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

Hey, good morning or good afternoon depending on where you are. I'm Samik Chatterjee. I cover hardware and networking footprint at JPMorgan. The next company we have the pleasure of hosting at the JPMorgan Virtual Tech Forum here at CES is Viavi Solutions. I have the pleasure of hosting Oleg Khaykin, who's the CEO; Henk Derksen, who's the CFO; and Bill Ong from investor relations as well. So thank you all for taking the time to host this session with me, definitely look forward to the next 30 minutes. I do want to remind even before I start with the questions for Oleg and Henk here is that investors have the option of sending in their questions as well, and I'll ask on your behalf. I think there should be something on the website where you can send your questions in, so please use that.

Oleg, Henk, thanks for taking the time. I think, Oleg, we were discussing this offline, obviously, with the spike in Omicron cases, one of the things that I did want to get an update from you on is things appear to be stabilizing or improving a bit back in November around the supply chain. Now with the fresh spikes, I mean, how are you thinking about the impact of this? Does this pull back some of the improvement of the supply chain we're seeing? Just give us your thoughts around that as a starting point here and thanks again for participating.

Thank you. Pleasure to be here and good morning to everybody, good afternoon and happy new year. So as I was saying in December, we felt that December quarter was going to be the trough in terms of the tightness of supply chain. And we were proven largely right. We have seen a lot of the constraints relaxing and we've taken opportunity to actually build up some inventory of raw materials and components as they became more available. And I would say we've seen significantly more components that had long lead time, lead time shorten and components becoming available, and we promptly took some delivery. And we are now in the process of reassessing our future orders. As the lead times get reduced, you obviously have to recalculate your expectations on how much inventory you need to hold and what your orders are going to be. So I think there's still obviously some challenges on certain parts. I mean, FPGAs continue to be somewhat tight but getting better and better. Some of the more, it's primarily, I would say, these kind of mid-life nodes, kind of I'd say, of 14-nanometer to 28-nanometer range is where the capacity still remains to be a bit tight. But even there, we are seeing lead times and availability improving.

No. That's helpful. Is there, I guess, just let me follow up on that, Oleg. Like if the Omicron overall was to spread a lot more to these Southeast Asian countries, do you see any risk stemming relative to the supply chain from that or do you think largely, at this point, the supply chain knows how to handle most of these kind of new disruptions and there should be a better outcome than we've seen over the last 18 months or so?

Yes. I don't think that's going to be an issue. I think everybody pretty much knows now how to operate in this environment. And from all the at least data we are seeing, Omicron, it's less lethal, less disruptive than the prior versions of COVID. So I think in many cases, a lot of these countries there they have already close to natural immunity or people had it. And in any case, they do know how to operate. I think the bigger threat to supply chain continues to be in China, the energy rationing. I mean, certain factories have to work reduced hours and things like that. But even there, people are finding ways to operate by swapping credits with neighbors and things like that. So I think generally, at this point in time, the supply chain has been very well adapted. And there's plenty, I would say, buffer stock sitting between or building up to provide a smoother operation.

Oleg, I mean, I'll go through a lot of the questions that we usually kind of ask you about the demand check and et cetera. But let me first up here, given kind of what's changed overall over the last couple of months, get your views on the very hot topic here, which is all the back and forth between the Department of Transportation and AT&T and Verizon on 5G deployments. Given your position and the insights you have into that ecosystem, just share your thoughts about what's probably the likely outcome here that you think is probably where the industry is headed as a resolution. The delays that we've seen, which was 1 month back in December, has been extended by another couple of weeks, what that means for, again, the ecosystem of suppliers and their readiness for deployment. Just kind of talk us through this kind of new topic that's been coming up a lot just because of the back and forth on this.

Well, as I have mentioned, we've been kind of working on it before it became the big news for the past 3 months. It kind of came up about 3 months ago as the early warning. And the reality is globally all radio altimeters operate between 4.2 and 4.4 gigahertz range. And given that this is kind of, I would call, a Goldilocks spectrum where everybody, every operator wants to have their frequencies, a lot of the tenders put it close enough. And everybody can dismiss it and the technology is designed, in a theoretical world, it should not be a problem. But we all know it's never a problem until you have a first major incident. And if things can happen, they will happen because there's a lot of older planes with older radio altimeters, the build-out and deployment is not always uniform. There is always a chance that some of the 5G signal or other signal that operates in that range can bleed into that spectrum where the radio altimeters operate. And that is the FAA's concern is they've been burned with Boeing by dismissing some of the potential problems and that obviously resulted in some very tragic accidents. And I mean, this is one area that when you're doing instrument-based approach or if you're coming in the really bad weather, a radio altimeter is the most critical thing you have. It gives you the distance between ground and the plane. And nobody, I mean, I think there is going to be a solution. I think it's going to be a combination of monitoring. It's going to be a combination of power cycling in the base towers on the approaches. And I know there's a lot of testing and there's some really advanced work being done by the U.S. government and a lot of the entities affiliated with FAA that do this kind of testing, and they're not going to take just a service provider's word for it or the OEMs, they're going to determine for themselves and most likely they're going to put some margin of safety on it. So I think the 5G will be deployed, but there will be a lot of constraints and monitoring put in place to ensure that it stays that way. And by the way, it's not only a U.S. problem, it's a global problem because nobody is going to go and retrofit 40,000 aircraft out there that have radio altimeters. And what they're going to do is, and depending on the country, some of them have less of a spectrum crowding around that area, some have more. So I think there's going to be iterative set of solutions and monitoring to make sure that the safety works. And for Viavi, just happens to be a very good thing.

Got it. No. I mean, it sounds like the way you're thinking about it. I know I saw some comments from the people saying that they're not going to ask for more than a 2-week delay that they've already asked for, but sounds like you think there's more rigorous testing that needs to be done that probably delays this further than what's been promised at this time.

Yes. You can do all the testing you want in a lab. But the moment you do in the field, you need to then supplement it with a field testing under different weather conditions. So for example, if you have a very electrical storm or big storm, you can have harmonics of various frequencies get generated depending how things are changing in the atmosphere. I mean, that's the thing about wireless. So all you need is you just got to make sure that whatever spurs or bleed out gets into the radio altimeter spectrum it's substantially weak signal enough or there's enough guard bands that it does not interfere with the function of the radio altimeters.

Okay. Good. So moving on from that topic, but that's a great way into the NSE group and how should investors think about it, particularly around calendar 2022. We did see an acceleration in NSE last quarter. I think revenues were up 24% year-on-year or something like that. Your guide is for a slightly more modest kind of increase year-on-year but still pretty robust. But when we think about the drivers here for calendar 2022 for NSE, how should we think about the drivers, particularly 5G deployments are a bit slower or delayed, how should we think about the drivers?

Well, I mean, the 20-plus percent growth year-on-year was an easy compare because it was a much weaker quarter a year ago. I mean, going forward, we still continue to see very strong demand and a lot of the driver is fiber. And as you can imagine, fiber is everywhere. I mean, we often talk about fiber, but you can also read it into wireless. Every time you deploy a wireless base station, you also need fiber tools and fiber monitoring. So I call it fiberification of the network is going much bigger and much deeper. And of course, the 5G is now entering the real ramp-up phase, and we are seeing a lot of interest and demand for our instruments from the installation, from monitoring deployment. And then there's a whole area of private 5G, which is 5G getting into enterprise, which looks very promising. So while we do have some of the legacy copper like DSL declining, I would say, generally, cable remains fairly steady, and it's really the fiber and wireless that's going to be driving bulk of our growth in calendar 2023.

How much of that growth that you're expecting in calendar 2022 and beyond are you really thinking comes through, in some way, supported by the infrastructure bill or government subsidies for that matter? How reliant do you think this outlook is on that subsidy coming through?

At this point, not much. It's primarily mainstream budgets from major service providers that are driving the deployments. But we are seeing a lot of the RFP, RFQ type activity from Tier 2, Tier 3 operators that normally don't really play in that space. And those players are looking to be the beneficiaries of a lot of the rural broadband and things like that. So I would say we'll probably see more of that type of opportunities popping up later this calendar year and into next year as the money trickles into all these different geographies. But even when it happens, it's still going to be relatively, it's going to be a nice icing on the cake, but the mainstream majority of the spend is being done by major telcos. Now it could well be that they are also getting significant funding from the government and that may be driving that. But I mean, to me, it looks like it's more in line with their traditional deployment schedules.

Okay. Going back to 5G, and you've been with the Cobham acquisition, you've had a fairly robust business in 5G lab testing. You've been vocal about trying to gain share in 5G field test as well. And there your competitors are, I think, Anritsu, Rohde & Schwarz. Those are the more kind of incumbent players in that market. And there's one aspect of it, like how much of a success are you seeing just purely from the basis of being a strong player in lab testing and you're expanding into field testing. How much of a traction are you seeing with customers on that front? And the second part to that question that I wanted to add with that is, how much of a benefit are you seeing from customers saying that I want to work with a regional test equipment supplier where I have better visibility on the supply chain, I don't need to really be disconnected from the supply chain by working with an international company as much. How much of a benefit is that proving based on your relationship with the OE customers?

Well, so I mean, interesting, so being a leader in lab basically gives us visibility on everything that's important and everything that needs to be tested and what can go wrong, will go wrong type scenario. So in that respect, it gave us very good bona fide in talking to the service providers. And in fact, in many cases, they view whose equipment the NEMs are using, and they think they're using Viavi. So in many ways, a lot of that equipment gets written into the maintenance manuals and things like that. So in that respect, it has really been, I would say that's a must-have, but there's still a lot of work to be done. So by being already there, it gave us entry into the market. And then, of course, once you're in, the next leg right now as we go into the deployment, we need to market also directly to all the installation contractors and things like that who are less familiar with Viavi. So that is really right now is all of our marketing, all our outreach is to the contractors. In terms of the regionality, actually, I think we are not seeing any of it. I mean, in fact, customers want the best available equipment and they want to know, they're looking what the NEMs are using in their own field trials and they generally try to use the same thing. Now there are some exceptions like countries like Japan. They always like to work with their own Japanese. But even now there, I'll say, in Japan, we've been extremely successful, all things considered, taking a nice chunk of share from the, you call it the local team, right, Anritsu. And I mean, they're clearly going to have quite a bit of share because it's just Japan. But in a market which is extremely partial to domestic suppliers, we have taken significant cut. And everywhere else, it really is not an issue.

Okay. Just on that, well, the customer, the broad customer base that you work with, and if I particularly now take the future technology road map and if we talk about O-RAN a bit, what are you seeing in terms of engagement with nontraditional customers at this point? Is O-RAN able to already drive some new customers to come into the ecosystem where you're increasingly having those conversations?

So O-RAN is a very interesting thing because what it does, it expands the customer base beyond the usual suspects, right? You get a lot of these new entrants or even companies like, let's say, like Dell or Amazon, Facebook, they are all looking at what kind of play they're going to do in 5G networks. And that brings them to the table, and they are basically buying a lot of our equipment as they try to understand and develop solutions to take advantage of the 5G deployment. So in the test business, you want 2 things that drive your business. One is number of customers and the second one is number of uncertainties and problems that they face. 5G is giving us both. It's actually allowing the field to expand all the potential players in there. And we all know that it's a very revolutionary new technology and there's a lot of issues everybody is running into. So if you want to use 5G for your autonomous driving, well, guess what, latency and extensive testing is going to be required. And that is really playing right to our core competencies. So in that respect, we are seeing O-RAN being a big driver, even though not so much in the deployment as of yet. Remember, as a test company, we make money when people just consider that it's going to be something going to happen and they develop products. But even further up, you look at U.S. government, I've never seen so much interest from the 3-letter agencies and the armed services in 5G network. I mean, they're actually some of the biggest buyers of equipment as they are looking all the different ways as they try to revisualize their operations down the road. And in that respect, it's very interesting. And it all today falls under umbrella of private 5G. And if you look at any big names like Ericsson, Nokia, Samsung, private 5G is a huge topic of conversation for them because that really gets them into the wireless enterprise, right, for a lot of applications. So we do think that could potentially expand the market well beyond just the service providers.

Okay. Let me take one of the questions that came in from the audience. So I think it's 2 parts really. So the first part is about the FAA and the AT&T, Verizon issue. We're talking about constraints. Have FAA-related 5G issues delayed any of the deployments? The second part to that question is, is component availability better than expected? And if that's the case, can it drive upside to revenue given lower constraints? So I'll let you take one at a time.

Well, I'm not aware that any of these FAA issues have slowed down the deployment because it really just popped up in the last, I'd say, 2 months in earnest. So a lot of the equipment that was being delivered continues to be delivered and it continues to be installed, whether it's going to get turned on is another question. And clearly, it really only impacts the areas on the approaches to the airports, right? It doesn't impact the rest of the 5G. So I think there is going to be a lot of, I think that discussion is going to continue well into 2023 and there's going to be a lot of additional trials and things like that. I just don't see FAA just giving a blanket go ahead. Politicians, remember, you get blamed if something goes wrong, right? And of course, operators want to make money. And guess who has a more impartial view. So I think there's still going to be quite a bit of discussion and testing and delays. But I don't think it's going to slow down the rest of the 5G deployment, but there's probably going to be carve-out zones until this information becomes valid. In terms of the supply, for us, we never really missed more than about 5% of our revenue. It's like 3% to 5%, the worst case when we had shortage of components. So now that's become available, clearly, it will just improve our, whatever, like 2%, 3%, we may leave on the table any given quarter because of the slippage on the components. I think that probably will get resolved and we should be able to provide quicker commitments to the customers. So I mean, it obviously should be a bit positive on our revenue side.

So maybe changing gears here and let's talk about SE a bit specifically around your plans with SE. I remember like the last Analyst Day that you hosted, you were still really thinking about SE, to focus investments in SE related to where you can see synergies with the NE group itself. More lately, you've been more talking about ramping up investments in SE to drive that to be a stronger growth business over time. So maybe just, I know you haven't done an Investor Day recently, but give us an update on how you're thinking strategically about SE, where does it make sense to invest on that front?

So I mean, I think everybody should mark their calendar for the September of this year. We're going to do our once every 3-year Analyst Day, and we'll talk a lot more about it and then people will see the in-depth. About 4 years ago, we really restructured our SE business. We cut it back to focus on a profitable core. And then we said, okay, well, we're not going to fight the 3G and 4G battle. We're going to really target if we are going to get back in, intercept the 5G. And that strategy has worked very well for us. And we are seeing, we've now had 2 quarters, as I say to my GMs, 2 quarters does not make a trend, but the momentum is there and it's moving in the right direction. We are getting very good reception for our products. Our 5G story very much resonates. The private 5G plays very well to our capabilities. So we do, we are cautiously optimistic that SE could become the next growth driver for us. And obviously, it's a very attractive segment once it starts growing again. It's a very high margin obviously as it's a software. So it's a contributor to the gross margin. And we are also running, continue to run a very disciplined model for that business. We're not throwing limitless OpEx just because it's a software revenue. Every dollar of revenue we bring in comes in profitably. So I mean, there's a lot of software companies that are losing money hand over fist and all they talk about is growth. And they will never make any money because in the end you've got to have OpEx that is sustainable to maintain the revenue. And we do believe we now have the right model and the right products to take our SE segment and turn it into a growth segment.

Okay. Again, let's just move to another segment here. And if we talk about 3D sensing business. I mean, one of the things we've seen here over the last 2, 3 years is there was this huge optimism about where 3D sensing can go. And then as the Android camp didn't really adopt 3D sensing as quickly that some of that optimism has faded. So maybe talk a bit more longer term, one, like where is Android today? And then stretching beyond, extending beyond smartphones, do you really see an opportunity for the optical filter when it goes to like automotive LiDAR, et cetera? What kind of opportunities do you see for the optical filter in non-smartphone opportunities?

So I mean, today, it's largely an iOS phenomenon for 3D sensing. And we have a very good position in that market and the road maps in all the future applications. So we feel pretty good about this business. Clearly, Android has been a disappointment. But never say never. I mean, there's plenty of people, especially in China, are still trying to get it to work. And we do think, eventually, there will be at the very least a world-facing camera, time of flight, 3D sensing. And as it comes, it will be a welcome upside. But for now, we are focusing on the applications with customers who are big incumbents in that space and they have many new products on the way leveraging 3D sensing. And so for now, we think for all practical reasons, that's going to be the mainstream market. If Android and any player, probably will be some Chinese players, if that happens, it will be a very welcome upside. We don't really budget or count on it. And the big R&D activity today is around the automotive. And we are working with every major player from the car manufacturers to their Tier 1 suppliers to the technology providers. And in the end, I tell my team, we don't care who wins as long as we design with everybody. And when it comes, it will come. But let's be practical, automotive, every time we say automotive at a 3- to 4-year lead time to it. But you got to be in the R&D process, you've got to be in the labs with all the key customers in order to benefit down the road. But we are seeing also the 3D sensing being adopted a lot into industrial automation. So volumes there are not as big as the mobile handsets, but the ASPs are typically order of magnitude higher because the unit volumes are lower.

Let me bring in Henk here since he will be in charge of giving the margin guidance at the September Analyst Day. So really a two-part question for you, Henk. One, as investors try to think about the long-term margin trajectory here or kind of what your guidance might look like. Firstly, like we are in clearly an inflationary environment, what is the kind of, how do you think about the confluence of being able to pass pricing through to customers as well as this inflationary environment not being temporary but being a bit more permanent and impacting long-term outlooks? And the second being what's the, then as we start to think about margin expansion, what are the real drivers, underlying drivers for the business?

Yes. Great question. And again, thank you for inviting us and happy new year, everyone. So on the inflationary environment, we've been looking at this, tracking it closely, and we've been implementing price increases. So we're seeing inflation. We think inflation is real. It's not transitory. We think it's there to stay. And we've been successful in passing this on in terms of price increase. We're monitoring it very closely, and we have the ability because basically, especially in the NSE business, most of what we do is a book-and-turn business, and we have the ability to adjust pricing. And pricing for us not only means increasing list prices. It also means thinking about discounts, being smart about it. So we've been successful in passing on prices so far and able to keep margin levels consistent at prior levels. Now in terms of the outlook, I was excited. Investor Day is coming up this year. And compared to the plan that we shared with you 3 years ago, we're ahead of our margin profile and we continue to be ahead here. The big drivers for margin upside and margin expansion going forward is revenue growth, leverage on revenue growth, especially in the NSE segment, where the incrementals are extremely attractive. If we grow the NSE business, it's not only accretive to our overall gross profit margin, but it's especially accretive to the operating profit margin line. So it's revenue growth within the NSE business that drives margin expansion. And within NSE, as Oleg spoke about a minute ago, the SE business and growing the SE business is especially accretive to our margin profile.

As a quick follow-up here. I mean, you mentioned the incrementals are really high for any revenue growth that you get in NSE. And we talked earlier about the investments in SE, although you're not going to really throw money at it. But how do you think about the investments in SE impacting that incremental margin that you're thinking about or would you rather be very disciplined about the investments in SE so that the incremental margins can remain very strong?

Yes. I think we will continue to be very disciplined here. We made the investments. We believe we have the investments in place. Doesn't mean that we not continue to invest, but not at levels as we grow revenues. So revenue growth will outpace the growth in R&D.

Got it. Last quick one, let me squeeze this one in before. I know we are out of time. On your M&A, just talk about, first, how much of an appetite do you have then as you still think about SE investments, do you foresee M&A on that front? And then M&A broadly, like how are you thinking about the pipeline for the broader other segments as well?

Sure. I mean, clearly, we always have an active funnel. I mean, we are continuing to be very disciplined as to what we're willing to pay. We've made a number of bids on certain properties. And just the expectations where the deal ultimately closed was above our appetite, where we felt was prudent so. But we do continue to find good opportunities on a smaller size where we actually get the technology and plug it into our distribution model and get the significant leverage. We find that, that type of deals work the best for us. And on SE, you're well aware, I mean, the multiples of semiconductor company, I mean, the software companies are just crazy. I mean, semiconductor multiples are also crazy, but software even more egregious, right? So what we find is we go outside the U.S. The intelligence is not a sole domain of California. We're actually finding very good technology, very good talent in Europe, in Asia. And we look to acquire it and integrate it into our value proposition and then use our global footprint and marketing and sales arm to drive the sales. And that model seems to be much more attractive for us and work well for us in the future. Now that doesn't mean there's no opportunities for transformational deals, but they need to make the right math for us to consider something of that scale.

I know we've run out of time. So thank you, Oleg, Henk, Bill. Thank you for taking the time. This has been great. Thank you.

Thank you and happy new year to everybody.

Happy new year.

Thank you, everyone.

Bye-bye.