Viavi Solutions Inc. — FY2017 Form 10-K
Reporting period: Fiscal year ended July 1, 2017 (52 weeks), compared primarily with the year ended July 2, 2016. The request metadata says “2016 Q4,” but the filing is an annual report for FY2017. The Lumentum business is reported as discontinued operations; the discussion below focuses on continuing operations unless noted.
Business context
Viavi provides network test, monitoring and assurance products and services through Network Enablement (NE) and Service Enablement (SE), and optical security and performance products through OSP. NE and SE together are Network and Service Enablement (NSE). The company completed the Lumentum separation in August 2015 and sold its remaining Lumentum shares during FY2017.
Financial results and liquidity
| Metric | FY2017 | FY2016 |
|---|---|---|
| Revenue | $811.4 million | $906.3 million |
| Gross profit / margin | $486.0 million / 59.9% | $549.7 million / 60.7% |
| Operating income (loss) | $13.6 million | $(84.3) million |
| Continuing-operations net income (loss) | $165.3 million | $(50.4) million |
| Net income (loss), including discontinued operations | $166.9 million | $(99.2) million |
| Cash from operating activities | $80.0 million | $52.9 million |
- FY2017 basic and diluted EPS were $0.73 and $0.71, respectively. Results included a $203.0 million gross gain on sales of Lumentum shares; reported net income therefore substantially exceeded operating income.
- Revenue fell 10.5%. Product revenue declined $82.4 million (10.2%) and service revenue declined $12.5 million (12.8%). Gross margin contracted 0.8 percentage points.
- Cash and cash equivalents were $1,004.4 million, short-term investments $432.2 million, and restricted cash $11.2 million at year-end. Working capital was $1,438.2 million. Management said existing cash and investments should cover liquidity and capital spending needs for the next 12 months.
- Operating cash flow was $80.0 million; investing cash flow was $113.7 million and financing cash flow was $325.3 million. Capital expenditures were $38.6 million. Operating cash flow included the effect of the $203.1 million investment gain, which was deducted in reconciling net income to cash flow.
- Convertible-note principal totaled $1.07 billion: $610 million of 0.625% notes due 2033 and $460 million of 1.00% notes due 2024. Balance-sheet long-term debt carrying value was $931.4 million. FY2017 included issuance of the 2024 notes and repurchase of $40 million principal of the 2033 notes. The company reported compliance with debt covenants and no short-term debt.
Material changes and segment performance
- NE revenue decreased 12.0% to $444.0 million, mainly from weaker North American service-provider demand for field instruments and slower NEM and Chinese telecom spending. Cable products benefiting from DOCSIS 3.1 upgrades partly offset the declines. NE gross margin was 64.5%, down 0.8 points.
- SE revenue decreased 12.0% to $135.2 million, reflecting the planned narrowing of the portfolio, runoff of mature Assurance products and nonrecurring prior-year Data Center deals. SE gross margin was 63.8%, down 0.9 points.
- OSP revenue decreased 6.4% to $232.2 million as anti-counterfeiting demand weakened with lower banknote volumes; consumer and industrial growth partly offset this. OSP operating income was $100.3 million, with a 43.2% operating margin.
- NSE operating income was $7.3 million, down from $12.7 million, and its operating margin fell to 1.3% from 1.9%. GAAP operating income improved to $13.6 million from an $84.3 million loss, partly because FY2016 included a $91.4 million SE goodwill impairment.
- Research and development expense fell 18.1% to $136.3 million and SG&A fell 14.4% to $300.5 million, reflecting restructuring and cost reductions. Restructuring charges increased to $21.6 million from $10.5 million.
Outlook, risks and unusual items
- For FY2018, management expected continued decline in mature SE Assurance revenue. OSP anti-counterfeiting revenue was expected to moderate in the first half as customers rebalance inventories, then rebound in the second half. Initial 3D-sensing product shipments were expected in the first half, with a larger ramp in the second half; the filing cautions that market and growth estimates are uncertain.
- FY2017 restructuring included a focused NSE plan affecting approximately 300 employees and an OSP plan to exit printed security products affecting approximately 30 employees. Management estimated approximately $43 million of annualized gross savings from restructuring activities initiated in the prior year. Execution, timing and savings remain uncertain.
- SICPA represented 20.6% of FY2017 revenue, creating customer and channel concentration. Viavi relies on SICPA to market and sell OVP pigment for document authentication under a supply and license agreement.
- Other key risks include telecom and cable capital-spending weakness, pricing pressure and competition, product mix and currency fluctuations, dependence on limited-source suppliers, technology shifts toward virtualized networks, and potential impairment of goodwill or other assets. Backlog declined to approximately $177 million from $234 million and is not necessarily predictive of future revenue.
- The company recorded a $7.4 million pension-related legal accrual; the estimated liability range was $7.4 million to $10.9 million, and the matter remained subject to legal proceedings. Management said other ordinary-course claims were not expected to have a material adverse effect, while acknowledging uncertainty.
- A previously reported material weakness in interim income-tax controls was remediated by year-end; management and the auditor concluded internal control over financial reporting was effective as of July 1, 2017. The auditor gave an unqualified opinion on the financial statements and controls.
- Subsequent to year-end, Viavi repurchased $146.5 million principal of its 2033 notes for $162.0 million cash and acquired Trilithic for $55.0 million net cash. The company also disclosed a potential tax risk if the Lumentum separation were ultimately determined not to qualify as tax-free.
Important facts for investors to verify
- How much of FY2017 earnings and cash generation is repeatable after excluding the $203.0 million Lumentum share-sale gain?
- Whether NE demand stabilizes, SE restructuring and cost savings improve profitability, and the expected FY2018 Assurance decline is contained.
- Whether OSP anti-counterfeiting demand rebounds as forecast and 3D-sensing shipments achieve the anticipated ramp and economics.
- Customer concentration and SICPA agreement terms, including minimum-purchase commitments and dependence on SICPA for OVP sales.
- Debt repayment, conversion and potential dilution implications, particularly following the post-year-end 2033-note repurchase and the notes’ holder put rights.
- Potential cash and earnings effects of the pension litigation, restructuring obligations, tax exposures, and any limits on use of tax-loss carryforwards.