for large international companies that rely on system integrators such as Dell EMC for their global IT solutions. The new partnership gives us access to new markets and additional sales channels for the Ensemble software.

Furthermore, our Ensemble Activator software plays a key role in the disaggregated cell site gateway defined and promoted by the Telecom Infra project known as TIP, that is receiving great interest in the mobile network operator community.

And finally, I want to highlight that we were able to win another application in the Openreach solution portfolio. The U.K. specialists for network access solutions uses our FSP 150-GO102Pro series as a network termination technology for the nationwide launch of small cells.

The compact cell site gateway with high-precision phase synchronization plays a key role in providing 5G mobile services in the U.K. The 5G technology is starting to have a positive impact on our revenues and opportunities.

We are expanding the differentiation of our market-leading hardware portfolio and moving into higher margins with our technologically advanced software solutions and services offering.

Moving forward to Slide 8, network synchronization. For network synchronization solutions, our success rate for tenders remains very high. The Oscilloquartz portfolio is technologically leading and key products have been validated by the European Advanced Networking Test Center, EANTC, for their IEEE 1588 Precision Time Protocol, known as PTP interoperability, in a series of tests focused on the new 5G timing requirements. We've also won a number of customers for 5G infrastructure rollouts.

Furthermore, we launched the industry's first service for monitoring of satellite-based timing that is powered by artificial intelligence. We're using our software knowledge to offer solutions that help carriers deal with full picture solution sets, in this case, it's all the timing coming off of the satellites.

In addition, together with Nokia, we demonstrated an end-to-end 5G synchronization solution. As I mentioned already, the portfolio is a highly differentiated portfolio, growing 2x the ADVA average rate. And we see interesting opportunities in new verticals.

And off to my final Slide #9, growth strategy and portfolio update, bringing it all together. As stated, our technology tripod is developing very well with each leg fulfilling an important role in the network transformation happening in every market segment. The much discussed introduction of 5G pushes the fiber deeper into the access area of networks.

Corresponding technological advances such as IoT and edge computing also require a new, innovative and scalable telecommunications infrastructure, with more efficient optical transmission technology, new virtualized models for service provisioning and more accurate network synchronization. Our portfolio is precisely tailored to these trends and we are making progress on all fronts.

Let me summarize, starting with the Cloud Interconnect in the upper right-hand corner. Our new TeraFlex terminal is shipping. Performance and customer feedback are excellent. We have started to take orders and we see new opportunities not only in DCI but also in carrier infrastructure. Our differentiated events link monitoring system known as the ALM and our MicroMux plug are opening new doors, expanding our application space and delivering growing revenues at higher margins.

In the cloud access space, we are expanding the differentiation of our market-leading hardware portfolio around the FSP 150 and moving into higher margins with our technologically advanced Ensemble software solutions. Our universal CPE architecture is best-in-class, best in the industry, and we've won many accounts already.

And with Oscilloquartz, our network synchronization portfolio, we use our technological leadership to gain market share and expand into new verticals. Win rates are very high, now also in Latin America, which was a challenge for us to begin with, leading to revenue growth in excess of our standard revenue growth.

I'm excited to see the high win rates with new generation products that will ultimately also help to support stronger margins.

And with that, I'll hand it over to Uli for the finance performance section.

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Ulrich Dopfer, ADVA Optical Networking SE - President, CFO & Member of Management Board [4]

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Thank you, Brian. Welcome, everybody, and thank you for joining our Q2 conference call. I will review our second quarter results and also our view on Q3.

As Brian stated in the beginning of this call, revenues in Q2 2019 amounted to EUR 133.2 million and were 7.6% up from EUR 123.8 million in Q2 2018. This result is within our guidance of between EUR 130 million and EUR 140 million.

Gross profit contribution increased to EUR 46.5 million, up from EUR 45.4 million in the year ago quarter. Our pro forma operating income margin was at 3.3% of revenues, down from 5% in Q2 2018. This result is near midpoint of our guidance of between 2% and 5% of revenues.

Net income was at EUR 1.3 million compared to a net income of EUR 4.6 million in the year ago quarter. Consequently, earnings per share decreased from EUR 0.09 to EUR 0.03.

Without considering IFRS 16, net debt in Q2 2019 improved to EUR 31.9 million compared to EUR 36.6 million in the year-ago quarter. The implementation of IFRS 16 explains the overall net debt increase of EUR 31.5 million to EUR 68.1 million versus Q2 2018.

Next slide, please. Our revenues grew sequentially by 3.9% and 7.6% year-over-year. The increase in revenue is driven by solid demand from all customer groups in all technology areas. With EUR 4.3 million or 3.3% of revenues, we were able to improve our pro forma operating income sequentially, both in absolute and relative terms. Compared to the year ago quarter, pro forma operating income decreased by EUR 1.8 million or 1.7 percentage points, respectively.

We are pleased with the sales development. However, our margins in Q2 2019 were behind our expectations. This was mainly due to the strong U.S. dollar and additional costs resulting from international trade conflicts. In order to respond to the current margin pressure resulting from before mentioned challenges, we are taking additional measures to reduce our operational costs.

On the positive side, our order intake was very strong and we are entering the third quarter with a well-filled order book. We see promising projects and activities in all regions and among all customer groups, pointing to a strong second half of the year.

Let's move to the next slide, please, quarterly revenues per region. EMEA revenues increased by 24.7% year-over-year, now representing 53.3% (sic) [52.5%] of total revenues. We are traditionally strong in this region, leveraging our well-established partner landscape and our reputation as a trusted supplier to a broad and loyal customer base.

The Americas region contributed 39.1% of total revenues. In particular, business with network operators developed well in this region.

Asia Pacific continues to be dominated by project-based business, leading to quarterly fluctuations. Asia Pacific now represents 7.4% of total revenues.

Next slide, please. Balance sheet ratios. Q2 2019 credit metrics remain solid with an equity ratio of 47.8%. We improved our gross leverage to 1.2 due to a stronger operating cash flow and increased loan repayments in Q2. Financial debt of EUR 116.3 million consists of liabilities to banks of EUR 80.1 million and IFRS 16-related lease liabilities of EUR 36.2 million. Year-to-date, ROCE was at 1.9% and net working capital was at 23.9% of sales.

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. Compared to the year ago quarter, we were able to increase our operating cash flow significantly by 21.5%.

Next and final slide, please. As Brian stated, the growth drivers for our industry are fully intact. Digitization is changing the networks and bringing the investment focus closer to us. Our 3 core competencies are strategically relevant to the transformation of networks, and we have a high win rate with our new products contributing higher margins.

We have a strong order book going into Q3. Our positive revenue development continues. Margins in Q2 were behind our expectations, primarily due to the strong dollar and the additional costs resulting from international trade conflicts. In order to respond to current margin pressure, we are taking additional measures to reduce our cost base.

For the current quarter, Q3 2019, we project revenues of between EUR 135 million and EUR 145 million, with a pro forma operating income margin of between 3% and 6% of revenues.

Overall, we remain committed to the positive outlook for the current fiscal year. Thank you. And operator, please open the Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question received is from Simon Scholes, First Berlin.

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Simon Scholes, First Berlin Equity Research GmbH - Senior Analyst of Technology, Biotech, Medtech, and Resource [2]

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Yes. I have 3 or 4 questions, if I may. Firstly, I was wondering, to what extent you're seeing momentum behind the establishment of local data centers at the network edge?

And then another momentum question. I was wondering what momentum you're currently seeing behind 5G-related ordering?

Then on NFV, besides the Ensemble platform, I was wondering what extent -- to what extent the NFV topic is increasing the proportion of software within your revenues?

And fourthly, on Huawei, I was wondering if you could comment on potential downsides for ADVA from Huawei's response to U.S. sanctions?

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Brian L. Protiva, ADVA Optical Networking SE - Co-Founder, CEO & Member of Management Board [3]

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So I think I'm going to take most of that. And that is -- first one is local DCs. Clearly, locally DCs, it's fundamental to our vision, our strategy and our business long term. And that is, we believe the cloud's going to be pushed to begin with centralized and then it moves out to the metro and to COs, central offices, and then all the way out to the very edge of the network. It will be driven to the enterprise, it will be driven to the mobile, network out with things like MEC. And it even is driven out for the IoT infrastructure.

So we see that as an ongoing business opportunity. We're investing heavily in that. We are a definitive leader right now in the local, when it looks like from an enterprise perspective, on-premise little data center that can host applications. So again, it's fundamental to what we're doing. We think it's moving forward quite nicely. You see massive investment also from the big cloud titans in this particular space. I mean, you have a lot of the carriers and some of the local providers feeling that this is their opportunity to also compete with the cloud titans due to security, locality, (foreign language) -- what is it? Protection -- data protection of individuals and things like that. So very interesting market space for us.

It's driving some business, not as much as we would have anticipated looking back 12 and 24 months ago, but it's the future. It is coming. Transformation in the carrier space takes time, and therefore, we have to be a little bit patient.

Second question is 5G ordering is influencing our -- us already. We're winning deals. We're upgrading existing customers. We have a very nice architecture to address it. I think, we've won a number of the synchronization and timing bake-offs that's relevant for 5G. We have won some of the mobile infrastructure pieces as well. We named Openreach this time around. And we have built an end-to-end architecture that we believe encompasses optical packet NFVi as well as sync and timing to be differentiated. I think we're one of the very, very few, if not the only one that can offer all of those technologies in some form, or a combination to address 5G. And therefore, we think we can expand our market opportunity through those 5G ramps.

Clearly, right now, most of the spend is in infrastructure. Most of it is some RAN investment and leveraging existing 4G-type of infrastructures out there. It's just starting. Everybody's trying to bring up and say we're 5G-capable or whatever, but it's just starting. Most of the spend is in licensing but it's going to ramp. And over the next 3 years, it's going to be a very interesting business for us.

The third question was NFV. And yes, it has some, because I think some of the NFV and the centralization of EPC and some of the other applications out there, it's happening as we speak. It's driving bandwidth over the network. So it continues to help provide applications and bandwidth to drive optical infrastructure, point 1. Point 2, yes, we have our own NFVi infrastructure solution set, and we're driving that into the market. Relatively low revenues. It's one of the areas we're investing heavily in, and we will continue to focus on that opportunity. It doesn't have much direct influence on our revenues today, but I would say, in 24, 36, 48 months, it will have a rather large influence.

I think the industry as a whole has been hyped, let's say, has hyped both SDN and NFV. It's taken longer than expected but they're fundamental technologies that are fundamental for transformational change in the carriers, to virtualize, the networks become more flexible, more scalable, less dependent on personnel and operational costs. So it's going to happen.

And the final question was wrapped in and around Huawei. And I've always been wary in our calls to say, "Oh this is great for us," because we don't know. It's a very powerful company. And sure enough, I think Huawei is reacting aggressively in some accounts. So we share some accounts with them, and they've been aggressive in some of these accounts because of what's happened. So there's opportunity coming our way in certain customers deciding they don't want to work with Huawei. But at the same time, on the other side, we have more competitive pricing pressures in some other accounts.

I think it's awash right now. And that's what I've been saying. I said that's not one of the areas I'm looking at to go drive our business but it's not needed either. We share many accounts with them already. They're rock solid. They're not going away. I think we're ahead of a tide of ups and downs because I do fundamentally believe that the U.S. and China will agree, at some point in time, in the trade conflict. So again, it's not something that we're strategically pushing. And it's both a positive and a negative for us right now.

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Operator [4]

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The next question received is from Robin Brass from Hauck & Aufhäuser.

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Robin Brass, Hauck & Aufhäuser Privatbankiers AG, Research Division - Equity Analyst [5]

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Yes. Also one question from my side, specifically concerning the -- to the U.S. market and North American market. How do you see the dynamics here from a demand perspective? I mean, how is the evolution here going especially for your products?

And also from a competition side, generally, so how's the competition currently acting? And also related to this second question would be, how do you see the acquisition of Acacia for your business, also going for the whole market in general?

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Brian L. Protiva, ADVA Optical Networking SE - Co-Founder, CEO & Member of Management Board [6]

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So from a demand perspective, I see the U.S. is a good market for us, we're doing well. They're clearly very open-minded when it comes to technology leadership. So if you were to look at our -- some of our newer products, we are gaining traction there, often first, and winning infrastructure opportunities, software opportunities, et cetera.

We're broadening out our customer base. I very much liked -- see what's happening there. From a competitive landscape, clearly, Ciena's the big kid on the block. And then you have the Ciscos, Nokias, Infineras, kind of the others that we compete with on a regular basis. And I think clearly, Infinera's still a little bit wounded so we have to watch closely to their pricing strategy and what they do. But I think it's a fairly normalized competitive environment.

And technology matters, so we're leading with technology. And as many of you know, we've invested very aggressively, to we believe, transformation is coming in our industry, and we've invested very, very aggressively in R&D, PLM, BD in order to position new products in every one of our tripod areas accordingly. And those new products now are leading to, I think, strong positioning in North American market. Now we just have to realize that, push that through, conclude on some of the opportunities that we're working, move forward.

Second question around Acacia is, we've been moving to balance that dependency for the better part of 18 months. And I think we have a very nice strategy in place to balance that. I think, of anybody out there, we're probably the least dependent because we aren't in the long haul, where they're truly differentiating for us. We're not in that market space as a #1 market target. Having said that, if you see our announcements from yesterday, we have the best data, best pack, best distances available. So Acacia is a market leader in their space. They're an important supplier to us, but we have alternatives, point 1.

Point 2 is Cisco has gone out of their way in writing to commit that they will not change the business model that they're committed. Having said that, clearly, how does Cisco act in 2 years? Do they price accordingly that we can use Acacia DSPs and compete? That will be a question, but this will not impact any of our longer-term commitments. So anything that we have in market today and even kind of the next things that we're working on at all, because we have commitment pricing, support services and all the pieces. So this is not something that is a short-term issue for us but we will continue to monitor it and manage it very closely.

And honestly, I'm still not certain that this even goes through. I just continue to believe China, unless they have a major trade negotiation that will solve all of it, I just think ZTE is in bed with Acacia as well, and there will be pushback on this because it's supporting one of the large Americans. I just think with the pushback that America has done to the large Chinese, that there will be lots of jumps and flips in order to make this deal even happen. But having said that, not too worried about it. We're just going to manage it and move forward.

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Operator [7]

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We have no further questions for a moment. (Operator Instructions) The next question we received is from [Sascha Zeiller].

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Unidentified Analyst, [8]

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It's regarding on the -- firstly, on the cost measures that you mentioned. I would be curious to know what steps you take at the moment. And maybe you can also remind me how your manufacturing footprint looks, whether there's potential to take out some costs there?

And a second question with regard to this trend of vertical integration in general, whether you think it makes sense for you to also look into vertical integration or you want to basically still be independent of any component business?

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Ulrich Dopfer, ADVA Optical Networking SE - President, CFO & Member of Management Board [9]

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All right. Thank you, [Sascha]. This is Uli speaking. So cost measures, yes, I mean, we're looking in several options, what we can and what we should do. Clearly, what we realized is that the mentioned pressure on the gross margin will not go away anytime soon. So as said, we're going to react to this. I think the -- we have identified certain pockets within our organization where it makes sense to drive cost out. Clearly, where we need to be careful, and we're saying this all the time, is we've got to be careful that we don't jeopardize our opportunities for the future.

So we're going a fine line here, not taking the momentum out of the company of all these wins that we are having, of all the future wins we will have, of all the products we have on our road map. On the other hand, we understand we need to get more efficient, drive cost out, and this is what we will do. We have had certain ideas, many ideas and we will execute soon.

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Brian L. Protiva, ADVA Optical Networking SE - Co-Founder, CEO & Member of Management Board [10]

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So adding to that, a couple of things is, from a manufacturing perspective, we've actually had costs go up, and that's because of short-term issues, things like the trade conflict, which is costing us money. A couple of million this year, if we -- as we're managing, we're trying to manage that down but it's real dollars for us, real profitability, real dollars.

And at the same point, as these things come and surprise us, we're having to drive things like freight -- airfreight and rapidly get products into a market because of potential trade duty that's going to be imposed, costing us lots of money. So there, it's -- we're in the 7-digit as well. So you have some of these issues in manufacturing that will be neutralized, we believe, as we counter -- we have countermeasures in place, whether the trade negation goes well or not, we're not being dependent on that. We have a strategy in place to move out. If they then solve it, we can leave certain things in, but we have a plan to manage that effectively.

And stability in the manufacturing model helps us. So I think there's -- it's gone up relatively. I think it's actually going to come down into -- for the next 18 months naturally with some of the efficiencies. But yes, we are also driving consolidation and cost optimization and manufacturing throughout. But like I said, it's up for now, coming slowly down already and optimizing over an 18-month period of time.

From an R&D perspective, one can imagine, we have really spent a lot of money in getting products to market, huge amounts of money to get -- so those markets, most of our new products are at market now. They're there, we're starting to sell and stuff. So we can also there manage investment costs, et cetera, very effectively.

And looking at the big picture is we have the revenue growth. Our margins are low because of a number of issues. Some of them we can influence, some of them we can't, but that to us, we are very much focused on things like cost reductions and a plan to increase our margins with some of the new products, the software contact, the services, it's all happening as we speak. So that should help us address that margin piece.

And then at the same time, as Uli said, the OpEx piece needs to be driven down because we're at a stage right now where we've done a lot of the heavy lifting. We're moving into market, we can optimize. We did 3 significant acquisitions over the last 5 years. There's further things that we can make sure that we're managing extremely efficiently.

So as tough as the margins have been for us, and clearly, we've got a plan in place in 2 areas: one is margin expansion, and the second is OpEx management, that I think that we can do quite well in over the next period of time. And especially things like capping OpEx, flat OpEx over a longer period of time, we can do that without, as Uli says, impacting our competitive position and/or the opportunities that we're pursuing.

Last question was the vertical integration piece and that is, absolutely. We are starting to realize -- and in fact, we're selling to some of our competitors vertical integrated solution sets. You will see us get a lot more active with our positioning over the next maybe 6 months, where we're starting to expand the vertically integrated product portfolio, even market that more aggressively externally.

So you'll see us doing more there. We have an outstanding team there. We do it very efficiently. We're leveraging outside resources if we want to build any infrastructure. And I feel very positive and upbeat about that opportunity because we're already having some successes there.

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Operator [11]

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The next question received is from [Stefan Kieppe] from Commerzbank AG.

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Unidentified Analyst, [12]

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I understood all that you said there with the cost measures you're taking and with the price pressure and the margin upside. So the only thing which is missing here is some quantification a little bit, in my opinion. So when you talk about price pressure on the one hand, so you say that your Chinese competitors are very aggressive in Europe at the moment, and that's impacting you and in the U.S. obviously, the things are not looking up due to the U.S. dollar. And at the same time, you're saying you have new products out there where you can realize higher margins. So what's the net-net effect all of that?

And what kind of cost measures? I mean, yes, what kind of cost measures -- OpEx -- reducing OpEx, you said that many times. But can you quantify that and where should that leave us, net-net, looking into 2020, when even probably more of your latest equipment will be shipped where you should have a higher margin. So can we probably talk about that a little bit number-wise, from a numbers perspective?

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Ulrich Dopfer, ADVA Optical Networking SE - President, CFO & Member of Management Board [13]

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Brian, do you want to start with the Huawei topic?

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Brian L. Protiva, ADVA Optical Networking SE - Co-Founder, CEO & Member of Management Board [14]

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So first of all, Huawei's not the one that's -- we said there's some positives and negatives. We share some accounts who have gotten aggressive in some things. But I don't think that's fundamental to our margin issues. I think, again, there the quantifications, we have low (foreign language) margin in Germany is called gross margins in the U.S., and it's quite low on a -- you look at multiple quarters back to back to back, and we feel that we're going to turn that and slowly increase that again with a combination of our cost reductions and the new product introductions into the market.

What is hard to quantify for you is that, what if the dollar goes to EUR 1.08. I sit here and quantify -- we think we can increase it by 0.5% per quarter over the next 6 quarters, and the dollar of course -- because the dollars really hurt us, probably close to 2% probably. It's a hard model to look at, but remember, we buy a lot in dollars, we sell in pounds, we sell in euros in a big way. And therefore, it does hurt us. So it's -- clearly, our planning was at a much different -- at a different layer than it was or a level than it was today. And therefore, it's not easy to give you a quantifiable. But I do believe that dollar being stable, that we can increase that quarter for quarter over the next 4, 5, 6 quarters, always with considering product and customer mix. So step-by-step in the margin expansion.

On the operational cost expansion, I think I already made my comments, Uli and I are aligned, and that is Q2 needs to be net capitalization effects, Q2 needs to be our standard. And we've always been increasing our operational costs as a company, investing in more, investing in more products and more things. And I think we can cap that for a longer period of time. And that's our goal, is to clearly, the CFO and CEO of the company, completely aligned OpEx. And what we then need to do is grow the top line, regardless of anything else, our numbers get better. But the upside is that we really can leverage the new products, software services and maybe even get lucky with the dollar, and or the trade tension issues and the costs that are coming from other places.

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Unidentified Analyst, [15]

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Okay. I got all that. And I know it's hard for you to estimate. But at the end, you have the new product out there, the TeraFlex product, which is faster than the industry, and you're going to probably, as you said yourself, have good sales on the back of that. At the moment, we have very good momentum anyhow on the sales perspective, but nothing is coming through and the mix, we don't see that at all at the moment. So is your assumption that the mix in the next 2 to 3 quarters is helping? And OpEx, you see rather developing flat. Is that what you're going to -- is that's what you're saying here at the moment?

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Brian L. Protiva, ADVA Optical Networking SE - Co-Founder, CEO & Member of Management Board [16]

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What I said, I think what we commit to is that we feel that we're growing in top line. We feel really good about Q3, feel good that we get in the second half of this, continue to grow like we had said in the upper single-digit growth range. The market seems to be supporting that into next year. There's no indication at all with 5G and some of the investment dollars that are coming down the pipeline. So feel good about the revenue number.

Feel good that we can control the OpEx spot on, that's only in my responsibility at this point. And we've started. I mean, there's things happening to optimize since 1 month, 2 months. So we were saying, okay, we're bringing all the products now, we can start to pull in the reins, and we're doing that work as we speak.

And then from a margin perspective, yes, the new products definitely will help us to expand margins. But the fact is, that's really -- that's a much harder one to call for you today. My personal feeling, it's not a company feeling is that, yes, we can increase. And that, over the next 6 quarters, gradual increase quarter for quarter as we sell in our new products, services and software, more aggressively out there and footprints that we've won and are going to win. But I can't sit here and give you a number -- an exact number on the margins.

Having said that, even if the margins were stable and we do growth plus OpEx, we're getting better.

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Unidentified Analyst, [17]

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Can I ask another question? With regard to the sales perspective and sales momentum. With the new TeraFlex product, okay, you said you started shipping in Q2, feedback is good, Q3 is looking great. So do you think the momentum is still building? Do you see it only at a, let's say, starting point at the moment and we should see the big growth in Q4 and the first half 2020? Is it right to think that?

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Brian L. Protiva, ADVA Optical Networking SE - Co-Founder, CEO & Member of Management Board [18]

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I would say that TeraFlex will be an evolving product that's growing quarter for quarter for many quarters to come. And we have the breakout scenario if we win the large cloud titans with a product like that, but that's always been -- I've always said that's the breakout scenario. We're going to compete for everything. But TeraFlex should be a very nice product that evolves.

Some shipments in Q2, more shipments in Q3, viables -- revenues that start to help us in Q4 and then a really strong product for 2020. That's the way I would view the TeraFlex.

With breakout scenarios, if we add certain large customers, the technology, very, very competitive. The software infrastructure and the product very, very competitive. We have all those pieces, but there are many things that go into winning strategically large customers. So that's how I would frame TeraFlex today.

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Operator [19]

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The next question received is from Mirko Maier from LBBW.

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Mirko Maier, Landesbank Baden-Wurttemberg, Research Division - Investment Analyst [20]

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A couple of questions for Uli mostly, please. I want to come back to the weaker margin in Q2. You have mentioned the dollar and -- but we have also mentioned the weaker revenue mix when it comes between products, categories and customer segments. Could you share some puts and takes between those? That would be great.

And then you have also mentioned one project where you have to push off the revenue recognition. Could you explain what that means? Is this just postponed the project or is this totally skipped? And the reason behind and the volume would be great?

And then when it comes to Asia. In Q2, the revenue dropped for the low -- single-digit range, a level we have seen lastly in 2017 -- if I mentioned right -- without MRE. Have you lost some key player at MRE so the cross-selling isn't working anymore? Or has something gone wrong with the integration?

And then -- and the cost numbers and the sales and marketing is rather very heavily -- what's the reason behind this increase?

And then, once again, to the new TeraFlex product. You have mentioned the tests are going well. You have also some orders on hand but no revenues in Q2. Is this right?

And then the last question for your margin guidance in 2019. Previously, you have guided for a margin higher than level in 2018, what was 4.6 percentage points. And now you're guiding for mid-single-digit. Is this a lowered guidance or have you just opened the range a little bit?

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Ulrich Dopfer, ADVA Optical Networking SE - President, CFO & Member of Management Board [21]

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All right. Thank you, Mirko, for your questions. So let's start with the U.S. dollar revenue mix impact and so on. So Brian already said it, the U.S. dollar costs us margin -- gross margin and increases our OpEx base. So if you -- just as a rough idea, if you would compare our Q2 2019 with Q2 2018, if we were to have the same U.S. dollar, we would probably have EUR 0.5 million more gross margin.

Then we have the impact from the trade war, the increased tariffs is also Q2, if you want to compare it with Q2 2018 is also between, I would say, EUR 300,000 and EUR 400,000. So you have alone, almost 0.7, 0.8 percentage points gross margin -- lower gross margin compared to the previous year.

The customer mix, I mean, that's something that all this impacts us and some -- our business is partially project-driven and how projects fall, how they get recognized. Just as -- if you can have a big swing in a quarter from one quarter to the other, that's clearly one impact. The stronger margin projects, depending on the region, depending on what project is it, is it an enterprise project, is it rather a carrier project? I mean, the margin levels are different, and that's why you see the change in the margin.

Let's see, the other question was related to the recognized or not recognized projects. So this was -- I cannot give you an exact number, but it's several million that we shipped. We were just not able to recognize the revenue. There are certain rules when you can recognize revenue. There has to be an acceptance from a customer. The network has to be up and running. We have done our part. And this project is, for sure not skipped because we have shipped and it will be recognized within Q3.

The next question was regarding Asia Pac. I don't know, Brian, if you want to comment on that one or if I should?

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Brian L. Protiva, ADVA Optical Networking SE - Co-Founder, CEO & Member of Management Board [22]

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So I think it's nothing to do with the integration. It's nothing do with the product focus or concentration. It has to do with particularly one customer that has taken a break because of local market dynamics, point 1.

Point 2 because of inventory levels. If anything, we're stronger than ever at that customer because we're replacing one of our large competitors in another application. And hope to have some contributions coming again in Q4 and hopefully a strong 2020, maybe not as strong as our 2018, but strong contributions coming from them, which would then help the Asia Pacific number as a whole, clearly. But I don't think it's because of lack of execution on our part, but a more customer-specific situation that's led to that situation.

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Ulrich Dopfer, ADVA Optical Networking SE - President, CFO & Member of Management Board [23]

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All right. And I take the next question regarding the selling and marketing increase, cost increase. Actually, you should be really excited about that one. Why do I say this? Because -- I say this because most of our sales force is -- the salary is variable, or a big portion of the salary is variable, and this reflects -- essentially the increase in sales and marketing costs reflects our strong order entry and our strong momentum that we have because we have to pay higher variables for the sales team.

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Brian L. Protiva, ADVA Optical Networking SE - Co-Founder, CEO & Member of Management Board [24]

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The other aspect of that is we are investing in sales in the year 2019 because we've got the products. We need to go sell them and win footprint.

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Ulrich Dopfer, ADVA Optical Networking SE - President, CFO & Member of Management Board [25]

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Are your questions answered, Mr. Maier?

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Mirko Maier, Landesbank Baden-Wurttemberg, Research Division - Investment Analyst [26]

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No. But the last one -- I have 2 open questions, one was on the TeraFlex, about revenue in Q2, if there are any and the margin guidance, was the question.

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Ulrich Dopfer, ADVA Optical Networking SE - President, CFO & Member of Management Board [27]

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So we have not recognized any TeraFlex revenues in Q2. I guess, we always said first shipments in Q2, first recognition in Q3. So there's no recognition of revenues of TeraFlex within Q2.

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Brian L. Protiva, ADVA Optical Networking SE - Co-Founder, CEO & Member of Management Board [28]

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But we had orders and we shipped products.

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Mirko Maier, Landesbank Baden-Wurttemberg, Research Division - Investment Analyst [29]

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Okay. And on the margin?

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Brian L. Protiva, ADVA Optical Networking SE - Co-Founder, CEO & Member of Management Board [30]

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Can you -- I'm sorry, I was -- I had a question asked in the background. Can you repeat your question? Sorry.

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Mirko Maier, Landesbank Baden-Wurttemberg, Research Division - Investment Analyst [31]

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The last question was regarding your margin guidance for 2019. Previously, you have guided for a higher margin than 2018 and that means roughly 5 percentage points you want to reach. And now you have skipped this guidance and now you're guiding for mid-single-digit. So what implies that it could be also a margin below 2018 margin? Can I -- is it right that you have lowered your guidance or are you just opening the range of possible margin, if you will?

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Brian L. Protiva, ADVA Optical Networking SE - Co-Founder, CEO & Member of Management Board [32]

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This is my understanding, and Uli, correct me if I'm wrong, is that we had always said high single-digit growth, mid-single digits for pro forma EBIT, but our intent was to beat last year. That was our communication. So we said mid-single-digit with intent to beat last year. And I think our comments today is we are still -- believe that we can be in the mid-single-digit range for 2019. Uli, correct me if I'm wrong.

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Ulrich Dopfer, ADVA Optical Networking SE - President, CFO & Member of Management Board [33]

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That is absolutely correct. This is what we said. And clearly, we're shooting to exceed 2018 in absolute and relative terms.

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Brian L. Protiva, ADVA Optical Networking SE - Co-Founder, CEO & Member of Management Board [34]

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Okay. But clearly, at this point, I mean, we would have to have a strong -- we have to meet the high end of Q3 and have a breakout Q4 in order to do that. But I think we still feel confident in our second half, and therefore, we're reiterating the mid-single-digit guidance but with challenges to beat the -- the 4 -- the high 4 percentage from 2018.

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Operator [35]

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There are no further questions. Ladies and gentlemen, thank you for your attendance. This call has been concluded. Moderators have the possibility to say goodbye to the audience.

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Stephan Rettenberger, ADVA Optical Networking SE - SVP of Marketing & IR [36]

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Well thank you, everybody, for joining today's call and the active dialogue and Q&A. We will be back in touch with our Q3 numbers late in October. Thank you, and goodbye.

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Brian L. Protiva, ADVA Optical Networking SE - Co-Founder, CEO & Member of Management Board [37]

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Thank you.

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Operator [38]

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Ladies and gentlemen, thank you for your attendance. This call has been concluded. You may disconnect.