GLW - Viavi Solutions: Benefiting From The Less-Known Areas Of 5G And Fiber Testing

Summary

• With a market cap of just $3.19 billion, Viavi remains relatively less known.
• The same is the case for its equipment, which is crucial in testing 5G and fiber networks as they are deployed.
• I also touch upon supply chain risks as well as adverse effects, which can be caused by a strong dollar amid heightened macroeconomic concerns.
• With more of its gear being required in deploying today's more complex networks, the stock is a buy.
• It is available at $13.6 and a P/E of less than 15x.

In addition to 5G wireless, Viavi Solutions ( VIAV ) also caters to the network testing and monitoring requirements of fiber networks. With a market cap of just $3.19 billion, it is less known than network plays like Cisco ( CSCO ) who get most of the attention.

However, at a share price of less than $14 and a price to earnings of 14.35x, this remains a company you do not want to ignore, especially given the fact that it is down by nearly 19% during the last year as shown in the chart below.

My objective with this thesis is to make an investment case using the financial results of the fourth quarter of 2022 (Q4) which ended in July, but, first, I start with an often overlooked aspect of the latest generation of communication technologies.

The Importance Of Testing And Monitoring

There is a lot of talk about 5G as well as the companies that are going to profit from related developments, namely service providers like T-Mobile ( TMUS ) who should see more subscription revenues or suppliers like Ericsson ( ERIC ) who are expected to sell more radio antennas. However, for 5G to work, a lot of testing is required and in this respect, there is complete radio silence on the companies who make the relevant equipment, with one of them being Viavi.

Furthermore, in the shadows of large optical fibers manufacturers like Corning ( GLW ) or service providers like Comcast (CMCSA), the Arizona-based company designs testing gear for wired networks. This is no loss-making start-up that has just come up with innovative technology. Instead, it has been designing quality assurance solutions since the days of 2G.

Going into detail, in addition to expanding their networks to support the fifth-generation wireless technology, service providers have to make sure that there is no latency, or delay when communicating over 5G or fiber links. For this purpose, while 3G was mostly about voice and text, 5G was more about data and streaming, with more stringent demands for quality. The reason is that it is expected to support applications like online gaming or Industry 4.0, where users cannot afford to have gaps during transmissions, like when two gamers are playing an Augmented Reality game or a robot taxi is waiting for instructions from a control center.

For such high levels of performance, it is important to have the best testing and monitoring tools as those procured from Viavi. Consequently, its quarterly revenues have been increasing as shown in the table below.

Profitability is on the rise too, but, the company's advanced gear necessitates a lot of electronics and as such, it becomes important to assess how it is faring amid all these supply chain issues and high inflation levels impacting various parts of the world.

Supply Chain Issues, Costs, And Profitability

In fact, when I covered the stock back in May, I had raised supply chain issues, especially due to a large part of the components originating in China. At that time, several of the country's cities including ports were in lockdown mode in order to limit Covid infection. For Viavi, it meant an additional $8 million in shipping charges for fiscal 2022. Additionally, there was European exposure for about 1% of its yearly sales.

However, Q4’s results have shown that the U.S. company has overcome these challenges as in addition to improving revenues by 7.8% on a year-on-year basis, gross margin also increased by 0.5% to 62.5%. Well, this is no big increase but shows that the company has not suffered from rising costs of sales normally associated with supply chain issues or higher (inflation-induced) prices.

Continuing on a positive note, operating margins increased by 4.4% (above table) made possible by higher revenues combined with more disciplined spending, offset partly by reduced margins in OSP (optical security and performance) segment. This segment which is suffering from rising materials costs saw its sales figures peaking in 2021 led by pandemic demand for anti-counterfeiting products. Still, as shown in the table below, strength in both the network enablement ("NE") and service enablement ("SE") segments has offset weakness in OSP.

The company’s record revenues were driven by increased orders for its products used in Fiber-to-the-Home deployments, 400GbE network use in data center upgrades, and O-RAN for network expansions.

In this respect, Viavi remains a key player in O-RAN which is about using open standards in the radio access network ("RAN"), as opposed to more “proprietary” solutions. In this respect, the company was one of the first to adopt the open route, with the likes of Aliostar and Mavenir. Now that O-RAN has been adopted by large service providers like Japan's Rakuten ( RKUNY ) and DISH Network ( DISH ), others are also getting into the space, resulting in the “ broadening of the wireless customer base” for Viavi.

As for wired or fiber, after the digital transformation momentum unleashed by Covid lockdowns, governments and service providers are extending fiber to people’s homes, especially in Europe. Thus, the company is seeing more equipment sales as data centers upgrade from 400 Gig to faster 800 Gig and also thanks to more enterprises adopting a multi-cloud strategy.

Therefore, the company has strengths in both fiber and wireless, which means that it can address a wide number of use cases. Also, to address long-term supply chain challenges, Viavi is in the process of completing its Arizona production facility, which was initiated in February 2021. This should help to onshore some production to the U.S. for a company that is present in many countries throughout Europe, the Middle East, and Asia.

This said, with recession concerns looming, there could be some customer pullback in terms of deployment or trimming down R&D budgets. Thus, expectations are for the company to grow by around 5% (mid-single digits) in FY-2023, lower than the 7.8% in the last fiscal year which ended in July. Furthermore, based on the $324 million guidance for Q1-2023, there should be a regression of revenues both sequentially and on a year-to-year basis, attributed partly to seasonal trends.

Valuations And Key Takeaways

It is this guidance that may have spooked investors, causing the shares to fall by over 14% since mid-August as well as confirmation of the Fed Chairman's more hawkish tone during the Jackson Hole Symposium last week. In this case, rising interest rates do not bode well for Viavi which has $744.6 million of debt. However, looking deeper, debt has been reduced since the Oct 2021 quarter.

Furthermore, looking beyond growth, metrics like recurring revenues and cash flow also matter, especially during periods of inflationary pressures. For this purpose, the company’s customers are mostly service providers and fiber/wireless operators, which tend to be financially strong. Thus, while they may delay orders for deployment projects over a longer period of time in case of an economic slowdown, they are not likely to stop ordering entirely. Also, they are unlikely to delay orders for their R&D projects for fear of losing their competitive edge.

As a result, $178 million of cash flow from operations were generated in 2022, or an $11 million increase over last year. This translates into operating cash flow margins of 13.7% which is above average . After subtracting capital expenses, Viavi generated an FCF (free cash flow) of $106 million. Going ahead, cash flow should increase after some investments in the supply chain were made at the beginning of 2022.

This investment in the supply chain can also help the equipment play to benefit from more contracts, and this is at the expense of competitors. In this industry, big customers tend to split procurement contracts between suppliers to make sure that there is no project delay in case one fails to deliver on time. Consequently, since the company has strengthened its supply chain, it is likely to benefit from more orders.

As for valuations, taking into consideration Viavi's ability to increment profitability by navigating skillfully through both supply chain and inflation challenges, it deserves better P/E and EV/EBIT multiples as per the table below. Hence, adjusting the P/E based on the sector median of 18.34x, I obtain a share price of $17.4 (18.34/14.35 x 13.6) based on the current share price of $13.6.

However, in the short term, this target can only be achieved if the Fed signals a more dovish tone in view of the weakening of job numbers for August. For investors, weak employment numbers show that there is a slowdown in hiring because of growth concerns and the Fed will now have to be careful not to raise interest rates too sharply as it may trigger a recession.

Furthermore, with around 70% of revenues for fiscal 2022 coming outside of the U.S., Viavi is not immune to a strong dollar triggering currency devaluations, especially in regions like Europe or Asia. In case this happens, then the stock should be volatile.

Still, with multiyear fiber deployment projects in Europe and 5G infrastructure now being disaggregated to support an additional edge layer, more testing and monitoring gear is required than before to calibrate increasingly complex networks. Moreover, there is Viavi's operating cash generating capacity together with the continuous reduction in debt in order to improve the capital structure, while strengthening its supply chain.

Finally, the share buyback of $45.5 million not only boosts the value of the stock, but also shows management's confidence in the company's future prospects.

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