Viavi Solutions Inc. (VIAV) Earnings Call Transcript & Summary

Good afternoon. This is Samik Chatterjee. I work at JPMorgan, and I cover some of the networking stocks as well as some hardware stocks. The next company we're hosting is Viavi. And we have Oleg Khaykin, who is the CEO; Amar, CFO; as well as Bill Ong from the Investor Relations here in the audience. So thank you all for making it to this conference. Thank you all for participating. Let me just start off with asking Oleg here to maybe -- Oleg, if you can start off with a bit of background about the company, just to introduce the company to new investors in the new -- room. Thank you.

Thank you. Good morning, everybody, here. My name is Oleg Khaykin. I'm President and CEO of Viavi Solutions, and with me here is Amar Maletira, who is our CFO. Both of us joined this company about 4 years ago when Viavi got -- when JDS Uniphase split into 2 into Lumentum Solutions (sic) [ Lumentum Holdings ] and Viavi. Viavi business, for those of us who are new to the story, is a test and measurement company for field instrumentation for telecom and datacom and wireless networks. And the second business of our company is Optical Security and Performance Products. About, let's see, 2/3 of our revenue comes from network test and measurement, and that includes instrumentation as well as the test and measurement software and assurance software for public networks. And the other part includes optical security pigments for anti-counterfeiting applications and advanced thin-film products, thin-film optics as well as the fast-growing new segment for 3D sensing. So we are the leader in 3D sensing optical filters and Engineered Diffusers.

That's great. So Oleg, if we can start off with kind of the big theme for the networking equipment industry, particularly in 2020 where everybody wants to just discuss 5G and that's kind of the only topic on everyone's mind mostly at this point. What -- where do you think we are in North America and maybe if you can touch on some of the international regions in terms of 5G investments? As well as when you kind of think about the pace of investments, how you're thinking about kind of the upside opportunities as well as the risk around that pace of investment?

Sure. Well, I mean, our view on the 5G cycle is more akin to the 1G. It's not like a 4G deployment, which was very -- fairly quick, with majority of deployment happened within 3 to 4 years. We really view 5G is going to be a decade-long, maybe decade-plus deployment. If I use the baseball analogy, North America, I'd say, is in the first inning; Korea, I would say, is in the third; Japan, maybe third, fourth; China is probably still also third, fourth inning given the size of the country. So it's very early deployment. What we're seeing today is just a lot of -- everybody, frankly, is hyping the hell out of that story, but the actual deployments are actually being happening is taking much longer. 5G network, unlike 4G and 3G, is entirely different topology and a completely new technology and as such is taking longer. Our play in 5G spans from the system test, where we start playing -- at the moment, people build base station and telecom gear and do the simulation and testing in a lab in test and production. And then when the product goes into deployment, we supply field test and measurement equipment as well as the assurance solution to optimize the wireless network.

Traditionally, Viavi has had a bigger presence in the lab equipment side. How -- what are you seeing in terms of large network equipment manufacturers being positioned in terms of releasing 5G-compliant products into the market? And how are you thinking about kind of sustainability of the growth on the product side once the early deployments are done?

Sure. Well, when we look at the deployment, clearly, companies like Huawei are pretty far along, and they have a very strong domestic incentive as well as the subsidies to roll out the network and build the critical mass. Pretty much -- I don't want to opine on any of the other customers we have. But they are at various stages of delivering the products. They all have at least the initial batch of products rolled out to the market. There's a lot of troubleshooting and optimization going on as they start their field trials. There's a second theme developing with the operators, really pushing this time seriously for open radio access network, ORAN, standard and insisting that there is a greater level of interoperability. And we are seeing that there's -- this time around there's much more willingness on the part of the NAMs to play that game than before. So I think, clearly, there's a lot of trials going on. Everybody has shipped their products. Some are doing better than the others. Some are not doing as well as the others. There's -- but I'd say pretty much across the board, there's a lot of debugging and a lot of learning as to what it takes to operate effectively the 5G network in various markets.

Maybe on a side note, if I can ask you, you mentioned 5G here will be very much similar to 1G deployment in terms of trajectory. How do you think 5G [ will be different ] relative to 4G and kind of the trajectory for Viavi in that case and the implication there?

Well, I'm old enough to actually remember 1G deployment. It was my first job out of college. I was working for Motorola. And 1G deployment meant engineers went in the field, climbed up the towers and connected the equipment to try and figure out what was going on. And through that, we developed rules of thumb. We developed the procedures that technicians eventually were able to do that. In many ways, what made 1G so tough, it was a completely new topology, architecture, completely new technology, a lot of unknowns. In many ways, what we see with 5G is the same thing. It's a completely new topology of the network. Unlike going from 2G to 3G to 4G, you had pretty much the same topology of the network and you just upgraded equipment with better, faster, broader, more automated, more capable equipment. With 5G, maybe with not stand-alone, you could kind of ride the 4G wave where you could put some initial 5G capacity or capability on to the 4G network, but it nowhere near addresses the 5G promise. So really, once you go into the not the stand-alone deployment and others, it's a completely different ball game. And different operators are looking to 5G to address different challenges in North America. There's a lot of interest in the fixed wireless access in areas like Asia. I mean clearly, density is a big problem. So they're looking to resolve the spectrum density challenges. And of course, the whole millimeter wave promise that has a long way to go before it gets to work. So I mean, from that perspective, I think we are in the early learning stages. And if you really look at deployments in some of the early markets like Korea and Japan, there is now a second way of going back and figuring out how to make the equipment work better and learning from the initial deployment.

Great. So there are 2 distinct market opportunities here, one being the lab equipment, the second being the field equipment. So can you just remind us of the addressable market that you see for lab and then compare that to the field equipment? And how do you feel about Viavi's position in each of those segments?

So the lab equipment for us, and I want to differentiate, when we say lab, there's many labs. There's a chip design lab, there's the board, the box design and then there's a system test. So we don't play in the chip design and the board design. We play in the system test. So if you are a NAM, you're developing a base station or a wireless router. You have a system, and then you need to test it on one side against thousands, tens of thousands, hundreds of thousands of mobile phones. You've got to run emulation protocol test. And on the other side, you want to test it against the 5G, 4G core of the network. We provide the solution on both sides of your box. On one hand, we do emulation testing for significant -- we emulate tens of thousands to any number of user devices. And on the other hand, we provide the core emulation to see how your equipment works with the core. So that's what we define as a lab for us, and that's -- our customers are all major wireless equipment OEMs. Now the -- what drives that business is very much the new technology development, but also evolution of standards. As 3GPP and ORAN evolve, you have to continuously deliver new protocols, new codes to make sure that your previously designed equipment and new equipment is compliant with all the different standards. The same equipment is sold to the service providers as well as the compliance labs that are now increasingly looking to test ORAN compliance. So that's where we play on the lab side. The next step from lab is production. Once you design your products, you've got to put them out. You have to run some type of test on all your production units. So there, you use fairly similar type of equipment, but more streamed down with less bells and whistles to test the production testing.

[ Any way ]...

In terms of position, we are well north of 80% market share in that market. So we pretty much see every OEM, every deployment, every compliance being run in the market.

Okay. Great. So given kind of your market position, where do you think the kind of the largest market share opportunities for Viavi are? Particularly, if we focus on the field equipment side, how do you think about kind of who amongst your competitors is kind of the weakest and you can go after? Which regions are the most -- easiest at this point in terms of market share wins?

So our play into wireless network is relatively new. JDS Uniphase and subsequently Viavi were predominantly known for fiber testing, cable and telecom network tests. With the acquisition of Cobham assets, the old Aeroflex business, that kind of propelled us into the 5G wireless testing. And the lineage of our 5G test actually goes all the way back to the early days of Marconi. So that's the U.K. business. That's their lineage. So we are very deep -- we gained through acquisitions significant depth of understanding of the wireless, but more of a system and a network wireless test. Through that -- and that's a big market. We're already a major player, and there continues to be growth in that market. But the bigger opportunity I see for us is as the deployment starts for Viavi to enter the wireless field instrumentation, we are market leader in fiber, in DSL and in cable, and we see an opportunity to piggyback on our strong position in the lab and in the field trials to develop a portfolio of field instrumentation to carve out a nice market for ourselves. We have already rolled out our portfolio of products. We are in field testing with various service providers. And I view that when the deployment starts in earnest at the end of this year, early next year, that will present us with an opportunity to build a field instrumentation in the wireless space. And in many ways, wireless space is fairly primitive when you compare them to cable, DSL and fiber. In cable, DSL and fiber, field maintenance and field testing is highly automated. It's very small instrument, fairly unsophisticated technician. Today in wireless space, it's still very sophisticated technician with very expensive, inflexible instruments. What Viavi brings to the table is, yes, we can capture the same data in test and signal analysis and all the things that a very expensive test equipment do, but we do it with a workflow management in mind, which means automating field deployment. It's very important because if you look at the challenge being faced by service providers, to fully deploy 5G when it's all said and done, we're going to have 5 to 6x more sites than we have in 4G. You don't have enough technicians and trucks to roll all over there to do all the nitty-gritty, sophisticated installation and testing. Thus, we believe a more automated, more virtualized test that we can bring with our expertise to the wireless space presents us with a good opportunity to build a wireless test instrumentation. In terms of the players that are in the market today, it's companies like Anritsu, Japanese, some Rohde & Schwarz, but it's mainly more -- they more do kind of lab instruments that are kind of have been bastardized to work in the field. They don't really have a, what I call, rugged field instrumentation that is highly automated.

You mentioned fiber testing as your core capability. Maybe just help me, help investors also think about this fiber densification is obviously one of the major themes as we look at 5G, but there's also been kind of warning signs put out by the fiber manufacturers in terms of cautioning on how much fiber densification happens in the near term. Particularly, somebody like Corning has mentioned that a lot of service providers and cable companies have pushed out fiber densification. So what are you seeing in that terms on the ground? And are you seeing any risk to kind of the fiber testing segment that you have?

Well, I mean, it's a very good question. I mean you've got to understand the market dynamics. I mean in the last 2, 3 years when fiber companies like Corning and others were having a field day, everybody was asking us, "How come you guys are not seeing so much fiber?" Well, it's a different story. They have a big [ blimp ] for 2, 3 years when they build out a lot of fibers and lay a lot of fiber in the ground. We see business for the next 7 to 10 years, as that fiber gets [ lit ] up and as the ultimate [ end ] fiber termination connections connect to the end customer. So that's the different nature of our business. We don't have this big feast or famine in fiber deployment. We live off of the actual service being turned on. So with densification, we see -- it's kind of a virtuous circle. We see the metro/core is being upgraded because you see telecom and cable and wireless carriers are pushing fiber deeper into the field. And now with the 5G, you've got fiber running all the way to the antenna. So every end point now has a fiber, right? Before, you had a coax cable. So for us, it presents a great opportunity because every one of these connections need to be tested. It's kind of test before connect because if you have a contaminated fiber and you connect it to the board, you will crush the glass and you'll have to throw away thousands of dollars of hardware to replace the connectors. So when we see all these things coming together deeper, well, now when you're a wireless installer, you're no longer thinking about RF testing. You've got to connect fiber. You've got to connect Ethernet. You've got to connect wireless. Well, we have technology depth in all these fields. So when we talk about field instrumentation, it's no longer just wireless RF testing. Our instrument comes with the antenna test. It comes with the fiber test. It comes with Ethernet test, and it comes with the RF test. So it's all-in-one. So for us, when we talk about this densification, it starts with the metro, where you upgrade the core. So you sell very expensive, kind of high-speed test equipment and software. Then you get the trunk upgrade. That's more test equipment. And then you have all the way final connection to the end user, be it the sell-side or a home or a business. And then you need [ plain ] OTDR to certify the instruments. So in that respect, for us, we -- our sales grow with the actual end user connectivity and turnaround of services.

Got it. Okay. That's helpful to understand. Let me check if anybody in the audience has any questions, or I can move over to another kind of set of questions that I had. So maybe let me move over to more financials-related question, and maybe this is more for Amar at this point is we've seen a big transformation in the P&L itself where the margins on the NSE group or the operating margins have gone from roughly 0% in fiscal '15 to 12% in fiscal '19. Walk us through kind of the big driver of that improvement. And how do you think about the kind of headroom from here on in terms of margin improvement in the NSE group?

Yes, sure. So when you look at -- yes, it was 0% in fiscal '15, and we delivered about 12% in our fiscal '19 number. So it was a significant improvement in operating margins. And when you look at what we did, it was going back to the business -- the basics of the business. We looked at our product line, our product portfolios. We restructured product lines that were unprofitable. We were very surgical in the way we drove operational efficiency across all the functions. For example, in R&D, we talked about it during the Analyst Day how we consolidated platforms and drove efficiencies in R&D. We drew efficiency in sales. We have less number of salespeople and higher productivity from sales. We drove efficiency in marketing, even in G&A. We closed down legal entities. We shut down sites. About 30% of the sites were shut down. And so that's the basic stuff. And also, we did a very -- we managed our costs very tightly, and we continue to do that. Additionally, I think we have now created an operating leverage in the model where $1 of revenue, a significant portion of that drops to the bottom line because we -- our philosophy is if we were driving x percent growth in revenue, we will drive our cost much lower than that. Now moving forward, I think, as I said, there's an operating leverage in the model. That is point number one. Point two is we continue to have a funnel of operational efficiency programs that we'll continue to drive. As an example, and we've not talked about it much, just yesterday, we went live on a new ERP system. We have been working on upgrading our ERP in both the front end and back end for the last 2 years. We've been investing in that, and now we have gone live yesterday very successfully on our new ERP system. Now what does that mean? We had -- if you look at our company, we have about 1,750 key processes, and of course, the derivatives of that, about 1,750 key processes. Only 50% of those were actually automated. And by going to this new ERP system, we'll have almost 75% to 80% of those automated, which means we'll drive more efficiency going forward. Now once we brought our classic Viavi onto this new ERP system, we are now working on bringing our 2 key acquisitions that we did from Cobham, AvComm and Wireless, which are on different IT systems, on to our -- on to the Oracle IT system that we have. So that will drive more efficiency there. By the way, we have already realized the synergies for that business when we acquired and integrated the business. So whatever we were going to drive further, the cost savings will be on top of what we have generated, right? And so that's -- those are the programs. We still have a lot of legal entities to close because as we do acquisitions, more legal entities get added, more cost; similarly, more real estate sites that we have to go close. And so there's more programs that we're going to run. So what that means is in our NSE business, we have an opportunity to go expand our operating margins from 12% to 14%, while driving about 2% to 5% growth on the top line. So the top line also will be an important element in margin expansion. And overall for the company, we'll go from 17.5% to about 20% by fiscal 2022. That's our guidance and which will be a result of margin expansion both on the test and measurement, which is the NSE business as well as margin expansion on our OSP business. Because as we start scaling 3D sensing, our gross margins will improve in that business because now we have the scale, and we are expecting that business also to have a good margin expansion.

You mentioned the 2% to 5% growth on the top line for the NSE group. The concern that some investors might have is there's always a lot of focus on CapEx spend from AT&T, Verizon. And all of these telecom service providers have generally been publicly communicating either flat CapEx or modestly declining CapEx, which is leading to concern for every networking equipment supplier that how can networking equipment suppliers have revenue growth when the overall CapEx is really moderating. So what gives you confidence in that kind of 2% to 5% number? And kind of what's the visibility into that that's driving that...

Sure. So I think our business on the field side is more of an OpEx play than CapEx, right? It's not necessarily CapEx for the test and -- for the service providers. And also, we talked about 2 secular growth trends. One is in wireless driven by 5G. And in the field instrument business, where our market share is minimal, we probably -- we want to get to 30% of the market share. As Oleg talked about, on the field side, there's a big opportunity. And then secondly, on the fiber side. So we believe that these 2 businesses will be -- today, when you look at fiber plus wireless and look at the mix of our portfolio, it is roughly 2/3 of the mix of our NSE business in the growth areas. And we believe the wireless business should grow high single digit to low double digit and our fiber business should be growing low single digit. And our base business, which is roughly 1/3 of that business, should decline slightly, mainly on the access side. So I think we feel good about the guidance we provided of 2% to 5%. Barring some huge -- so macro meltdown, I think we are sort of confident that, that is achievable.

I would add one more thing. The -- as Amar said, we are more driven by OpEx, which is a very interesting phenomenon because similar to what we talked about fiber earlier, and you mentioned companies like Corning, in the last 2, 3 years, there's been a lot of capital spent by service providers. For them to monetize and get return on that investment, they have to sell services and turn on the customers. For that, they need our equipment. So really, the demand for our equipment is driven by them trying to grow the revenue and margin and actually turning on the new services for which they bought all that equipment and spent all that CapEx. So in that respect, the OpEx trend kind of follows the CapEx trend.

Let me do a check again if anybody in the audience has any questions, or I can move to -- okay. I can move towards 3D sensing kind of as a topic. What are you seeing in terms of adoption of 3D sensing both on the world-facing and the front-facing side, particularly with the Android OEMS? And at this point, we know it's consensus that Apple would have a world-facing adoption of 3D sensing, where it would be interesting to know what you're seeing in terms of interest levels from other OEMs in kind of doing the same.

Well, I mean, given our market position, I mean, anybody who deploys 3D sensing, whether front-facing or world-facing or rear-facing, is good news for us. To the extent they do time-of-flight, it makes it even better for us because we have both diffuser and filter. About 2, 3 years ago when we started initial shipments, we had one customer, one device. That was pretty much the market. And it was very volatile. We had a very strong September, December and pretty much nothing in March and June. Second year, things got better. There was more models. And then last year, we now started seeing more Android customers coming in, and it still was very much only one socket, so to say, per device. And this year, and I'm not going to comment on customers, but there's multiple customers who will be rolling out world-facing cameras, and that effectively doubles the number of sockets for us in every phone. And I view 3D sensing as an inexorable trend. I mean the mobile phone manufacturers are leading the charge. The market is exploding. I mean the facial recognition is becoming key. The reality of the 3D sensing that's done in a phone is much more accurate. You cannot [ fool it ] with a photo. For security applications at the airports and elsewhere, the technology is catching on as well. And of course, the next big wave will be automotive. I mean we are pretty much engaged with every LiDAR or ADAS system developers because they're all looking -- they're using infrared spectrum for sensing. And that's really, I'd say, once, I mean, the consumer electronics wave starts to plateau in the next several years, that's when I think the automotive is going to start taking off. Even though this trade show has got a lot of focus on ADAS, I think -- I'm skeptical that you will see anything till '24, '25 in terms of any kind of major deployment aside from the luxury cars in-cabin gesture recognition because I think a lot of the automotive applications need to undergo a lot more field testing for safety and reliability reasons.

You've now owned RPC Photonics for, I think, over a year. And when you made that acquisition, I think the rationale was to be able to bundle both the filter and diffuser on a lot of the applications that you have. So what are you seeing in terms of trend in adoption of both of them together by your OEM? Is that playing out roughly the way you imagined?

Sure. So I mean, one of the biggest synergies from those 2 companies is your go-to-market strategy. When you go to a module manufacturer or a handset manufacturer, you need your salespeople, you need your application engineering, you need all the support. While if you only have one socket, all that cost sits on one filter. If you have a filter and diffuser, there's virtually no additional cost in that. So clearly, that was one big benefit. And we're also working -- seeing opportunities to bundle these diffusers by working directly with the laser manufacturers because there is a trend towards greater integration, putting diffuser directly on the laser. And that can give you further optimization and performance improvement. So in that respect, understanding how the whole value chain works from the laser beam to the sensor helps us to drive improvement in both diffuser and the filter products. And when we work with module manufacturers, I mean, clearly, cost is becoming a big pressure on them as the technology becomes more broadly deployed and they are looking for price savings. And clearly, volume discount is one of the things we can offer when we have both sides of the product.

One last question, kind of M&A. I think on the -- at the Investor Day, you outlined kind of a base case revenue target of $1.255 billion. But when you think about kind of the strategy for growth, how are you thinking about M&A in terms of the driver of growth beyond that? And particularly, I think you've also mentioned that some of the adjacent market segments that you're looking into are also in trying to monetize the NOLs that you have at the balance sheet. So just help us kind of put those 2 together, how you think about eventual scale that the company -- you're kind of imagining how the company looks 5 years from now and how do you go about monetizing the NOLs.

So M&A is clearly a part of our corporate development strategy, but it's got to be at the right price, on the right terms. One of the things we're looking for is clearly, anything that can drive scale for us in sales and go-to-market and the R&D is a big plus. We've seen it with Cobham. It was -- basically, we acquired the whole business with virtually 0 investment in G&A and effectively, flat sales organization. That kind of thing, as I call it, go deep. These kind of deals are very appealing to us because they try and give us significant scale and major drop-down into the bottom line without expanding sales organization or R&D organization. But also, as Amar mentioned, with our new ERP system, that -- actually our fixed cost is down. Everything we add on top of it drops down to the bottom line. The other element we're looking for is, obviously, it's got to be profitable. There's -- we have a huge set of NOLs, courtesy of JDS Uniphase, over the past 20 years. We have billions and billions, to paraphrase Carl Sagan, of NOLs. And for us to make meaningful use of it, we do not want to buy PowerPoint companies. We need to buy companies with real products and real profits. And to the extent we can shield these profits against taxation, we get significant increase in the amount of profit that drops to the bottom line. So between the driving the scale in the business and monetizing the NOLs, that's how we see the M&A.

If I can just add, it's more broadly on tax optimization, right? So we have -- in addition to what Oleg said, we have been operating at 17% to 19% tax rate for quite some time. And we have been working on our tax optimization initiatives, too. We've not been talking about it more publicly because it takes time. And we have a strategy where we will -- we are trying to go execute on strategy to see if we can optimize the tax further. It might take a couple of years. For example, just to give you some more color, we pay about -- 80% of our tax that we pay today is in 3 tax jurisdiction outside of the U.S. And we are now looking at how do we -- and those are China, France and the U.K. U.K. was not a big element, but with the acquisition of this asset from Cobham, it's a very profitable business in the U.K. So we are looking at how to optimize the tax by using a super distributor model and other tax strategy. And so that's also part of our funnel of opportunities that we will continue to drive, and those are sort of fiscal '21 and beyond.

That's all the time we have, but thank you for taking my questions. Thank you for participating in our conference.

Thank you.

Thanks for having us.

Thank you. Enjoy the show.