Item 7. Management’s Discussion and Analysis
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read the following discussion of our financial condition and results of operations in conjunction with the financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and in this Annual Report on Form 10-K, particularly in “Risk Factors” and “Forward-Looking Statements.”
Our Industries and Developments
Viavi Solutions Inc. (VIAVI, also referred to as the Company, we, our, and us) is a global provider of network test, monitoring and assurance solutions for communications service providers (CSPs), enterprises, network equipment manufacturers (NEMs), original equipment manufacturers (OEMs), government and avionics. We help these customers harness the power of instruments, automation, intelligence and virtualization to Command the network . VIAVI is also a leader in management solutions for 3D sensing, anti-counterfeiting, consumer electronics, industrial, aerospace, automotive and medical applications.
To serve our markets, during fiscal 2021 we operated the following business segments:
• Network Enablement (NE);
• Service Enablement (SE); and
• Optical Security and Performance Products (OSP).
Refer to “Item 1 Business” for information related to our business segments.
COVID-19 Pandemic Update
The COVID-19 pandemic has prompted authorities worldwide to implement measures to contain the virus, which include and are not limited to, travel bans and restrictions, quarantines, shelter-in-place orders, temporary business closures among others. The COVID-19 pandemic and these aforementioned measures, have had and continue to have, a substantial macroeconomic impact on businesses and economies worldwide. These conditions may continue and could result in an adverse impact to our operations.
Worldwide distribution by central governments of the vaccines commenced in late 2020. There have been logistical and operational challenges with the rollout and global demand for the vaccine has far exceeded supply. It will take some time for the global population to receive vaccines, allowing for widespread immunity to develop. At the same time, new and potentially more contagious variants of the virus are developing in several countries and regions in which we operate.
Our priority during the COVID-19 pandemic has remained focused on protecting the health and safety of our employees, customers, suppliers, and communities, including implementing early and regular updates to our health and safety policies and procedures. We continued to follow the strict COVID-19 pandemic protocols as required by local, state and federal guidelines during the fiscal first half of 2021 and began to relax these restrictions based on government guidelines during the fiscal second half 2021. These COVID-19 pandemic protocols have not thus far had a substantial net impact on our liquidity position. We continue to generate operating cash flows to meet our short-term liquidity needs, and we expect to maintain access to the capital markets. To date, we have not observed any material or materially adverse indication of impairments under the authoritative guidance, to any of our assets or a significant change to the fair value of assets due to the COVID-19 pandemic.
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We have experienced and may continue to experience disruption of our facilities, suppliers and contract manufacturers, which has impacted and may continue to negatively impact our sales and operating results. In addition, we have experienced and may continue to experience shipping and logistics challenges as many of our customers have also closed their facilities and are operating under similar restrictions. NSE has experienced some impact to customer demand. Customer demand will continue to be challenging to calibrate, due to the nature and timing of the COVID-19 pandemic. In addition, we operate a shared services center in Pune, India that provides important finance and IT support services. The recent substantial increase of reported COVID-19 transmission rates in that country due to the emergence of a more virulent variant of the virus has led to a significant spike in illness and death rates. If the situation in India does not improve, our operations and employees there could be negatively impacted. We will continue to take the measures described above to ensure the health and safety of our employees and those they come in contact with.
We have a global supply chain footprint with our primary manufacturing partners located in China, France, Germany, United Kingdom and the United States. We have experienced increased freight and logistics costs due to supply chain shortages resulting in extended lead times with respect to our NE Field Instrument products. Our supply chain team has been working to meet our customer needs by executing on a risk mitigation plan, including multi-sourcing, pre-ordering components, transforming our logistics network, prioritizing critical customers, working with local government agencies to understand challenges, and partnering on solutions that limit disruptions to our operations while ensuring the safety of our employees, partners and suppliers. Nonetheless, surges in infection rate, new shutdowns, emergence of new and potentially more contagious variants of the virus and the slow pace of vaccine rollout may impact our suppliers and our ability to source materials in a timely manner. COVID-19 has brought unprecedented challenges, we believe that we have a robust and adaptable supply chain. While our industry faced supply chain challenges resulting from the COVID-19 pandemic such as diminished manufacturing capacity and materials shortages resulted in extended lead-times, increased logistics costs, and product volume impact these factors did not materially impact our business in fiscal year 2021.
While capital markets and worldwide economies have stabilized and recovered since being significantly impacted by the COVID-19 pandemic, on June 8, 2020 the National Bureau of Economic Research announced that the U.S. was in a recession. As the pandemic spread across the globe in Spring 2020, there was a tightening of the credit markets. We entered into a $300 million secured credit facility in May 2020 to strengthen our liquidity position but have not drawn on this facility to date. If there is a prolonged global recession, we could face future liquidity challenges and may not be able to obtain additional financing on favorable terms or at all.
Despite the continued challenges that we are facing due to the COVID-19 pandemic, we remain confident that the actions that we are taking to manage such challenges, combined with our strong liquidity, position us well to navigate through the current economic environment and continue to execute on our long-term value creation strategy. We expect our principal growth drivers, 5G Wireless, Fiber and 3D Sensing to continue driving growth and profitability in fiscal 2022.
Recently Issued Accounting Pronouncements
Refer to “Note 2. Recently Issued Accounting Pronouncements” under Item 8 of this Annual Report on Form 10-K, regarding the effect of certain recent accounting pronouncements on our Consolidated Financial Statements.
Critical Accounting Policies and Estimates
Our Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP), which require management to make judgments, estimates and assumptions that affect the reported amounts of assets and liabilities, net revenue and expenses, and the disclosure of contingent assets and liabilities. Our estimates are based on historical experience and assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. We believe that the accounting estimates employed and the resulting balances are reasonable; however, actual results may differ from these estimates and such differences may be material. We believe the following critical accounting policies are affected by significant estimates, assumptions or judgments used in the preparation of our Consolidated Financial Statements.
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Revenue Recognition
We derive revenue from a diverse portfolio of network solutions and optical technology products and services, as follows:
• Products : NE and SE products include instruments, microprobes and perpetual software licenses that support the development, production, maintenance and optimization of network systems. Our OSP products include proprietary pigments used for optical security and product enhancement applications as well as optical filters and Engineered Diffusers™ used in a range of applications for the consumer electronics, government, automotive and industrial markets.
• Services: We also offer a range of product support and professional services designed to comprehensively address customer requirements. These include repair, calibration, extended warranty, software support, technical assistance, training and consulting services. Implementation services provided in conjunction with hardware or software solution projects include sale of the products along with project management, set-up and installation.
Steps of revenue recognition
We account for revenue in accordance with the revenue standard, in which the following five steps are applied to recognize revenue:
1. Identify the contract with a customer: Generally, we consider customer purchase orders which, in some cases are governed by master sales or other purchase agreements, to be the customer contract. All of the following criteria must be met before we consider an agreement to qualify as a contract with a customer under the revenue standard: (i) it must be approved by all parties; (ii) each party’s rights regarding the goods and services to be transferred can be identified; (iii) the payment terms for the goods and services can be identified; (iv) the customer has the ability and intent to pay and collection of substantially all of the consideration is probable; and, (v) the agreement has commercial substance. We exercise reasonable judgment to determine the customer’s ability and intent to pay, which is based upon various factors, including the customer’s historical payment experience or credit and financial information and credit risk management measures that we implement.
2. Identify the performance obligations in the contract: We assess whether each promised good or service is distinct for the purpose of identifying the various performance obligations in each contract. Promised goods and services are considered distinct provided that: (i) the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer; and (ii) our promise to transfer the good or service to the customer is separately identifiable or distinct from other promises in the contract. Our performance obligations consist of a variety of products and services offerings, which include networking equipment; proprietary pigment; optical filters; proprietary software licenses; and support and maintenance, which includes hardware support that extends beyond our standard warranties, software maintenance, installation, professional and implementation services, and training.
Identifying and evaluating whether products and services are considered distinct performance obligations may require significant judgment particularly in NSE due to the underlying nature of the product and service offerings. We may enter into contracts that involve a significant level of integration and interdependency between a software license and installation services. Judgment may be required to determine whether the software license is considered distinct in the context of the contract and accounted for separately, or not distinct in the context of the contract and accounted for together with the installation service.
3. Determine the transaction price: Transaction price reflects the amount of consideration to which we expect to be entitled in exchange for transferring goods or services to the customer. Our contracts may include terms that could cause variability in the transaction price, including rebates, sales returns, market incentives and volume discounts. Variable consideration is generally accounted for at the portfolio level and estimated based on historical information. If a contract includes a variable amount, the price adjustments are estimated at contract inception. In both cases, estimates are updated at the end of each reporting period as additional information becomes available.
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4. Allocate the transaction price to performance obligations in the contract: If the contract contains a single performance obligation, the entire transaction price is allocated to that performance obligation. Many of our contracts include multiple performance obligations with a combination of distinct products and services, maintenance and support, professional services and/or training. Contracts may also include rights or options to acquire future products and/or services, which are accounted for as separate performance obligations by us, only if the right or option provides the customer with a material right that it would not receive without entering into the contract. For contracts with multiple performance obligations, we allocate the total transaction value to each distinct performance obligation based on relative standalone selling price (SSP). Judgment is required to determine the SSP for each distinct performance obligation. The best evidence of SSP is the observable price of a good or service when we sell that good or service separately under similar circumstances to similar customers. If a directly observable price is not available, the SSP must be estimated based on multiple factors including, but not limited to, historical pricing practices, internal costs, and profit objectives as well as overall market conditions.
5. Recognize revenue when (or as) performance obligations are satisfied: Revenue is recognized at the point in time control is transferred to the customer. For hardware sales, transfer of control to the customer typically occurs at the point the product is shipped or delivered to the customer’s designated location. For software license sales, transfer of control to the customer typically occurs upon shipment, electronic delivery, or when the software is available for download by the customer. For sales of implementation service and solution contracts or in instances where software is sold along with essential installation services, transfer of control occurs and revenue is typically recognized upon customer acceptance. In certain instances, acceptance is deemed to have occurred if all acceptance provisions lapse, or if we have evidence that all acceptance provisions will be, or have been, satisfied. For fixed-price support and extended warranty contracts, or certain software arrangements, which provide customers with a right to access over a discrete period, control is deemed to transfer over time and revenue is recognized on a straight-line basis over the contract term due to the stand-ready nature of the performance obligation. Revenue from hardware repairs and calibration services outside of an extended warranty or support contract is recognized at the time of completion of the related service. For other professional services or time-based labor contracts, revenue is recognized as we perform the services and the customers receive and/or consume the benefits.
Business Combinations
We use the acquisition method of accounting under the authoritative guidance on business combinations. Each acquired company’s operating results are included in our Consolidated Financial Statements beginning on the date of acquisition. The purchase price is equivalent to the fair value of consideration transferred. Tangible and identifiable intangible assets acquired and liabilities assumed as of the date of acquisition are recorded at their estimated fair values as of the acquisition date. Goodwill is recognized for the excess of purchase price over the net fair value of assets acquired and liabilities assumed.
The allocation of purchase price requires management to make significant estimates and assumptions in determining the fair values of the assets acquired and liabilities assumed. With respect to intangible assets, critical estimates in valuing intangible assets include, but are not limited to, future cash flows from customer relationships, developed technology, trade names, acquired patents and discount rates. Management estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. Unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions, estimates or actual results.
Goodwill Valuation
Goodwill represents the excess of the purchase price paid over the net fair value of assets acquired and liabilities assumed. We test goodwill for impairment at the reporting unit level at least annually, during the fourth quarter of each fiscal year, or more frequently if events or changes in circumstance indicate that the asset may be impaired.
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The accounting guidance provides us the option to perform a qualitative assessment to determine whether further impairment testing is necessary. The qualitative assessment considers events and circumstances that might indicate that a reporting unit’s fair value is less than its carry amount. These events and circumstances include macro-economic conditions, such as a significant adverse change in our operating environment, industry or market considerations; entity-specific events such as increasing costs, declining financial performance, or loss of key personnel; or other events, such as the sale of a reporting unit, adverse regulatory developments or a sustained decrease in our stock price.
If it is determined, as a result of the qualitative assessment, that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, a quantitative test is required. Otherwise, no further testing is required.
Under the quantitative test, if the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recorded in the Consolidated Statements of Operations as impairment of goodwill. Measurement of the fair value of a reporting unit is based on one or more of the following fair value measures: (i) using present value techniques of estimated future cash flows; (ii) using valuation techniques based on multiples of earnings or revenue; or, (iii) a similar performance measure.
Application of the goodwill impairment test requires judgments, including identification of the reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, a qualitative assessment to determine whether there are any impairment indicators and determining the fair value of each reporting unit. We generally estimate the fair value of a reporting unit using a combination of the income approach, which estimates the fair value based on the future discounted cash flows, and the market approach, which estimates the fair value based on comparable market prices. Our significant estimates in the income approach include our weighted average cost of capital, long-term rate of growth and profitability of the reporting unit’s business and working capital effects. The market approach estimates the fair value of the business based on a comparison of the reporting unit to comparable publicly traded companies in similar lines of business. Significant estimates in the market approach include identifying similar companies with comparable business factors such as size, growth, profitability, risk and return on investment, and assessing comparable revenue and operating income multiples in estimating the fair value of the reporting unit.
We base our estimates on historical experience and on various assumptions about the future that we believe are reasonable based on available information. Unanticipated events and circumstances may occur that affect the accuracy of our assumptions, estimates and judgments. For example, if the price of our common stock were to significantly decrease combined with other adverse changes in market conditions, thus indicating that the underlying fair value of our reporting units may have decreased, we might be required to reassess the value of our goodwill in the period such circumstances were identified.
In the fourth quarter of fiscal 2021, we performed the goodwill impairment test in accordance with the authoritative guidance for NE, SE and OSP reporting units, and determined no indicator of impairment. Refer to “Note 9. Goodwill” under Item 8 of this Annual Report on Form 10-K for more information.
Income Taxes
In accordance with the authoritative guidance on accounting for income taxes, we recognize income taxes using an asset and liability approach. This approach requires the recognition of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in our Consolidated Financial Statements or tax returns. The measurement of current and deferred taxes is based on provisions of the enacted tax law and the effects of future changes in tax laws or rates are not anticipated.
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The authoritative guidance provides for recognition of deferred tax assets if the realization of such deferred tax assets is more likely than not to occur based on an evaluation of both positive and negative evidence and the relative weight of the evidence. With the exception of certain international jurisdictions, we have determined that at this time it is more likely than not that deferred tax assets attributable to the remaining jurisdictions will not be realized, primarily due to uncertainties related to our ability to utilize our net operating loss carryforwards before they expire. Accordingly, we have established a valuation allowance for such deferred tax assets. If there is a change in our ability to realize our deferred tax assets for which a valuation allowance has been established, then our tax provision may decrease in the period in which we determine that realization is more likely than not. Likewise, if we determine that it is not more likely than not that our deferred tax assets will be realized, then a valuation allowance may be established for such deferred tax assets and our tax provision may increase in the period in which we make the determination.
The authoritative guidance on accounting for uncertainty in income taxes prescribes the recognition threshold and measurement attributes for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Additionally, it provides guidance on recognition, classification and disclosure of tax positions. We are subject to income tax audits by the respective tax authorities in all of the jurisdictions in which we operate. The determination of tax liabilities in each of these jurisdictions requires the interpretation and application of complex and sometimes uncertain tax laws and regulations. We recognize liabilities based on our estimate of whether, and the extent to which, additional tax liabilities are more likely than not. If we ultimately determine that the payment of such a liability is not necessary, then we reverse the liability and recognize a tax benefit during the period in which the determination is made that the liability is no longer necessary.
The recognition and measurement of current taxes payable or refundable and deferred tax assets and liabilities requires that we make certain estimates and judgments. Changes to these estimates or a change in judgment may have a material impact on our tax provision in a future period.
Contingencies
We are subject to various potential loss contingencies arising in the ordinary course of business. In determining a loss contingency, we consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as its ability to reasonably estimate the amount of loss. An estimated loss is accrued when it is probable that an asset has been impaired, a liability has been incurred and the amount of loss can be reasonably estimated. We regularly evaluate current information available to determine whether such accruals should be adjusted and whether new accruals are required.
Contingent liabilities include contingent consideration in connection with our acquisitions, which represent earn-out payments recognized at fair value on the acquisition date and remeasured each reporting period with subsequent adjustments recognized in the Selling, General and Administrative (SG&A) expense of our Consolidated Statements of Operations. Contingent consideration is valued using significant inputs that are not observable in the market pursuant to fair value measurement accounting. While we believe the estimates and assumptions are reasonable, there is significant judgment and uncertainty involved.
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Pursuant to instruction 1 of the instructions to paragraph 303(a) of Regulation S-K, discussion of the results of operations for the fiscal year ended June 27, 2020 and fiscal year ended June 29, 2019 has been omitted. Such omitted discussion can be found under Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended June 27, 2020, filed with the SEC on August 24, 2020.
RESULTS OF OPERATIONS
The results of operations for the current period are not necessarily indicative of results to be expected for future periods. The following table summarizes selected Consolidated Statements of Operations items as a percentage of net revenue:
Years Ended
July 3, 2021 June 27, 2020 June 29, 2019
Segment net revenue:
Network Enablement 62.3 % 65.7 % 65.3 %
Service Enablement 7.6 9.0 9.1
Optical Security and Performance 30.1 25.3 25.6
Net revenue 100.0 100.0 100.0
Cost of revenues 37.6 38.6 39.4
Amortization of acquired technologies 2.8 2.9 3.0
Gross profit 59.6 58.5 57.6
Operating expenses:
Research and development 16.9 17.0 16.5
Selling, general and administrative 28.2 27.7 30.4
Amortization of other intangibles 2.8 3.1 3.4
Restructuring and related (benefits) charges (0.1) 0.3 1.4
Total operating expenses 47.8 48.1 51.7
Income from operations 11.8 10.4 5.9
Interest income and other income, net 0.3 0.8 0.6
Interest expense (3.0) (2.9) (3.0)
Income from continuing operations before income taxes 9.1 8.3 3.5
Provision for income taxes 5.3 5.8 2.8
Income from continuing operations, net of taxes 3.8 2.5 0.7
(Loss) income from discontinued operations, net of taxes — — (0.2)
Net income 3.8 % 2.5 % 0.5 %
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Financial Data for Fiscal 2021, 2020 and 2019
The following table summarizes selected Consolidated Statement of Operations items ( in millions, except for percentages ):
2021 2020 Change Percent Change 2020 2019 Change Percent Change
Segment net revenue:
NE $746.6 $746.7 $(0.1) —% $746.7 $737.8 $8.9 1.2%
SE 91.3 102.7 (11.4) (11.1)% 102.7 103.4 (0.7) (0.7)%
OSP 361.0 286.9 74.1 25.8% 286.9 289.1 (2.2) (0.8)%
Net revenue $1,198.9 $1,136.3 $62.6 5.5% $1,136.3 $1,130.3 $6.0 0.5%
Amortization of acquired technologies $33.2 $32.7 $0.5 1.5% $32.7 $34.4 $(1.7) (4.9)%
Percentage of net revenue 2.8% 2.9% 2.9% 3.0%
Gross profit $714.4 $665.3 $49.1 7.4% $665.3 $651.4 $13.9 2.1%
Gross margin 59.6% 58.5% 58.5% 57.6%
Amortization of intangibles $33.3 $35.1 $(1.8) (5.1)% $35.1 $38.1 $(3.0) (7.9)%
Percentage of net revenue 2.8% 3.1% 3.1% 3.4%
Research and development $203.0 $193.6 $9.4 4.9% $193.6 $187.0 $6.6 3.5%
Percentage of net revenue 16.9% 17.0% 17.0% 16.5%
Selling, general and administrative $337.5 $315.0 $22.5 7.1% $315.0 $343.5 $(28.5) (8.3)%
Percentage of net revenue 28.2% 27.7% 27.7% 30.4%
Restructuring and related (benefits) charges $(1.6) $3.5 $(5.1) (145.7)% $3.5 $15.4 $(11.9) (77.3)%
Percentage of net revenue (0.1)% 0.3% 0.3% 1.4%
Interest and other income, net $3.3 $9.6 $(6.3) (65.6)% $9.6 $6.2 $3.4 54.8%
Percentage of net revenue 0.3% 0.8% 0.8% 0.6%
Interest expense $(36.1) $(33.7) $(2.4) 7.1% $(33.7) $(34.3) $0.6 (1.7)%
Percentage of net revenue (3.0)% (3.0)% (3.0)% (3.0)%
Provision for income taxes $63.3 $65.3 $(2.0) (3.1)% $65.3 $31.5 $33.8 107.3%
Percentage of net revenue 5.3% 5.8% 5.8% 2.8%
Foreign Currency Impact on Results of Operations
While the majority of our net revenue and operating expenses are denominated in U.S. dollar, a portion of our international operations are denominated in currencies other than the U.S. dollar. Changes in foreign exchange rates may significantly affect revenue and expenses. While we use foreign currency hedging contracts to mitigate some foreign currency exchange risk, these activities are limited in the protection that they provide us and can themselves result in losses. We have presented below “constant dollar” comparisons of our net sales and operating expenses which exclude the impact of currency exchange rate fluctuations. Constant dollar net revenue and operating expenses are non-GAAP financial measures, which is information derived from consolidated financial information but not presented in our financial statements prepared in accordance with U.S. GAAP. Our management believes these non-GAAP measures, when considered in conjunction with the corresponding U.S. GAAP measures, may facilitate a better understanding of changes in net revenue and operating expenses.
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Fiscal 2021 and 2020
If currency exchange rates had been constant in fiscal 2021 and 2020, our consolidated net revenue in “constant dollars” would have decreased by approximately $15.5 million, or 1.3% of net revenue, which primarily impacted our NE and SE segments. The impact of foreign currency fluctuations on net revenue was not indicative of the impact on net income due to the offsetting foreign currency impact on operating costs and expenses. If currency exchange rates had been constant in fiscal 2021 and 2020, our consolidated operating expenses in “constant dollars” would have decreased by approximately $9.8 million, or 0.8% of net revenue.
The Results of Operations are presented in accordance with U.S. GAAP and not using constant dollars. Refer to Item 7A “Qualitative and Quantitative Disclosures about Market Risk” of this Annual Report on Form 10-K for further details on foreign currency instruments and our related risk management strategies.
Net Revenue
Revenue from our service offerings exceeds 10% of our total consolidated net revenue and is presented separately in our Consolidated Statements of Operations. Service revenue primarily consists of maintenance and support, extended warranty, professional services and post-contract support in addition to other services such as calibration and repair services. When evaluating the performance of our segments, management focuses on total net revenue, gross profit and operating income and not the product or service categories. Consequently, the following discussion of business segment performance focuses on total net revenue, gross profit, and operating income consistent with our approach for managing the business.
Fiscal 2021 and 2020
Net revenue increased by $62.6 million, or 5.5%, during fiscal 2021 when compared to fiscal 2020. This increase was driven by strength in our OSP segment, partially offset by a decrease in our SE segment.
Product revenues increase by $46.2 million, or 4.6%, during fiscal 2021 when compared to fiscal 2020. During the period we realized strength from our OSP segment, which was offset by declines in our NE and SE segment as further discussed below.
Service revenues increased $16.4 million, or 12.5%, during fiscal 2021 when compared to fiscal 2020. This increase was primarily due to increased support revenue from our NE segment, primarily driven by increased support revenues from our Wireless and Legacy Assurance products offset by declines in our SE segment further discussed below.
NE net revenue remained relatively flat between periods despite the impact of the COVID-19 lockdown, which resulted in a significant decline in the first half of fiscal 2021 and was offset by a recovery in the second half. This was consistent across Field Instruments and Lab and Production Equipment.
SE net revenue decreased by $11.4 million, or 11.1%, during fiscal 2021 when compared to fiscal 2020. This was primarily driven by decreased volume in our Data Center and Growth Assurance products.
OSP net revenue increased by $74.1 million, or 25.8%, during fiscal 2021 when compared to fiscal 2020. This increase was primarily driven by growth in revenue from our Anti-Counterfeiting and 3D Sensing products.
Going forward, we expect to continue to encounter a number of industry and market risks and uncertainties that may limit our visibility, and consequently, our ability to predict future revenue, profitability and general financial performance, and that could create quarter over quarter variability in our financial measures. For example, while the majority of our net revenue and expenses are denominated in U.S. dollars, a portion of our international operations are denominated in foreign currencies. The strengthening of the U.S. dollar relative to foreign currencies could negatively impact reported revenue.
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Additionally, we have seen demand for our NE and SE products affected by macroeconomic uncertainty. We cannot predict when or to what extent these uncertainties will be resolved. Our revenues, profitability, and general financial performance may also be affected by: (a) pricing pressures due to, among other things, advanced chip component shortages, a highly concentrated customer base, increasing competition, particularly from Asia-based competitors, a general commoditization trend for certain products and increased freight and logistics costs; (b) product mix variability in our NE and SE markets, which affects revenue and gross margin; (c) fluctuations in customer buying patterns, which cause demand, revenue and profitability volatility; (d) the current trend of communication industry consolidation, which is expected to continue, that directly affects our NE and SE customer bases and adds additional risk and uncertainty to our financial and business projections; (e) the impact of ongoing global trade policies, political tensions between the U.S. and China, tariffs and sanctions; and, (f) regulatory or economic developments that slow or change the rate of adoption of 5G, 3D Sensing and other emerging secular technologies and platforms.
Revenue by Region
We operate in three geographic regions, including Americas, Asia-Pacific and Europe Middle East and Africa (EMEA). Net revenue is assigned to the geographic region and country where our product is initially shipped. For example, certain customers may request shipment of our product to a contract manufacturer in one country, which may differ from the location of their end customers. The following table presents net revenue by the three geographic regions we operate in and net revenue from countries that exceeded 10% of our total net revenue (in millions) :
Years Ended
July 3, 2021 June 27, 2020 June 29, 2019
Americas:
United States $ 330.0 27.5 % $ 341.6 30.1 % $ 342.1 30.3 %
Other Americas 85.6 7.2 % 73.2 6.4 % 84.2 7.4 %
Total Americas $ 415.6 34.7 % $ 414.8 36.5 % $ 426.3 37.7 %
Asia-Pacific:
Greater China $ 277.0 23.1 % $ 245.7 21.6 % $ 216.6 19.1 %
Other Asia-Pacific 133.5 11.1 % 122.5 10.8 % 155.6 13.8 %
Total Asia-Pacific $ 410.5 34.2 % $ 368.2 32.4 % $ 372.2 32.9 %
EMEA:
Switzerland $ 76.6 6.4 % $ 64.6 5.7 % $ 97.0 8.6 %
Other EMEA 296.2 24.7 % 288.7 25.4 % 234.8 20.8 %
Total EMEA $ 372.8 31.1 % $ 353.3 31.1 % $ 331.8 29.4 %
Total net revenue $ 1,198.9 100.0 % $ 1,136.3 100.0 % $ 1,130.3 100.0 %
Net revenue from customers outside the Americas for the fiscal year ended 2021, represented 65.3% of net revenue, an increase of 1.8% year-over-year. This increase is primarily due to revenue growth in NE from EMEA and OSP from Asia-Pacific. We expect revenue from customers outside of the United States to continue to be an important part of our overall net revenue and an increasing focus for net revenue growth opportunities.
Gross Margin
Gross margin in fiscal 2021 increased by 1.1% to 59.6% from 58.5% in fiscal 2020. This increase was primarily driven by higher revenue volume, favorable product mix and improved factory utilization within our OSP segment. The increase was partially offset by gross margin reduction in our SE segment, further discussed in the Operating Segment Information section below.
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As discussed in more detail under “Net Revenue” above, we sell products in certain markets that are consolidating, undergoing product, architectural and business model transitions, have high customer concentrations, are highly competitive (increasingly due to Asia-Pacific-based competition), are price sensitive and/or are affected by customer seasonal and mix variant buying patterns. We expect these factors to continue to result in variability of our gross margin.
Research and Development
R&D expense increased by $9.4 million, or 4.9%, during fiscal 2021 compared to fiscal 2020. This increase was primarily driven by targeted investments to support increased demand in our growth products. As a percentage of net revenue R&D remained relatively flat during fiscal 2021 when compared to fiscal 2020.
We believe that continuing our investments in R&D is critical to attaining our strategic objectives. We plan to continue to invest in R&D and new products that will further differentiate us in the marketplace.
Selling, General and Administrative
SG&A expense increased by $22.5 million, or 7.1%, in fiscal 2021 compared to fiscal 2020. This increase was primarily due to a one-time decrease in the fair value of the earn-out liability of $ 29.6 million related to the RPC Photonics, Inc. (RPC) acquisition in fiscal year 2020, partially offset by continued reduction in net expenses driven by our on-going cost reduction efforts. As a percentage of net revenue, SG&A remained relatively flat at 28.2% in fiscal 2021.
We intend to continue to focus on reducing our SG&A expense as a percentage of net revenue. However, we have in the recent past experienced, and may continue to experience in the future, certain charges unrelated to our core operating performance, such as acquisitions and integration related expenses and litigation expenses, which could increase our SG&A expenses and potentially impact our profitability expectations in any particular quarter.
Amortization of Acquired Technologies and Intangibles
Amortization of acquired technologies and intangibles for fiscal 2021 decreased $1.3 million, or 1.9%, to $66.5 million from $67.8 million in fiscal 2020. This decrease is primarily due to the runoff of intangible assets becoming fully amortized in fiscal 2021.
Acquired In-Process Research and Development
In accordance with authoritative guidance, we recognize acquired in-process and development (IPR&D) at fair value as of the acquisition date, and subsequently account for it as an indefinite-lived intangible asset until completion or abandonment of the associated R&D efforts. We periodically review the stage of completion and likelihood of success of each IPR&D project. The nature of the efforts required to develop IPR&D projects into commercially viable products principally relates to the completion of all planning, designing, prototyping, verification and testing activities that are necessary to establish that the products can be produced to meet their design specifications, including functions, features and technical performance requirements.
Restructuring and Related Charges
From time to time we have initiated strategic restructuring events primarily intended to reduce costs, consolidate our operations, rationalize the manufacturing of our products and align our businesses in response to market conditions. During fiscal 2021, we recorded a net restructuring benefit of $1.6 million. As of July 3, 2021, the ending balance of our restructuring accrual was $0.5 million which is expected to be paid during fiscal 2022. We estimate annualized gross cost savings of approximately $33.7 million excluding any one-time charges as a result of the recent restructuring activities. Refer to “Note 13. Restructuring and Related Charges” under Item 8 of this Annual Report on Form 10-K for more information.
Interest Income and Other Income, Net
Interest income and other income, net was $3.3 million in fiscal 2021 as compared to $9.6 million in fiscal 2020. This $6.3 million decrease was primarily driven by $2.1 million unfavorable foreign exchange impact as the balance sheet hedging program provided a less favorable offset to the remeasurement of underlying foreign exchange exposures for fiscal 2021 and a decrease of $4.2 million in interest income due to lower yields on money market funds in which we invested excess cash during fiscal 2021 coupled with cash repatriation from a jurisdiction with relatively high interest rates to a jurisdiction with low interest rates prior to fiscal 2021.
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Interest Expense
Interest expense increased by $2.4 million, or 7.1%, during fiscal 2021 compared to fiscal 2020. This increase was primarily due to an increase in the commitment fee on unutilized portion of the revolving credit facility, an increase in the amortization of issuance costs related to the revolving credit facility as well as an increase in debt discount accretion on the 2023 Notes and 2024 Notes during the current period.
Provision for Income Tax
We recorded an income tax expense of $63.3 million for fiscal 2021. The expected tax expense derived by applying the federal statutory rate to our income before income taxes for fiscal 2021 differed from the income tax expense recorded primarily as a result of domestic and foreign losses that were not realized due to valuation allowances and to a $19.1 million charge related to the state tax impact of the internal intellectual property restructuring transactions.
On July 2, 2021, we completed a planned series of internal transactions restructuring certain of our intellectual properties. The result of which aligns the properties in a single entity which owns, manages, directs, and protects the properties, including but not limited to patents, product designs, processes, manufacturing technologies, know-how, and trade secrets. In conjunction with the internal restructuring, $2.3 billion ($482 million tax effected) of US federal net operating loss carryforwards were utilized, we recognized a new deferred tax asset relating to the book and tax basis difference of certain intangible assets of $589 million. Given the full valuation allowance that is carried on US deferred tax assets, the change in deferred taxes as a result of the transaction did not have a material impact on the financial statements. We recorded state tax expense including reserves for uncertain tax positions of $19.1 million related to this transaction.
Based on a jurisdiction by jurisdiction review of anticipated future income and due to the continued economic uncertainty in the industry, management has determined that in many of our jurisdictions, it is more likely than not that our net deferred tax assets will not be realized in those jurisdictions. During fiscal 2021, the valuation allowance for deferred tax assets decreased by $109.6 million primarily related to expiration of federal net operating losses, capital losses and federal research credits.
The decrease in income tax expense of $2.0M or 3.1% during fiscal 2021 compared to fiscal 2020 was primarily driven by the lower differing impact from the aforementioned fiscal 2021 state tax charge of $19.1 million as compared to the $32.5 million charge in fiscal 2020 for withholding taxes expected to be paid on the repatriation of $324 million of foreign earnings that were no longer considered to be permanently reinvested. This reduction in charges was offset in part by increased income taxes resulting from higher earnings in fiscal 2021.
We are routinely subject to various federal, state and foreign audits by taxing authorities. We believe that adequate amounts have been provided for any adjustments that may result from these examinations.
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Operating Segment Information ( in millions ):
2021 2020 Change Percentage Change 2020 2019 Change Percentage Change
NE
Net revenue $746.6 $746.7 $(0.1) —% $746.7 $737.8 $8.9 1.2%
Gross profit 474.2 482.4 (8.2) (1.7)% 482.4 473.3 9.1 1.9%
Gross margin 63.5% 64.6% 64.6% 64.2%
SE
Net revenue $91.3 $102.7 $(11.4) (11.1)% $102.7 $103.4 $(0.7) (0.7)%
Gross profit 59.9 68.8 (8.9) (12.9)% 68.8 71.0 (2.2) (3.1)%
Gross margin 65.6% 67.0% 67.0% 68.7%
NSE
Net revenue $837.9 $849.4 $(11.5) (1.4)% $849.4 $841.2 $8.2 1.0%
Operating income 92.2 108.8 (16.6) (15.3)% 108.8 99.6 9.2 9.2%
Operating margin 11.0% 12.8% 12.8% 11.8%
OSP
Net revenue $361.0 $286.9 $74.1 25.8% $286.9 $289.1 $(2.2) (0.8)%
Gross profit 218.1 153.0 65.1 42.5% 153.0 145.8 7.2 4.9%
Gross margin 60.4% 53.3% 53.3% 50.4%
Operating income 161.3 102.1 59.2 58.0% 102.1 98.0 4.1 4.2%
Operating margin 44.7% 35.6% 35.6% 33.9%
Network Enablement
NE gross margin decreased 1.1% during fiscal 2021 to 63.5% from 64.6% in fiscal 2020. This decrease is due to unfavorable product mix within Field Instruments.
Service Enablement
SE gross margin decreased 1.4% during fiscal 2021 to 65.6% from 67.0% in fiscal 2020. This decrease was primarily due to unfavorable product mix due to lower revenue volumes in Data Center.
Network and Service Enablement
NSE operating margin decreased 1.8% during fiscal 2021 to 11.0% from 12.8% in fiscal 2020. The decrease in operating margin was primarily driven by decreased revenue volumes and product mix in our NE and SE portfolios and higher operating expense from R&D which lead to a decline in our operating margin.
Optical Security and Performance Products
OSP gross margin increased by 7.1% during fiscal 2021 to 60.4% from 53.3% in fiscal 2020. This increase was primarily due to favorable product mix driven by higher revenue in Anti-Counterfeiting and 3D Sensing products and increased factory utilization.
OSP operating margin increased 9.1% during fiscal 2021 to 44.7% from 35.6% in fiscal 2020. The increase in operating margin was primarily due to higher gross margins.
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Liquidity and Capital Resources
We believe that our existing cash balances and investments will be sufficient to meet our liquidity and capital spending requirements over the next twelve months. However, there are a number of factors that could positively or negatively impact our liquidity position, including:
• Global economic conditions which affect demand for our products and services and impact the financial stability of our suppliers and customers;
• Impact of the COVID-19 pandemic on our financial condition;
• Changes in accounts receivable, inventory or other operating assets and liabilities which affect our working capital;
• Increase in capital expenditure to support the revenue growth opportunity of our business;
• Changes in customer payment terms and patterns, which typically results in customers delaying payments or negotiating favorable payment terms to manage their own liquidity positions;
• Timing of payments to our suppliers;
• Factoring or sale of accounts receivable;
• Volatility in fixed income and credit market which impact the liquidity and valuation of our investment portfolios;
• Volatility in foreign exchange market which impacts our financial results;
• Possible investments or acquisitions of complementary businesses, products or technologies;
• Issuance or repurchase of debt or equity securities, which may include open market purchases of our 2023 Notes and/or 2024 Notes prior to their maturity or of our common stock;
• Potential funding of pension liabilities either voluntarily or as required by law or regulation;
• Compliance with covenants and other terms and conditions related to our financing arrangements; and
• The risks and uncertainties detailed in Item 1A “Risk Factors” section of our Annual Report on Form 10-K.
Cash and Cash Equivalents and Short Term Investments
Our cash and cash equivalents consist mainly of investments in institutional money market funds, short-term deposits held at major global financial institutions, and similar short duration instruments. Our strategy is focused on the preservation of capital and supporting our liquidity requirements that meet high credit quality standards, as specified in our investment policy approved by the Audit Committee of our Board of Directors. Our investments in debt securities and marketable equity securities are primarily classified as available for sale or trading assets and are recorded at fair value. The cost of securities sold is based on the specific identification method. Unrealized gains and losses on available-for-sale investments are recorded as other comprehensive (loss) income and are reported as a separate component of stockholders’ equity. As of July 3, 2021, U.S. subsidiaries owned approximately 47.4% of our cash and cash equivalents, short-term investments and restricted cash. The recent COVID-19 pandemic has caused disruption in global capital markets and over time may impact our ability to obtain credit and/or negotiate acceptable financing terms.
As of July 3, 2021, the majority of our cash investments have maturities of 90 days or less and are of high credit quality. Nonetheless we could realize investment losses under adverse market conditions. During the twelve months ended July 3, 2021, we have not realized material investment losses but can provide no assurance that the value or the liquidity of our investments will not be impacted by adverse conditions in the financial markets. In addition, we maintain cash balances in operating accounts that are with third-party financial institutions. These balances in the U.S. may exceed the Federal Deposit Insurance Corporation (FDIC) insurance limits. While we monitor the cash balances in our operating accounts and adjust the cash balances as appropriate, these cash balances could be impacted if the underlying financial institutions fail.
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Revolving Credit Facility
On May 5, 2020, we entered into a credit agreement (the Credit Agreement) with Wells Fargo Bank, National Association (Wells Fargo) as administrative agent, and other lender related parties. The Credit Agreement provides for a $300 million senior secured revolving credit facility, which matures on March 1, 2023. The Credit Agreement also provides that, under certain circumstances, we may incur term loans or increase the aggregate principal amount of revolving commitments by an aggregate amount of up to $200 million plus additional amounts so long as our secured net leverage ratio, determined on a pro forma basis does not exceed 1.50:1.00. The proceeds from the credit facility established under the Credit Agreement will be used for working capital and other general corporate purposes. The obligations under the Credit Agreement are secured by substantially all of our assets.
Amounts outstanding under the Credit Agreement accrue interest at a rate equal to either, at our election, LIBOR plus a margin of 1.75% to 2.50% per annum, or a specified base rate plus a margin of 0.75% to 1.50%, in each case, depending on our consolidated secured leverage ratio. We are required to a pay commitment fee on the unutilized portion of the facility which ranges between 0.30% and 0.40% per annum depending on our consolidated secured leverage ratio. As of July 3, 2021, we had no amounts outstanding under the Credit Agreement. Refer to “Note 11. Debt” under Item 8 of this Annual Report on Form 10-K for more information.
Year Ended July 3, 2021
As of July 3, 2021, our combined balance of cash and cash equivalents and restricted cash increased by $161.0 million to $708.4 million from a balance of $547.4 million as of June 27, 2020.
Cash provided by operating activities was $243.3 million, consisted of net income of $46.1 million adjusted for non-cash or non-operating charges (e.g., depreciation, amortization of intangibles, stock-based compensation, amortization of debt issuance cost and discount and net change in fair value of contingent liabilities), including changes in deferred tax balances which totaled $173.5 million, offset by changes in operating assets and liabilities that provided $23.7 million. Changes in our operating assets and liabilities related primarily to an increase in accrued payroll and related expenses of $23.1 million due to timing of salary and related payments, a decrease in other current and non-current assets of $14.9 million, an increase in income taxes payable of $18.1, an increase in deferred revenue of $12.3 million, and an increase in accounts payable of $7.0 million driven by timing of purchases and related payments. This was partially offset by cash outflows from a decrease in accrued expenses and other current and non-current liabilities of $22.4 million, an increase in accounts receivable of $15.0 million, and an increase in inventories of $14.3 million.
Cash used in investing activities was $48.7 million, primarily related to $52.1 million of cash used for capital expenditures and $0.7 million cash used for acquisitions. This was partially offset by $4.1 million proceeds from sales of assets.
Cash used in financing activities was $58.8 million, primarily resulting from $42.2 million of cash used to repurchase common stock, $17.9 million in withholding tax payment on vesting of restricted stock awards, $2.8 million cash paid to settle assumed debt from an acquisition in fiscal year 2020, $1.2 million of cash used to pay acquisition related to contingent consideration, and $1.3 million payments related to financing obligations, including issuance costs. This was partially offset by $6.6 million in proceeds from the issuance of common stock under our employee stock purchase plan.
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Contractual Obligations
The following summarizes our contractual obligations at July 3, 2021, and the effect such obligations are expected to have on our liquidity and cash flow over the next five years ( in millions ):
Payments due by period
Total Less than
1 year 1 - 3 years 3 - 5 years More than
5 years
Asset retirement obligations—expected cash payments $ 3.7 $ 1.3 $ 0.6 $ 0.4 $ 1.4
Debt:
2023 1.75% senior convertible notes 225.0 — 225.0 — —
2024 1.00% senior convertible notes 460.0 460.0 — —
Estimated interest payments 23.2 9.5 13.7 — —
Purchase obligations (1)
187.6 178.8 7.9 0.9 —
Operating lease obligations (2)
50.3 11.7 16.2 8.7 13.7
Non-cancelable leaseback obligations (1)
28.8 2.9 4.8 4.9 16.2
Royalty payment 2.8 1.3 0.8 0.7 —
Pension and post-retirement benefit payments (3)
104.3 9.2 13.8 12.6 68.7
Total $ 1,085.7 $ 674.7 $ 282.8 $ 28.2 $ 100.0
(1) Refer to “Note 18. Commitments and Contingencies” for more information.
(2) Refer to “Note 12. Leases” for more information.
(3) Refer to “Note 17. Employee Pension and Other Benefit Plans” for more information.
Purchase obligations represent legally-binding commitments to purchase inventory and other commitments made in the normal course of business to meet operational requirements. Of the $187.6 million of purchase obligations as of July 3, 2021, $90.8 million are related to inventory and the other $96.8 million are non-inventory items.
As of July 3, 2021, our other non-current liabilities primarily relate to asset retirement obligations, pension and financing obligations which are presented in various lines in the preceding table.
Off-Balance Sheet Arrangements
As part of our ongoing business, we have not participated in transactions that generate material relationships with unconsolidated entities or financial partnerships, as is defined in rules promulgated by the SEC, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Employee Defined Benefit Plans and Other Post-retirement Benefits
We sponsor significant qualified and non-qualified pension plans for certain past and present employees in the U.K. and Germany. We also are responsible for the non-pension post-retirement benefit obligation assumed from a past acquisition. Most of these plans have been closed to new participants and no additional service costs are being accrued, except for certain plans in Germany assumed in connection with an acquisition during fiscal 2010.
The U.K. plan is partially funded and the other plans, which were initially established as “pay-as-you-go” plans, are unfunded. As of July 3, 2021, our pension plans were underfunded by $104.3 million since the Pension Benefit Obligation (PBO) exceeded the fair value of plan assets. Similarly, we had a liability of $0.4 million related to our non-pension post-retirement benefit plan.
We anticipate future annual outlays related to the German plans will approximate estimated future benefit payments. These future benefit payments have been estimated based on the same actuarial assumptions used to measure our projected benefit obligation and currently are forecasted to range between $5.1 million and $8.0 million per annum. In addition, we expect to contribute approximately $2.4 million to the U.K. plan during fiscal 2022.
During fiscal 2021, we (amounts represented as £ and $ denote GBP and USD, respectively) contributed £1.5 million or approximately $2.0 million, while in fiscal 2020, we contributed £0.5 million or approximately $0.6 million to its U.K. pension plan. These contributions allowed us to comply with regulatory funding requirements.
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A key actuarial assumption in calculating the net periodic cost and the PBO is the discount rate. Changes in the discount rate impact the interest cost component of the net periodic benefit cost calculation and PBO due to the fact that the PBO is calculated on a net present value basis. Decreases in the discount rate will generally increase pre-tax cost, recognized expense and the PBO. Increases in the discount rate tend to have the opposite effect. We estimate a 50-basis point decrease or increase in the discount rate would cause a corresponding increase or decrease, respectively, in the PBO of approximately $9.0 million based upon data as of July 3, 2021.
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Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.