2012 Annual Review Germain Lamonde
Chairman of the Board,
President and CEO

Letter to Shareholders

Fiscal 2012 in Review

Like most suppliers in the telecom space, EXFO experienced a challenging fiscal 2012. Following 33% and 32% sales growth in the previous two years, I have to admit that a 7% sales decrease in 2012 is below what shareholders and I have come to expect from EXFO — even if this adds up to a respectable 10-year CAGR of 20%. This marks only the third time in our 27-year history — along with the 2008 economic recession and massive 2001-2003 telecom downturn — that we have endured a sales decrease. Market conditions were particularly difficult in Western Europe, the United States and China, leading to revenue decreases of 16.4% in EMEA and 4.6% in the Americas, while sales in Asia-Pacific grew by 1.2% in 2012.

The reasons behind this annual sales decrease? An uncertain global environment, not fully recovered from 2008, combined with difficult regional economic conditions like:

  • Rising debt levels in Greece, Spain, Italy and several other developed countries;
  • China’s government holding back on infrastructure spending due to significant inflation and reduced growth; and
  • Several G20 countries experiencing stifled growth or recession, along with high levels of unemployment.

All these factors tempered carrier spending in 2012, leading to a reduction of EXFO’s revenues to $250 million and a resultant drop in adjusted EBITDA margin* from 11.3% in fiscal 2011 to 5.4% in 2012.

Although these financial results are not to my satisfaction, we still made headway against several strategic priorities while improving our competitive position for 2013 and beyond:

Key Accomplishments

  • Delivered market-share gains for a 27th consecutive year (end-markets were down 10% according to internal estimates) and expecting a return to growth in 2013, assuming stable market conditions;
  • Increased Protocol sales 4.4% year-over-year on our strength in wireless backhaul, 4G/LTE and 10G/40G/100G network upgrades. This software-intensive product group expanded sales from $11.5 million in 2006 to $113.7 million in 2012 for a 47% CAGR;
  • Increased sales in the wireless market from about 21% of total revenue in 2011 to 24% in 2012;
  • Increased sales in Asia-Pacific, excluding China, by 37.9%;
  • Penetrated 10 of the world’s largest 15 network operators with our FTB-880 NetBlazer Multiservice Tester, mainly used in wireless backhaul;
  • Improved gross margin* to 63.3% of sales, marking the ninth increase in the last 10 years; 
  • Increased market acceptance of the FTB Ecosystem (platforms, modules and software) thanks to EXFO Connect, a game-changing initiative;
  • Generated $25.3 million in cash flows from operations; and
  • All this while strengthening our long-term market position.

Looking to the Future

Despite difficult, short-term macro-economic conditions, I am a firm believer that fundamental drivers and growth opportunities remain intact in our end-markets:

  • Internet-connected devices are expected to reach 9.6 billion by the end of 2012, climbing to 28 billion by the end of 2020 (IMS Research);
  • Proliferation of smartphones continues to ramp up (shipments now at almost 170 million units per quarter — Gartner, Inc.) with video applications driving growth in bandwidth demand and forcing deeper deployments of pico and femtocells as well as distributed antenna systems (DAS);
  • Approximately 360 network operators in 105 countries have committed to commercial LTE network deployments or are engaged in trials, technology testing or studies, according to the GSA (global mobile suppliers association); and
  • Mobile IP traffic will increase by a factor of 18X from 2011-2016 with video accounting for more than 70% of such traffic (Cisco, Visual Networking Index).

Wireless Explosion: As stated above, 3G and 4G/LTE deployments, as well as additional bandwidth outlays in wireless backhaul, are still in the early stages of a long investment cycle. At this point, wireless operators are beginning to introduce 4G/LTE as a data overlay to 3G, since LTE-enabled phones must have fallback capabilities between 4G and 3G for voice services. As network operators continue to invest a larger proportion of their spending budgets on wireless infrastructure, we expect to increasingly benefit in upcoming years based on the initiatives that have been undertaken.

We made strategic progress in the wireless market in 2012 and are in a stronger position than ever to take advantage of future investments with new solutions like our distributed analyzer and portable iPro capturing device, which are designed for 3G and 4G/LTE network troubleshooting. We also introduced our FTB-880 NetBlazer, a productivity enhancement tool for accelerated wireless backhaul deployments. In addition, we launched our QA-805/813 simulation platforms to enable wireless network equipment manufacturers and wireless operators to emulate the huge explosion of data on their networks. To that end, we also signed a long-term partnership with Japan-based Artiza Networks to jointly offer the industry’s highest-capacity, end-to-end 4G/LTE simulation solution. Such a system is mission critical for network equipment manufacturers and the world’s largest wireless operators to validate how next-generation networks will support ever-increasing data traffic, new handsets and a diversity of applications.

High-Speed Network Upgrades: Although fiber deployments continue in core networks and have accelerated in the access, the primary choice for network operators in dealing with increased bandwidth demand is to increase transmission rates on existing fiber and to have optical networks provide greater traffic path flexibility. On a global scale, the telecom industry will witness transitions from 1 GigE to 10 GigE, 40 GigE and 100 GigE, and even to 400 GigE in a not too distant future. Operators have learned that network upgrades often present challenges, so they turn to EXFO for test instruments that qualify and troubleshoot optical fiber and perform high-speed Ethernet confirmation testing.

Moving toward higher-margin Protocol sales

FY 2006

Total revenue: $107.4 M

FY 2012

Total revenue: $250.0 M

  • Protocol
  • Other

Moving toward higher-margin Protocol sales

IP Network Operation: Today’s IP networks increasingly support a growing universe of real-time applications such as video streaming, interactive on-line gaming, mobile business solutions and cloud-based applications. There is far less tolerance for delay, errors and interruptions in packet flows. Again, operators rely on EXFO’s portable test sets to ensure that their networks deliver optimal performance. We also introduced our next-generation probe for service assurance, the BV-3100. This verifier allows operators to significantly reduce their operating expenses during the full lifecycle of their network including deployment (wireless backhaul, metro Ethernet), turn-up and operation phases.

These opportunities in wireless, high-speed network upgrades and IP network operation are important growth vectors for what we call our Protocol-Layer family of products. This product group, which includes our transport and datacom, wireless and service assurance solutions, has demonstrated strong resilience with a 5-year sales CAGR of 46.1%. During the past six years, it has grown from 11% to 45% of total revenue, or from $11.5 million to $113.7 million. I remain confident about our market positioning and ability to continue growing our Protocol-Layer product group faster than our end-markets and returning our Physical-Layer activity to growth mode in 2013, assuming market conditions remain stable.

Intelligent Growth, our strategy

Focus on Profitability

Improving profitability is clearly at the top of our priority list for 2013 and beyond. While EBITDA increased fairly consistently over the past several years, fiscal 2012 proved to be a disappointment due to a lower revenue level. We have proceeded with a nearly completed restructuring effort that will sharpen our competitive focus and reduce our expenses by nearly $9 million.

Going forward, we intend to continue raising our gross margin from 63.3% in 2012 based on an increased contribution from higher-margin, software-intensive Protocol solutions. We also plan on increasing our sales volume to better absorb the cost of being a global player, thus leveraging economies of scale. My objective for EXFO is to generate an EBITDA margin of 15% (net of foreign exchange gains or losses) on an annual run-rate of $350 to $400 million, or within the next three to four years if sales growth is less than expected.

Why We Win

The EXFO brand is synonymous with innovation and unmatched customer experience. This is hardly a coincidence, since from the very beginning our organization has deployed relentless efforts to serve leading network equipment manufacturers and network operators. As such, EXFO has become a trusted technology partner to design, build and operate the most advanced and future-ready networks in the world.

On the innovation front, EXFO has built a tradition of being first-to-market with game-changing solutions. This is one of the main reasons why we have gained market share for 27 consecutive years. EXFO’s innovation platform has developed solutions well beyond the requirements expressed by even our most demanding customers. We strive to instill superior product management, highly professional account management and a top-notch customer support organization to collectively find the best ways to resolve fundamental customer pain points. Being market-driven rather than technology-focused has delivered innovations that are the very fabric of EXFO’s success in FTTH, Ethernet, wireless and service assurance markets.

Passion for customers. At EXFO, the pursuit of delivering a great customer experience ensures that first-time customers will never settle for anything less in the future. This passion for detail is shared across the entire organization, not just within our customer support and post-delivery teams and partners. It all starts with our hardware and software products that are designed to meet the highest quality standards. Next comes a strong focus on continuous improvement as we always seek to do better. Finally, as a responsible corporate citizen, we are fully engaged in where we live and adhere to the most stringent environmental standards.

In terms of acquisitions, I remain a firm believer that an organization must be in great shape internally before expanding through acquisitions, and this is precisely where EXFO stands. We completed the fiscal year with a strong cash position of nearly $70 million and negligible debt. We will not embark on an industry consolidation strategy, but instead we will remain strategically acquisitive for companies with synergistic, best-in-class technologies that are early in their growth cycle. EXFO is a highly disciplined acquirer and, as such, I feel no obligation or urgency to move ahead with a transaction. We will carefully move forward only when the risk-reward equation is there for the benefit of shareholders.

Conclusion

The ongoing explosion in demand for smartphones, tablets and video is placing a strain on fixed and mobile networks, thus creating great opportunities for EXFO. By delivering innovative solutions that help reduce operating expenses, accelerate deployments and improve network quality, EXFO is enabling network operators to gain new subscribers and retain existing ones. In the process, we continue to capture market share with a relentless focus on increasing profitability to maximize shareholder value.

In closing, I am thoroughly delighted by the passion and dedication demonstrated by our global workforce on a daily basis. I want to thank them wholeheartedly for their commitment to EXFO. I also want to thank our Board of Directors for its guidance, foresight and experience. We foster a corporate culture of high performance at EXFO. It represents a critical success factor that will allow us to continue outperforming in the long run.

Germain Lamonde

Sincerely,
Germain Lamonde,
Chairman of the Board, President and CEO

  • *
  • Gross margin, EBITDA and adjusted EBITDA are non-IFRS financial measures. Gross margin represents sales less cost of sales, excluding depreciation and amortization. EBITDA is defined as net earnings (loss) before interest, income taxes, depreciation of property, plant and equipment and amortization of intangible assets. Adjusted EBITDA represents EBITDA excluding changes in the fair value of the cash contingent consideration and the gain from the disposal of discontinued operations.