Spirent Communications' (SPMYY) CEO Eric Hutchinson on Q4 2016 Results - Earnings Call Transcript

| About: Spirent Communications (SPMYY)

Spirent Communications Plc ADR (OTCPK:SPMYY) Q4 2016 Results Earnings Conference Call March 2, 2017 4:30 AM ET

Executives

Eric Hutchinson - CEO

Paula Bell - CFO

Analysts

Gareth Jenkins - UBS

Will Kirkness - Jefferies

Operator

Okay. Welcome everybody to the Spirent Results Presentation. Thank you for attending our results. And so let's move on. Just note please to the content of the safe harbor statement containing the usual caveat.

Okay, so let's just hit on some highlights. Whilst the total revenue decreased in 2016 for the reasons that we flagged last year, we actually saw growth in our core business and we saw growth in profit.

In the networks market, we clearly gained share from our innovative high-speed Ethernet testing and test automation. We had double-digit growth in our Ethernet IP test business. We are the first deliver 400 gigabit Ethernet test to the market.

We launched the industry's first Quint-speed Ethernet test product for 10 gigabit to a 100 gigabit Ethernet testing ability and with first 2.5 and 5 gigabit Ethernet test platform and we lead the market in virtual and cloud stress test solution.

We remain the market leader in positioning, navigation, timing test solution and that business grew again this year. We made significant advances in security tests, launching CyberFlood, the world's highest performing application layer test solution and started an ethical hacking called SecurityLabs.

The business is positioned to capitalize on the need for comprehensive security test operating at high speed. In our service assurance market, we're excited about the prospects for our service assurance business, as we offer solutions to transition network functionality from the lab into the operating network and utilize our IP test and analytics system to measure performance over time.

We completed the deployment of our customer and network analytics system InTouch, the major operator in Mexico. We booked orders for our 100 gigabit Ethernet probes that to be deployed in production network for the Tier 1 carrier in the United States.

In connected devices in the wireless arena, we expanded the footprint for our Elevate product, winning multiple deals for video and audio quality testing. We won a deal to reduce the time and cost test IoT devices in a large Tier 1 carrier and we launched our new next-generation channel emulator, Vertex, which addresses the need for advance 4G and 5G wireless application.

So in short, we strengthen our expertise and product offerings in everything we do, all aimed at future requirements for test, measurement, validation and assurance.

During the year, we undertook a deep dive business review with the aim to accelerate progress in executing our strategy. The objective was to focus on the areas we have the highest probability to deliver earnings growth that will target the market opportunities that matter most to our customers.

And that would achieve internal synergies both technical and customer product offerings, allow reorganization of our sales and marketing to deliver more efficiently and more effectively and allow a streamlined management structure.

So today, we're announcing three new market focused segments that are driven by the growth trends in our industry, Networks & Security, Lifecycle Service Assurance and Connected Devices.

I will explain the market dynamic. Our market share, our expected growth rates for those market, our solutions and key customer. Have available to restated financial numbers for the new reporting segments for both 2016 and 2015. Having said all that, of course, the financial report of 2016 will be on the old segmented format.

So I am delighted to introduce you to our new CFO, Paula Bell, who will report on 2016 financial performance on that basis. So over to you Paula.

Paula Bell

Thank you, Eric. So good morning, all. Just way of introduction, I've met with a lot of you in the room, but, yes, I joined in September. I was previously CFO with John Menzies for the last three years and before that worked with many engineering and technology firms. So really looking forward to working with the Spirent agenda.

And had a chance to visit some operations, and quite a few of them out there, that was team had a review of the strategic and operational agendas and I think a lot opportunity, a lot of potential, good momentum and its quite excitement time to be dialing.

So let me take you through the results. So first as I look at the financial headlines before we delve into the figures in a bit more detail. So that our revenue down 4%. We saw the predicted slowing in wireless device testing activity. We had a strong comparative year in 2016 for handheld devices.

So we did benefit from strong growth in our core businesses, Network & Applications and our Positioning business and by driving efficiency we improved both growth and operating margins in the year.

Operating profit was up 10% to $46.5 million. We are focused on taking action in all areas of the cost base. In the second part of the year, we initiated a sales organization review. External consultants benchmarked the sales force and recommendations are now being worked on.

As a result, we implemented headcount reductions at the end of the year, maximize benefit in 2017 and that had a resulting cost of $4.8 million and we have a further $2 million to $3 million in 2017, and that’s going to produce annualized savings of about $13 million.

As Eric said, a fundamental review of all our business lines was performed to establish priority areas for investments and that’s the key growth drivers. So some smaller parts of the business were identified as non-core and we will actively manage them from the portfolio.

So this review clearly indicated there were technical and resourcing issues to begin from restructuring and realigning our operation. But as a result, the Wireless & Positioning businesses which were together in the old segment will not be together in the new format and this exposed to wireless acquisition goodwill held on the balance sheet, which required impairments as you can see on the screen there.

Cash closed at $96.1, EPS is up 6% and the effective tax rate 27%, almost identical to 2015. And we expect that to continue looking forward subject to any US government changes of course.

In dollars, the dividend remained unchanged, final payment of $2.21 [ph] making full year dividends of $3.89 [ph] In sterling its good to note this represents the 15% growth to our shareholders.

So let's take a look at Network & Applications. This is the largest segment of the business and revenue grew by 6%, continued strong demand for Ethernet testing. Eric is going to provide more details of the new product launch in the year, which together with cost focused actions, we held the cost base reflected you can see here. So a material increase in operating profit and also an increase in operating margins.

Turn to Wireless & Positioning, as 4G driven activity slows, the predicted headwinds for device testing requirements are in play and impacted volumes by some $0.25 in our wireless business.

But in contrast, positioning had a very good year, growing top line by 9% and importantly delivering strong growth and profitability. This was due to some tailored solutions, particularly for US customers and some new product launches which have been successfully sold into China.

So overall for this segment, revenue declined 14%, if profit improvement was delivered. This was due to positioning of higher margin characteristics against strong cost management overall and operating targets of 15%, and you can see here an increase in operating margin as well.

So forward, we do recognize the continued slowing of demand for device testing. Smartphone volumes do continue to decline and we are repositioning ourselves. We've got growth downstream in 5G and the Internet of Things, and we're going to be looking at new product launches. So this is an area we need to be very responsive to market changes.

Let's turn to service assurance. The one-off higher levels of handheld device sales in 2015, as I said, meant a strong comparator year. So as previously flagged revenue was down 17% and the focus during the year was to actively manage the cost base.

The mix of products sold gave rise to improved gross margins, but as you can see here, operating margins were held at 14.6% but on a lower revenue base.

Right, your pages in the pack are out of sequence here, so I'm going to do the cost base next. So, if you just turn ahead one. So just looking at the cost base, as I explained earlier we are running a suite of programs, starting with sales potentially optimizing our effectiveness. We're refreshing how we approach the market, how we drive return on our investments.

So in 2016, despite inflation you could see the cost here reduced overall and the sales restructuring program, as I mentioned is looking at how we best face our customers, develop engrained key account management; and how to increase software sales. So we will continue to focus on this area and have to balance R&D investments, together with an effective cost structure.

So always good to look at cash; just a couple of moving parts on here to explain, depreciation is down year-over-year, as we did make an asset disposal last year when we outsourced some of our engineering activities to India. Now, we can see a slight increase in working capital to the end of the year, we did have higher inventory levels, commensurate with new product launches, and with regard to pension, we have agreed now the triennial pension funding plan, it is higher than last time at $6 million starting from the 1st of January '17 and we made a one-off payments in July '16 of $3 million. For those interested in the accounting basis, the pension deficit closed at the end of the year at $12.8 million, which was $6 million improvement since the previous year.

Turning to tax, you can see 2015 benefited from some tax refund, and turning to CapEx, you can see its running lower in '16 and the prior year did include some key office moves and higher levels of demonstration equipment. So going forward, I would expect CapEx to run at a similar level to '16. So overall cash closed at 96.1, slightly down on 2015.

So really, just to summarize where we are with financials. We've flagged the headwinds that we managed carefully, they have impacted revenue, key parts of the business are delivering actually very well, and our profit improvement was still achieved.

And following a busy year of reshape, with a view to focusing on key growth areas, I hand over to Eric, who will give you lots more progress, add more color on our progress.

Eric Hutchinson

Thank you, Paula. Let me turn to the markets we serve and the strategic focus for 2017 and beyond. Given the positive market dynamics and the backdrop in the industry, we'll grasp the opportunities that are offered. Spirent offers customers high-performance systems to test, measure, validate and assure devices and network high volume, high speed, high density in a highly reliable and high quality way.

This allows them to increase - customers increase the product quality, reduce time to market; grow revenue, assess the security of their solutions; and get visibility network performance and customer experience.

Our key capabilities, our expertise in developing test methodologies, active test in the lab and in the network, real time and predictive analytics and test automation. And this realizes efficiencies, scalability and reliability. We help our customers transform their products, networks and business, and outperform their competitors and the customer’s expectations.

We give our customers the solutions to help them build market future, by providing leading-edge first to market solutions that help our customers connect, perform and secure their products in our connected world.

The industry is defined by the relentless growth in traffic and the business imperative is to reduce operating costs and capital expenditure. This explosive growth, in IP, drives innovation. Cisco reported that IP traffic will triple by 2020. Operators cannot afford to match the traffic growth with spending on the transport equipment. The cost of telecoms equipment is dropping 13% a year and traffic is climbing at 22% a year.

Operators are challenged to reduce operating expenses and toward the new architectures and operating practices, as these challenges drive network operators towards software defined network, and network functions virtualization.

Spirent is positioned to meet the network virtualization challenges, leverage our expertise and product in both laboratory and production network. There are several areas that are bringing strong market disruption and driving new investment.

They are virtualization, the Internet of Things, cyber security and 5G wireless. These create new challenges to the industry, but they also create business opportunities for Spirent.

Network virtualization is the only way to support the exponential growth of data cost effectively. Not only does virtualization radically reduce the capital costs, network deployment, it also allows rapid adaptation to new demand on the network to setup and tear down services quickly.

Active test techniques are required to understand the performance of the virtual network function under various condition before deployment under various times during operation as network conditions change.

The thing to note is that hybrid network, with all their inherent complexity, will exist for a decade or more. We offer test systems that do both physical tests and virtual network testing.

On security, high-profile security incidents continue to make headlines across all industry segments and the overall prevalence of sophistication of cyber crime is on the rise. According to a recent report from the UK National Crime Agency, cyber-enabled fraud surpassed all other types of crime.

The US Government is set to spend 35% more on IT and cyber security during 2017 and we expect the overall spending on cyber security testing to increase with the need to better detect and protect against these threats. We have tools to help customers test their security of devices and network.

The Internet of Things is growing rapidly. The volume and variety of things connected to connected devices creates new challenges for developers and network operators. Test and assurance is critical to avoid network overload, disruption and security breaches.

5G wireless will allow new applications to access extreme bandwidth, and offer ultra-low latency, such as virtual and augmented reality. A myriad of new test capabilities will be required to support 5G and 5G will enable a further revolution and ubiquitous use of high-definition video.

So in summary, we've aligned our investment and product plans with these key markets disrupters to meet the challenges and to grow the business. So during 2016, we undertook a fundamental review of what was working well, what showed the best future outcomes; and what was underperforming and we've reorganized accordingly.

We've realigned the business units to focus on the top opportunities and there new segments, networks and security, lifecycle service assurance, and connected devices. Our network and security business will maximize the opportunity presented by virtualization in security and we are including resilient positioning, which is really driven by security concerns and we're looking to provide scalable and modular test systems, for high-speed, complex traffic.

Lifecycle services assurance will maximize the opportunity in the operational network for virtualization, mobile network and Internet of Thing, providing active service assurance and analytic solutions for service providers operations and lifecycle management for virtualized network functions.

Our connected device business will maximize the opportunity presented by 5G wireless and Internet of Things, providing cost-effective automated test systems for connected devices to accelerate the development and simplify network connectivity.

With a sharp focus on our target business opportunities, we are leveraging our technologies and core capabilities to increase the long-term value of the business.

Let's turn to networks and security, you'll see we serve a market of about $1.3 billion in 2016, we project the gross rate to the market to be about 10% each year over the next three years and we had $263 million last year about 22% market share. Clearly, a highly profitable operation with operating profits that are running at 18% margin.

Our customers, our network equipment manufacturers, service providers, e-commerce companies, security equipment developers, governments and large enterprise customers, the focus is on – the focus is product network quality prior to launch; through testing network functionality, performance in real-world conditions, the security of firewalls, and application of fire walls; and application of ware network.

In these segments we had many achievements in 2016, I'll note some of these, I'll just comment on a couple here. A leading equipment manufacturer started a new project to develop their next-generation 400 gigabit Ethernet platform and they purchased our 400 gigabit boost program, allows customers to start testing early. The standards are still evolving and if they change, we'll swap hardware with industry-compliant versions, until the standard is rectified.

We introduced the innovative software as a service solution, TeMeVa, for network and cloud testing and we contributed actively to the ETSI specifications for pre-deployment testing, and active monitoring of failure detection as an illustration of our test methodology expertise.

In cyber security, we launched on the CyberFlood test tool. CyberFlood is the world's highest performing testing solution, emulating realistic application traffic or validating security coverage from enterprise to carrier grade network capacity.

We won key deals in a US network operator, leading security product companies, and major financial institutions. In positioning, navigation and timing, we launched three major new products. One to note is our Interference Detector, which monitors live RF environment, for potential sources of interference and automatically detects potentially disruptive events.

We're able to simulate and test navigational systems to enable mission-critical functions to be tested for resilience against failure, error, spoofing [ph] and blocking.

Turning to lifecycles assurance - service assurance, we serving an $800 million market. We project this to grow at around 7% a year. We had just under $100 million of revenue, 12% market share and, on a restated basis here you see its about 11% margin business.

Our customers are service providers, primarily wireless carriers. The focus is on real-time active testing, analytics, and operational network, managing network functions, virtualization, in hybrid networks.

Active tests and analytics reduces operating costs; avoids downtime; provides real-time monitoring and provides insight about user experience. Our system can validate network functionality and test network closely, under many conditions given visibility and allowing proactive rectification.

Again, in this statement a number of achievements in 2016. Just to have a look at a couple of examples again. We launched Lumos, our service assurance system for turn-up and monitoring Ethernet IP networks. This year Lumos helped a North American operator accelerator their turn up of small cells, so they were able to deliver 10 times increase in their rate of small cell turn-up.

We also launched VisionWorks, a new active service assurance solution for mobile networks. We closed several large orders in two Tier 1 carriers in United States. This is an attractive near-term growth business for Spirent, starting this year and continuing to years to come, as virtualized networks are deployed and managed, and network operators adopted active test and analytic solutions.

So what does this mean in the real world? Special events with enormous crowd, pose unique challenges for mobile service providers, attendees expect the same level of service as they do normally, while exerting huge pressure on the network, with extraordinary voice, data and video amount.

As a service provider, and as reported for Super Bowl 51, a major sporting event in Houston, Texas this year, they deployed more than 220 small cells to increase capacity, adding 18 times the normal capacity. Over half of the attendees use the network consuming 11 terabyte of data on Super Bowl Sunday, an increase of about 50% over the same event last year.

Top five uses were uploading and watching videos, social media, web browsing, uploading to the cloud and sports apps, such is NFL mobile. The moment of highest usage was when Lady Gaga did her swan dive into the arena, at half time.

Surprisingly, more than any other time during the Patriots spectacular comeback, during which I suppose the fans were watching the game rather than blogging it. Where do we come in? Via an in-touch system, facilitated monitoring for subscriber service during Super Bowl, providing insight into the individual service platforms and overall quality of experience. We provide real-time data analytics from different network data sources.

This ability to monitor and troubleshoot enables network operators to deliver superior levels of service under strenuous conditions, whether these are special events for doing regular network operations.

Looking at connected devices, the market is about $550 million, declining on average projected rate of 30% over the next three year. There's been a severe market decline in 2015 and 2016, and we forecast the market will recover again from 2018 with the adoption of 5G wireless and more Internet connectivity.

Spirent has revenue of just under $100 million and 18% market share. In this business we provide technologies test performance of wireless devices, smartphones and any connected device. The market is in a hiatus between 4G rollouts, the services and the development of 5G wireless and the demand for connected devices has started to heat up rapidly and innovation is driving us towards the age of hyper connected - hyper connectivity and pervasive computing.

Our business focus is on accelerating the development and deployment of all connected devices in a secure and reliable manner. We have strong products for both voice and video testing, location-based services, channel emulation and security.

The wave of wireless technologies drives a cyclical demand for test equipment. We saw the ramp in demand, as network equipment and devices are initially developed and manufactured, test equipment spending subsides as the market adopts that generation and eventually the market looks forward to the next generation.

In 2016, we clearly had market contraction for 3G and 4G test equipment, driven by the consolidation of smartphone vendors and network equipment manufacturers. We're in an investment trough, but 5G R&D spending has already starting to emerge.

So we're optimistic about the future 5G development AND compelling new applications in 5G that will be enabled. Some new underlying technologies will be required, including massive multiple input, multiple output technologies, small cells; network virtualization; and the use of automation and analytics to streamline network operation and management.

Again, the achievements to note in this segment, we enhanced our wireless test platform, branded Elevate, introducing the industry's most compact and powerful enhanced packet core and IMS network emulation for evaluating the next-generation of mobile services.

We won several deals in chipset vendors and carriers, for video and audio quality testing. We delivered first to market solutions for the industry's new Enhanced Voice Services, which is a high definition audio codec. And we see the business opportunities to 5G and IoT device network testing as a mid term growth business for Spirent.

Last October, Mirai virus turned millions of people's security cameras into weapons, in a distributed denial of service attack that brought down most of America's major Internet sites, such as Netflix, Twitter, Reddit, Airbnb for hours. The attack targeted the dying company that controls much of the infrastructure for the Internet domain name system.

Was this a complex security attack? No, not really. Devices with poor password were exploited. For example, user IDs and passwords that were both set to their default or admin passwords; the passwords were simple; some were saved in plain text. And so Internet logins could be cramped.

Typically these types of attack infect and utilize computers. This one was different that infected devices. The Internet of Things, the connected devices such as phone security cameras and internet-enabled child monitor, it’s not the first time we've seen this type of attack, but the scale of this was extraordinary, it’s also the first time we've seen a significant recall of equipment due to it.

What made it worse was that these devices were not designed to be recovered in the field, they had to be recalled and replace, so it’s very expensive. Also last November 900,000 routers in Deutsche Telekom crashed, due to the exploitation attempts by a variant of Mirai, which resulted in interconnectivity downtime.

Where do we come in? The functionality and performance security of devices that will be connect to the network should be tested as they developed before they are sold and deployed and they should also be tested periodically after being connected to the network.

We have wireless device test products and automation test management products suitable for testing connected devices. We have a new security test product an ethical hacking service that can identify those security vulnerabilities, prioritize the risks and make recommendations and we have an analytic system that can detect abnormal device behavior on the network.

So no developer or operator wants to be tarnished with a reputation of being culpable in a large Internet cyber attack that damages their business customers and consumers.

So why -what are our strengths and why do we believe that we can win in this market because strong relationships with Blue-Chip customers and the fast leading developers. We've always worked closely with customers to understand their business challenges, develop and innovative solutions to meet or ideally exceed their expectations.

And we've gained deep expertise through working with many of the worlds most innovative companies as they developed products and applications, where as they operate and manage network.

We have highly respected expertise in these test and measure - and measurement across our industry, providing insight and to changes in development to ease our customers through demanding transition.

We believe we win business and our reputation is earned from our four core competencies which is the basis of our competitive edge, expertise in developing test methodologies; active test capabilities in the lab and the network, real time and predicative analytics and test information.

Our technologies and insights allows to deliver first to market solution and we now talk about launching zero state solutions, right, is not the first, but even before first. Our service levels are second to none and our portfolio is among the strongest in the industry.

So in summary, we've got a sharp focus on the target market opportunities that matter most to our customers. We develop new products and solutions to meet these key market disruptions. We expect ongoing success in our high-speed Ethernet virtualization and security businesses.

We expect growth in 2017 in our active test and analytic solutions for the operational network. And, we've realigned to realize internal synergies, allowing us to manage our expenditure more closely. And all of this gives us confidence that we'll see a return to growth in 2017.

Thank you for your attention and with that, we will open up to questions. Gareth?

Question-and-Answer Session

Operator

Q - Gareth Jenkins

Thanks, Its Gareth Jenkins, UBS. A couple if I could. Firstly, I wondered if you could talk about market share in gig-Ethernet and whether you feel the acquisition by Ixia or of Ixia by Keysight is an opportunity for you or a threat?

And then secondly, if I roll up all of your market targets, it looks like you get to about 7% growth for the top line for the overall business. Is that something you feel is achievable in the current year, or is that kind of a medium-term target?

Eric Hutchinson

Okay. So, in the Ethernet test market, we've been seeing strong double-digit. Our key competitor, actually reported a decline in the network test business throughout 2016 and, really, a very marked decline in the fourth quarter where we are down about 15.5%.

We know from our customers that we've been gaining share and, really, that really endorses that. We are making advances and we put a lot of investment as you know over the years to put ourselves into a better position, both in terms of capability, but also support of the utilization of those test pools by our customers. So, we're feeling very good about that.

The acquisition of our major competitor, Ixia which was announced by Keysight two weeks ago, clearly put some uncertainty into the market about what would happen, I mean, clearly both very capable and competent company, putting them together will allow them to emerge some of those activities.

That create uncertainty near term and there's a bit of a scramble going on at the moment, but both – both ourselves and our competitors to hang on to the market share they've got and gain share.

It is causing some concerns. There maybe a near term opportunity for us to take advantage of that. I think the thing to remember is whilst we compete on some key areas such as Ethernet, we do have new capabilities that are neither part of Keysight's portfolio nor Ixia's. So you know we do have very strong offerings in live active test technologies, test automation, in whole area of connected devices we're differentiated.

I think there is some threat in the Keysight – strongly in some regions than Ixia were in some channels, so that may make life certainly more comfortable for us, but generally speaking I think we are rising to the challenge and we see an opportunity to be seen as the independent expert in the Ethernet test market and we will expect confidently to continue to gain share. I guess, in the short term, I can just note, on that particular product line, 2017 has started extremely well.

In terms of our growth projections on the market, that’s clearly a projection based upon the next three years expectation and I think that some modest growth in – expectation for 2017 on top line, and that’s really because we still got the mix effect. As I indicated, we're still seeing some headwinds, probably in the wireless test market.

In the near term we are confident that we'll see growth in the other segments. So probably the way to project it is that not really guiding to any changes on in expectations for 2017 and but we're starting to setting ourselves up for a stronger growth in '18, '19 and onwards. Yes, question here?

Unidentified Analyst

And I was just wondering what the kind of OpEx guidance would be going forward, you have talked about $13 million reduction in cost structure, so will that all kick in through the course of this year or is that something that will be felt more next year?

And in the strategic review, did it throw up anything where you probably shouldn’t be and which is sort of not your area of core competence, or where you're slightly sub-scale and a little bit difficult and is it better for you to exit some of those businesses and invest more in other businesses and if so what could those be?

Paula Bell

The OpEx question, yes, the actions that were taken with restructuring, will give us the OpEx savings, which would implement during the quarter of 2017 and that’s going to give us a good protection against cost inflation and protection against investment in other areas that we'll need to be doing.

So our overall intention is trying to keep the cost base level year-on-year, which will mean that we get a good operational gearing effect, once we get revenue increases coming through, which will drive margin improvement. So that's the general direction of travel there.

Offsetting inflation, yes, it’s maintained a flat level cost base instead of increasing, yes.

Eric Hutchinson

And then none of that has been skewed towards making sure that our connected devices business is – that it’s not a loss making business, even though we see some headwinds. So some of that revenue change is because we are pulling back on areas and it's flagged in the press release, where we've taken impairment, it’s based upon reducing activity levels.

So, some of those areas in protocols and connectivity, we are pulling back, its not so we don't think those businesses can succeed, it's just we don’t think they can succeed in a big way within the next three years.

So we rather put our money into growing our capabilities and virtualization in active base testing and test automation. So those are the areas that we're pulling back on and we will actively manage those down through the year.

So there is not something that I could put a book together and do a sales process with a high degree of confidence. That's not to say that we won't try to spin them out, if we can; we will.

Will Kirkness

Thanks. Its Will Kirkness from Jefferies. Two questions. Just to follow on that portfolio trimming. Will that be assuming some revenues might come back, or will it largely be the EBIT neutral?

And then secondly, I was wondering if you could talk about, when some of the investments or some areas of the business come to you with investment ideas, can you talk at all about the internal hurdle rate or what kind of what metrics you look to press go?

Eric Hutchinson

So the – whatever we're doing on trimming we'll certainly look to be EBIT neutral in terms of our plans for 2017 compared to 2016 and some of those areas were losing money. So it helps the positioning in terms of increasing the EBIT result, the operating margin in 2017 in a modest way. These are not huge numbers.

In terms of our investment hurdles, we're really looking at revenues that we get from the new investment over the next three years, ensuring the gross margins are and acceptable levels and often the gross margins are actually better than the existing product. So, we're looking - we tend to look at you know, how quickly does that investment payback. And so we're ranking it on that type of metric.

We're looking to see if we can improve the way that we do that, and Paula's taken the challenge to do some work on improving our metrics on that area. Gareth?

Gareth Jenkins

Two questions. Firstly, border tax or US potential for taxes. I presume that most of your components are primarily US made, and your production is largely based over there as well. But would there be an impact in terms of if there were an import duty in place?

Paula Bell

We are looking at that very carefully, and as you'd quite imagine, and so you're quite right, we do have a lot of inbound stuff. But, actually, we're net exporter still, because we still sell a lot of our kit from the US into other areas. So there is going to be changes on both sides.

Now, we don't know what those are going be yet. So we'll monitor it carefully, but we're very mindful. But you are right, we do import, but we also do – we're still a net exporter in the round.

Eric Hutchinson

Yes. So we generate a lot of the intellectual property and most of the product value that we sell is in the intellectual property in the equipment. The actual physical hardware is off-shored. So, as Paula says, we import, but our net export position, we are a much stronger exporter in net.

Gareth Jenkins

This next question's on virtualization. If we go back a year ago, Eric, you weren't quite sure if this was going to be a threat to your business moving towards a software business model or a real opportunity. It feels now it's moving towards more the opportunity than maybe a threat. Would you agree with that one year on?

Eric Hutchinson

Yes, I think the threat was that that with bare metal switches going in, that the value in the hardware test business could be undermined. It's been pretty clear to us, so the physical test requirement then go away, you may be selling to different people in the industry, but they certainly don’t go away.

But we do see is that the challenges of deploying virtual network management technologies is a huge challenge and that’s actually created some significant business opportunities for us and we move quickly if we have to give people some very strong validation tools around the deployment of those new technologies.

And so on net-net we now feel that this is a positive for the company and that certainly, the physical test requirements are still there and we certainly haven’t seen any diminution in that. And in fact, when we sell virtual test technologies from our perspective actually it, actually, pulls through additional demand for our physical test equipment with that same customer.

Gareth Jenkins

You didn’t mention automotive which I think you had mentioned last year as one of your target areas, and is that because it’s a the slow burner and you're not seeing attractivity there?

Also, on the IoT side you seem to have got a little bit more sort of interested than you were previously talking about the attacks and things like that, becoming a more tangible revenue contributor as we see it, or is that still somewhere down the line?

Eric Hutchinson

So automotive is still there. In our terms, automotive, the connected vehicle everything to do that world is a specialized part of a connected device and we haven’t – we still driving on our initiative where we are adapting our Ethernet test tool to apply to the Ethernet network within the vehicle and we have sold that to major manufacturers in terms of their development activity.

And so we still see that as a significant opportunity within our networks and security business. The connectivity of vehicles, we've won contracts for connected devices on large earthmoving trucks, so you can't get much bigger in terms of the device connected.

So from a technology perspective we are looking at it more as the device connectivity question rather than purely automotive. In terms of the development of the network on the vehicle itself, then it is slow burn. It takes a long time to get into the industry. We're still going at it and we've won some interesting contracts.

But in terms of being a significant growth driver for us in the next couple of years, it won't be significant. But we will be there and it maybe that in 10 years time that will be a key part of Spirent's portfolio, in both the vehicle, but also more importantly in the Smart highway and in the infrastructure side, because none of this work unless you’ve got Smart highways to go with it. And that really does play to our network testing strength. Any other questions?

Eric Hutchinson

Okay. Well, thank you very much for attending and interest in the company. And we look forward to driving the business forward in 2017. Thank you.

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