VIAVI SOLUTIONS INC. annual report, FY2018

VIAVI Solutions Inc. — FY2018 Form 10-K

Reporting period: Fiscal year ended June 30, 2018. VIAVI provides network test, monitoring and assurance solutions and optical security and performance products. The results are for continuing operations; Lumentum was separated in 2015 and is presented as discontinued operations.

Financial performance

Revenue rose 8.5%, mainly from Network Enablement (NE), including $77.8 million of revenue from acquired AvComm and Wireless (AW), and organic growth in cable testing. Service Enablement (SE) revenue fell 8.4%, while Optical Security and Performance Products (OSP) fell 6.1%. Product revenue was $783.1 million and service revenue $97.3 million.

Gross margin declined four percentage points, reflecting lower NE and OSP margins and increased amortization of acquired technology. Net loss included $47.3 million of interest expense and $13.4 million of income tax expense. FY2017 net income was significantly boosted by a $203.0 million gain on Lumentum share sales; FY2018 had no comparable gain.

Cash, liquidity and debt

Operating cash flow declined to $66.0 million; capital expenditures were $42.5 million, implying approximately $23.5 million of operating cash flow after capital expenditures. Cash and investments fell by $659.8 million, primarily reflecting $509.9 million of cash used for acquisitions and cash used to repurchase debt and shares.

At year-end, the company reported $611.4 million in cash and cash equivalents, $169.3 million in short-term investments and $7.3 million in restricted cash. Convertible notes had $962.0 million aggregate principal outstanding: $277.0 million of 2033 Notes, $460.0 million of 2024 Notes and $225.0 million of 2023 Notes. Their reported carrying amount was $833.2 million, including unamortized discounts and issuance costs. The 2033 Notes were classified as short-term debt. Subsequent to year-end, holders surrendered $134.3 million principal of 2033 Notes for repurchase, which VIAVI accepted and paid in July 2018. Management stated existing cash and investments were expected to cover liquidity and capital needs for the next 12 months; the company was in compliance with debt covenants.

Material changes and unusual items

• Acquired Trilithic in August 2017 for $56.4 million and AW from Cobham in March 2018 for $469.8 million. Acquisitions increased NE revenue and goodwill and contributed to higher amortization and integration costs.
• NE revenue increased 21.3%; SE revenue decreased 8.4% as the company continued to narrow the segment’s scope and mature Assurance offerings faced contract expirations. OSP revenue declined following a prior-year banknote redesign cycle; 3D-sensing revenue grew.
• VIAVI repurchased $181.5 million principal of 2033 Notes for $198.0 million cash and exchanged another $151.5 million principal for 2023 Notes. It issued $225.0 million principal of 1.75% convertible notes due 2023.
• Restructuring charges were $8.3 million, down from $21.6 million. Management estimated approximately $9.2 million in annualized gross savings from recent restructuring actions.
• The Tax Cuts and Jobs Act reduced the U.S. federal corporate tax rate and drove substantial deferred-tax remeasurement, largely offset by valuation allowances. The deemed repatriation estimate remained provisional.
• Adoption of the new revenue standard in fiscal 2019 was expected to reduce reported FY2018 and FY2017 revenue by $5.4 million and $7.6 million, respectively, primarily from changed timing of software revenue recognition; cash flows are unaffected.

Outlook, commentary and risks

Management expected FY2019 NSE revenue to increase, supported by 5G testing and deployment and fiber-to-the-home deployment. It expected OSP anti-counterfeiting revenue to rise in the first half of FY2019 on banknote redesigns and moderate in the second half; 3D-sensing revenue was expected to rise in the first half and decline in the second, reflecting smartphone seasonality. These are expectations, not quantified guidance.

Key risks include demand and capital-spending uncertainty among telecom and cable customers, pricing pressure and product-mix volatility, rapid technology shifts toward virtualized/software networks, integration and execution risks from acquisitions, dependence on limited suppliers, and seasonal and cyclical OSP demand. SICPA represented 14.7% of FY2018 revenue, down from 20.6% in FY2017. The company also cited trade-tariff uncertainty, foreign-exchange exposure, cybersecurity threats, potential litigation and environmental liabilities. Pension plans were underfunded by $106.7 million. A UK pension-related legal matter remained accrued at $7.8 million; VIAVI was pursuing a claim against the law firm involved.

After year-end, management approved additional NSE workforce reductions affecting an estimated 200–250 employees, with charges of up to approximately $19 million expected through calendar 2020. Management and the auditor reported effective internal control over financial reporting as of June 30, 2018; AW was excluded from that assessment and audit because it had recently been acquired. A prior income-tax material weakness was reported as remediated in 2017.

Important facts for investors to verify

• Whether acquired AW and Trilithic businesses deliver expected growth, profitability and integration savings, given acquisition-related costs and the decline in gross margin.
• The remaining 2033 Notes balance and cash requirements after the July 2018 repurchase, alongside the other convertible-note maturities and potential dilution.
• Whether operating cash generation improves and working capital—especially receivables and inventory—remains controlled after acquisitions and 3D-sensing inventory build.
• Revenue concentration and renewal or minimum-purchase terms with SICPA, and the timing and cyclicality of banknote redesign and 3D-sensing demand.
• The final tax effects of the Tax Cuts and Jobs Act, continued use of tax-loss carryforwards, and the effect of adopting the revenue and lease accounting standards.