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

We will get started here right on time. I am Meta Marshall. I cover the networking space here at Morgan Stanley. We're pleased here today to have Oleg Khaykin, CEO of Viavi; and Amar Maletira, CFO from Viavi. I'm going to read a brief safe harbor, and then we can jump right into questions. So please note that for all important disclosures, including personal holding disclosures and Morgan Stanley disclosures appear on the Morgan Stanley public website at morganstanley.com/researchdisclosures or at the registration desk.

So we'll maybe start off with the question of the day. So just -- are there any areas of your supply chain where ongoing coronavirus outbreak is having an impact?

So I think just to level set, when we talk about supply chain, we have both internal operations and then we rely on the external contract manufacturers. At this point in time, based on our kind of immediate and near-term visibility, both our internal operations and external operations are running just fine. And we don't see any problems with the, I'd call, first-order disruptions. Obviously, it's much more difficult to say if there's going to be a second-order disruption because we may be able to deliver the product, but somebody else may not. And then the customer cannot ship the end product. So those things we're not aware of. But at least for the first order, our supply chains are back to normal, including our Chinese operations.

Got it. So maybe starting off kind of on the main NSE business. You've made some meaningful improvements to that business [ it grew in ] the last year, kind of with scale and acquisition of the Cobham wireless business. Looking forward, how do you think about continuing to improve that margin? The margins of that business or the scale of that business to be in line with other as measurement peers?

Sure. When we talk about the gross margins or operating margins, it's a different story. So when we talk about gross margins, clearly, mix is one of the biggest drivers of the gross margin. To the extent we sell more products in the -- we grow faster our Service Enablement or lab business. Clearly, it drives the gross margin expansion. To the extent we grow more our field instrumentation, it's on the lower end. So it kind of pulls down the gross margin expansion. Net-net, we are pretty happy where we are on the gross -- overall blended gross margin. I mean, we're not going to lose business. If we see opportunities to grow more field equipment, we're going to grow more field equipment. Because in the end, really the only margin that we really are focused about expanding is our operating margins. And as you've seen in especially December quarter, we have a tremendous operating leverage. So the more top line growth we drive, everything drops to the bottom line, and we were able to hit 20-plus percent operating profits, purely by driving volume in NSE. And to us, NSE is a single biggest lever to keep driving revenue to expand operating margins. OSP business is growing very nicely. And there, we also see a mix. We're seeing more consumer business, 3D sensing. So there, we guide people say, "hey, don't pay so much attention on the gross margin because these different businesses come at different margin." But if you look at the operating margin, we've been able to kind of guide 35% operating margin at the OSP business models.

So just to add to that, we -- similar to what we did in the first 3 years where we had an efficiency funnel, we continue to have an efficiency funnel for the next 3 to 4 years. And then that efficiency funnel will continue to drive efficiency in our R&D organization, as we consolidate platform. As on the NE side, we consolidated from 30 to 6 platforms. On the SE side, we continue to consolidate from 3 to 1 platform, as an example, continue to drive productivity in the sales force. On the G&A side, there are more opportunities as we look at -- we have recently upgraded our ERP system to the latest Oracle Version of ERP, and that's a big step in the direction of driving more efficiencies through G&A, as we can implement more robotics, et cetera. But there are a lot of entities still that we have to consolidate. We have real estate to consolidate. So when you think about the AvComm and Wireless Business that we acquired from Cobham, we have fully integrated from a go-to-market, R&D, et cetera, and operations but the systems are not yet integrated. So as we go integrate the system, we can drive more efficiencies and more cost savings there. So when you think about our operational efficiency funnel, remains very strong. So in addition to the revenue leverage that we have, the product mix that will come in will also continue to drive the cost reductions in the business. We'll invest some of it back to the business, and some of it will be -- will result in margin expansion.

And so I mean, as you think of those OpEx efficiency, it's really -- probably not even all of those are from Cobham necessarily. They're still...

Yes, sure. It's broad, very broad.

We have 25 years of JDS acquisitions that every time we reduce number of legal entities or consolidate them and put them all in the same IT infrastructure, it drives a lot of operational efficiencies.

Got it. Okay. The Cobham wireless business has been pretty much as good of an acquisition as you could have imagined it to be. And looking forward to 5G, it has the opportunity to pull-through kind of other Viavi products. And so are you starting to see some of that traction with this end-to-end philosophy?

Well, I mean, I think it's very interesting because one of the -- I mean, end-to-end, you always like to talk about it. But in the end, each customer wants to buy what they want to buy. What we're trying to do is leverage where we have very strong presence of relationships, let's say, like with the network equipment manufacturers as they go into field trials, we introduce our instruments to them. And one of the things especially in wireless space, a lot of deployments are done by service entities of NAMs, much more so than on fiber or anywhere else. So in that respect, we work very closely with them to show them the tools that can accelerate the -- and automate the installation of 5G. And 5G is a significantly bigger problem because you've got to build out 5 to 6x more locations than in 4G. And you don't have 5 to 6x more technicians. So you've got to do it with the existing workforce. So what they're all thinking, how can I make my workforce more efficient, make them more automated, make them more predictable and drive certainty and predictability of outcomes. And we have extensive experience in cable and DSL. And if you look at the professionalism of field maintenance and rollouts that you see in DSL and cable it's -- or fiber, it's way more industrialized than when it comes to wireless. Wireless is still very much a cottage industry. And we feel by bringing in the technology that we acquired, combined with our traditional strength in workflow automation, we can actually make a compelling case to drive penetration in the field out of market.

Got it. And maybe just kind of circling in on 5G, it's still on very early days. But you noted it would be relatively muted, maybe in the first half of this year. Just what do you see as some of the catalysts for 5G? And when could be, obviously, some of that revenue relative investments?

Well, our view is, it's just physical getting it done. So we watch very closely what the service providers are doing and not look at what they say about what they do. And then at the same time, you have a realization that 5G is a way more challenging deployment than 4G. And it means you need to secure tens of thousands of technicians, equip them with the right equipment, provision all the right of way licenses, so you can hang antennas in additional locations. All that takes time. So when we were talking in last year, people were saying, oh, you guys are being conservative, I know, realistically, how are you going to make it happen. So physical rollout and a lot of brand-new greenfield build-outs, and that's not trivial. Plus the technology is new. And operators are pretty sure bunch. I mean, until they see that something is really working and it's -- they've done all their trials and all that, I think they're just not there yet. So they continue to be doing, they continue to be testing, they continue to roll out selectively. And remember, to make a statement that we are a 5G cost-to-cost network, all you have to do is put a 5G in every stadium in the major cities, and you can [indiscernible] the 5G network. So separating the marketing from the actual deployment penetration, that's how we look at it when we make our guidance.

Got it. And maybe just some of the strength you saw over the last year from Cobham, working out better-than-expected versus kind of your expectations, was it just maybe stronger earlier 5G builds, better market position, just where did you see that strength....

Well, I think the strength is clearly came out of lab. I mean, we have pretty much the preeminent position in system test. And if you work with any major service -- the network equipment manufacturers, they rely heavily on us to make sure that their equipment is field-ready, rollout-ready. And in the testing at [ no jam ] every permutation and as new standards come out, you need to get new software upgrades. And that allows them to accelerate the time to market. Now another big thing happening in the market is the operators are insisting -- really insisting this time that you have -- you'll be in ORAN compliant. It's open radio access network, standard compliant. Well, how do you ensure compliance? Well, you have a -- you need a neutral third-party that you can hook up that equipment to any mix of network equipment, manufacturer's equipment and they all have to interoperate. So that's how we see another big opportunity. Next wave of opportunities for us is to provide test equipment to do the ORAN compliance testing. And we're seeing is now that whole slew of lapse proliferating being set up by service providers and third parties to do the third-party testing to ensure ORAN compliance. So they're actually opening up. Given that we are the leader in the system test, a lot of people coming to us say, "Hey, we want you to also provide ORAN testing."

So it's just build the network. You're at the play for it.

That's -- I mean, pretty much, exactly.

Exactly. Okay. Carrier CapEx has been relatively muted over the past couple of years across a variety of sectors. Do you think that Sprint T-Mobile has the ability to confer that competitive investment? Do you really think DISH is going to build out a network this time? Where do you think kicks off that next investment cycle?

Well, I mean, listen, I think in the end, every service provider they are run by very assured finance people. They do not want to spend more money than they absolutely need to. The only thing that can accelerate and really upset carefully laid out plans is you have an interloper coming in trying to steal your market share. When you are down to 2 fairly stable players. There is a level of equilibrium that exists in the market. Sprint by itself, T-Mobile by itself were just not strong enough to challenge any of the big 2 [ industrialist ] in the North America. But as we see, like in other countries, the moment you have more than 2, and the third one is trying to make a move and carve out share, all the best careful plans become upset, and it becomes a free for all. So I really do think the Sprint and T-Mobile coming together, they now have the critical mass to become a greater threat to be established 2 major competitors. And I'm probably not the best person to opine on it, but I would imagine if they not come together, the next thing you want to do is show more growth and grab more share. And the moment you go for that, that's where a lot of competitive equilibrium will get upset, and it will be the next wave of competition trying to bring out best services to -- in some cases to retain the share and the other cases to grab share. For us, it's a good scenario.

Yes. So maybe moving on to the 3D business, which is what a lot of people -- brought a lot of people to your story that may not have known about it. The market has developed outside of your largest smartphone customers' ecosystem maybe a little bit slower than people expected. And so where do we -- you think we are on the cycle? And you do think we're at an inflection?

I think we're still in very early stages when it comes to the Android ecosystem. I think what people are realizing is this technology is not a slam dunk. You cannot just go into the next contractor and say, "just give me off the shelf." There's no such thing, you got to develop it yourself. And a lot of the contract manufacturers or third parties who are developing these modules were struggling when they really understand, wow, that's pretty complex science. So I think a lot of the initial challenge is kind of now getting behind and people are figuring out how to do it better. So I do expect that to continue proliferate, I think the facial recognition is becoming the norm. It's one of the main authentication reasons. Now we're also seeing this year, we're going to see the first share of the world-facing cameras coming out. And I think that one is going to be a very exciting application. I mean, facial recognition's security and everybody needs it, but there's always alternatives for that, right? And some are better, some are worse. But I think with the -- depending on the set of applications that are going to come out for world-facing cameras, the augmenting realities and all the cool things it does, I really do believe it's going to become master feature. So for us, it's a big deal because it: a, not only doubles the number of potential sockets, it's more than doubles it. Because in the world-facing cameras like time-of-flight, we have 2 opportunities, both diffuser and the filter. And we see very good opportunities for that.

Okay. Got it. And maybe outside of the smartphone ecosystem, auto is always the area that gets talked about. When it's still -- there's a lot of the ecosystem that needs to come together. But just how do you see the rest of the ecosystem?

Yes, I think the technology already exists, except it's very expensive. It needs to be cost reduced before it goes in the cars. So we're already seeing 3D sensing present today in the high-end cars in cabin, gesture recognition, just monitoring if you're falling asleep. So -- but it's a low volume, relatively speaking. We're in all these designs. But it's -- it doesn't move the needle. It's -- not even remotely the volumes of the handsets. The really big opportunities in automotive is the -- I won't say, autonomous, but I'd say, assisted or a more automated driving because there it's not so much the volumes, it's the area. I mean, there, you're looking at significantly bigger filters and a lot more complexity to them. And I think filter is not the obstacle. I think the -- really being able to deliver a solid-state LiDAR is really what it's all about to get that cost per unit down significantly. And there's a plethora of companies working on it, and we're engaged with most of them. And they're all working, they're all developing. And IV automotive is a 2- to 3-year at the earliest opportunity. For us, I mean, we view consumer is what's going to drive, build the scale, drive down cost to drive the yields, create the ecosystem, the manufacturing capacity and then automotive will come in after that.

Got it. And I think investors are clear that if it's security or high accuracy used cases like autos, Viavi is absolutely essential as the filter. Does do that share stay the same when we move to AR-used cases? You mentioned, also kind of the diffuser purchase you have...

Well, in the end, so if you think about the cost of the module, when we talk about a filter, we're talking pennies. When we're talking module, we talk dollars. A slightest yield loss costs you a fortune. And reality is, on cost, on performance, we can outclass anybody in the market. Now we're not going to take profit less prosperity. I mean, we got to make money. But the reality is, I think we are more than capable of holding our own. And on top of it, we have a very strong IP portfolio, which we are not afraid to enforce?

Right, which we have seen of late.

Absolutely.

And just to add to that, we also have a diffuser now, so we have more units and more sockets per unit.

More time...

Than before, when it comes to world facing and time-of-flight.

And maybe building on that, clearly, you bought into the -- or gave the diffuser through your purchase of RPC Photonics. Are there other areas of, kind of, that ecosystem or that module that we should be thinking of areas where you guys could participate?

Well, we're not going to -- I mean, clearly, there's other opportunities in that space, and we are looking at them. One thing we're not going to go -- we're not going to go into the active components because it's a completely different play, we'd rather prefer to partner with a major active component vendors, like lasers and things because we're very complementary, and we can work in partnership. And that's, to us, is a more important opportunities for growth because it creates new channels and new pull-through for our products.

Got it. The OSP business remains a very large, stable kind of value driver for you guys. It's not necessarily a big growth driver, but as we think of -- how do we think of the interplay of influences between reprints, redesigns and the move towards more cash flow and technology than what play that has on the OSP business?

Well, I mean, cashless technology, I think we will all retire, before we'll be truly cashless. And look, I mean, the whole world is not Sweden, right? And in many economies, people -- also remember, you have to really trust government and banks to really go cashless. And in many economies, they just don't have the trust or there is not ecosystem to do it. And in fact, if we look at the actual number of printed notes, it continues to grow year-on-year. And what's even more important the penetration of security features into these notes is nowhere near as penetrated. So there is a penetration driver. There is a number of security features per note driver. And so even if you say, note count is stabilized or starts to decline as long as penetration and the number of features per note keeps increasing, and which is what's happening, we feel pretty good that for the foreseeable future, it's going to continue to be a very good business. We're not looking -- we're not investing dramatically into it. We are not harvesting it. Our goal is to continue to maintain and extract lot of cash, while we invest and grow other businesses. But I see for the intermediate future, it's going to continue to be a very good business for us.

Just to point out, in our guidance for the 3 years, the 3 outlook that we provided during Analyst Day, we assume that this business will be a stable, steady state business without a major redesigns coming in because you cannot really time those redesigns. To the extent that those redesigns come in and they're timed in such a way, it can be an upside to the model. So we see redesign funnel is strong. It's just a question of when countries will start the redesigning new currency notes. And it drives higher volumes. And we saw that in 2016, when you had 2 out of the 3 big cash economies actually redesigning. And there's a big spike in revenue. And the revenue actually grew 39% in that business year-on-year.

Got it. And then on the SE business, which I think I had largely considered to be more in maintenance mode. We had a very strong quarter in fiscal Q2. While some of that was a pull forward of -- or making up some of what had been -- what you expected in fiscal Q1. How should we think about that segment and is there growth in that -- potential in that segment?

Well, so I think we've done significant restructuring of the business. And in the last 2 years, we've been really retooling. And we have not been overinvesting. We've been very disciplined about the spend, but we've been repositioning this business to be -- become a growth driver for the company as well. And today, we have 2 businesses. One is targeting enterprise. We are releasing a new platform where we are targeting not only network performance, but also some of the security applications. It targets a broader customer base. So we do believe we see an opportunity. I mean, in the past, we've never seen a single 7-figure deal. And now we see a lot of 7-figure deals. The problem with 7-figure deals, if any one of them slips, you could have a shortfall. And if any one of them comes through, you have a big upside. And that's what we've seen. We've seen September quarter was weaker because some of those get pushed out. They happened in the December quarter, we've seen significant upside. Also, we've been retooling our service assurance platform. And we view 5G transition as the very good inflection point, where we can drive for a significantly greater share of the market. We've missed -- or JDS missed the 4G transition. We intend to build and have a bigger share in 5G. So that could become a next growth driver for us. Today, our software businesses are not a drag on the company, and we expect them to become a catalyst for margin expansion and growth for the company in the next several years.

I mean, I remember when you joined, that was kind of the dynamic, where the SE had very large deals and NE kind of had smaller deals and you wanted people to switch away from chasing bluebirds, I believe with the [ 5G ] to kind of getting into that normal course business. So how -- like do you just feel like you have better focus of your sales force now where they can -- you can have that interplay?

Yes. So we have 2 different sales forces now. There's one that sells services. I mean, the software, they are very focused on that. And then there's others who are supporting the network infrastructure. And the first thing we did is focus on where you make money. And not only chasing the big deals, it's also chasing them at any cost. The first thing we dropped is that NE cost, right? So we have to become cost -- we cut back the investment and we're really refocused on the parts where we were competitive. And now we've retooled the architecture of the platform. We've repositioned what we're going to address. And I think 5G actually plays to our -- that additional strength, which is much more in the EDGE. Whereas 4G was all about the core. And if you didn't have a strong core solution, you couldn't really make money. The 5G, all the intelligence is moving to the EDGE. So actually having very strong technology on the EDGE, we believe is going to position us well for taking bigger share in 5G.

Going back to OSP. Just a quick question. What's the usual seasonality for OSP into June? And sort of what are the moving pieces we should be thinking about?

Okay. Well, I got it now..

So yes. So I think OSP business and the seasonality is on the anti-counterfeiting side, it's really difficult to predict the seasonality within the year. But when you look at the 3D sensing side because we have one large flagship customer, and typically, the -- or the second half of calendar year, which is first half of our fiscal year is the strongest and then the -- and this first half of the calendar year, which is second half of our fiscal is when it actually goes down and then picks back up in the -- so that's the seasonality depending on how they pull in the volumes.

And as more and more customers come in, more platforms, more vendors, more models, you will still see, I think, the second half of fiscal year is relatively stronger. But you're going to see less pronounced valleys in the second half of the fiscal year, which is first half of calendar year because you just have much more variability.

Just one more question. Just on the gross margin side, is there any reason to think that gross margins would be down year-over-year in fiscal year '21?

Well, we -- well, if the volumes go down, definitely, it might, right, in the OSP business. But at this point in time, we are not expecting gross margins to decline. We're expecting gross margins at the minimum to remain flat or to expand. Now it all depends on the mix of the products in the NSE business, too. Because NSE business in fiscal '20 is -- has a lot of lab business as we go and drive wireless field. Wireless field comes in at a relatively lower gross margins than the lab. And so we can see a sort of a negative impact from the mix. But overall, I think gross margin should be flattish.

And more importantly, operating margins is really what it's all about, is expanding those.

Got it. Any other questions from the audience? All right. You still have a substantial number of NOLs, and so how do you think about M&A, both in terms of kind of the current valuation and disruption we're seeing, but just opportunities to bring further scale to the business?

Sure. I think, listen, clearly, we are -- what we're looking, we're looking for profitable businesses. Because the only way you get NOLs is you got to have profits, right? And I think what we are looking at, these NOLs, clearly, we have some running out in this year and next year, but we're going to have a huge long tail with significant NOLs remaining. So for us, first and foremost, it's got to be right strategic deal, it's got to be profitable deal, but we're not going to go buy a revenue and profits at any cost just to save on taxes. It's got to be the right strategic deal for us as a company.

Got it. And then maybe, we're just finishing, the move of M&A, just how do you think about the capital structure of the business and other uses of cash?

Yes. So I think our capital -- we have about $680 million of debt. Our leverage ratio is roughly about 3x. We'd like to maintain a leverage ratio between 2 to 3x. We had a net debt situation of $150 million. So we have enough of cash against that debt. The way we think about our capital allocation is in 3 buckets, right? First is we do need to invest in our business, so organic investment in the business. We typically run our CapEx between 3% to 5% of the revenue. And the mix of the CapEx changes every year. In 2018, 2019 fiscal years, we were investing in building out our 3D sensing capability. As we shifted to fiscal 2020, we invested in our wireless business because our lab wireless business was growing, so we invested CapEx in that business. And we also invested in upgrading our ERP system as an example. And so as you go through the year, the CapEx will change but it's 3% to 5%. We also will invest inorganically, Oleg did talk about that, it has to be accretive, it has to be profitable, it has to be with technology tuck-ins or driving industry consolidation as an example. And finally, we will continue to retain a -- return cash back to the shareholders in the form of buybacks. We've been -- now we did about $149 million of share buyback in the last 3 years. And we have a $200 million of buyback that's authorized. So we'll continue to do that, and we'll be very opportunistic on how we do that to the extent that we can avoid dilution from stock-based compensation. So that's our capital structure and our capital allocation priority.

Got it. Well, that takes us just about the time. So I want to thank Viavi for being here, and I hope you have -- everybody stays well. Thank you very much.

All right. Thank you very much.

All right, thanks, Meta.