Viavi Solutions' (VIAV) CEO Oleg Khaykin on Q1 2017 Results - Earnings Call Transcript

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About: Viavi Solutions Inc. (VIAV)
by: SA Transcripts

Viavi Solutions, Inc. (NASDAQ:VIAV) Q1 2017 Earnings Conference Call November 1, 2016 4:30 PM ET

Executives

Bill Ong – Head of Investor Relations

Oleg Khaykin – President and Chief Executive Officer

Amar Maletira – Chief Financial Officer

Analysts

Jorge Rivas – Craig-Hallum Capital Group

Rod Hall – JPMorgan

Dmitry Netis – William Blair

Meta Marshall – Morgan Stanley

Operator

Good day, ladies and gentlemen, and welcome to the Viavi First Quarter 2017 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. If anyone should require assistance during the conference, press star, then zero on your touch-tone telephone. As a reminder, this conference call is being recorded. I would now like you to introduce your host for today's conference, Mr. Bill Ong. Sir, you may begin.

Bill Ong

Thank you, Kaley. Welcome to the Viavi Solutions First Quarter Fiscal 2017 earnings call. My name is Bill Ong, Head of Investor Relations. Joining me on today's call is Oleg Khaykin, President and CEO, and Amar Maletira, CFO. Please note, this call will include forward-looking statements about the company's financial performance. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our current expectations. We encourage you to review our most recent SEC filings, specifically the risk factors that are described in those filings. The forward-looking statements including guidance we provide during this call are valid only as of today. Viavi undertakes no obligation to update these statements. Please also note that unless we state otherwise, all results except revenue are non-GAAP. We reconcile these non-GAAP results to our preliminary GAAP financials, and discuss the usefulness and limitations in today's earnings release. The release includes supplementary slides, which include historical financial tables, are available on our website. Finally, we are recording today's call, and will make the recording available by 4:30 P.M. Pacific Time this evening on our website. I would now like to turn the call over to Amar.

Amar Maletira

Thank you, Bill. Fiscal Q1, we have a revenue of $210.8 million, it was above a guidance point of $209 million, and delivered revenue above its guidance mid-point. Revenue decline of 8.2% year-over-year was driven by the expected pullback of OSP revenue from its peak of $64.2 million a year ago, and also the expected steep decline in revenue. Viavi's operating income at $27.5 million declined 4.2% year-over-year. Operating margin at 13% exceeded the high end of the guidance range, and was up 50 basis points year-over-year, the result of good operating expense management. Overall, Viavi operating expenses declined 12.4% year-over-year, up $14.6 million, driven by expense reduction and R&D spend optimization. EPS at $.09 exceeded the high end of the guidance range, and a 12.5% increase from the $.08 EPS a year ago.

Now moving to the results by business segment, starting with the NSE performance. NSE review at $155 million declined 6.3% year-over-year, driven by a 24% decline in the segment, which was partially offset by NE, which grew roughly 1%. As a reminder, although Q! 2017 is a normal 13-week quarter, the year-ago quarter was slightly longer at 14 weeks. The year-on-year SE decline was impacted by the steep decline in products, as well as the decline in the enterprise business. Any revenue was slightly up from a year ago, driven by mid-single-digit growth in our lab instrument business, while our field instrument business was flat. We saw continued strength in our fiber products, which grew double digits, partially offset by softness in Access and Metro products.

NSE growth margins at 63.7% declined 220 basis points year-over-year. This decrease was primarily due to gross margin reduction in our SE segment, which decreased 11.2 percentage points, compared to the same period a year ago on unfillable product mix from lower enterprise revenue, coupled with lower margin, in a growth assurance business as a result of acceptance of solution by a key customer. Any gross margins at 64.3% improved 90 basis points on fillable mix, and good cost management. NSE's operating margin at 2.6% increased 110 basis points year-over-year, primarily due to continued operating expense reduction in this business. The book-to-bill ratio for both NE and SE was below 1.

Now turning to OSP. OSP revenue of $55.8 million declined 13.1% from year ago levels, driven by the expected inventory adjustment in our anti-counterfeiting business. Gross margin at 56.6% fell 100 basis points on lower volumes, and unfillable product mix. However, through better operating expense control, operating margin of 41.9% improved by 90 basis points from last year. Moving to the balance sheet, our total cash and investments ending balance was approximately 1 billion. This includes the remaining 3.4 million shares of momentum, valued at $141.1 million, as of fiscal Q1. Also during the quarter, our OSP segment received an advanced payment from a customer to expand capacity to meet the long term needs. During fiscal Q1 we had 3.9 million Lamentum shares for a net proceed of $114.6 million. Our book cost basis on this share is approximately $8.57 per share. As a result, we realized on a GAAP only P&L an accounting gain of approximately $81.5 million.

Under the share buyback program previously announced in February 2016 and subsequently increased to $115 million, we have repurchased, since the program inception, 5.4 million shares of Viavi stock at a cost basis of $7.41 for a total of approximately $39.7 million. We will continue to be opportunistic in monetizing our Lamentum position and also repurchasing our Viavi stock. Operating cash flow for the quarter was $10.3 million.

Now to our guidance. Given the uncertain customer spending environment in North America for our NSE business, we expect fiscal second quarter 2017 revenue for Viavi to be in the range of $187 million to $207 million, operating margin at 11%, plus or minus 1%, and EPS to be $0.05 to $0.08. We expect NSE revenue to be at $148 million, plus or minus $8 million with operating margin at 1.5% plus or minus 1%. We expect OSP revenue to be at $49 million, plus or minus $2 million, with operating margin at 40%, plus or minus 1%.

Our tax expense is expected to be between $ million to $4.5 million. We expect other income and expenses to be a net expense of $2 million to $2.5 million and our share account to be approximately 234.5 million shares.

With that, I will turn the call to Oleg.

Oleg Khaykin

Thank you, Amar. Our operating margins and EPS exceeded the guidance range. Net in common increased 10.7% from a year ago, despite the 8.2% drop in revenue. Network enablement, or NE, saw revenue strains in fiber test equipment, driven by high demand for 100-gig optical products being offset by weakness in access in Metro products. Although cable declined for two quarters in a row, cable revenue improved from a year ago level as we are starting to see early DOCSIS 3.1 adoption in Europe. We expect the upgrade cycle to remain gradual over the next several years.

In DOCSIS, the G.fast upgrade cycle has been slow, but there are signs of service providers deploying G.fast technology in early calendar 2017. As a result, we expect to start seeing benefits from G.fast deployment in late fiscal 2017.

Service enablement, or SE, became more challenging in Q1 as we continued to pursue a more focused, scaled-down SE business. SE revenue declined 9.4% from a year ago, driven by decline in mature business as service maintenance contracts expire. We have also begun scaling back in our investment in new SE products.

During our August earnings call and during our Analyst Day in September, we mentioned a challenging carrier discretionary CapEx spending environment in North America. Since then, the level of uncertainty did not improve and indeed may have increased. NSE revenue is facing particularly strong headwinds in Q2 as our major North American service providers are either engaged in major M&A activity or post-merger integration, which is impacting their spend. We expect this to be an ongoing trend for the next several quarters as newly announced mergers progress into post-merger integration.

In addition, we have not seen any meaningful end of the year budget flash in the past two years, and it is still not clear if that would occur in the final quarter of calendar 2016. However, irrespective of a soft business environment in North America, the business climate in Europe and Asia Pacific remain good.

OSP anti-counterfeiting revenue, as expected, declined both sequentially and year-on-year due to the customer inventory rebalancing to align within market demand. The optical coding business addressing the automotive, industrial, and military experienced improved demands sequentially and year-on-year as we diversify and expand our OSP opportunity beyond our traditional anti-counterfeiting applications. We are successfully and selectively targeting high volume consumer desensing applications in mobile handsets. However, we would like to know that this is still an emerging market and it is too early to discuss any specific short term impacts.

As we discussed during our September Analyst Day, we expect fiscal Q2 OSP revenue to decrease sequentially. That said, we expect Q2 to be the low point in OSP revenue and we expect to see the revenue recovery in the second half of fiscal 2017, driven by sequential improvement in anti-counterfeiting business.

Irrespective of the near term adverse customer dynamics, we continue to pursue our strategy to reduce business complexity, improve operating efficiencies, and improve profitability. During the Analyst Day in September, we announced a shift in our strategy toward [indiscernible] and focused SE. I am pleased our progress to date, as we are starting to implement plans for a more focused SE business and developing alternatives for SE product lines that are no longer part of our ongoing strategy. The implementation and execution will take time, as it involves fulfilling existing obligations to our customers and possibly identifying suitable partners for future support.

We have a clear strategic NSE roadmap to extend our leadership position in both lab and field instruments while at the same time consolidating multiple hardware and software platforms to further increase our operating leverage.

I would like to thank our employees for their hard work in delivering a good fiscal Q1 result, and their commitment to execute our new strategy. I also would like to express our thanks to our customers and shareholders for their continued support of Viavi.

Now I'll hand it over to Bill.

Bill Ong

Thank you. Oleg. I'd like to highlight the following upcoming investor relations events. We will be participating in William Blair's Optical Bus Tour held our corporate office on December 13.

Kaley, let's get a question and answer session.

Question-and-Answer Session

Operator

[Operator instructions] Our first question comes from the line of Jorge Rivas with Craig-Hallum. Your line is open.

Jorge Rivas

Thanks for taking my question, guys. First, I wanted to dig in on the mix on the SE business between legacy and growth products.

Bill Ong

So, is the question the mix between SE legacy?

Jorge Rivas

Yeah. The question is what was the mix in the quarter between legacy and growth products?

Bill Ong

Yeah, so SE growth in this quarter was roughly 66%, 67%.

Jorge Rivas

Okay.

Bill Ong

And the balance has been matured. So about 33% to 34%. So, just as a recap, when we exited fiscal 2016, the ratio was roughly 60% SE growth and 40% SE mature.

Jorge Rivas

Okay. Okay, thanks. And then moving on to OSP, specifically on 3D sensing. A two-part question. First, what's the competitive environment that you are seeing now versus maybe three months ago? I believe at your Analyst Day you guys touched on how proprietary your technology is and that Viavi was your only game in town for solutions in the consumer electronics segment. Wondering if you are seeing competitors emerge in the environment right now?

That's the first part of the question. And the second part of the question, I understand you cannot say that many details, but wondering if you can give us a high level perspective of how big the opportunity is, either in content per unit or in dollar terms at the market? And that's all from me, guys. Thank you.

Oleg Khaykin

Thank you. So, there's always competitors. I mean, there's many different ways to implement better; however there are better ways and not so good ways. We've been working with customers in that space for a number of years and we are very comfortable about our leadership in that area. Also, we have a very strong IP portfolio that covers probably the most effective way of doing 3D sensing. And clearly as a number people announce their product, we certainly hope they're not violating our IP, because we will defend it vigorously, and very aggressively. So, clearly there will always be competitors.

There are better ways of doing it, and not so good ways. We believe we have one of the best ways, and that has been confirmed by most of the major customers with whom we engage, and we are far along the design cycle. In terms of the opportunity, I would prefer not to speculate. At this point in time, there is no firm launch date yet confirmed by our customers, and there are still a number of them thinking. All of them have different view of how many cameras and how many sensors to use for handsets. If we get closer to the launch window, clearly we will provide greater degree of resolution.

Jorge Rivas

Fair enough. Thanks a lot. I'll step out of line now.

Operator

Thank you. Our next question is from the line of Rod Hall, with JP Morgan. Your line is open.

Rod Hall

Yeah, hi, guys. Thanks for taking the question. I wanted to zero in on the NE numbers again, and NSE in total as well. The guidance is weak as we would probably expect, given how weak carrier CapEx is here at the end of the year. I just wonder, could you comment on when you think the earliest recovery for that business might be? It is possible to think that March gets better, or do you think we have to wait until the middle of next year for things, potentially, to stabilize a little bit more? And then I have a follow-up to that.

Bill Ong

Well, I think it's always good to desegregate. I'm pretty happy with India and Asia Pacific. It's doing pretty well. I mean, North America, particularly, just by contrast from a year ago, a year ago it was all vectors pointing in the same direction, and all major service providers spending aggressively on Access and Metro infrastructure. This year, it seems like this switch was largely turned off. As we saw, numerous M&A announcements come out from major providers, it's literally within a week, a lot of the discretionary CapEx span discussions came to an abrupt end. Clearly, while a lot of instruments that we sell, the field test instruments, are not what I would say mission critical for these providers. I mean, they can go on for a while, but what they've got, I would say it's analogous to the home maintenance.

If you don't do anything like fixing your roof, and painting your house, in the end, you'll have to spend more to catch up. I don't know if March would be a catch-up quarter. It's too early to tell. We know that at least this quarter we're not seeing anybody announcing any end-of-year budget slash, or anything like that. But we do also see some capital being released, and obviously then, if you have the product on the shelf, you grab the orders. I certainly do hope that sooner or later, they return back to managing networks, rather than chasing M&A, and we'll see recovery in the order pattern. But as I said, that whole phenomena is very much North America, and we're seeing fairly good business climate in India, Asia Pacific, and actually even in Latin America.

Rod Hall

Okay, and then my quick follow-up: I didn't hear you guys comment on the Lumentum share position. Could you just give us an update on the position as it stands now, and the activity during the quarter, and what the plans are, with respect to liquidation of that position?

Amar Maletira

Rod, hi, this is Amar here. So we have 3.4 million shares of Lumentum that's remaining, out of the 11.7 million shares that we had. We did liquidate a good chunk during the quarter in Q1. We'd like to be opportunistic about this position, and how we liquidate it and monetize it in the next couple of quarters. So we're very opportunistic about it, and we have been in the last couple of quarters. So 3.4 million shares, currently valued at $141 million, but this was of last year Fiscal Q1, and since then, Lumentum shares have actually gone down.

Rod Hall

Has that liquidation been more recent? Can you give us any idea of the timing on that?

Amar Maletira

The timing of when we are going to monetize?

Rod Hall

No, when you sold shares this quarter that you're talking about.

Amar Maletira

You mean when we bought the quarter shares in fiscal Q!?

Rod Hall

No, no. Amar, I think that you guys have been selling some shares in the quarter just reported, and maybe beyond that as well. I'm just curious if you knew some idea of quantity.

Amar Maletira

We sold the shares about a couple of months ago, and then we had to lock down, because we were doing it under Form 144, and that limits how much we can actually monetize, and I think that restriction is lifted now. So we'll be more opportunistic.

Bill Ong

I think I know where you're heading. To answer your question, were we responsible for our recent sell-off that drove down the stock? Absolutely not. We are big believers in Lumentum, and I think they got a great business ahead of them.

Rod Hall

Great. Thanks, guys.

Operator

Thank you. Our next question comes from the line of Dmitry G. Netis, with William Blair. Your line is open.

Dmitry Netis

Thank you very much, guys. I wanted to hear a little more on the NSE. I think you said 40% for mature product, so with that, it was a little bit above consensus, with $4 million. I'm just curious, was it the mature products that outperformed expectations here? And also, if you can comment in that same vein, on the Enterprise side of the business, I think you mentioned it was slower than expected, or it had slowed down this past quarter. So, any comments on what's going on there? And when the rebound is expected?

Bill Ong

I got the enterprise question, but I didn't follow the first one, because the audio was not good. You want to know the mix of SE?

Dmitry Netis

No. We got the mix. I think you said it was 40% for mature, so I was just wondering if the outperformance in SE by about $4 million versus consensus came from the mature side of the business.

Bill Ong

No, it was not. First of all, let me make sure you have the right numbers. In Q1 of '17, the SE mature was 33%, and SE growth was 67%. That's the mix. 67% growth, versus 33% mature, right? The 60/40 was in fiscal '16. We are at 67/33. Now the outperformance in SE was this consensus, was mainly because we drove acceptance of a key solution in one of our big customers. We actually accelerated the acceptance of the solution by about a quarter, and so we basically brought it forward, and that helped us to some extent in outperforming the SE revenue.

Dmitry Netis

Okay, that's the growth side. And then, on my second question, as part of the Enterprise?

Amar Maletira

On the Enterprise side, we have seen Enterprise sort of bottom out in Q4 of '16, and then it started to slowly recover in Q1, and we expected that sequential improvement to continue in Q2. Now when you do a year-on-year compared, a couple of things we have to keep in mind. One is last year, the same period, we did have large number of deals which were $1 million and above. And we did not see that kind of volumes in Q1 this year. That is number one. Number 2 is we had some leadership changes. We brought in a new leadership team about a couple of quarters ago, and they have hit the ground running, and now we have started seeing the improvements that they're driving. And so we expect the sequential improvement to continue in the Q2.

Dmitry Netis

And then I have one more question for Oleg, again on SE. This has to do with the timing, when Oleg, you took over the business, and I think, put the SE on a probation period, for lack of a better term. I think you've given six months for the leaders in that group to turn the business around. We're probably coming in this December on to that six-month period. I guess my question is, next time we'll talk to you, end of January, early February. The question is, do we have to wait for to you make the decision of what is going to be done with SE, continue on the path, and take another scenario.

Oleg Khaykin

Yeah, thank you. You know, the analyst, I think we already made some of our direction and our intentions clear by saying we're going to be focusing and driving much more NE and we will scale back SE accordingly. You know, just stepping back and look at our SE business, as the more I learn about it and the more I spend time with our management team, it's a good news bad news, right? On one hand, we have a phenomenal technology. It's very good. But on the other hand, I also look at our scale and what it takes to bring this product to market, and more importantly, implement them in market and roll them out and the amount of investment and cost that it's going to involve. And I just do not see that for us the foreseeable future that we will make it a positive contribution business over the next several years. We decided to scale back the SE business and really only focus on the components of it that are very title-linked to our instrumentation base and then seek either partners or transition out of the segments which requires substantial investments and substantial commitment over a very long period of time to continue trying to win the market share and convert customers to our solution. So I think, in that respect, my conclusion has already been made as to where we need to go with that business.

Bill Ong

And Oleg, just one last on -- in terms of investments with the [indiscernible] rates had been. What are you doing to scale that or is there anything quantitative that you can provide as far as how much investment has been taken out of that business and where you think you will end up, let's say in one of the two? .

Amar Maletira

Yeah, so let me just get started here and I'm sure Oleg will jump in. The bond rate we talked about was roughly $45. So, the bone rate we talked about during the Analyst Day was roughly $40 million.

Oleg Khaykin

Net bond rate

Amar Maletira

The net bond rate, of course. Yes, that's right. Now, you know, as we work through our plans, it will take some time to basically unwind some of those contracts, et cetera. So we are working to a plan on how do we -- how do we take down the OpEx as well as the other costs and that's about at least 12 to 18 months type of process. Now, in some cases we will be able to accelerate it, but in some cases, depending on how the strategic alternatives pan out, it will all depend on that. But if that thing is ahead of us, it is not in the numbers that you see today that we have posted and it's something that is futuristic.

Oleg Khaykin

And what Amar commented on is that would be, what with our organic path forward would look like. At the same time, we are also looking for opportunities to accelerate it and the key component for us is ensuring continued support of our customers. So we had a number of interested parties approach us who are interested in picking up the business and moving it forward to the extent we see that the value is compelling and our customers will be taken care of, we may accelerate this forward by partnering with other parties to pick up the business and move it forward.

Dmitry Netis

Very well. I appreciate it. Thanks, gentlemen.

Oleg Khaykin

Sure.

Operator

Thank you. Our next question comes from the line of Meta Marshall with Morgan Stanley. Your line is open.

Meta Marshall

Hi. A couple of questions for you. First, if you could just kind of give some tone as to what the sales force reception was to kind of some of the changes that came out of the Analyst Day. And then the second area, I know you commented that DOCSIS 3.1 was kind of positive in you were encouraged by that, and that there was some general kind of CapEx slowdown causing the NSE slowdown for Q2. But, just is there anything more specific about particular categories like is DOCSIS 3.1 in North America slow? Or copper slow? Just some more granularity there would be helpful. Thanks.

Oleg Khaykin

I think clearly in the access category, the world is moving to our new standard. On the cable side it's DOCSIS 3.1, on the Telco side it's G.fast. We've seen fairly slow progress towards migration. Most customers are not in a hurry to replace their installed equipment. But we are finally seeing in Europe DOCSIS 3.1 being adopted, and we're seeing also same intense -- intention being communicated by our customers in North America. We don't think it's going to be a step function, we think it's going to be rather a gradual swap of the existing equipment with the newer equipment. They rotate their installed customer premise equipment.

On G.fast, we are now starting to see some deployment happening in Europe. Usually it means they buy the central office equipment. The data center equipment. And once that is installed, they start rolling out the customer premise equipment. And that's when we start seeing demands for our instruments. So, that's why we said we think later in the fiscal 2017 we will start seeing G.fast demand for the access equipment.

In terms of the reaction of our sales, clearly there are -- there is a concern among especially sales people who are primarily solution driven as to what their future is, and clearly we're working through it. But also, we're not completely getting out of the service assurance business, we're just focusing on the service assurance that is much closer to our core strength in the instrumentation field. So, I think we'll be focusing much more on the lower levels players of the protocol stack rather than the segments that are far removed from our core market presence.

Meta Marshall

Thank you.

Operator

Thank you. And I'm showing no further questions at this time. I'd like to turn the call back to Mr. Ong for closing remarks.

Bill Ong

Thank you, Kaley. This concludes our earnings call today. Thank you, everyone.

Operator

Ladies and gentlemen, thank you for participating in today's conference. That does concludes the program and you may all disconnect. Everyone have a wonderful day.