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

Welcome, everybody. I'm Meta Marshall. I head up the networking research here at Morgan Stanley. We're very pleased today to have the Viavi Solutions with us. We have Oleg Khaykin, the CEO of Viavi. We also have Bill Ong, Head of IR, with us as well. And welcome virtually to TMT 2021. All right.

So Oleg, maybe to start. It's been quite the year in 2020, was a more challenging environment for any business, managing both customers' need to have more distributed traffic, but having less budget to spend. How have your customers accommodated to this need? And how have you helped that? And what does the trajectory of that look like into 2021 as we head back to a new normal?

Thank you, Meta, and happy to be here. And thanks for having us. So clearly, when the whole pandemic started, there was a initial shock for a lot of service providers, and they kind of like Wall Street's just put their head in the sand, and they just said, we're not going to go do anything. Well, it didn't quite last that long because in the end, we all went to work from home. And one thing that everybody ran into very quickly is the -- that consumer broadband is good enough for a lot of basic like streaming videos or maybe doing e-mail. The moment you have to work and do 2-way video, it was a -- systems start breaking down. So I would say somewhere by the middle of the summer, a lot of network operators said, hey, you know what, the world didn't come to an end. And boy, we have a lot of problems with customer satisfaction and network maintenance and things like that. And they started triaging, initially just responding and plugging the holes while also putting -- getting more geared up and say what do we need to do, start making permanent improvements, changes to the network. And then we saw like towards the end of the year, so they don't move very fast, but really kind of through September, it kind of got going and it really accelerated in December. And now we're seeing a whole slew of well-structured programs that they are doing, which a lot of it is just upgrading and retooling their networks and really making them more robust, changing the way the spectrum is allocated between the upstream and downstream and so on. And that's, obviously, started it's resulting in a lot of very healthy business for a lot of our field operations products. And in fact, as the things continues to gain momentum, we saw one of the better outlooks for the March quarter because seasonally, we see March quarter is a seasonally down quarter for us. But here, we saw pretty strong momentum carrying over in. And even today, still, there's a lot of serious programs and now more permanent, more capital-intensive upgrades being put in place. And we expect this calendar year to be quite healthy as a lot of these decisions finally manifest themselves in the truck rolls and network performance enhancements.

Got it. I also realize I forgot to start with the disclosures that I have to read. So circle back real quick and just say for important disclosures, please see the Morgan Stanley research website at morganstanley.com/researchdisclosures. [Operator Instructions] So with that, we'll circle back to questions. You mentioned kind of a much healthier environment evolving towards the end of the year. Just any difference in geography or kind of layouts of networks or customer types to those trends you're seeing?

Well, I would say North America was much more volatile last year, right? I mean it's kind of like it was all nothing or all full speed ahead. I would actually amazingly say Europe did not really skip a beat. Even in the downturn, things were happening. Because Europe, actually, most European countries have a broadband upgrade programs already defined and rolling. They might have slowed down a little bit, but they keep moving forward. I mean like, for example, in U.K., you have an open reach initiative that just basically looking to pass every house in U.K. with fiber. And when you have these multiyear programs rolling, you just -- it's -- you get in the cadence and you just, come hell or high water, things are happening and things are doing. And in fact, when the COVID hit, it became that much more important than -- a lot more urgency was placed on it. So -- and I'd say pretty much same thing goes for Germany, France. So we saw Europe actually continue to grow and do really well for us last year. North America was the big down and an equal rebound in the second half. And actually, what's really amazing is Latin America, which is a small market to start with for us, but I mean, it's a good kind of an indicator, it's actually coming back very strong now because they, too, have to work from home. And of course, imagine the quality of networks in South America. They're even worse than in many places in the U.S. So there's a lot consumer demand for improving that. And Asia for us is predominantly [ leaven ] production and engineering test market. And that continued to be pretty strong last year and pretty strong into this year.

Got it. You mentioned there was a moment of kind of relief of service providers of kind of saying, okay, the network didn't break. But they're still having to invest past that point. And so I think we always think of service providers as not spending money that they don't need to spend. So if they kind of made it through the initial influx, what is kind of -- where is their focus? Where are they interested in kind of investing to make sure that they can handle additional traffic?

Well, I think while it did not completely collapse and break, but I mean -- and then again, I cannot speak for the rest of the country. I live in -- well, I lived in Silicon Valley last year, right, in the heart of it. And let's put it this way, I would basically -- if I had important meetings, I would go to the office because I mean my broadband would go down for anywhere between 15 minutes to an hour a couple of times a day. And those -- it got a little better towards the end of the year, but -- and it's usually the peak hours of meetings like 9 to 10 and, I would say, 3 to 4 was the worst performance. And yet everybody had the turn off the video, so you can preserve the broadband and making calls. So I think -- and this is one of the better networks, right? So it tells you something, the issues. And of course, I mean we're not even going to talk about power problems, but it's a different matter altogether. So -- but it kind of generally limped through, but it also identified a lot of political hot potatoes. Because as you imagine, when consumers start complaining and they complain to their representatives, when the Washington gets a lot of complaints, broadband service providers do not like political pressure. So I think in combination of all of this, because the reality is you do have a monopoly for broadband in any given market, right? There's not many choices. And we saw whether through the goodness of their heart or under significant pressure, the thing was on and you have to improve the broadband delivery. And for better or worse, it actually moved in the right direction.

Got it. So within any, you've been upbeat around the opportunity around 5G and the phases of investment, not just kind of the piece that you acquired from Cobham, but the ability to pull through other business. Can you just remind us of the opportunity could be larger and more durable than prior generations?

Sure. Well, I mean, first of all, when we talk about 5G, I mean traditionally, we played with the acquisition of Cobham on the engineering test and management market, right? So it's your big names. It's a service provider labs and so on. With the 5G deployment, we're entering also field instrumentation market, which is about -- basically about $300 million market, and we think we could capture anywhere between 25% to 33% of the market. And because of the -- we always thought it's going to take longer rather than shorter for 5G to be deployed. It's actually taking even a little bit longer than we thought. I think end of this year, it looks like really the year at time that things are going to start rolling out. But the net-net of it, it gave us an ample opportunity to develop a full portfolio of products required to play in that space. And today, I'd say we probably have the best field instrumentation suite for tax and construction and deployment groups. And what's even more to that is when we talk about 5G, we cannot talk just wireless, we also have to talk fiber because fiber and 5G are symbiotic. Every location you install a base station or small cell needs to have a fiber connection. That means a lot of the fiber plant has to be put in place before you start hanging the new base stations. And in that combination, we feel we are entering a kind of called super cycle of deployment. And the other, what I would say a positive element for our business, 5G is much more like a 1G. In other words, it's a completely new technology. It's not something that a lot of operators are familiar with. And we're seeing it already in the field trials. The problems that come up, they're just like, wow, we haven't really faced those in the 2G and 3G and 4G because really each one of them was really more of the same and more or less newer version of the prior technology. Whereas 5G is a very different way, the signal goes, the antennas work, in how things are being switched and how the network is architected. And obviously, with that come a lot of problems. And if you're in a testing -- test measurement business, that's a good thing to have because the more problems you have, the more test equipment, the more software you buy to figure out what's going in the network until we develop the new kind of rules of thumb how to manage network. And we do view that the whole 5G deployment over the next 5 to 8 years all over the world will be continuously a good driver of our business.

Got it. And just on talking about 5G spending being later on this year. Is that just because that's when C-band spectrum might be deployed? Just timing of your -- when you would see wireless spend versus kind of network spend by the operators?

I think the point here is that hope is eternal because even though we were always treated as the most pessimistic person in terms of when we thought it's happening, we always were like said later rather than sooner, and a lot of people would get upset at us. Well, we're now almost entering the end of 2021, and only now we're seeing trials are continuing to progress. And we've just done a survey of a lot of operators. I mean there's a lot of cities bringing up 5G. Unfortunately, it's only a few parts of the city. They claim 5G, but it's really just a small portion, so we can claim we have 5G. As problems get resolved and equipment starts happening, now the auctions have been completed. I just hope they have money left to buy equipment after all those auctions. But I mean I believe it's going to be a more measured rollout rather than all out because, I mean, I think a lot of operators are feeling rather poor these days, especially after spending $92 billion on spectrum. I mean that's money that could have gone for equipment. So I think there's going to be budget set, and they're going to spend it in a measured way. But also, I don't think people have the luxury just kind of go at their own pace because remember, unlike in prior deployments, you now have 3 -- in the North American market, you have 3 major players, and it's an opportunity to grab share, right? So I think as much as some of the players would love to go slower and rebuild their balance sheets, I don't think they have the luxury. So it's a classical game theory where I think you have to spend, whether you wanted or not, because if you don't, somebody else will try to grab your share. So I think despite the rational financial behavior that would tell you go slow, I think we're going to see things accelerating. That's the scenario that we are banking on.

Got it. I mean in terms of -- on the last earnings call, you brought up 5G as an opportunity for enterprises with a number -- just what do you see as that opportunity with enterprises? And how can Viavi play in that?

Well, we call it like more of the private 5G network. And actually, this is where we're seeing a lot more activity, especially in Europe today already, is the 5G enterprise. And that opens a whole new market. It's more similar to what we do when we sell testing and production equipment to enterprises, like the engineering companies. And that market is driven by budgets, company budgets. You're not just relying on the service provider cyclicality or the dividend payments, what have you. It's down by dollars and cents. Every enterprise spends between 2% to 4% of their IT, and that's the money that's going to get spent. And for the first time, 5G gives them the kind of bandwidth and latency that a lot of like industrial networks need and the advantage there, you don't need to run the gigabit ethernet to every point. So collecting data from sensors, and it enables you to just put a lot more contact points all over the enterprise. And we're also seeing a lot of interest in the -- among the government installations and 5G deployment. So I view that this is like plays very well for us in terms of the -- not only test and measurement sales, but also in terms of the assurance software because that becomes more of an enterprise sale rather than trying to win 1 of 3 big service providers. So if you don't win one, you're kind of out. Whereas when you go into the enterprise, every opportunity is an opportunity for you to win more business. And I would say, last but not the least, is the -- it opens up market to the third parties, so like ORAN. So maybe in the big network deployment initially, operators will go with a tried and true, one of the major suppliers, do the full turnkey, you take responsibility, make it work. Whereas the private 5G network, it's going to be more of an open architecture and people will buy, mix and match different equipment because at the fixed setting, like an enterprise network, it's good enough. And that actually introduces a whole new set of opportunities for us with new vendors to whom we can sell our ORAN test suite and ORAN monitoring and things like that.

Got it. Maybe stepping away from the NSE business. On the flip side, OSP had a phenomenal, particularly second half of the year, driven by both currency and 3D sensing upside. Can you just explain some of the sources of the currency upside and just how we think of some of that strength persisting into 2021 and onward?

Sure. So the -- clearly, let's start with the most basic. When the government make -- governments make stimulus, a chunk of it always manifest itself in cash that's getting injected into the market, right? So the initially, when the COVID started, governments took cash out of inventories, and they send it into the market. At the same time, for about 2 quarters, many printworks were shut down around the world. So you depleted all those inventories. And then there is the -- came a second wave, third wave of stimulus. So now they need to print more. So they reopened the networks and they pulled whatever inventory they had in terms of ink and paper and they printed more. Well, very quickly, they came to a realization, well, inventory hasn't been replenished because it's been shut down. So it created not only more money being sent into the market, it create a big urgent need to, a, replenish the finished goods inventory and then also replace all the pipeline of inventory from paper to ink and pigment, so on and so forth. So now we have this trifecta, the higher end market demand, depleted inventories and depleted inventories all the way through the supply chain. So very similar in many ways, what we're seeing in semiconductor industry, right? So now as everybody is trying to meet this demand, we are seeing effectively our factories are running at 7 days a week, 24 hours a day, full out capacity. And it will take several quarters to catch up to rebuild inventories. And by the way, we've already sent all the -- we generally maintain contractually significant inventories. They're all being depleted. So not only do we need to meet demand, we also have to replenish our own inventory. So even if there is -- we -- for a while, our customers that we have enough for now, we still need to run those factories for more because we need to rebuild our own inventories. And that means absorption will be much stronger than usual. So your margins will be even higher at the lower revenue down the road. So that's really what we are dealing with. And on top of it, the world is converting to more advanced anti-countering features, which using our more advanced technology. And on top of it, there's a lot of redesigns are now being launched. So you have higher demand for existing nodes, inventory replenishment, redesigns and all-in adoption of new features. You get it all together, we feel that it sets us for a pretty nice demand cycle.

Got it. Got it. And then moving on to kind of the 3D sensing piece of OSP. You guys have done extremely well. Is this all just from additional units from your largest customer and addition of different modules? Or are you finding ways to kind of increase content beyond kind of the traditional filter that we would think of?

Well, I mean so far, this space has really been driven primarily by the market leader in 3D sensing, right? 3 years ago, there was only 1 phone, just the world rear-facing camera. Today, we have practically every phone has a rear-facing camera. And at the end of the last calendar year, we saw world-facing cameras being deployed. All of that obviously drove a lot of volume, right? So I mean -- and our volume is driven by the adoption, by the models and penetration of the 3D sensing into the phone, right? And one area that's been conspicuously absent is the Android. It started out pretty good with the Huawei actually having a lot of technological sophistication to do it. But with the sanctions and issues that their high-end mobile phone business has, it's pretty much fallen back. And I think at this point in time, I think Android is pretty far behind in the facial recognition technology for the rear-facing cameras. However, many of them have designed or have designs on the shelf for the world-facing cameras. They just delayed introducing it because they weren't sure how well the market will adopt it. Well, judging from the success of the initial product launch, it looks like a lot of them are moving forward, and we'll see quite a few Android models starting to order it later this year and launching early next year. And we do hope that 3D sensing will spread into Android. And there, we have more opportunities because we also have diffusers as well as filters in Android space. And ultimately, we also have diffusers in the other customers as well.

Got it. And the ecosystem is very -- the 3D -- the ecosystem is very high on kind of LiDAR opportunities within auto right now. Just how do you see those developing, I guess, both in-cabin and out-of-cabin?

Well, we love, auto. It's a great story for to talk about 3 to 4 years out for the assisted driving, right? It is a very complex technology. And it's -- but what we are seeing already now -- and we are working with pretty much every LiDAR company out there. I think there will probably be 90% fewer of them 4 years down the road. They'll be a shakeout, but we're not picking a champion. We're working with everyone, and we hope that whoever succeeds, we are right there with them. Now the situation is a little better with the in-cabin monitoring. It's mainly -- it's already there today, and we are in many of these opportunities. Now unfortunately, volumetrically, it's still very small unit volumes because it mainly goes into very high-end cars. And even if you have a 1 million high-end cars, well, heck, it's more than a daily volume in handsets. So it's -- we can talk about it, but it really doesn't move the needle one way or the other. But it gives you engagement with these customers and allows your factories to get automotive certified. We're now -- all our sites, our automotive supply chain is certified. So that kind of the first big obstacle you got to overcome before seeing automotive demand. And also, the in-cabin monitoring is really much more like a mobile phone. It's a small sensor, small filter. Whereas the bigger, more interesting space is for the assisted driving or autonomous driving, the LiDAR cameras. Because there, the sensors are bigger, the filters are bigger, and you need a lot of other technical performance characteristics.

Got it. Another question we get is just about some of the AV -- AR/VR headsets. And so is that an opportunity...

Yes, it's another -- it's an interesting market, but very small. In fact, it's smaller than the industrial robotics. We sell more filters to industrial robots, and that's a very good market, but the volumes are -- I mean in the end, by comparison to mobile phones, everything is a piggy. It's a teeny, tiny market relative -- so but I mean we could meet the whole world demand with one day production, let's put it that way, right? So just to put things in context and how big the mobile phones are. And I do believe the automotive, when they finally -- the LiDAR starts getting adopted for the driving, I mean, it would become a big second market. But there's another opportunity in 3D sensing. People don't talk about it, but a lot of companies are working on. It's health care. I mean using 3D sensing for metrology, like vital signs monitoring. I mean you already see things from monitoring the blood oxygenation and the people working on blood pressure. I mean everybody and their brother is working and it requires a very sophisticated, much more sophisticated 3G filters. And I mean I don't know when, but I'd say next 2, 3 years, we may see some people finally succeeding and introducing it. And those wearables could become quite big. Those volumes, while not as big as mobile phones, actually, it could become quite significant. Plus the ASP is probably going to be much greater than what you see in the mobile phones.

Got it...

I view there's a lot of opportunity in 3D sensing.

Okay. I think we've checked a lot of boxes there. In terms of M&A, you guys have -- you've been acquisitive. You clearly still have a lot of NOLs. Just how do you think about kind of what fits? Do you look at scale? Do you look at new technologies? Like just how are you thinking about M&A currently?

Well, I'd tell you, I mean, there -- in many ways, M&A is like you get what you can get, right? I mean, while we have a very clear map, what is the must-have versus nice to have. I mean, for us, must-have is to continue to build operating scale, which means you generally want to consolidate, okay? And we -- and acquire things in the place where you're playing because the biggest challenge in our market and the difference from -- like you take somebody like Keysight, they sell to engineering labs. And we have a nice business, it does the same thing. And that business is great because it doesn't have that many customers, and you can cover them with a relatively small sales force, and it has very high operating profit leverage. Whereas when you add the now service providers, there is really -- there's hundreds of them out there. And to hit even the Tier 1, Tier 2 players around the world, you need significant sales force. And that is a big chunk of the OpEx. So anything that we can put more that this sales force can carry gives us tremendous leverage to the bottom line. Because remember, the margins in that space come north of 60%. So every incremental dollar we can sell through our channels drops 60-plus percent to the bottom line, and we really don't need more salespeople because I mean we already cover the world. And in fact, during the pandemic, we were a big beneficiary because we have at least minimum scale. Any smaller players actually lost share because they couldn't travel or get to the customers to win the business.

Got it. Okay. And then just because it's topical. With so many companies kind of moving out of Silicon Valley right now or at least that being written about, you announced a few weeks back you'd be moving your headquarters out of Silicon Valley to Scottsdale, Arizona. What informed the decision? How did you pick a new location?

Well, I mean we have already moved. So actually -- I'm actually in Scottsdale, Arizona. And listen, it's very simple. I mean we do -- it's a combination of 2 things: a, we needed to expand our manufacturing operations for our OSP business unit. And given the -- I mean two of the most important things for us is the availability of skilled labor, ability to attract the top engineering talent. And second, the most important is the stability of electrical power, okay? And our current site in Santa Rosa has big issues with all three. We're not even bringing up the fires and the enterprise risk you run with these kind of things, which has become almost an annual occurrence. So -- and post the split of JDS into Lumentum and Viavi, really most of the people went with Lumentum. So we had a very small presence in the Bay Area. And a lot of the people that we do have in G&A there, they can just as easily work from smaller office or work from home. So for us, when we decided to make this move and make a major investment, we've looked at many locations, and Arizona was a big winner in terms of connectivity to the major hubs, stability of electrical power, availability of labor. And the big deal is regulations. I mean it's got about 1/4 as many regulations on a book as California. So when you have to make a $100 million investment over the next multiple years, you have to think big and decide do you want to stay where you are or it's time to move, and we felt it was a good move. And we got extremely strong support from the governor of Arizona and the Chamber of Commerce and Arizona Commerce Authority. So I mean, as you can imagine, there's a lot of companies moving and it's not -- I mean I love California, but boy, I tell you, it's -- when you separate your -- where you -- a nice climate and all that from the ability to operate, and it was not even a competition.

Got it. Well, that takes us to time. Oleg, Bill, I appreciate you guys being here today. And hopefully, next year, we'll do this back in person. All right.

I look forward to it. Today is actually exactly a year since my last business trip. So I look forward to it. Thank you very much.

All right. Have a good one. Thanks.