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Dear Shareholders

Fiscal 2014 proved to be a challenging year for the telecom industry and EXFO was not exempted as we faced a number of headwinds, especially in the Americas. Reduced spending by tier-1 network operators, delayed projects due to intensified merger activity, and the overall review of network investment and architecture strategies (with the advent of NFV and SDN technologies) resulted in reduced business opportunities. Overall, our sales decreased 4.7% to US$230.8 million in fiscal 2014, while adjusted EBITDA* totaled US$14.4 million, or 6.2% of sales.

Although I cannot be satisfied with these results, I would like to share a few data points to shed more light on EXFO’s 2014 performance:

  • We posted bookings growth of 3.0% year-over-year to US$240.4 million for a book-to-bill ratio of 1.04 versus 0.96 in 2013, which was a more difficult year.

  • Following a challenging first quarter in which bookings dropped 10% year-over-year, we delivered bookings growth between 6% and 10% in the next three quarters as we started to fully benefit from key technology platforms that were introduced in late fiscal 2013.

  • On a geographical basis, sales decreased 4.9% in the Americas, 4.5% in EMEA and 4.3% in Asia-Pacific, but bookings increased in all three regions, especially in Asia-Pacific and EMEA.

  • On a product-line basis, Physical-layer and Protocol-layer sales decreased 6.3% and 1.2%, respectively, but bookings for both product families increased 3.0% year-over-year.

  • We completed two strategic acquisitions during fiscal 2014, namely the assets of ByteSphere of Boston, MA which provides EXFO with highly intelligent and automated network infrastructure monitoring, and the assets of Aito Technologies of Espoo, Finland that add customer experience analytics to EXFO’s solutions portfolio. Both technology acquisitions greatly enhance EXFO’s position in network visualization and predictive network analysis across fixed and mobile networks.

  • Although we paid cash for these acquisitions, our cash position increased by US$9.6 million to US$59. 8 million at the end of fiscal 2014 (US$0.98 per diluted share).

  • We increased our gross margin from 61.8% in fiscal 2013 to 62.4% in 2014 on the strength of an increasingly software-intensive product offering.

As EXFO’s CEO and largest shareholder, my top priority is to significantly increase profitability. In the following paragraphs, I would like to outline EXFO’s strategy designed to gradually ramp adjusted EBITDA margin from 6.2% towards our ultimate target of 15%. Clearly, our plan cannot simply rely on improved market conditions as this variable is not within our control.

Growth Strategy

 View CEO video: Fully ConnectedAs the theme of our Annual Review implies, EXFO is a key enabler in the telecom supply chain, helping to ensure efficient delivery of services and quality of experience in fixed and mobile networks. The telecom industry, however, remains in constant flux, driven by rapidly evolving consumer needs and growing expectations as our global society transforms itself into a fully connected world characterized by the availability of any content, on any device, at any time.

As we crafted EXFO’s strategy, the major shift in capital spending from fixed to mobile networks, the migration from legacy to packet-based IP architectures, the evolution from fixed, hardware-based networks to cloud-based virtualized environments and, finally, the heightened competitive landscape were all part of our assumptions.

  • Evolving into a Solutions Supplier.

    EXFO has achieved global recognition as a technology- leading and best-in-class test company for more than 29 years.  While this still remains true, we have gradually evolved into a solutions supplier that helps network operators increase productivity by “doing-it-right-the-first-time” as they strive to deliver ever-increasing bandwidth, broader support of new applications and improvements in customer experience.

    This evolution began in 2008 when we acquired Brix Networks to move into active network service assurance. Fiscal 2011 was marked by the launch of EXFO Connect, the industry’s first cloud-based solution transforming individual portable test units into a fully connected test environment that improves productivity and process compliance.

    We further accelerated this transformation in 2012 with our iOLM technology for OTDRs and continued in 2014 with auto-focus fiber inspection probes that remove the guesswork out of fiber connector testing while speeding up the process. We also launched wireless capture and analysis probes, along with analytics software, to provide end-to-end visibility of 4G/LTE networks. As well, we completed the technology acquisitions of ByteSphere and Aito Technologies, supporting our transformation into a holistic, end-to-end solution provider that is increasingly brought in early into the game by telecom executives to help resolve strategic deployment and operational issues. Look for more higher-margin, end-to-end solutions from EXFO in the future.

  • Expanding Business with Mobile Network Operators.

    While EXFO continues to leverage its strong market position in broadband deployments in fixed networks, our largest growth opportunity remains in mobile networks due to explosive adoption of smart devices, mobile video and new applications that are driving higher bandwidth needs enabled by 4G/LTE.

    Looking back on 2014, bookings with mobile network customers increased to an estimated 30-32% of total bookings, up from 26-28% in 2013, representing an estimated 15% to 20% growth in wireless bookings. This marked the fifth consecutive year that we posted bookings growth related to the mobile market.  Interestingly enough, this mobile growth is now applied to a bigger number and, therefore, is starting to really move the needle. We achieved this growth by steadily increasing our mobile network focus, forging relationships with mobile network operators, and introducing innovative solutions across wireless access, backhaul and core network market segments. I am also pleased about our two wireless wins with tier-1 network operators with whom EXFO had done little business in the past. These two accounts will start to gradually affect our revenues as we move into fiscal 2015.

    Looking ahead, EXFO has developed a unique offering to deliver wireless deployment and troubleshooting solutions as well as end-to-end visibility of, and analytics on, wireless backhaul, small cell, DAS and metro Ethernet networks. Our active service assurance solutions also enable mobile operators to proactively monitor quality of experience of voice-over-LTE (VoLTE) deployments. We plan to continue investing in solutions designed for mobile networks in 2015 and increasing our market share in this growth sector.

  • Growing Share of Wallet with Tier-1 Fixed and Mobile Operators.

    Based on public documents, the top-100 network operators generated an estimated US$1.6 trillion in revenues and more than US$196 billion in profit in calendar 2013 with the top-15 representing about 65% of revenues. While EXFO already does business with most of these operators, we are heavily focused on growing our share of wallet with the top-15.

    Since 2010, we have vastly improved our account management sales structure and built executive relationships to initiate or accelerate business with the world’s largest network operators. Today, we are in a better position to expand revenues based on these growing relationships and our highly attractive portfolio of end-to-end solutions that tackle the challenges that tier-1 network operators are facing.  In short, we are now in a position to accelerate revenue growth with tier-1 operators without ramping up R&D, sales or support costs.  

  • Increasing Profitability.

    These two words are dictating the course of our priorities and actions until we reach our 15% adjusted EBITDA margin target. I am confident that we will reach this goal since several implemented initiatives are already starting to bear fruit:

    • We delivered cost savings of US$6.2 million in fiscal 2014 and US$9.0 million in 2013. We have managed our business prudently in recent years without compromising on long-term strategic opportunities. We intend to continue along this path as we remain unwaveringly committed to achieving our profitability target.

    • We improved our gross margin from 61.8% to 62.4% in 2014, marking the eighth time out of the last 10 years we have raised our gross margin. This trend should continue in upcoming years based on our continued shift towards a more software-intensive product offering and gradual transformation from a supplier of boxes to a supplier of systems and solutions.

    • We have developed more effective go-to-market capabilities to increase our global presence, relevance and relationships within the highly strategic wireless industry and among tier-1 network operators in order to accelerate revenue growth and take advantage of market opportunities.

    • Given key technology platforms were launched in fiscal 2013 and early 2014, our innovation engine has returned to its historically strong growth mode with incremental innovations generating market-share winning solutions aligned with current market trends.

Early results from our efforts are positive with year-over-year bookings growth between 6% and 10% in the last three quarters. In the second half of 2014, we got a glimpse of the leverage in our operating model with sales of US$123.6 million and gross margin of 63.1% generating an adjusted EBITDA margin of 10.6%.

As we enter fiscal 2015—the 30th year of operation for EXFO—I am convinced that we will continue our bookings growth. Now that our backlog has been rebuilt in 2014, our book-to-bill ratio should stay closer to 1.0 in 2015 to allow bookings to transform into revenues. Moreover, I am committed to gradually improving gross margin while reducing SG&A and net R&D, as a percentage of sales, to start delivering more earnings and gradually raising adjusted EBITDA margin to our 15% target.

 

Wrap-Up

We have designed a prudent plan to deliver improved profitability without relying on market conditions to magically improve. I believe one of the main reasons why EXFO has been successful in gaining market share—especially in the last three quarters—is because we have been quicker and more agile than our competitors. Playing a little bit on Charles Darwin’s famous words, I would like to conclude by saying that it is not the largest (company), but the one most responsive to market changes that will thrive.

Thank you for your continued support,

Germain Lamonde

Germain Lamonde,
Chairman of the Board, President and CEO
November 27, 2014

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  • Adjusted EBITDA represents net earnings before interest, income taxes, depreciation and amortization, stock-based compensation costs and foreign exchange gain.