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

We will get started here. Welcome, everybody. We're happy to have Viavi here with us today. We have Oleg Khaykin, CEO; and Henk Derksen, CFO, with us. I'm Meta Marshall. I cover the networking space here at Morgan Stanley. I'm going to start with a brief disclosure that if you have any questions, please check morganstanley.com/researchdisclosures or check with your sales representative on any disclosures. So I think that's enough time to say disclosures in one sentence, we're covered. We're seeing a lot of CapEx cycles kind of across service providers right now. And so I think maybe it would be helpful just to start with where you guys are exposed to those various CapEx cycles? And how you can kind of help aid them along in these CapEx cycles?

Sure. Well, I mean -- so when you think about a service provider, a CapEx cycle, that's usually when there's 2 of them, right? One, when they build out the network, when they lay fiber, for example, it's a lot of digging. So we participate in that because when you're laying fiber installing, you got to certify, you got to test it and so on. And then when they're buying equipment from NAMs and installing in central offices, that also obviously needs to be certified and verified and things like that. And so in that perspective, we do sell some equipment. We are part of that cycle, but it's by far not the biggest part of spend. The bigger part during the first phase of the cycle is the NAMs because when they are shipping equipment, they need to be testing it. So there we sell into the production. So -- and then once it's all installed with some delay, the deployment starts when they're rolling out the services. And that's normally where we see the bulk of their field instruments. So if I look at it, we really don't depend on any one particular step in the cycle. We play along the entire life cycle during the development phase of the NAM's equipment, during the production phase and the installation and certification and maintenance and monitoring. Maintenance and monitoring is usually the bigger bulk of the spend. But we also, I'd say, probably maybe 50-50; 50% on the field and maintenance, and then 50% would be in the R&D and production and deployment.

Got it. That's helpful. Maybe sticking with the NE business for a second, how have your discussions with customers changed? Or how has their buying patterns changed as we've seen this rapid, more distributed traffic over the past couple of years? And how does that reverse as we kind of maybe reach an equilibrium now?

Well, I think the -- clearly, everybody realized most of the networks were designed to really just pull data one way. And there was, of course, enterprise networks that were 2-way. Well, when everybody started working from home, all of a sudden, you had an asymmetry. So there needed to be a lot of bulking up and expansion of the network. So that's where a lot of the, I'd say, demand was in the past couple of years. What we are seeing now -- and the other element that's changed, I'd say, in the last 2 years, I'd say Europe and Asia are still as good as ever strong and growing, but the biggest change was in North America. And for the first time, I would say ever since I joined Viavi about 6 years ago, we are seeing the big service providers are going back to managing and building and optimizing their networks. And this whole era of content and all that is now behind everybody. And it's all about a race to be the best network provider, have the most efficient network, the most cost-effective, highest quality, best service. So -- and that's been a big deal because even though we have diversified significantly from the North American market, North America is still good 40% to 50% of our business. So to the extent that piece is not coming back and spending money, and there's a lot of catch-up that needs to be done, especially among the big telecom service providers. Cable players have always been spending and maintaining their networks, but it's the traditional telecom, AT&T, Verizon wireless carriers. We're seeing a lot of catch-up and expansion of the network. And that's -- we are benefiting significantly from that.

Okay. Perfect. You're seeing -- obviously, that's driving strength in kind of the fiber field products, both here and in Europe. Can you just talk about maybe the trajectory of that business? Should we think of it as driven by some of the infrastructure builds that we're seeing? Like, just how to think about that fiber business over the next couple of...

Well, so I think about -- there's -- it depends on the carrier, right? So like in North America, clearly, companies like AT&T have always had -- they owned twisted pair plan for the last 120 years. Well, DSL has come to end of the line, and you cannot compete with cable, you cannot compete even with wireless. So one thing they are -- really set of core strategies become on the fiber-to-the-home. And that means massive investment and -- which will probably take a good part of that decade to really rewire everybody to have a fiber to the home. And that's what they've been rolling out. And it gives them tremendous leverage, not only because they then capture very high-speed link to the home and become a good alternative to cable for all broadband services, but it's also -- remember, once you have a fiber to every part in the United States, you can hang a small cell on it. So now if you also bring out 5G, you have the core of the network that's ready to go. So that's, I guess, specific to North America. Companies like Verizon always have a lot of fiber as they're also investing in fiber, of course, the 5G as well. And in Europe, it's a national mandate. Europe, unlike U.S., most of the people had DSL whereas here, we all have cable, right? So cable was a natural high-speed broadband into the home. So in Europe, I mean, it's now become a national mandate. Like in U.K., you have a BT Openreach, and their goal is to use to connect every single home in -- by 2025, which looks like it's going to slip maybe 2026, '27 to the fiber. And that's a combination of more than -- see, before, in DSL, we would sell only a meter of field instrument. When it comes to fiber, we are selling on both ends of the network. In the central office, the whole fiber monitoring infrastructure, it's racks of infrastructure equipment. And then, of course, in the field, the meters and various types of equipment to monitor and test fiber links.

Got it. I mean a question that we often get from investors just around kind of this transition to fiber is that Europe is clearly moving to all-fiber, whereas in the U.S., cable has at least indicated that they're going to kind of hold on to coax for a while longer. Just -- do you see that as a mistake for them to try to kind of hold on to coax? Or...

No, actually, people that are saying -- I mean, I wouldn't even call cable companies cable anymore. Really, with the exception of the last 100 or 200 yards, it's all fiber already. And remember, for the last link, coax cable can easily give you gigabit speeds, right? So that's pretty good for home. And the only one, I'd say, hurrah left in cable is the next DOCSIS 4.0, and that will be truly bidirection because -- and it's easy. They can do bidirectional. And the only way they can do bidirectional, yes, there is a DOCSIS 4.0 standard, but what allows them to be fully bidirectional, it means they move fiber almost right to your curb or at least into your block. And from there on, they can run -- coax is good enough.

Okay. Okay. Perfect. The Cobham business that you bought brought you kind of a tremendous wireless business and exposure to that. Just how have you been able to kind of co-sell some of the core Viavi products to that?

Sure. Well, so here's an example. Up until Cobham acquisition, we were basically a wireline company, fiber, coax, twisted pair. I mean where we are -- if I say, like, 5 years from now, it will be fiber and wireless. That's it. There's nothing going to be in between. So today, so when we talk about wireless, clearly, 5G is now really starting to ramp up in the U.S., right? And when people talk about 5G, I would actually say there's more fiber content in enabling 5G than there is RF content. So what we've done is we're actually fusing the 2 product lines together. Clearly, there's a fiber that you need to test, like, things, like, for latency and how your edge of your network is working. And so there's a lot of -- all these wireless carriers are buying a lot of fiber equipment. But then, of course, the installation, you need to have both. You need to have a spectrum analyzer, the traditional wireless instruments, but you also need to test the fiber because every antenna, every base station terminates into a fiber. So what we've done is taken our expertise in fiber and the new expertise in wireless and now we are putting out 1 product that does both. So you only need to bring 1 box with you to do the whole installation and certification and troubleshooting of your wireless network.

Got it. I was at Mobile World Congress last week. ORAN is certainly an area where there is more of like a national security imperative to -- to diversify radio sources. And so where -- just how are you participating in this opportunity? What are you seeing in terms of kind of what's going on in your 5G cycles or investment kind of in that area?

Well, so let me start with the economic perspective on ORAN. So ORAN is a tremendous opportunity. And there's -- depending on whether you're an incumbent or a newcomer, everybody will give you their story. But the reality is, it's an executable trend. You have an open network, and even the big players are all understanding that's going to happen. So for us, it's a big deal because traditionally, you'd have maybe 3, 5 major players, and that's all you sell to. As a test and measurement company, you benefit from 2 things to grow your business: complexity and problems with technology and 5G guided in spades. It's a new stuff. Nobody understands it. Everybody is running into a lot of problems, sometimes, at least in case in point, radio altimeters and 5G, right? And the other one is number of customers. And what ORAN is doing is now the number of customers is exploding, everybody entering. They may want to be just a pure-play DU, RU or CU. And everybody is entering that space, and they have to buy at least 1 or more systems. So whereas traditionally, we would kind of see the waves when the big 3, big 5 kind of buy equipment and kind of go into maintenance mode. Now it's becoming a continuous growth. So our business has continued to grow largely because of a lot of the ORAN. And, also because before, when everybody had proprietary network, you just needed a system that tested a black box, ingress and egress. Well, now you have -- you broke it up into 3 parts. So now there's 6 points you need to test, which means you now tripled the number of test points you need to test, and that actually expands the market for us as well. So purely from selfish view of growth, it's all goodness, no matter which direction you look at. And -- but also, what ORAN is bringing, it's enabling a lot of innovation. Everybody is coming out with new applications and things like that. And all of these things need to be tested through -- because you cannot put new software application on a wireless network without understanding how it's going to behave with the network dynamics. And so now even the software developers now need network emulation. And before, we never sold to software companies.

Got it. That's helpful. Maybe turning to the SE business. That business had lagged for a number of years, just given -- getting out of some of the scaling down of some of the legacy businesses, and we're now seeing kind of a turnaround in that business, one with 5G coming out also the NITRO platform. Just what are your expectations here for how that business can grow going forward?

Well, about 5 years, 6 years ago, when I joined, I mean, we had JDS Uniphase bought a whole bunch of software companies. And that was just it, lots of different software packages that didn't really work with one another. Each one had to be invested individually, and they all needed money. So when we looked at it, it's, like, that's not a business we can build. Also, it was too late to participate in 4G. So we radically scaled the expenses back and we restructured that business. And we said, you know what, we're going to put in, in the maintenance mode for the next 3 to 4 years, while I said I want to have 1 platform, 1 architecture that's going to service certain segments really well, and we're going to take 5G as the inflection point by which we need to intercept the market. And that's what we did. So it was very much in a maintenance model. Our legacy ran out and then it's kind of bottomed out at about $20 million a quarter. And it was -- at very least, it was always breakeven. We decided it's not going to cost us any money. And we took that 5 years to totally reengineer the platform completely new architecture. We call it NITRO, but it's really a cloud-centric architecture. So it's really all about where the market is going, and we started rolling it out last year. And last 4 quarters, we had sustainable growth, and it's even before the 5G hit. So we feel we actually hit the market right in the sweet spot. We have a very competitive solution, and we expect this business to grow. I mean in December quarter, they almost hit like $30 million. So we think now high 20s moving to mid- -- low 30s, moving to mid-30s and then to $40 million per quarter run rate is where this business we want to grow. And I'd say now we have 4 quarters of pretty good track record. I'm reserving a judgment to see a bit more. So when we have our Analyst Day in September, we'll talk a lot more about it. Hopefully, by the end, we really have a good story and trajectory to share. But that is a big element. If that becomes a growth part of Viavi, a growth driver, it's a very powerful thing because, A, it's obviously above average gross margin on that business and above-average operating profit once it gets into about $120 million, $140 million a year run rate. So it will be accretive to the top line, bottom line and the middle line.

Perfect. So now jumping into 3D sensing, which everybody -- we would be remiss if we didn't touch on it.

Yes. Sure.

But just -- you guys had some strength in that business this year. Just -- are we -- we've largely been relying on 1 customer kind of over this time. Just what are the opportunities that you see either in the short term or medium, long term for growth in that business?

Well, so in the short term, it's still very much taking very good care of that 1 customer and innovating as they move the technology forward. What it's proved to be is this technology is very difficult. And Android and all the players in it have really miserably failed to master this technology. There was only one company, it was Huawei. They actually had a very good product, but due to sanctions, their high-end business is pretty much dead. So I think eventually, they will get it. But right now, we don't even look at it. So for the -- I'd say for the foreseeable future in the next several years, it's very much mobile phones only, like, 1 customer primarily. So it's kind of fairly steady, flat business. There's obviously some growth in industrial, robotics, machine vision, drones. But it's noise relative to the mobile phones. The next big wave is going to come with the automotive. When you have the cost-effective LiDAR and other technologies hitting the market. And I think it's at least 2 years until that happens. So for us right now, this business is in the maintenance mode and continued advanced development. We are seeing new opportunities like in telecom space and other things to continue to grow our optical business. But in terms of 3D sensing, it's -- I think it's going to be roughly flat for the next couple of years. So -- but we are going after a lot of the industrial, like, military and other segments to continue growing our optical business. Let's say, slower growth and the next step function will be the automotive.

Okay. That's different than some of the messaging of people who are far more excited about the metaverse. And so where do you...

Well, so -- okay. So okay, if metaverse really takes off and meta becomes more than just Meta Marshall, it's -- then it will be one, then our market will explode. But you know what, I'm very skeptical of this thing and how fast is it going to take. I still remember the excitement about Google Glasses, and it was really the stupidest, ugliest thing I've ever seen. But hey, we don't bet on the -- we don't get excited when we see the money, and it's clearly something you cannot live without. I can easily tell my -- I have my youngest is 9 -- 19, and I tell them, no, you're not getting Oculus glasses until -- unless you earn money and buy it yourself. So I just -- I think a lot of these things because the phone is already -- it's -- I'm a big believer in substitution, not in adoption. Adoption takes always longer, and it always takes many years longer, and it's always starts slower. The reason 3D sensing caught on so much because you already had a big installed base of phones, and you had a thumbprint and it was a superior technology, just kind of like CD player was better than a record player, although many of my friends will disagree. But the point is it's a substitution. So in substitution, you will have a very fast growth. When you are relying on a completely new technology being adopted, question is what is it going to substitute against. And I don't see, with the current gas price as many parents are giving $1,000 to their kid to go buy 3D glasses. But hey, if it happens, I would be very happy that it happens because it will drive a lot of business for us. And we are in all these products, and we are talking to those companies. But it's one of those things, like for the last decade, everybody has been talking about and it's still a science project.

Yes. Perfect. Circling through to the anti-counterfeiting business. Obviously, that business has seen a huge spike as we saw a lot of fiscal stimulus over the past couple of years. Just how should we think about the trends in this business? And just what happens as we move to more digital cashless?

So, I mean, reality is we were always digital. I mean the credit cards are digital, right? So you're substituting, really, more against the credit card when you're doing with your phone. But remember, in most of these things, the cash actually sits in the bank. And it becomes like, okay, there's an asset that sits and every time you redesign the currency and things like that, you turn it over. So I don't think -- look, over time, these things will be more and more digital. But if you really look around the world, the number of notes continues to grow year-over-year because in many countries, cash is still a big element. But even as things become digital, you still have to have a hard asset, which is a banknote sitting in the bank against which all these transactions are being done. Now there is like a digital yuan, digital dollar, people are experimenting with that, up to a point and you see every time there is a crisis, the first thing people want, they want a wad of cash. They -- because it's fundamentally going to be -- still going to remain a kind of security blanket so to say. So I think, look, eventually in the end, yes, it will be more -- it'd be all digital, but it'll take a very long time before it gets there. And I think there's a lot of money to be made in that space. And what we're seeing now -- is because even if eventually, you'll see the number of notes going down, the security features on the remaining notes are going up. And that's what drives the tonnage of material that we need to produce.

Got it. Maybe just lastly on supply chain. You guys have been kind of experts. You've used a lot of your past expertise to kind of leverage your position and manage this better than others. But can you just kind of touch on why it's been less of a concern for you guys and that maybe has been for the rest...

Well, sure. I mean, first of all, you have to anticipate. And we saw the shortage coming when -- any time you have a big shop where everybody shuts down, you run and buy a ton of components. We saw it in 2008 and we saw it again when COVID hit. So we actually put a lot of material on the shelf. And unfortunately, that material got depleted by last summer, and then we had to go and procure more. And clearly, knowing the supply chain, knowing where to get the product is important. But also ability -- in this business, if you offer somebody 10%, 20% more, you get the parts. And when your products are in the 65% to 85% gross margin range, and -- that means you're -- say, on average, say, 30% of your -- is cost of goods. Of cost of goods, active components are roughly 2/3, so I'd say 20% of that 30% is that. So if I offer somebody 20% premium, and you don't have to offer premium everywhere, it only moves my cost of goods by 4%. Well, I can easily increase my price by 5% to offset it. So in that respect, I get my unfair share and we can do it. If you are in a business where you are living off of 25%, 30% gross margin, which is a lot of consumer goods companies, well, you're paying 70% cost of goods. And of that, probably about [ 50% ] of 70% is your active components. Well, 20% increase is 10%. So you go from 25% to 15% margin and very quickly, you lose your money, and you cannot afford that. So that's the reality of it. I mean one is being aggressive, and we're not afraid to pay premium to get what we need. And you get a lot of love from all the semiconductor companies when you pay the premium. And -- but reality is, in this respect, we get our unfair share. And I do think the semiconductor supply chain is -- by middle of this year, is going to become, at least for us, fairly neutral. We're not going to be needing to pay a lot of premiums.

Got it. Henk, bringing you into the conversation.

Sure.

Thank you.

Oleg can [ get ] a cup of coffee.

Yes, exactly. Your -- any gross profit margins and operating margins was expanded in the last fiscal quarter. Clearly, against the backdrop where almost everybody else's gross margins are falling for what we just talked about. Can you speak to where the team has changed to increase leverage on this and how you expect that to develop going forward?

Sure. Yes. So gross profit margins in our NE business, 64.4%, up 180 basis points year-over-year, and we've done that with 18% growth, right, so revenue growth was 18%. So it tells you that there is good leverage in the business model. So it's mainly leverage. There is an element of product mix, so product mix. And we've been able to increase prices to offset some of the input costs. So all kinds of favorability in the gross profit margin line. Now we don't break out operating profit margin for NE. We do that for the NSE segment. And if we reflect upon the NSE segment for the December quarter, we ended at margins of 18.7%, again, top line, up 18%, $244 million of revenue. And we're starting to get close to that 20% operating profit margin that's available for this segment over time as we call revenues. So very good operating leverage in the business model, up 800 basis points year-over-year. Operating profit dollars doubled. So it's good to see that. Disciplined OpEx control, good leverage on top line drives a lot of operating profit margin expansion.

Perfect. And I expect to hear more at the Analyst Day about how all the...

Absolutely. Absolutely.

But in fiscal Q2, you also made some changes to strengthen the balance sheet, namely the redemption of the convertible notes. Can you just kind of speak to current capital allocation priorities or just balance sheet make up?

Yes. Yes. So as we reflect upon the balance sheet where we were beginning of the fiscal year and especially since our converts are in the money, they trade in the money, that has an adverse impact on our common stock, create sort of a lid. We thought through what else can we do with the balance sheet? Now the company does an outstanding job in improving its cash flow profile. In 2021, we generated $244 million operating cash flow, $190 million in free cash flow. So we sort of graduated out of the convert class and now have access to high-yield notes, long in tenor. And as we issued those early September still at attractive rates, right, given the U.S. That allowed us to take out roughly now 50% of our converts. We did that in part by offering cash by offering common stock. So these are complex transactions that I think you now start seeing coming through the income statement, but also as a result of reduced share count. As of the third quarter, you will see our share count come down and a further reduction into the fourth quarter. So we extended maturities at attractive rates. We have half of our converts out, still a little bit to go. We have $738 million of cash in the balance sheet with access to revolving credit facility of another $300 million. So we have plenty of capacity.

Perfect. And maybe one of the questions we've been asking a lot of people here is, obviously, any Russia-Ukraine impact that you would think to call out?

Well, I mean, aside of the emotional torment, and I think the -- our -- I mean, really, we have no more than 1% of our total revenue between all those Russia, Ukraine and Belarus. It's not material. So...

Right. Okay Got it. Perfect. And then lastly, we've obviously seen -- you guys have been active in the M&A market. You've also been disciplined in the M&A market. We've seen kind of a reset of some valuations here. Just -- and you clearly have a little bit more balance sheet flexibility now. Just how are you seeing M&A as a portion of the strategy?

So well, I mean, clearly, we have our M&A kind of landscape that we are looking at. And I would say, in the last several months, it's kind of 2 axes: actionability and affordability. More and more of the companies kind of been moving into the affordability bucket. But often initially, when people go down, oh, my stock had dropped, and I'm too low. Well, it takes several months to soak in that, hey, maybe there's a new adjustment and people get used to, okay, well, my valuation may have been too high and now it's the new normal, and then people become more willing to talk. So we are obviously always continue to be looking and we don't comment on any particular progress. But generally, as a framework, we see much more potential candidates in the affordability bucket than we saw before.

Perfect. Well, Oleg, Henk, thank you so much for being here today.

Pleasure.

Thank you for having us.

Good to see you after 2 years.

Yes. Thank you.

Excellent. Very good. Thank you.