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

All right. Welcome, everybody. We're at about a few seconds early, but we'll do that with the research disclosure. So for important research disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. Welcome, everybody. I'm Meta Marshall. I cover the networking names here at Morgan Stanley. We're pleased today to have Henk Derksen, CFO of Viavi. We saw other just last week at Mobile World Congress. So this is a good chance to kind of refresh on some of our conversations.

So, maybe to start with, Viavi has had a wild couple of quarters from a meaningful surprise pullback in spending in any -- in fiscal Q1 to kind of a quicker resurgence. Just what have you seen in your customer behavior over the past couple of quarters, particularly maybe on the NE front?

Well, first of all, thank you for having us, and it was good to see you catch up in Barcelona. Now on the NE side, we came off a record quarter in the June quarter, Q4 of fiscal '22, so results were very strong. And we saw a pullback in September quarter, most notably in the month of September for different reasons, we believe, as we sort of understand that we're now a couple of months further along, we well understand what drove that weakness. We think for the U.S. service providers, part of that weakness was driven by the desire, the commitment around free cash flow and maybe a slight change in capital allocation strategy with rising interest rates, maybe the desire to take some debt out of the system rather than refinancing it. So that drove some weakness in spend there internationally, depreciation of the U.S. dollar, up 6% or 7%, and most of our service providers deal with local currency budgets also drove some weakness there. And as a result, we guided December quarter down. We're happy to report that results came in better than we anticipated. But the weakness is concentrated on the service provider part of our business.

And was that primarily focused on wireless customers, where -- or your cable customers? Just kind of where was that pullback? And then where did you kind of see the recovery the most?

Yes. So [ pullback ] goes on the service provider's part, so call it a wireless deployment, a little bit more than the wireless part, both domestically as well as international. And that's where we actually saw some of the recovery as we worked through the December quarter, November was a little bit better. December recovered a little bit more. And we call that stabilization of demand, which I think is appropriate at this point, where we are.

Yes. Okay. Got it. You mentioned some of that is due to rising interest rates. Some of it was just due to overall caution. But is there any a sense of overbuild or just kind of cycles that came more suddenly than you were expecting?

I think it's a function of macro combined with maybe a little bit more typical cycles. There's nothing in end markets or in future build-outs that would suggest that we're faced with the situation of overbuild. Actually, one of the leading service providers here domestically announced a new vehicle that allows the service provider to further build out networks. So I would say the opposite. But the pull-down was quite significant in the September quarter.

Got it. As we think about some of these broadband deployment programs, government-funded programs, there's a lot of new localized service providers coming into the market. We think of traditionally a lot of these Tier 1s, but -- and those being your customers, just how do we think about you guys going after some of the opportunities with some of these newer smaller service providers or Internet service providers?

Yes. So it requires for us to adopt slightly in terms of our go-to-market. Does it mean that we no longer focus on Tier 1 -- but it means a reallocation of orientation towards the Tier 2s, slightly diet go-to-market model. I think we're addressing that appropriately, and we'll be well positioned to service both and going forward.

Okay. Got it. A big part of your Analyst Day was just this opportunity to cross-sell into customers, whether that be selling more fiber test into your wireless customers, some of the different approaches that you guys were taking. Just the dislocation that we're seeing or the macro sensitivity we're seeing in the market, make people want to consolidate vendors more so that you have more of those opportunities? Or do they just stick with what they had and some of those cross-sell opportunities are longer term?

Yes. So this is what we know and this is what we think. In the short term, we haven't seen any change in behavior, really. And for us, it's about our lab and production and our field and assurance sort of cycle that we're committed to. Selling capabilities to a broad set of customers continues to be an orientation. If anything, if things tighten up a little bit, one [ throw to choke ] is absolutely an opportunity for us. But again, we haven't seen any change in behavior. We think this is macro cycle oriented as things normalize and there's more certainty around interest rates, capital allocation, budgets are being set for this calendar year, we think things will normalize. And we think the business will sort of trough out in the March quarter, and we should see some recovery into the rest of the calendar year.

Got it. Rounding out this discussion on NSE. We just saw each other at Mobile World Congress last week. Viavi was capitalizing a lot of these areas of innovation like ORAN or consolidated network tools. Just what are some of the steps you're taking to address some of the newer growth areas within....

Yes. So we developed a lot of products for that 5G adoption cycle, and we can debate about the pace of adoption of ORAN, but we have a suite of products that you could see last week that tie into that's what we believe is secular plan. So you saw our TeraVM products, for example, you saw some of the field products. And you saw, of course, the NITRO, the SE solution in its comprehension, something we call NITRO.

Got it. I mean, what is -- one of the most compelling tools that I think I saw there was that combined kind of Swiss Army Knife tool where you could have fiber and coax and wireless test, kind of all in one. Where are you seeing adoption of that or ability for service providers to reduce their OpEx almost by having fewer reps in the field than having one multi-tool box.

Absolutely. It's combining our tools with workflow management that allows our customers to become more proficient, more efficient and to detect issues, whether it's a copper-based network, a fiber-based network. And that's some of the tools that you saw on the field side. So it differentiates us. It's clearly a different value proposition than our competitors are able to do. The workflow management is extremely important. It allows our end customers working through contractors to be comfortable that the job has been completed. It avoids repetitive truck rolls. So that's clearly something that's top of mind, especially in this environment where things are getting a little tighter.

Got it. SE has returned to growth over the past couple of quarters, just as that legacy business was worked down, the Nitro product, that you demoed at Mobile World Congress, showed this optimization software for the carriers. Just is it -- NITRO, like what are some of these opportunities you're seeing on the SE side?

Yes. Yes. So the SE portfolio been revitalized. It's been changed quite a bit. And I think we have now a set of products that are very appealing. What you saw was, for example, a capability that allows us to communicate to a different level within our customer base. This is KPI reporting. This is a very sophisticated information that allows a service provider also to [ serve -- grow ] some services. So we're very excited about it. We revitalized that portfolio. It's still a little bit early to sort of commit to a number here. But we've seen the SE business improve from quarterly numbers of low 20s now to mid-high 20 numbers, approaching at 30 million per quarter that we all like to see.

Do you think it will be from more of these kind of monetization tools you can offer them? Or will it be through the more traditional performance management?

No. No. The new tools provide a different [ end ] that allows us to further pull through, land and expand our existing opportunities. But this new [ model ] that we introduced there is clearly an area of focus and orientation and also helps us to develop new go-to-market models, partner slightly different than compare what we did in the past, where we mainly relied upon a direct sales force.

Got it. Just where does Jackson Labs kind of fit into some of your opportunities that...

Yes. So Jackson Labs is a capability we invested in. It sits within our NE business. We have an aerospace and defense business within NE. So it fits nicely into that capability. It's resilient positioning navigation and timing capabilities. We think that we can, with our go-to-market introduce this capability over time into more of a field orientation. That's a source of synergy. So we're very pleased with the capability. It's still early in, but I think we're off to a good start here.

Got it. OSP saw a resurgence during COVID with loosening monetary policy. I think sometimes investors I talk to, just struggle to figure out what is the run rate of this business and just how much of the volatility we're seeing is just fiscal tightening or inventory digestion?

So the OSP business can differ a little bit quarter-by-quarter depending on what's going on. But through the cycles, this business has been able to grow sort of mid-single digits. What we're currently seeing is the business clearly benefited from growth during COVID, stimulus, currency printing enable that growth. Also a little bit additional safety inventory build that we're now seeing being reduced. So the headwinds that we anticipate in the first half of this calendar year mainly a function of folks taking down their safety inventory a little bit. So this business is currently closer to core OSP and account fits closer to 50 million per quarter, and it could differ a little bit up to 60, low 60s per quarter given trends and dynamics within the end market.

So does the 60s require a looser monetary -- looser monetary policy, sorry, stumbling over that. Or is that reprints what would flex you from the 50% run rate up to 60?

New reprints, also stimulus could be a source of growth for this business to be back at that level. Looser monetary policy is part of sort of the more a stimulus' discussion. And so those are sort of the levers that can elevate this business into the low 60s compared to levels we are at today.

And just another longer-term question we get from investors often about this market is just how does the move towards digital payments affect OSP over time?

Yes. So the business has been able to grow. The installed base has expanded during COVID. So the placement on the installed base is certainly something we're seeing. And even at these slightly lower levels that we're currently seeing, the business is still ahead of the pre-COVID levels. So we think the store value of cash is there, is there to stay. We're battling all kinds of digital payment methods for years, whether it's going back to credit card or what have you. And the cash economies are currently driving a big portion of the growth in that business.

Okay. So cash economies in that certain countries where digital payments are a little less penetrated is where you're seeing the growth -- there's just plenty of those societies.

And the feature is typically on the higher denomination. So digital adoption, the lower denominations really doesn't impact us.

Got it. Okay. Because there's less current -- or less...

There's no installed base. We don't have any installed base there.

Okay. That's super helpful. 3D sensing has been a volatile market over the past couple of years and kind of a market where people have expected this next wave of growth for a long time. How are you seeing that growth trajectory of this business and just other opportunities to participate within that market?

Yes. So currently, it's mainly an iOS application. Well, we're all hopeful for adoption of this application within Android, which would be very beneficial. We think that's not short term realistic to anticipate that. So we're looking into other type of opportunities, automotive, LIDAR in cabin automotive are a couple of examples. And there are added applications ARVR, although lower, lower volumes that are on horizon as well.

I mean some of the laser producers have spoken about sensing, versus 3D sensing as a growing opportunity. And is that the same opportunity for you where there's opportunities within sensing in general that doesn't necessarily have to be 3D sensing?

There is some opportunity, although that's not something that we rely upon or is it short-term planning, but that's a little bit further out there.

Okay. So we should think of it as maybe autos or an Android still is sort of more near-term opportunities and then opportunities within general [ seeing ] a little bit right around.

Android is not a short-term opportunity for us just because -- yes.

Yes, yes, definitely. Okay. You laid out a 4% to 6% revenue CAGR and 8% to 12% EPS CAGR at the Analyst Day. You were already more cautious about those in year 1. But just given what you've seen in the last 6 months, just how do you view those targets? How do you view those targets today?

Good question. A fair question. I think we're still early in the planning cycle, right? We typically lay out goals for ourselves on a 3-year basis. And as we go back to the last 3 years of '19 to '22, the business was able to grow almost 5% on a CAGR, right? But growth never came linear, right? The growth in the OSP business actually came in '21, but the business expanded quite a bit. The growth in NSE came in the last year of the 3-year planning cycle where grew at 13%. Now off to a slightly weaker start, but we have enough levers and an ability to sort of claw that back. So it's too early in the planning cycle to give up on that goal.

And where does the operating leverage? Or where does the EPS growth in excess of the revenue growth come from?

So we have, of course, leverage on volume is a significant driver for EPS and growth and margin expansion. Our incremental margins on operating profit are roughly 50%. So that's the most significant level we have. But we've bought the level as well. We just spoke to a modest but still not insignificant cost restructuring program. We're taking our shares and we're buying back our shares. We're refinancing converts, reducing our convert exposure. So we have other type of levers in addition to, of course, M&A that we just did with the Jackson Labs acquisition.

Got it. We just spoke about Jackson Labs. There's obviously a big M&A conversation happening in test and measurement right now. Just how do you -- you guys have always been active but you've always said it's a difficult environment to find buyers and sellers at similar valuations. Just how do you view that environment today? And does everything that's happening with National Instruments? Or would National Instruments coming off the table have any impact to how you would see that M&A environment.

The National Instruments opportunity is not something that was actionable for us to begin with, right? So the fact that, that asset is in play confirms market attractiveness. So that's a good thing to begin with. Now whatever happens to that asset, happens to that asset, it's difficult for us to have a position from the outside in. But our environment is typically not as target rich. And as we look at M&A, it's always through lens of attractiveness and actionability. We're clearly in an environment where valuation multiples should be impacted because cost of capital is increasing. But we're also in this transition area where the bid-ask spreads are still fairly wide. So in the short term, our orientation is to look at smaller sized adjacent acquisitions where we are confident we can hurdle our ROIC targets. So that's an opportunity for us. And also in this part of the M&A market, we're seeing actually valuations to become a little bit more realistic.

Got it. I mean you've -- I think in the time that I've covered you, you guys have made acquisitions in OSP, SE and NE. Is there any area where you think is more target rich or just more where you see a better growth opportunity in?

No, I think it's equally I think all orientation segments or end markets are in play. Cultivation always takes time. So timing is always difficult to point to. So we have a funnel of opportunities that we're cultivating. And not all of them convert. It's a little bit like kissing box, right? But as they do, we'll report out and inform you.

Got it. I mean you spoke about the actions that you've taken on the convert. Can you maybe just recap investors on some of those actions?

Yes. So the journey started really 2 years ago, where we felt that the convertible notes over the long term, no longer part of our capital structure because of the dilution that it creates and other related issues. So we were effective in refinancing $400 million of convertible notes and just take that high-yield debt here domestically. So we've been through that process that reduce our exposure quite a bit. And more recently, we effectively added 2 years of maturity to our 2024 notes that were about to expire in March of next year in addition to taking out $68 million, [ a stub ] of the 2023 notes that will mature this quarter.

Okay. Got it. And just how do you see your capital or capital return plans or capital structure in light of the macro environment -- so how does it influence...

Yes. So we like a balanced capital allocation strategy, right? So organic initiatives always come first because of the ROIC, the ROIC is so attractive, because the incremental investment on the existing base. Now whatever is left in terms of free cash flow, we believe we allocate on a balanced way. For example, this year, by the end of March, we will have bought back approximately $70 million in shares with the P&T acquisition and a smaller bolt-on earlier this fiscal year, we also would have deployed $70 million towards acquisitions. So we believe in that balance. And that's the strategy, and you have years where you can execute on that balance like this year. There's also years where which is slightly different. Share repurchase for us is purely optimistic.

Got it. I want to see if there's any questions from the audience, all right, perfect. Maybe before I jump into later questions. I just want to get a sense of where in any business, you see the greatest growth opportunity. Because I think some of the questions we get from investors are; cable, there's going to may be bit less coax, wireless is certainly a growth area. Just where is that greatest opportunity for you today in that market?

So on the cable side, our exposure with NE is quite small. So there's not a lot of downside. I would argue, there may be a little bit of upside, especially if we think about another DOCSIS upgrade. The fiber opportunity continues and fiber expansion is, I think, a knowing that decision for most of our customers. And then on wireless, it's really tied to a 5G ORAN cycle. Again, we can debate how adoption will take place. But that's where the wireless opportunity plays the most.

Okay. Got it. So it's still wireless being the biggest growth driver about maybe some of the cable business well small, still being a bigger growth driver. Okay. On the SE side of the business, we spoke about some of these moving into more network optimization points. Where is that -- where you're seeing growth today versus where you hope to see growth? Like, I guess, where are you seeing the growth in SE and then where could that pick up in the future?

So on the products we introduced you just saw last week, we think there is growth in the future. Again, it's a different type of sale. It requires maybe a slightly different angle in terms of the go-to-market and the ecosystem. We think that is where the biggest opportunity is for growth. And in the short term, we're seeing the assurance business doing a little bit better recover. But for the longer term, clearly, that [ can go orientate ] that new product set that we introduce provides us with the most significant growth opportunity.

Got it. And then just given it's the topic du jour and we're asking everybody about it is just where are you seeing the ability to use AI in your products, the ability to use AI within the company to either help your customers with optimization or help within optimization of the company.

It was an AI question.

I got to ask it.

Well, thank you for the question. Yes. I mean, it's such a broad topic. It's difficult to answer when the business is helping our customers and solving solutions. And sort of the concept of AI and driving data and unlocking data is core to what we do. We own a lot of networks. We are in most of the networks. So we have that opportunity to unlock some of that data. So through that lens AI is a significant opportunity for us, right. How we're using it in our company? Not specifically, we don't have an AI agenda, but of course, we're using data in the smartest way possible. Hopefully that answers your question.

I'm sure there's some companies here that would be happy to sell you some products, so we're -- I don't know your AI strategy. All right. Well, with that, I think we'll draw the discussion to a close. But Henk, thanks so much for being here. It's been a pleasure.

Thank you for the invite.

All right.

That's great.

Thanks.