EXFO's (EXFO) CEO Germain Lamonde on Q3 2016 Results - Earnings Call Transcript

| About: EXFO Inc. (EXFO)

EXFO, Inc. (NASDAQ:EXFO)

Q3 2016 Earnings Conference Call

June 29, 2016 17:00 ET

Executives

Vance Oliver - Director, IR

Germain Lamonde - Chairman, President, CEO

Pierre Plamondon - Vice President, Finance, CFO

Analysts

Deepak Kaushal - GMP Securities

Tim Savageaux - Northland Capital Markets

Robert Young - Canaccord Genuity

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the EXFO's Third Quarter Conference Call for Fiscal 2016. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded Wednesday, June 29, 2016.

I'd now like to turn the conference over to Vance Oliver, Director of Investor Relations. Please go ahead.

Vance Oliver

Good afternoon. And welcome to EXFO's third quarter conference call for fiscal 2016. With me on the line today are Germain Lamonde, EXFO's Chairman, President and CEO; and Pierre Plamondon, Vice President of Finance and CFO.

A reminder that this conference call will include certain forward-looking statements and/or estimates concerning our intents, beliefs or expectations regarding future events that may affect EXFO. Please note that such comments will be affected by risks and/or uncertainties which may cause the actual results of the company to be materially different from those expressed or implied today. For more information about EXFO, I encourage you to review our Form 20-F which is on file with the Securities and Exchange Commission. Our annual information form is available with the Canadian Securities Commission as well.

Please note that non-IFRS numbers may be used during this conference call. A detailed reconciliation of these non-IFRS results with our IFRS results is available in the Q3 2016 press release on our Web site. All dollar amounts in this conference call are expressed in U.S. dollars, unless otherwise indicated.

So without further delay, I will turn the call over to Germain.

Germain Lamonde

Thank you very much, Vance. Good afternoon everyone.

Let me start with a summary of our fiscal financial results after the first three quarters of fiscal 2016. So I'm pleased overall with the progress of our results so far in this fiscal year, including the performance from both the physical and protocol product groups. After the first three quarters, total sales increased by nearly 3% year-on-year to $169.7 million, while bookings improved 6% to $177.9 million. For a book-to-bill ratio of 1.05 so far in this fiscal year.

Looking at our physical layer and protocol layer product groups, both have delivered revenue growth of about 3% year-on-year while bookings have increased, in fact still in both of them, by about 6%.

Now, in terms of gross margins, our first three quarters of 2016 are showing 100 basis point improvement year-on-year from 61.9% last year to 62.9% so far this year, partially driven by higher software content due to an improved product mix. More importantly, profitability have surged much faster than sales as mapped out in our strategic plan at the beginning of this fiscal year.

Adjusted EBITDA is up 80% year-on-year to $15.9 million after nine months into fiscal 2016. And in fact, we have generated so far more adjusted EBITDA after nine months into 2016 than for the entire reporting period of 2015. And from a cash flow -- from a cash position on hand business standpoint, so far this year we're almost adding $21 million to our cash position. So given the current macroeconomic backdrop and current telecom environment, I believe that we have performed steadily so far after three quarters.

Now let's talk a bit more about the third quarter 2016. Our sales have increased by 5% year-on-year to $60.9 million thanks to our leadership position in optical testing and the early innings in the 100-gig investment cycle. Our instruments business has delivered strong bookings and revenues. While we experienced delays in closing some system based deals which in turn has limited our overall bookings and revenue growth as well as our bottom line results in the third quarter.

I'd like to emphasize that our funnel for large system deals remain very strong and continues to grow. We remain positive about the sector for the long-term having deals pushed out are necessarily a part of growing pains related to transforming and transitioning from a box to a solutions supplier. Some deals were delayed in third quarter. They remain in our funnel and should close in the following quarter or quarters.

As we achieve a certain level of skill -- as we will achieve a certain level of skill in our systems based business, we will better be able to absorb the slippage of a few orders like that.

Looking at our third quarter gross margin, lower revenues from system based solutions along with unfavorable product mix within our instruments business have driven our gross margin down to 60.8 for the quarter. Although our gross margin may fluctuate from quarter-to-quarter, we should finish between our targeted range of 62% to 64% for the fiscal year and a long-term outlook remains positive for further margin expansion.

At the bigger picture level and after three quarters, EXFO is quite on track to deliver on its profitable growth strategy in terms of sales, bookings, gross margin and adjusted EBITDA for fiscal 2016. Moreover, EXFO is progressing well on its transformation into becoming more of an end-to-end solution partner and meeting the emerging needs of communication service providers in that regard.

In terms of market driven innovation, I'd like to highlight the third quarter launch of our LTB-8 Rackmounted platform and 100-gig Power Blazer test module for high-speed testing in labs and manufacturing environments for Internet, OTN, other channel and SDN or SDH technology.

The nice thing about our high-speed offering is that new modules can easily be swapped between LTB-8 for labs and FTB-2 pro for field platforms to ease the transition between lab and field testing. This new LTB-8 and new high-speed modules are additional highly differentiated solutions that makes a real difference in the daily lives of our customers.

Before we move onto guidance I'd like to address the Brexit situation and the potential impact it could have on our fourth quarter results. The decision by British people is causing quite fear in the financial markets like we all know, like the sharp decrease in both the British pound and euro against the U.S. dollar. Obviously there's a higher level of uncertainty surrounding this Brexit decision and its macroeconomic and currency impact, both for Britain and for the rest of the European Union.

From an EXFO perspective, EMEA accounts for 25% year-to-date of which 75% was done within the European Union, U.K. included. So the effect of Brexit in our current quarter remains uncertain for the time being as communications providers in Britain and Europe wait their respective large scale deployment decisions. It's too early to tell if service providers might hold off on bigger ticket investments.

Now let's talk about our guidance for the next quarter. So our financial outlook for the fourth quarter of fiscal 2016 we're forecasting sales to be between $57 million and $62 million for the reporting period. That is extending from June 1st through the end of August and that's comparing with $56.6 million for the same period of last year.

From a bottom line point of view, IFRS result, are expected to range between a loss of $0.01 per share to an earnings of $0.03 per share for the fourth quarter of 2016 and note that our IFRS net results are including $0.01 per share in after tax amortization of intangible assets and stock-based compensation costs. As well as $0.01 per share for foreign exchange losses based on today's exchange rates.

At this point, I'll turn the call over to Pierre Plamondon to discuss our financials. Pierre?

Pierre Plamondon

Thank you, Germain. Good afternoon, everybody.

Sales increased 5.4% to $60.9 million in the third quarter 2016 from $57.8 million in the third quarter 2015 and $13.6 million from $53.6 million in the second quarter 2016. Bookings slightly improved 0.8% to $59.7 million in the third quarter 2016 from $59.2 million in the same period last year and were flat compared to $59.7 million in the second quarter 2016. This amounted to a book-to-bill ratio of 0.98 in the third quarter 2016 and a total of 1.05 after nine months into fiscal 2016.

As Germain mentioned we increased our sales in Q3 largely due to our leadership position in optical testing and the early innings of the 100-gig investment cycle. Gross margin reached 60.8% of sales in the third quarter of 2016 compared to 61.4% in the third quarter 2015 and 64.7% in the second quarter 2016. Gross margin dropped year-over-year sequentially mainly due to less sales generated by our higher margin protocol layer solution in the third quarter of 2016. Indeed, protocol layer sales represented 31% of total sales in Q3 2016, compared to 39% in the previous quarter.

Also, an unfavorable mix within our physical layer product line further reduced our gross margin in 2016. After three quarters into fiscal 2016, our gross margin amounted to 62.9% of sales and based on the expected sale mix for the fourth quarter which results 2016 within a gross margin between our annual guidance of 62% to 64%.

In terms of operating expenses, selling and administrative expenses totaled $20.8 million or 32.4% of sales in the third quarter 2016 compared to $20.5 million or 35.5% of sales in the same period last year and $19.6 million or 36.5% of sales in the second quarter 2016. The $0.3 million increase in SG&A dollars year-over-year can be attributed to IRC commission on IRC 11 as well as inflationary forces. These elements were partially offset by an increase in the average value of the Canadian dollar and euro, compared to the U.S. dollar and year-over-year.

On a sequential basis, the $1.2 million increase in SG&A dollar is also related to higher expenses on IRC 11. But during this period, the Canadian dollar and the euro actually gained strength against the U.S. dollar, which had a negative effect on our SG&A expenses. For example, the average value of the Canadian dollar gained more than 7% against the U.S. dollar in the third quarter compared to the second quarter 2016.

As a percentage of sales, SG&A expenses in Q3 2016 decreased year-over-year and sequentially based on the significant increase in revenues. Net R&D expenses reached $11.3 million or 18.6% of sales in the third quarter 2016 compared to $10.9 million or 18.9% of sales in the same period last year and $10.2 million or 19% of sales in the second quarter 2016.

Net R&D dollar increased $0.4 million year-over-year, mainly due to a shift in the mix and timing of projects as well as inflationary forces in the third quarter 2016. These elements were partially offset by an increase in the average value of the Canadian dollar versus the U.S. dollar year-over-year.

Similar to our SG&A expenses, net R&D dollar increased $1.1 million sequentially as the Canadian dollar and euro gained strength against the U.S. dollars. As a percentage of sales, net R&D expense of 18.6% in Q3 2016 decreased year-over-year and sequentially, largely due to the healthy increase in revenue.

We remain on track to close fiscal 2016 within our forecasted annual range of 34% to 36% for SG&A and 17% to 19% for net R&D. IFRS net earning in the third quarter 2016 totaled $0.9 million or $0.02 per diluted share compared to $0.6 million or $0.01 per diluted share in the same period last year and $4 million or $0.07 per diluted share in the second quarter 2016. IFRS net earnings in the third quarter 2016 included $0.3 million in after tax amortization of intangible assets, $0.4 million in stock-based compensation charge and a foreign exchange loss of $1 million. Adjusted EBITDA amounted to $5.3 million or 8.7% of sales in the second -- in the third quarter of 2016, compared to $4.5 million or 7.7% of sales in the third quarter 2015 and $5.3 million or 9.9% of sales in the second quarter 2016.

Geographically, the Americas accounted for 59% of total sales in Q3 2016, Europe, Middle East, Africa represented 22%, while Asia-Pacific totaled 19%. In comparison, the sales split was 58%, 23% and 19% among the three geographic regions in the third quarter 2015.

In terms of customer mix, our top customer accounted for 5% of total sales in Q3 2016, while our top three represented 14.7%.

Turning to a few key points on the balance sheet. Our cash position increased to $46.3 million at the end of Q3 2016 from $44.4 million in the previous quarter. The increase is mainly due to $2.3 million in cash flow from operating activities. Finally, DSO increased to 66 days in the third quarter of 2016 from 63 days in Q2 2016, while inventory turns improved to 2.7x from 2.3x during the same period.

Now at this time, I'd turn the call over to the operator for the start of the Q&A. Thank you.

Question-and-Answer Session

Operator

[Operator Instructions] And your first question comes from the line of Deepak Kaushal [GMP Securities].

Deepak Kaushal

Hi, guys, can you hear me okay?

Germain Lamonde

Loud and clear. Hello, Deepak.

Deepak Kaushal

Hi, great. Germain, I was wondering, first question, if you could elaborate on the nature of the delays you're experiencing in the system sales and is this geographic based or broad-based or customer situation specific?

Germain Lamonde

It's pretty much across all three regions. We had some deals that were delayed. Not anything that is actually particularly big for our occupation because these deals are not lost. But basically what we learned is that as we're evolving to be more and more of a systems based type of business, we have to also get stronger in our forecasting and our ability in fact to bring the deals to the table faster. The goods news is in all these cases we have very unique differentiated solutions. Clearly, we see very strong customer commitment and looking good for the future. It's just like an impact here.

Deepak Kaushal

Okay. Are you seeing any like new complexity in contracting or in dealing with channel partners with respect to these deals?

Germain Lamonde

No, not quite.

Deepak Kaushal

Just the size of these deals?

Germain Lamonde

Really, in fact we've seen some of that in the past. It's been normal to have a few of those pretty much every quarter. We just had a bit more this quarter. There's nothing in the industry or nothing in the marketplace that makes things either more difficult or it's just a coincidence here that we have a little bit more this quarter than we normally see. We normally always see a little bit of delays on deals like that. We don't quite drive as deeply the agenda for the customers, we can do on the incident side and it's a bit more difficult to predict when there are more signatures to be obtained, when there is more approvals to be obtained, when there are more departments involved in making these decisions.

Deepak Kaushal

Okay. And then, just to be clear on your Brexit commentary, you haven't yet seen any impact and that wasn't related to the delays you've seen this quarter and it's still to early to tell, to know the impact, is that correct?

Germain Lamonde

That's absolutely correct. I would say the stage -- there could be impact on the currency themselves, like what will be the impact and how is that going to evolve today? The balance has gone back up a little bit more towards the end of the day. And what will be the impact of the euro. And I would say this uncertainty is -- we're probably amongst the very first company to report since the decision that was made on Friday last week, on Thursday last week, and I would say it's just too early to be able to really figure out all the details on how it's going to be unfolding within our P&L for the next quarter.

Deepak Kaushal

Okay. That's helpful. And do you have a sense of how long it might take to have some clarity on this? Are your customers talking yet or are they still in shock?

Germain Lamonde

I would say probably like many people in fact not only customers but the human beings behind the customers that are making decisions probably sit in shock to some degree. I think it came as a big surprise to many people. But with that being said, I would say the next two, two and-a-half years more or less by the time the England starts to signal the beginning of the negotiation and the two years window, it's going to take a bit of time. There will be a bit of economic impact. It will be emotional impact going through this. We can hardly predict how customers will actually be reacting. Is it going to have an impact on slowing down some investment plan's. It's hard to predict while eight of the board room along with the telecom operators will be -- how they'll be dealing with that situation across Europe and U.K. and England.

Deepak Kaushal

Okay. That's fair. And helpful. I did also have a question on the cost side, my last question. During your Investor Day, you talked a lot about revamping your go-to-market strategy. I'm wondering if you started to invest in that. There's a small up tick in SG&A, are we expecting to see more of that? Can you give us a sense of what on a dollar basis that run rate would be over the next 12 to 18 months? Are we looking at $20 million, $25million a quarter?

Germain Lamonde

As we mentioned basically there's no headcount impact to be expected in the next fiscal year, nothing to be significant in [indiscernible] between the sales and the marketing organization. It's going to be marginal. The quarterly fluctuation is more coincidence than anything to be reading. There's a big impact there. The main factor that you have to consider here is the fact that there is foreign exchange impact that's reflected through the P&L. So but it's not about like a radical change in anyway, shape or form in our cost structure and don't expect a radical change in our cost structure moving forward.

Deepak Kaushal

Okay. That's helpful. That's helpful for me. And that's all the questions from me. Thanks again, guys, for the time.

Germain Lamonde

Thanks, Deepak.

Operator

[Operator Instructions] And your next question comes from the line of Tim Savageaux [Northland Capital Markets].

Tim Savageaux

Yes. I think that was me. Good afternoon, everyone. I had a question about -- you seem to have a fair bit of strength on the physical layer side driven by optical test, both sequentially and I think year-over-year as well. I wonder if you might be able to provide us with a little more detail as to drivers of that strength. I think you mentioned 100-gig market. But, I did miss your kind of geographic breakout commentary, but I assume -- was from a geographic standpoint that was notable in terms of the optical strength in addition to any product color you might be able to -- product or market color you might be able to provide. Thank you.

Germain Lamonde

Very good question, Tim. First of all, you're right, basically part of the comment we're making is, first of all, all of our incident business is actually done fairly well, and it's like very well in fact in the last quarter and so far in this fiscal year. One of the segments that's doing very well, part of our optical high-speed testing, so that includes both the physical layer optical test and transport layer test for 100-gig. That segment remains strong, with Web 2.0, data centers, operators and that trend is started more in fact initially with the Americas from the Web 2.0 perspective.

The carriers enhancing their capacity and moving up to higher speed, that's basically a trend that's now across all three regions very clearly. We see it. In fact we're getting very good results both in America and EMEA and APAC. The business centers is more of an America trend for the time being but it's also something that we're expecting. We're taking action of course to take advantage of the EMEA and APAC region as well.

Tim Savageaux

Okay. And just to follow up briefly, anything happening on the access side, either in North America or China that's sort of worth commenting on at this point, sort of fiber to the prem, GPON or maybe even 10 GPON.

Germain Lamonde

Well, in fact, the broadband deployment remains like a very important segment. We're making gains in that segment as well. Both our optical gears as well as our access gear or basically copper testing area, we're doing great progress there, quite happy with this. In fact, it's basically been more post of the Q3 thing. There is a lot of good things going on in fact for us in that segment.

Within the quarter, I would say that from the GPON point of view, we see that the trend for GPON being adopted and moving up to -- that's basically the one gig to the home is a trend that's picking up speed and momentum across regions. Some countries will actually be more aggressive than others. But, clearly this is a trend that we see and we're benefiting from that.

Tim Savageaux

Okay. Thanks very much. I'll pass it on. Thanks.

Germain Lamonde

Thanks, Tim.

Operator

[Operator Instructions] And your next question comes from the line of Robert Young [Canaccord Genuity].

Robert Young

Hi. Good evening.

Germain Lamonde

Good evening, Robert.

Robert Young

I may have missed it, but I don't think I heard any update on that guidance that you're providing on the EBITDA, the absolute number of $22 million or greater for the full year. Did you update that or is that -- should we assume that's --

Germain Lamonde

That's a good question. In fact, we said at the beginning of the year that we'd do at least 20. And we updated that. We're thinking that we can do about 20 to about 22. We're still believers it's basically at reach to be above 20 is clearly part of our view that we'll be above 20. And the $22 million still remains at reach right now. The last quarter was a bit more of disappointment on our side from a solutions standpoint but nonetheless we're still believers that we can achieve these numbers.

Robert Young

Okay. Great. And on the gross margins, the weaker margins in the quarter, you said it was driven by mix. Forex, would that also have been a factor or is that mostly mix?

Pierre Plamondon

In the gross margin, the Forex has some impact as well, okay. But the mix between physical layer and Protocol layer has a big impact, as physical layer represented 69% of total sales, okay and this is where we deliver lower margins, okay. And the fact that within also the physical layer sales, some of the products, the product mix within some of the physical layer sales were not favorable as well. So these are the two main explanations. That is with the Forex, but the main impact of the Forex is on the OpEx and this is estimated to be about $1 million of additional expense in the OpEx in this quarter compared to the previous quarter due to the significant strength in the Canadian dollar as an average value.

Robert Young

Okay. And I think last quarter you said that you're hoping to bring margins into the high end of that range given some of the delays on the protocol side. Is that still something you can do or are you still aiming for the high end?

Pierre Plamondon

We're aiming to the high-end but probably will be landing between the midpoint up to the high end, so somewhere between those two targets.

Robert Young

Okay. And so should I assume that -- are you expecting to pull in some of these protocol deals here by the end of the year to support that margin performance, or I guess another way of asking, is hitting the top end of that range depending on pulling in those protocol deals?

Germain Lamonde

Yes. We're expecting the next quarter to bring more of our protocol layer test solutions down to the marketplace. So basically after three quarters, our gross margin is standing at 62.9%. Our range for this year is 62% to 64%. As Pierre was mentioning, between 63 and 64 is probably where we will be landing. But probably that's high to the top of the range. And we were thinking a while back during the days simply with the fact that the last quarter delays are basically impacting the overall result. It's a bit of a disappointment. But again, as we said, there's nothing broken. It's more of a coincidence but we cannot make it all back into the fourth quarter.

Robert Young

Okay. Great. That's very helpful. And last question. Last quarter you also said that you've seen good uptake on the EXFO Xtract solution. I think you said that revenue had had started at the beginning of the year, maybe give me an update on what you're seeing in the market for that solution and I'll pass the line. Thanks.

Germain Lamonde

Very good question, Robert. In fact, we're still seeing a lot of interest around Xtract. Clearly, this is something that has got a lot of traction in the marketplace. We have a very unique solution and we're executing better and better on bringing that to the market successfully. And clearly this is something that's going to continue to have a growing impact on our business. Q3 was not necessarily our best quarter in the solutions side of the house that includes of course Xtract. But fundamentally, the excitement around what we do here is humongous and it really brings basically solution to something that is so critical in the need for [indiscernible]. So thank you very much, Robert, for your questions.

Robert Young

Appreciate your answers.

Operator

And there are no further questions at this time.

Germain Lamonde

Okay. Well, thank you very much, operator. Just in terms of key takeaway before we conclude this call. First, I'd like to point that we’ve delivered so far significant financial results after three quarters of fiscal 2016 with improved sales, improved bookings, gross margins, good cash generation, as well as significant increase in EBITDA year-on-year by 80%.

Second, our assurance businesses have delivered healthy increase in sales and bookings in the third quarter of 2016, but we experienced some delays in closing some system based deals. We submitted our overall top line and bottom line results. Nonetheless, there's nothing broken and we don't think there's any significant issue here to be worried about. Basically I'd like to thank everyone and this concludes our third quarter 2016 conference call and on behalf of the entire EXFO team, I'd like to thank you all for joining the call today.

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