Viavi Solutions Inc.

Good afternoon and welcome to the VRE Solutions first fiscal quarter of 2023 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you'd like to ask a question during the session, please press star 1 on your telephone keypad. To withdraw your question, press star 1 again. Thank you. I will now turn the call over to Sagar Ebar, Head of Investor Relations. Please go ahead.

Thank you, Julie. Welcome to VRV Solutions' first quarter fiscal year 2023 earnings call. My name is Sagar Hebar, Head of Investor Relations. Joining me on today's call are Oleg Hykin, President and CEO, and Hank Tergson, 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 and estimations. We encourage you to review our most recent annual report and SEC filings, particularly the risk factors described in those filings. The forward-looking statements, including guidance we provide during this call, are valid only as of today. VRV undertakes no obligation to update these statements. Please 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 their usefulness and limitation in today's earnings release. The release plus our supplemental earnings slides, which include historical financial tables, are available on VRV's website at www.investor.vrvsolutions.com. 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 Henk. Thank you, Sagar.

Fiscal Q1 2023 was a challenging quarter for VIAVI. After record results in 2022, we saw an unanticipated deceleration in demand in the last three weeks of the quarter, concentrated among service providers. Fiscal Q1 revenue came in at $310.2 million. down 5.1% year-over-year and below our guidance range of $317 to $331 million. PIAVI's operating profit margin at 21.7% improved 40 basis points from last quarter, although down 100 basis points from last year and came in within our guidance range of 20.7% to 22.1%. EBS at 23 cents was down 4.2% from both prior year and prior quarter results, but within a guidance range of 22 to 24 cents. The current share count of 230.4 million shares includes the dilutive impact of the remaining convertible notes of approximately 1.4 million shares. Now moving to our reported Q1 results by business segment, starting with NSE. NSE quarterly revenue at $218.9 million declined 3.9% year-over-year and was below a guided range of $231 to $241 million. As discussed earlier, our mis-to-revenue guidance was a result of weakness in service provider segment late in the quarter. Within NSE, NE revenue of $194.9 million decreased 4.9% from a year ago. Field instruments was down 9% year over year. Lab instruments across both wireless and optical combined was roughly flat. SE revenue at $24 million increased 4.3% year-over-year. NSE gross profit margin at 64.7% was flat year-over-year. Within NSE, NE gross profit margin at 64.4% decreased 40 basis points from last year, primarily due to declines in volume. SE gross profit margin at 66.7% increased 280 basis points year-over-year because of favorable product mix. NSE operating profit margin at 13.2% was below the guide range of 14 to 15% and decreased 30 basis points from a year ago, reflecting the lower volumes, partially offset by expense control. Now turning to OSP. First quarter revenue at $91.3 million was down 7.7% year-over-year, coming off prior year record levels. Revenue exceeded our guidance range of $86 to $90 million. Cross-profit margin at 56.7%, decreased 100 basis points year-over-year, and includes the impact of startup costs in our new Arizona facility. Operating profit margin of 42.3%, exceeded the high end of our guide range of 39 to 41%, but was a decrease of 180 basis points from a year ago. Now turning to the balance sheet. The ending balance of our total cash and short-term investments was $517.1 million, down $47.8 million sequentially, primarily due to acquisitions, cursing translations, and sharing purchases to offset the dilution of our employee equity plan. Operating cash flow for the quarter was $26.6 million, a decrease of $26.8 million compared to $53.4 million in the year-ago period. The reduction was a result of timing of payroll and non-recurring income tax related payments. We invested $14.8 million in capital expenditures during the quarter compared to $15.7 million in the prior year, primarily to build out our new Arizona production facility. During fiscal Q1, we repurchased 1.3 million shares of our common stock for $18.7 million, thereby completing transactions under the 2019 Repurchase Plan that expired at the end of the quarter. As you may recall, in September, we announced that the Board authorized a new common stock repurchase program for up to $300 million worth of our shares. This new plan allows us to be opportunistic as we think of our capital deployment strategy. Now on to our guidance. In view of the sudden and unexpected reduction in demand, At the end of fiscal Q1 and continuing into October, we are reducing our outlook. We expect the fiscal second quarter 2022 revenue to be approximately $271 million, plus or minus $10 million. Operating profit margin is expected to be 14.4%, plus or minus 50 basis points, and EPS to be in the range of 10 cents to 12 cents. We expect NSE revenue to be approximately $195 million, plus or minus 8 million, with operating profit margin of 6%, plus or minus 50 basis points. OSP revenue is expected to be approximately $76 million, plus or minus 2 million, with operating profit margin at 36%, plus or minus 100 basis points. Our tax rate is expected to be between 24 to 26% as a result of jurisdictional mix. We expect other income expenses to reflect a net expense of approximately $6 million. Share count is approximately 230.4 million shares based upon current stock price levels and includes the dilutive impact of approximately 1.4 million shares of the remaining convertible notes. With that, I will turn the call over to Oleg.

Thank you, Hank.

The September quarter was a disappointing quarter for VIAVI, unexpectedly coming in below guidance. We exited fiscal 2022 with strong order momentum and demand visibility. For the most part, Q1 appeared to be on track with strong backlog and healthy demand across all segments. However, in the last three weeks of September, we noticed a significant deceleration in our bookship conversion across many major service providers in North America and Europe. The service provider business dynamics are characterized by a heavy percentage of bookship orders coming in in the third month of the quarter. Thus, a rapid slowdown in order conversion significantly impacted our field instruments revenue. The service provider segment aside, other VIAVI and market segments delivered as expected. The end-of-quarter bookship dynamics that we observed is a reflection of general pullback in spend by major service providers in North America and Europe during the month of September. We expect the slower spending environment to persist over the next several quarters as service providers work to reduce their OPEX and CAPEX by slowing down fiber and wireless deployment. Looking at the quarter in greater detail helps understand the underlying dynamics. The revenue came in at $310 million, which is about $7 million below the lower end of our revenue guidance range. Despite the lower revenue, our EPS came in line with our guidance at $0.23. The revenue miss was entirely driven by the lower revenue in our NFC business units. The OSP revenue came in above our guidance, but was insufficient to offset the shortfall in NFC. The NSE MIS was driven solely by Field Instruments product line. Our 11 production products, which includes 5G wireless and 400 gigi fiber, delivered as expected. SE business unit saw moderate growth of about 4% year-on-year, driven by continued improvement in demand for our assurance products. In early October, VIAVI acquired Jackson Labs, a leading provider of resilient PNC technology. Resilient P&T, which stands for Positioning, Navigation, and Timing, is a rapidly growing requirement in critical infrastructure and applications, including MilAero, Telecom and Datacom, and energy and transportation networks. This acquisition is part of our strategy to continue reducing VIAVI's dependence on volatile telecom service provider spend budgets and to accelerate VIAVI's growth by investing in high-growth, high-value applications. As we look ahead at the December quarter, we expect NSC demand environment continue to be challenging. Specifically, field instrument segment is expected to continue to see weaker demand as service providers reduce and realign their spend budgets and priorities. Furthermore, it is also highly unlikely that we will see any traditional year-end budget flash this time around. The 11 production segment is expected to be slightly down, as some of our semiconductor and NAM customers are also showing increased conservatism in capex spend. The SE business is expected to continue to perform in line with our expectations. Now, turning to OSP, the OSP business segment results were better than expected, with both revenue and profitability exceeding our expectations. The revenue were driven by stronger than expected demand for both the anti-counterfeiting and 3D sensing products. Looking ahead at the December quarter, we expect revenue to be seasonally down, primarily due to lower anti-counterfeiting demand as our customers work to adjust their year-end inventories. We're also seeing slightly softer than expected 3D sensing demand. We expect the macroeconomic headwinds and the end market demand volatility to persist into the near future. That said, the long-term VIAVI growth drivers and investment thesis remain intact. Strong liquidity position combined with strong operational execution and financial discipline positions us well to manage through the near-term macroeconomic uncertainty and come out stronger as markets recover. We remain positive on our long-term growth drivers such as 5G wireless, fiber, 3D sensing, and with the recent acquisition and entry, the resilient P&T. In conclusion, I would like to thank my VIAVI team for managing in this challenging environment and express my appreciation to our customers and shareholders for their support. I will now turn the call over to Sagar.

Thank you, Oleg. This quarter, VIAVI will be participating at the annual NEDAM Security, Networking, and Communications Conference virtually on November 15th. Julie, let us begin the question and answer session. We ask everyone to limit discussion to one question and one follow-up.

Thank you. At this time, I would like to remind everyone, in order to ask a question, press star 1 on your telephone keypad. To withdraw your question, press star 1 again. Your first question comes from Mehdi Oseni from SIG. Please go ahead.

Hi, this is Logan Ingress on behalf of MediHosseini. I guess for my first question, I wanted to touch on your second quarter guide for NSE operating margin of 5% plus or minus 50 basis points. I guess, can you give a little bit more color on what's driving the significant down crease there? It seems like that is expected to be your lowest operating margin for that segment in

uh several years so if you just provide some color there that'd be that'd be great absolutely it's an it's a revenue story for nse an unanticipated deceleration in demand allows us to guide 195 million at the midpoint and at the moment the nse business drops below 200 million in revenues per quarter we see significant degradation in the operating performance margin. The cost-profit margins are typically intact. It's just the deleverage that hit us on the bottom line.

So volume driven. All volume driven. Got it. And then I guess sticking to NSC, can you talk a little bit more about what you're expecting next quarter, especially from the service providers you mentioned that saw slowing demand, do you see any risk that the slowing field instrument demand could lead into slower lab and production at some point in the future, especially if macro headwinds get worse?

So when we saw the sudden deceleration of bookship conversion at the end of September, our initial thought was, you know, the thing is the customers have not canceled the works. The discussion was all about pushing it out and spreading it of several quarters. our initial thought is like well let's see how the october shapes up if i think it was really more of the end of quarter cash management or whatever well the october clearly showed that many major service providers are slowing down their plans and spreading the revenue over multiple quarters so with the weaker demand we felt it's prudent to lower the expectations clearly if the market bounces back and you know some of them decide to accelerate it will be an upside but we decided to take a conservative position and reset our internal planning as well as the expectations on the field instruments in particular with service providers um when we talk about level production the demand continues to be strong but you know i think it's only a prudent thing to do because many of the service pro nams and including semiconductor companies are seeing their end market demand slowing down looking at the history in the past when that happens you know you're also seeing a bit more conservatism on the r d capex not as much as not as volatile as the service providers but it's probably prudent to say that there's going to be some pullback and a bit um slower and burn rate and that's um more conservative spend environment. So that's why, you know, we're not really taking our level of production down that much, but I think it's prudent to take it down in the mid-single digits as the outlook.

Your next question comes from Alex Henderson from Needham. Please go ahead.

Thanks. So obviously you're giving some pretty valid guidance here for the December quarter. And I guess the question is, and I think you've implied it's going to persist for a couple of quarters beyond that. So as we look out into the back half of your fiscal year, should we be assuming that the fourth quarter is a good metric to be thinking about as a guide to how we'll be looking at 3Q and 4Q as well?

Sure. So, Alex, I mean, clearly, you know, nobody has a crystal ball. But one thing, as you well know me, me and Hank, our view is we don't want to be catching the falling knife and, you know, do a little decrease and then more decrease and so on and so forth. I think we decide looking in the past history and probably actually looking at the first COVID quarter is a good indicator we literally saw the span freeze after the what was like 14th of march of 2020 and then the next quarter was down and then another and then it after it takes about two three quarters for service providers to find their new um footing and then they start spending i mean in the end it takes it's really driven more like how long it takes uh the service provider players to reach the new equilibrium because the reality is they still need all these instruments. They still need all this deployment. But my experience has been it's never a quarter. I mean, it's like they move like an aircraft carrier, taking long time to pivot and find the new thing. The first thing they, you know, from what we've seen at the end of September, they froze all the travel and they really hit on any, whatever the POs and APECs, was hanging out there. Unfortunately, a lot of our revenue is treated as an OPEX, maintenance OPEX. So we got hit. In the second quarter, it usually comes to realignment of their capex and bigger spend, and then they announce the layoffs and what have you. In the third quarter, they now reassess where they are and start releasing funds. And we usually are the beneficiary On the opposite side, we are the early beneficiary when the OPEC spend becomes a bit looser. So we think effectively taking a three-quarter conservative view, this is being the first quarter, stabilizing in the March quarter, and looking stable to maybe slightly a recovery in the June quarter. So that's kind of our scenario under which we are operating. But we think next year is going to be a slower year with a lot of offset service providers as they try to lower their cost exposure. And in a way, we expected it next year to be slower. Unfortunately, the slowdown came in about 14 weeks sooner. When we talked at our analyst day, we guided flattish because we expected the first half continue to be strong and the second half to be weaker and that net thing will be similar to the prior year. I think literally right after the analyst day we saw, you know, the very quick degeneration of demand profile and the slowdown came in about 14 weeks sooner than we thought.

So based on the December quarter normally being one of your strongest quarters of the year, and the guide of $0.10 to $0.12. That sounds like you're talking about something in the $0.60, $0.65 range for 23 is kind of the ballpark. But if you looked out beyond that to 24, it sounds like you think a recovery will happen, but probably in calendar 24, not in the back half of it.

uh calendar 23 is that the right thought process well so that really depends how deep you think the recession will be and the what the next year brings i mean clearly if you think it's going to be a quicker recovery uh then clearly the bounce back will be just as you know much quicker if we think next year is really going to be a malaise or kind of dead calendar year uh then it's going to be more towards the lower end But, you know, we view it as an opportunity for us to actually further improve the structural positioning of the AVI. So when the recovery does come in, the operating leverage will be that much steeper and will recover much stronger.

Your next question comes from Tim Savazio from Northland Capital Markets.

Please go ahead.

Hi, good afternoon.

A couple of questions on the kind of nature of the slowdown you're seeing with the carriers. I guess first would be, are you seeing similar trends across fiber and wireless on the one hand? And then can you comment on what you're seeing out of the cable operators? I'll have a follow-up.

So interesting-wise, the cable operators, we did not expect much in the second half. But we do see actually more dynamic on the positive side behavior among cable operators, and they're pretty much taking everything they plan to take. And I think cable, we find cable operators to be a bit less neurotic in terms of their quarter to quarter spend. They have their plan and they just execute it. I think the, when it comes to the telecom service provider, it's largely today it's wireless and fiber. We don't do much DSL anymore. and it's really just how fast they're it's they're not canceling the programs they are moving forward but they're slowing down the pace because in some cases we're actually doing field deployment so we are physically going into their infrastructure facilities and installing racks of equipment and when they come back it's like hey we want to slow down the pace and we still need all the equipment but could you spread it over multiple quarters, and can you also increase my payment terms? So it's clearly, you know, I think the way it is, if you're not changing your plans, but what you're doing is you're spreading it over more quarters, thereby reducing your quarterly cash burn. So that's what we are seeing. I mean, remarkably, we haven't seen any order cancellations. It's really been all around pushing it out, spreading it over multiple quarters, and discussing the payment terms. So that's why, you know, nobody is really canceling their programs at this time that we can see. But cable, on the other hand, amazingly, so far it's been much more stable.

Okay, great. And I guess since you're focused on field instruments for the weakness, given your relatively recent entry on the wireless side, I assume that's, you know, more on the fiber side. And you can comment on that in the context maybe of this next question, which is about, you know, how broad-based, it sounds like, you know, pretty broad-based in terms of what you're seeing, you know, AT&T's decline in Q4 and kind of finishing their whole C-band building. I mean, that's pretty well established, and that's what's been driving a lot of this stuff. It sounds like you're seeing more than that, but how important is AT&T in this whole equation for you?

Well, I don't want to bring any particular things, but clearly when I say major North American and European, you can pretty much assume who we are talking about, right? But it's not just AT&T. It's actually broader, including them as well as the others. And reality is when they finish building out, this time comes in to turn up the services. And that's usually when a lot of our equipment comes in. And what we are seeing is they're slowing down some of that as well. So, you know, I think once they realign, who knows, they may come back and accelerate equipment purchases. But generally, whenever a CFO says, you know, reduce the OPEX, one of the easiest things to do in any company is shut down the travel and entertainment and any expenses that are in your OPEX. And unfortunately, field instruments for the purposes of service providers, are in their OPEX budget, not in their CAPEX budget. So the first thing they whack is any kind of OPEX-related purchases, and then they go and adjust their capital spent. But actually, the good news is when they reduce their CAPEX, usually their OPEX spend on instruments goes up because you do more with what you've got rather than buying new equipment. So it's a bit countercyclical in that respect.

And we saw the same thing happen during COVID and in prior cycles.

Your next question comes from Angela Jin from JPMorgan. Please go ahead.

Hi. Good afternoon. This is Angela. So just wanted to dig into pricing here. I know probably a few quarters ago you had mentioned that you had taken pricing up sort of ahead of all of these costs. now that some of these input costs are coming down and you're seeing demand slow down. Are you seeing any pressure on pricing, especially from sort of your large tier one providers? And then I have a follow up.

So the good news is there is no pressure on pricing. It's really ultimately demand. On the positive side, we're no longer doing any expedites. I think pretty much the components are becoming readily available and the situation continues to improve as we speak, and I think this quarter, I think we're not really seeing, we're not really chasing any components in any case. If anything, we're seeing some of the semiconductor device pricing is starting to come down. So in that respect, if you notice on the much lower revenue, our gross margin is holding really well. And that actually is more positive than that because what's in the gross margin is the whole operating costs. You know, there are operations overhead is built in there. So on the lower volume, if your gross margin is holding up pretty well, on the lower volume, it actually tells you when you get back to the higher volume, your margins are going to expand. So in that respect, I think our pricing is holding very well, and it really comes down to the velocity at which customers want to take up equipment. I don't think they are really looking for – it's not really, I would say, a competitive price environment.

Got it. So I guess just to follow up quickly on that, for supply, there's no components that you're seeing, not even like FPGAs or any other certain sort of special components where you're seeing pressure?

I think even FPGAs, I think we're now at balance. I think it's at equilibrium with the elite times are coming down very rapidly. And in some cases, you know, what used to be like uh three four months ago uh was given to you as an 18-month lead time you now have spot market availability so in some components it's been a very dramatic turnaround i mean there's i mean fpgas are still with now it's just a reasonable uh standard lead time i wouldn't say they're available on a stop spot market as easily but that's kind of the last thing element that's gonna uh fall in place but

there's been a rapid improvement in lead times and availability.

Your next question comes from Mike Genovese from Rosenblatt Securities. Please go ahead.

Great, thanks.

You've touched on some of this before, but I just want to ask maybe another way, which is... It sounds like you're saying that you're early, an early economic indicator here and that, you know, so do you think then that the NEMS, you know, the lab test customers will slow down further in the future because, you know, you're kind of an early indicator? Is that a right way to look at it?

Well, you know, I would say the field instruments because it is so, Easily, you know, it's an OPEX, and that's usually where we see the first thing. Now, when it comes to R&D, companies do not sacrifice their R&D as readily as service providers sacrifice deliveries to their field technicians. So generally, R&D spend stays more resilient, but I do think, you know, the you may see like 5% pullback or something like that, or maybe they'll push out the orders by a quarter. So I think the nice thing about lab equipment, it's not as volatile as field instruments, but it also does not bounce back as quickly as field instruments. So field instruments, you get whacked really hard and really fast, and just as quickly, you'll see the reversal of fortunes. The lab instruments, I think it's more resilient. It comes down less, but it also probably may take a couple quarters longer to recover.

Okay, that's fair. Okay, so as you mentioned, Oleg and Hank, you guys did the analyst day and gave a three-year outlook, and then things started to change. So obviously the beginning of this three-year outlook is different. So is the three-year outlook the same, or do we have to reevaluate?

that no we continue to be committed to the three-year outlook we're early in the cycle and and we have to better understand how demand plays out here over the next couple of quarters but especially in terms of profitability and cash flow generation we're committed to the plan and and we feel good about our end markets it's just that we have to work through the current softness so so give us one or two quarters see where we are before we give you an update there

And, you know, as we talked about it, we said we kind of got it. This was the first year of a three-year plan. And we said it's going to be roughly flat because we figured there's going to be a recession. And we figured, hey, first half, as we were meeting in Boston, the profile looked really good and outlook for the second quarter was quite good. But we figured there'll be a second half will be weaker. And I think it really got pulled in by about 14 weeks. So I would say this fiscal year will be probably a bit down from the prior year. But when you talk about three years, we assume by then you'll have a recovery. And the market fundamentals and the trends are still the same as they were. So I think as the economy recovers or demand recovers, I think when we think about three years out, it's too early to start downgrading.

Again, if you'd like to ask a question, press star one on your telephone keypad.

Your next question comes from Meta Marshall from Morgan Stanley. Please go ahead.

Hi, this is Mary Lennox on for Meta Marshall. I had a question on where you're seeing the weakness in the OSP segment in your guidance. Was there a pull forward of the 3D sensing or are currency volumes coming down in your assumptions?

Well, I think the generally what we see is the in the December quarter anti counterfeiting slows down, so that's really kind of the biggest cyclical downturn. I'd say on 3D sensing September quarter was pretty strong. Last year our major customer pulled in a lot more and then they realized that the rest of the industry couldn't deliver, so we had a much weaker December quarter. This time around I think the September demand roughly was in line with the market demand. And I think December demand was, you know, we have a rolling forecast. We did see some slight reduction in the forecast. I think listening to Qualcomm and some of the others, it kind of makes sense given the potentially more conservative outlook for number of phone sales. but it's um uh nothing like it was last year so it's still pretty good maybe a little bit weaker than we thought but it's i think december quarter is pullback is primarily driven more by traditional cyclical and counterfeiting adjustments julie is that the last question

And we have one more question coming again from Mike Genovese from Rosenblatt Securities. Please go ahead.

Yeah, just thanks. Just a couple of questions on the numbers on the model. I'm trying to get a split out more between core OSP and 3D sensing. So I guess I'll ask, was core OSP sort of in the mid-60s or high 60s? Where did that come in?

Mid-60s in the first quarter.

Okay, great. And then finally, with this increase in the tax rate we're looking at, I assume that's just because there's some sort of fixed taxes or international taxes and the tax rates higher now because the earnings are lower. So is that the case? And then how long do you think we'll have this 25 versus, say, 17 that we were looking at before?

I think it's specific to this quarter. That's exactly how you described it. It's geographical, jurisdictional mix in countries where we are paying tax, we're generating in Q2, expect to generate higher income, and we think that will normalize during the rest of the year.

And there are no further questions at this time. I will turn the call back over to Sagar for closing remarks.

Thank you, Julie. This concludes our earnings call for today. Thank you, everyone.