August 15, 2019 - 11:40am EST by
2019 2020
Price: 3.60 EPS 0 0
Shares Out. (in M): 56 P/E 0 0
Market Cap (in $M): 206 P/FCF 0 0
Net Debt (in $M): -4 EBIT 0 0
TEV ($): 202 TEV/EBIT 0 0

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EXFO is a provider of next-gen test, monitoring and analytics solutions for fixed and mobile communications service providers (CSPs), web-scale operators as well as network equipment manufacturers in the global telecommunications industry. EXFO’s broad portfolio of intelligent hardware and software solutions enable network transformations related to fiber, 5G and 4G/LTE, virtualization and big data analytics. Ultimately, customers rely on the Company’s solutions to increase network capacity and improve quality of experience for end-users while driving operational efficiencies. EXFO was founded in 1985 and is based in Quebec City, Canada.

Investment Merits

EXFO exemplifies the attributes of what we look for in a prospective investment, notably a leading market share, high gross margins, significant operating leverage, ability to generate significant free cash flow and a positive product cycle over the next two years. 


Yet, EXFO trades at a substantial discount to peers, due to management’s focus on the recent acquisition of Astellia which has caused operational missteps. While the Astellia/Protocol business has significant white space for future growth, these losses have masked the profitability of the physical test and measurement business. Moreover, with the founder owning ~60% of the business, the market assumes EXFO will remain a “value trap” through the foreseeable future.


Perception will likely change over the next two years as EXFO: (1) right sizes its cost structure over the coming years, with the first step recently undertaken; (2) re-focusing on the physical opportunity and (3) market focus on the 5G/optical opportunity as we get closer to roll-outs in FY2020. Furthermore, the founder, Mr. Germain Lamonde will need to monetize his stake at some point for which the Company trades at a steep discount to recent private market transactions. 


Our variant view for EXFO is merited by the following attributes:


Valuation Below Precedent Transactions


  • EXFO represents an attractive risk-reward trading at 0.7x revenues and 7.9x LTM EBITDA. This represents a significant discount to publicly traded peers and recent private market transactions. Furthermore, this is a cheap absolute valuation for a business with strong gross margins in excess of 60% and leading market share (40%+).

  • The M&A space for test and measurement companies has been very active over the past couple years.


    • In 2017, Ixia was recently purchased by Keysight Technologies for 3.3x revenues or ~$1.7B. Gross margins were relatively similar, and the Company is a noted competitor for EXFO. 

    • In 2018, Cobham sold its test and measurement business to Viavi for $455MM or 2.3x revenues.

    • Assuming a transaction multiple below recent comps of ~1.5x, EXFO would be worth $7.5 per share or 100% upside. 

  • Sentiment particularly on the sell-side is neutral as they believe EXFO will continue to remain a value-trap, yet the discount to private market values has become too great.  

  • Comparable businesses such as VIAV and Keysight trade in excess of 20x EBITDA and 3x revenues despite having similar market share. 


High Gross Margins, Significant Operating Leverage 


  • Driven by its 40%+ market share in markets such as optical physical test and mission critical nature, EXFO has been able to consistently generate 60% or greater gross margins since inception.

    • Physical gross margins range from 55% to 60%, while legacy protocol ranges from 70% to 75%.

    • While Astellia carries lower gross margins in the 50% range, it gives EXFO a strong foothold in Europe and positions it well for a 5G network roll-out. We believe Astellia/protocol should ultimately generate margins in-line with Spirient.

  • Given the strong margin profile and significant over-head, operating leverage is significant, dropping down at over 30% incremental EBITDA margins.

  • Moreover, EXFO has not been ran efficiently or with an eye on profitability as EBITDA margins significantly lag that of peers at 9% for FY16 and FY17 (versus comps at 20% or greater).  

  • The market is skeptical about EXFO’ ability to reach 15% EBITDA margins. The core physical layer business alone is generating ~$30MM to $35MM of EBITDA, with the current ~$25MM of LTM Adj. EBITDA includes $5MM to $10MM of EBITDA losses from the protocol business. This should close as we get closer to the 5G roll-out occurs in the back half of 2021.

  • Profitability has been overshadowed by integration expenses and costs on the protocol segment of the business (acquisition of Astelia for instance). 

Well Positioned for Growth


  • Increase in 100G/400G optical roll-outs and 5G will/has led to an increase in testing demand over the next three years:https://www.prnewswire.com/news-releases/5g-is-expected-to-amplify-the-need-for-network-testing-reports-frost--sullivan-300533018.html

  • Given its diversified customer base across North America/EMEA/Asia, EXFO’s physical test business has benefitted, growing in the mid to high single digits over the past three years.

  • 5G cycle should lead to increased demand for both physical and protocol. On the physical side, an increase of fiber build-outs and base stations is a positive tailwind, while on the protocol side EXFO should benefit from a move to network virtualization for probes. 


Why Does This Opportunity Exist?

  • EXFO has disappointed investors with its FY19E EBITDA guide of $24MM, which is down from $30MM the prior quarter. This was driven by a confluence of factors, mainly Astelia/Protocol losses continuing into the year at a tune of $6MM to $8MM per annum, mainly as revenues were pushed back as communication service providers push back their NFV/network virtualization efforts to the back half of CY19. The market expected break-even contribution from this segment and faster growth.

    • Adding fuel to the fire, the protocol business was expected to inflect in the back half of FY19, however won’t see any positive impact until the back half of 2020.

  • Low liquidity driven by high insider ownership (60%) and low trading volumes under $1MM per day. This has mostly kept EXFO out of indices. 

    • Similar to VPG, most of the market views EXFO as a value trap given its high inside ownership and historical lack of willingness to sell. This has been evident as the valuation multiple has remained at a steep discount to peers (very similar to VPG). Note competitors such as Viavi have been open in buying EXFO (likely at a significant premium) This has likely changed as the founder has vacated the CEO chair to Philpe Morin who came from Ciena in 2015 (as COO). 

  • Some commentary suggests market skepticism over future deals on the protocol side of the business vis-à-vis focusing on the current optical test and measurement

  • EXFO is underearning as EBITDA margins are 8.8% as of recent, whilst peers have generated 15% to 25% EBITDA margins. Note EXFO has committed to achieving 15% EBITDA margins over the coming years. 




Base Case

  • Our base case assumes revenue from the Astellia and a slight ramp from 5G/optical in FY20E. 


  • We assume OpEx is relatively held and EXFO exhibits operating leverage, leading to slight margin expansion to ~10% EBITDA margins, vastly below peers.



Upside Case


  • EXFO benefits from the 5G and 100G/400G upgrade cycles leading to strong revenue growth.

  • EBTIDA margins expand to 13%, 700 bps below peers and 200 bps below the targeted operating model.  

Stress Case


  • Assumes EXFO does not benefit from any upcoming cycles and protocol revenues decline.

  • EBITDA margins stagnant as the Company spends capital on the protocol side of the business.


Private Market Transactions

The test and measurement market has been highly active over the past five years as strategics look to consolidate the market. A majority of the assets acquired have similar gross margin profiles as EXFO, in excess of 50% and similar top-line growth profiles. On average, transactions have been consummated in excess of 2x revenues, a large premium to EXFO’s current trading multiple (0.6x). 


Assuming multiples below recent private market transactions, EXFO represents an attractive risk/reward: 



Technical Dynamics & Sentiment


  • Under 1% S/I.

  • Biggest issue is liquidity under $500K USD trades daily. Trades on appointment.

  • Coverage includes Northland, GMP, CIBC, RBC, BMO and Cannacord. Mostly neutral/market perform rated.

  • Founder/Chairman Germain Lamonde is the largest shareholder with a ~60% stake. Other shareholders include EdgePoint, RenTech, Fiera, Pender and CEO Philpe Morin (1%). 

Catalysts to Value Realization




Capital Allocation & Integration of Astellia 

  • Astellia is currently generating ~$10MM in run-rate operating losses. Hence as Astellia’s cost structure is right sized and volumes return, EBITDA should inflect positive.

5G and Optical Cycle Lead to Significant Revenue Growth 

  • Considering EXFO’s 60%+ gross margin profile, incremental EBTIDA and cash flow should be significant if these tailwinds (such as the metro fiber roll-out) come to fruition.

  • EXFO also benefits from an increase in webscale operator capex (AWS/FB/Google). 


  • EXFO trades at a steep discount to private market transactions at 0.6x revenues versus transactions ranging from 2x to 3.3x revenues, implying 100% or more upside;

  • The Chairman could effectuate a buy-out simply by rolling over his 60% stake and taking 2-3x of leverage on the physical layer assets.

Margin Upside

  • Management has stated they are looking to achieve 15% EBITDA margins over the coming years, driven by the integration and scale within the protocol business, a significant uptick versus FY17 EBITDA margins of 9%. 



Reflexivity & Degree of Total Leverage



Low / Medium / High 


How reflexive is the outcome? 


  • Worst case, EXFO trades range-bound below or near book value and a mid-single digit EBITDA multiple.

Degree of Operating Leverage?


  • High gross margins can lead to significant drop-down in operating cash flow.

Degree of Financial Leverage?


  • EXFO has little to no net debt. However, they do need ~$10MM in cash on the balance sheet for customer orders, etc.


Risks & Mitigants





Poor Acquisitions

Impairment, Focusing on Niches outside of the core business

  • Chairman/founder owns ~60% of the Company.

  • This risk has partially created the opportunity as the recent decline in share price has been derived

Insider Control

Take Under/Nothing Happens

  • Appointment of Philipe Morin as CEO signals a change. 

5G/100G/400G Opportunities do not materialize

Penetrated TAM Limiting Top-Line

  • This will leave EXFO a flat to no growth margin improvement story. Nonetheless, at under 1x revenues, little upside is priced in. 

Margin Improvement Fails to Occur

Lack of operating Leverage

  • Restructuring plan recently implemented.

Lack of Trading Liquidity


  • Trades on appointment/block.


 The author of this posting and related persons or entities ("Author") currently holds a long position in this security.  Author may purchase additional shares, or sell some or all of Author's shares, at any time.  Author has no obligation to inform anyone of any changes to Author's view of EXFO.  Please consult your financial, legal, and/or tax advisors before making any investment decisions.  While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note.  The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in EXFO.  READER AGREES TO HOLD AUTHOR HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE.  As with all investments, caveat emptor.


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.


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