Viavi Solutions (VIAV) – Earnings Review & Outlook
An applied technologies company that provides network and service enablement solutions for a variety of network system configurations. It currently operates through two main segments: Network Service Enablement (NSE) and Optical Security & Performance Products (OSP):
The company announced quarterly results after the bell yesterday. Here was the breakdown:
EPS of $0.10 vs $0.07 estimate – Beat
Revenue of $206.5M vs $197.7M estimate – Beat
Net Revenue down 2% Q/Q
Net Revenue down 11% Y/Y
Network and Service Enablement (NSE) revenue increased 1.7% Q/Q and declined 9.1% Y/Y. This result was at the high end of management’s guidance of $140-$156 million.
Network Enablement (NE) revenue was down 1.3% Q/Q and 14.2% Y/Y. NE benefited from strength in fiber test equipment, driven in particular by demand for 100G optical products, which was offset by weakness in access products, particularly in North America. NE remains challenged in North America as a result of softer service provider spending, previously attributed to M&A activity.
Service Enablement (SE) revenue increased 11.5% Q/Q and 10.0% Y/Y. The increase was due to improved demand for the data center segment, attributed to the efforts of the organizational restructuring, as well as increased assurance acceptance, which is expected to reverse next quarter. Stifel was out saying that they expect SE to steadily decline as maintenance service contracts end and as management scales back investments in new products in accordance with management’s objective of rationalizing and focusing its SE portfolio.
Optical Security & Performance Products (OSP) decreased 12.4% Q/Q and 16.8% Y/Y. Management did note that OSP was down, as expected, as a result of anti-counterfeiting customers adjusting product inventories. However, segment gross margin was up 110 basis points sequentially and 190 basis points Y/Y due to improved factory utilization. Management also noted that it expects its anti-counterfeiting business to recover in F2H17, which is embedded in guidance.
After its results, CEO Oleg Khaykin said, “We are executing to the plan laid out during our September 2016 Analyst Day. We are strengthening our NE core instruments business and scaling down to a more focused SE business. Our recently announced restructuring plan puts us on course to achieve our stated medium-term financial model. OSP revenue is expected to recover in second half FY17 with opportunities to leverage our optical coatings technologies into new markets in FY18.”
Outlook Commentary
Prior to Viavi’s earnings report, certain sell-side firms had spoken about potential catalysts heading into 2017. Here are a couple of examples:
Craig Hallum analyst Richard Shannon upgraded the stock to Buy (from Hold) and increased his price target to $10 (from $7) in December saying it has the best optical coating technology available in the market. He believes the recently announced customer prepayment is specifically to build capacity and Apple (AAPL) is likely the source of the prepayment. Mr. Shannon said Apple is driving the supply chain and the prepayment strongly suggests Viavi has a highly differentiated device.
J.P. Morgan analyst Rod Hall said that their detailed carrier capex model output indicates that wireless spending in the US could pick up in 2017. He believes this could benefit Viavi, whose wireless segment has come under pressure in 2016 due to a slowdown in the US. Regarding the company’s test opportunity, Mr. Hall expects Viavi to benefit from increasing spending in its various end markets (100Gbps and Mobile) in CY17. He is forecasting the Metro optical telecom equipment market to grow by ~15% in CY17, driven by 100Gbps deployments globally. Lastly, in the wireless market, Mr. Hall expects a rebound in US carrier spending in 2017.
Mergers & Acquisitions
For Viavi, I believe it is also worth mentioning that M&A in this space is on the minds of many investors. On January 30th, Dealreporter was out saying private equity interest in the space bodes well for Viavi. As a reminder, Viavi was one of the suitors mentioned in the potential acquisition of Ixia (XXIA). Ultimately, as we saw on Monday morning, Keysight Technologies (KEYS) was the eventual acquirer.
Taking a look at a Stifel research note from December, they point out that industry consolidation was front and center amongst investor questions. They said that their research “indicates the combination of Viavi’s solid net cash position, free cash flow generation, stake in Lumentum, and ability to use its equity as a currency put the company in an attractive position to be acquisitive in the T&M industry.” Management is clearly biased towards M&A that would increase the depth or breadth of its instrumentation portfolio, which would provide the best scale and synergy benefits, and is shying away from software tuck-in acquisitions that would just increase the complexity of the business. Importantly, meetings highlighted that the company believes it has the capacity to make acquisitions while de-emphasizing/divesting SE assets.
In addition, Stifel said, “Adding to the intrigue of Viavi as a potential industry consolidator is the company’s roughly $5.0 billion in U.S. Federal NOLs which would allow the company to shield domestic profits of any acquired entity.” They note the first tranche of NOLs, a total of $1.2 billion, expire FY21, with some NOLs useable out to 20 years.
From the research provided, Viavi is clearly focused on potential deals. On the strategic front, Viavi is focused on instrumentation and any M&A needs to help the company either deepen its position in its core market, or widen the company into near adjacencies. From an operational perspective the company is adamant it does not want to repeat mistakes made from JDS Uniphase – namely it needs to acquire businesses that can be integrated into Viavi operations. Lastly, the target entity needs to fit the Viavi culture of accountability, leading technology, and progress toward leadership in instrumentation.
In terms of option flow, the following bullish trade was placed on January 27th:
