Fabrinet (FN) Q3 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to Fabrinet's Third Quarter 2013 Financial Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. Now, I'll turn the conference over to your host, Chief Administrative Officer and General Counsel, Paul Kalivas. Please begin.

Thank you for joining us on today's conference call to discuss Fabrinet's financial and operating results for the third quarter of fiscal year 2013, which ended March 29, 2013. With us on the call today are Tom Mitchell, Chief Executive Officer and Chairman of the Board of Directors of Fabrinet; TS Ng, our Chief Financial Officer; and John Marchetti, our Chief Strategy Officer. This call is being webcast and a replay will be available on the Investors section of our website located at investor.fabrinet.com. During this afternoon's discussion, we will be presenting both GAAP and non-GAAP numbers. Our GAAP results and reconciliation of our GAAP to non-GAAP results are attached to our earnings press release, which is also posted on our website. I would like to remind you that today's discussion may contain forward-looking statements about the future financial performance of the company. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from management's current expectations. These statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to revise them in light of new information or future events, except as required by law. For a description of the risk factors that may affect our results, please refer to our recent SEC filings, in particular, the section captioned the Risk Factors in our Form 10-Q filed on February 5, 2013. We will begin the call with brief remarks by Tom, John and TS, followed by time for questions. I would now like to turn the call over to Fabrinet's CEO and Chairman, Tom Mitchell.

Thank you, Paul, and good afternoon, everyone. I am pleased with our third quarter results. Both revenue and earnings per share were above our guidance range, demonstrating the consistency of our operating model. We're optimistic about the long-term opportunities for growth, which include new business from existing customers, potential business from new customers and our efforts to further diversify our revenue and customer base. As always, I want to thank our employees for their hard work and all of our customers for their continued trust and support of Fabrinet. I will now turn the call over to John Marchetti, Fabrinet's Chief Strategy Officer, for a further discussion of the market we serve.

Thanks, Tom, and thanks, everyone, for joining us today. In terms of overall demand trend, not much has changed over the last several quarters. Quarters, while for the most part stable, remained stubbornly flattish. And these demand trends are prevalent across several of our lines of business and are not attributable to any 1 particular customer or end market vertical, suggesting to us that demand continues to be adversely affected by sluggish spending trends in multiple markets. Near term, we expect these current demand challenges to continue. In Optical Communications, we experienced increased stability relative to the order cuts that we experienced in the December quarter. However, we did not see a material increase of orders that we were hoping would materialize toward the end of the quarter. There continues to be a great deal of focus and effort in some of the more advanced components and modules, which we believe is encouraging, and we expect that these trends will continue. It is this activity that gives us confidence that the underlying fundamentals of our Optical business remains strong, and we expect to benefit through our customers once spending on optical equipment begins to accelerate. Our Laser, Sensor and Other business, while flat quarter-over-quarter, remains an important avenue of growth for us. And we will continue to explore ways to accelerate our diversification efforts in niche and potentially other new markets. Our laser market appears to have stabilized somewhat as some of the weakness that we saw in the government and research markets over the last couple of quarters appeared to flatten out while the industrial market remains mixed. We expect that over the near term, our laser business may continue to experience some sluggishness. However, we continue to believe that the overall laser market is in the early stages of outsourcing and represents a significant opportunity for growth over the next several years. The demand and visibility on our automotive segment remain solid, and we are encouraged that signs point to this continuing. We continue to win new business in this segment and are excited about the opportunities for growth in the coming quarters. Overall, we remain confident that our laser, sensor and other segment will be a critical driver of our top line growth for the next several years. Taking a longer-term view, we remain encouraged by the overall growth prospects for our business. We continue to have success in new customer acquisition and in winning new programs from existing customers. And while these new wins always take time to generate meaningful revenue, we believe the pipeline for both of these growth avenues is strong. With that, I would now like to turn the call over to TS, our Chief Financial Officer, for a report on our financial results. TS?

Thanks, John. Good afternoon, everyone. I'm pleased to report that Fabrinet delivered fiscal quarter 3 results above our guidance range. I would like to start with an update on the insurance recovery status, then go through a review of the results for the third quarter and end with our outlook for fiscal quarter 4. As a reminder, we continue to expect our financial results to be impacted for multiple quarters due to the timings of approval and payments of insurance proceeds. Claims for all losses related to equipment, inventory, property and business interruption, has been submitted and we continue to work with our insurance syndicates to settle these claims. In the third quarter, we received an insurance payment for our own inventory claim in the amount of approximately $11.4 million. This is the third consecutive quarter where we have received insurance payments against our claims, and we will continue to aggressively pursue the balance. We will disclose additional information on the timings and payments of our insurance claims as it becomes available. Now to review the results for our third quarter. Please note that all numbers are GAAP, unless otherwise stated. Our total revenue for the third quarter of fiscal 2013 was $155.6 million, a decrease of 7% sequentially and an increase of 12% compared to the third quarter for fiscal 2012. Please remember that the third quarter for fiscal 2012 was still impacted by our flat recovery efforts. On an end market basis, revenue from Optical Communication was $108 million, or 70% of total revenues for the quarter. While Lasers, Sensors and Other revenue was $47 million, the remaining 30%. As Tom indicated in his prepared remarks, we will continue to look for ways to further diversify our revenue base. Our share-based compensation expenses for the quarter were $1.3 million, of which roughly $1.1 million was included in SG&A. This compares to share-based compensation of $1.4 million last quarter and $1.3 million in the March quarter of fiscal 2012. Our flood-related item for the quarter was income for $11.4 million, which represents an insurance payment on our inventory claim for Fabrinet-owned inventory. This amount is included in our results as other income and is excluded from our non-GAAP results. We intend to put the gains on the insurance proceeds in future periods as those amounts become reasonably certain. Our effective tax rate for the quarter was 4.2%, including the effects of flood-related insurance recovery, as well as the release of some profit tax provisions. Without this item, our normalized tax rate would have been 5.3% within our expected range of 5% to 6%. On a non-GAAP basis, net income totaled $11.5 million for the quarter or $0.33 per share, calculated from a base of roughly 35 million fully diluted shares. Non-GAAP net income decreased 17% sequentially compared to non-GAAP net income of $13.8 million last quarter, and increased 17% compared to non-GAAP net income of $9.9 million in the same period last year. On a GAAP basis, including flood-related income, share-based compensation expenses and follow-on operating expenses, our net income was $21.1 million or $0.61 per share. In the near term, we expect that our GAAP results will continue to fluctuate due to the size and timing of future insurance recovery. Moving on to the balance sheet and cash flow statement. We ended the quarter with a cash balance of more than $157 million. The $29 million plus sequential increase was primarily due to positive operating cash flow and the proceeds on the interim insurance payment. Please note that Fabrinet did not receive any proceeds from the follow-on offering that was completed in March. I will now like to discuss guidance for next quarter. As both Tom and John discussed, we have yet to see signs of a sustained increase in orders from our customers. As a result, we are remaining conservative in our outlook for fiscal quarter 4. We expect revenues of between $148 million and $152 million. We anticipate non-GAAP net income of $0.27 per share based on a fully diluted share of 35 million shares. GAAP net income remains subject to the timings of insurance recovery. That concludes our prepared remarks. At this point, I would like to turn the call over for questions. Operator?

[Operator Instructions] Our first question is from Patrick Newton of Stifel. Patrick M. Newton - Stifel, Nicolaus & Co., Inc., Research Division: I guess just on the revenue guidance, I want to dig down a little bit into that. Of course, my question is, I'd love for you to extrapolate what's driving you to guide down sequentially. I look back at June and from a seasonal basis, it's typically, at worst, flat. You discussed demand trends being flat throughout the quarter and you've been at the high end of your guidance for 2 consecutive quarters now. So given that we don't think you're losing share because of competitive positioning, should we just view it as conservative?

Exactly. It's John. Yes, I mean, I think if you really look at it, right, while we did come in above our guidance this quarter, if you look at our guidance that we're giving for June relative to the guidance that we gave for March, it's essentially the same guidance. But it's flat on a sequential basis, if you look at the guidance. And essentially, that's what we're seeing out there. We're always a little bit conservative, so maybe we're airing a little bit more on the side of caution. But when you really look at it from a guidance perspective, the guidance for June is essentially flat with the guidance we gave for March. And that, I think, is reflective at least right now of what we're seeing from the bulk of our core -- from the bulk of our customers. Patrick M. Newton - Stifel, Nicolaus & Co., Inc., Research Division: Okay. And I guess if we think about what drove the beats in the March quarter, if I recall, you had talked about kind of orders accelerating a little bit exiting December. And I believe that picked up some momentum in the month of January. As we proceeded through the quarter, how'd that linearity look, and then I would assume that we've kind of flatlined into April, thus far, but would love your thoughts there.

Sure. I mean I think you touched on it. We essentially flatlined. As we saw that little bit of an uptick and I think we talked a little bit about some of the cuts that we saw in the month of December, I think we've picked up maybe a little bit more of that in the end of January into early February. And then, really, it's been pretty consistent quite frankly since then. Patrick M. Newton - Stifel, Nicolaus & Co., Inc., Research Division: Okay. And I guess just on the gross margin front, I think you were a little bit softer than I would've expected and I'm backing into the 10.6% pro forma rate, which is the lowest outside of flooding or recessionary periods. So I'd love if you could extrapolate on some of the impacts on -- what impacted gross margin this quarter. Was it a mix issue? Did FX have an impact? With Casix soft, I assume based on some commentary from some peers that Casix was soft, what was impacting that margin profile?

Yes, Patrick, this is TS. I think it's merely following the trends. Previously, we discussed about the headwinds from the Thai baht. But I know you followed that the Thai baht is at a 16-year high recently. So -- and we discussed already the factor in our release, our factor in the 10-K and 10-Q. We talked about our operating model is susceptible to the non-U.S. dollar exchange rate fluctuation. And again, this coming quarter, this -- at Q4, we even fewer stronger headwinds. So the non-GAAP EPS guidance down essentially all because of the foreign exchange. Patrick M. Newton - Stifel, Nicolaus & Co., Inc., Research Division: Okay. And then I guess one other question is on a sequential basis, I think you should have had some benefit to your gross margin from the lower insurance cost. So if we stripped out the effect of the Thai baht, would that have been the case?

A small impact, okay? Because as we go into the year, we might realize more because we still have some refund from last year. And we also -- essentially, our insurance for last year ended on March 31. So there'll be some spillovers this quarter, but I would say September quarter, we might see some impact on that, getting impact on that.

Your next question is from Sherri Scribner of Deutsche Bank.

I just wanted to follow up on the previous question. Thinking about the SG&A, it was up this quarter despite the fact that revenue was down and it's a bit higher than it's been in a while. Was that primarily related to the Thai baht or were there other things that drove the SG&A up?

Yes, SG&A, we also included, Sherri, the follow-on offering, secondary offer, the expenses there. And we can't cast out non-GAAP EPS. So if you look at our non-GAAP to GAAP EPS reconciliation, you'll see that about close to $0.5 million spend on the secondary offer.

Right. But if you strip that out, it still looks like it was higher in terms of sequentially versus December even though the revenue was down.

Yes. So I think it's about $6.2 million like if you strip that out. And yes, we basically think that around $6 million, we'll set between $6 million to $6.5 million. So we skew that, yes, around that range.

Okay. So going forward, you expect it to be $6 million to $6.5 million?

Yes, but some of it also a chain because we have SG&A, the local spending there, too. So a chain impact get into gross margin, as well as SG&A, too.

And could you give the magnitude of the impact from the FX this quarter?

No.

Okay. And then just thinking about the gross margins in terms of the guidance, the gross margin is down sequentially. What type of contribution margin do you guys think about for the business? I know the revenue is expected to be down, but just trying to understand how much leverage is there and how much fixed cost is in the COGS number.

Okay. Yes, Sherri, the volume of leverage is tremendous here, even though Patrick mentioned about gross margin, 10% plus or so on. But our contribution margin out there, at least double that amount. So as we do this, you still have -- if you get to $190 million and if you look at the way we guide $150 million to $190 million, there's $40 million there. If we can get that $40 million upside, tremendous leverage on the fixed overhead, and therefore, the margin so.

Our next question is from Subu Subrahmanyan of The Juda Group.

Could you talk about what the mix of things were which led to the upside in the quarter? Were there any particular products areas, geographies or customers that led to that? And similarly, in the tone of the orders and forecast your customers are indicating, they're still expecting a second half improvement. But they don't have visibility for that, and I'm just wondering how that's coming down to your forecast past the June quarter?

Sure, Subu. This is John. I mean I think to the first part of your question, I don't think there's anything or anyone in particular that we would call out as the upside relative to the guidance. We're a little bit stronger, I think, on both sides of the house, if you will, relative to our plan going into the quarter. So I thought it was nothing that I think I could really point a finger to and say it was 1 or 2 specific items. In terms of looking out to June, I think our guidance reflects certainly the orders that we have coming in. But I do think, to your point, there still remains a bit of an expectation that things are going to get better. It's just, I think, similar to what we've been talking about for a little while, it's a question of when. And quite frankly, we're as hopeful for it as anyone. But until we really start to see it, we're not going to, certainly, factor any of that into a forecast or any kind of guidance that we give.

Understood. And then to follow up gross margin, TS, is it fair to assume that with slightly lower revenues, gross margin and the input in the numbers have implied is flat to slightly down going into the June quarter?

Yes, all because of the foreign exchange impact. That's right.

Our next question is from Ehud Gelblum of Morgan Stanley.

I'll stick on the FX issue for 1 quick moment just to make sure I understand. Your revenue is not impacted because it's -- all your revenue contracts are in U.S. dollars, is that correct?

That's correct.

Okay. So on the COGS and OpEx lines, what was the average baht rate that you saw in the quarter and what was the baht rate in the prior quarters we can compared to the actual -- and calculate its actual impact?

Okay, if you look at -- actually, we have a hedging policy in place, right? So, Ehud, if you track the spot rate, not necessarily that we will close the book at that spot rate because we're hedged about 3 months ahead of the operation. So -- but I can tell you that between last quarter at Q3 versus the coming quarter at Q4, the foreign exchange grew by about THB 1.135 to U.S. dollar. So currently, baht is running about THB 28.5, THB 29, around that range. As you can imagine, previous quarter, we were using about THB 30 to THB 29 to U.S. dollar. So one quarter alone, the backdrop about 1.13 million, excuse me -- THB 1.135 for U.S. dollar. That created about a $0.03 impact, and that's why we got about $0.03. Other than that, everything else comes flat. But like what John said, flat from the -- at Q3 last quarter guidance.

Okay. So if I can just make sure I understood you correctly, you hedged 3 months in advance and the change from last quarter to this quarter was a move of about THB 2 up from like THB 31 to THB 29?

Yes, you can think about 3%, 3% to 3.5% baht within 1 quarter, it moved downward appreciated by 3% to 3.5%.

So the impact was only THB 1 from 1 quarter to the next?

Yes, right.

What are you assuming for your guidance going forward? Another...

The guidance, it's about, yes, $0.26 to $0.28, right? So if you take the midpoint, $0.27. In the previous quarter, we guided about $0.29 to $0.31. If you take the midpoint, it's about $0.30, right? So it's down $0.03 quarter-to-quarter.

But the revenue is also lower? But I guess, the revenue's the same in terms of guidances, okay.

Correct, yes.

Okay. So we should assume -- and what is the absolute number for the baht? Is it THB 29 that you're assuming now?

Going through the quarter, yes, going through the quarter, we assume to be 9.5 because we had the contract to diverge that baht at that price, yes.

Okay. We should assume it's now 1 less the 28.5?

And the spot as of today is 28.5. That's correct.

That's where you're hedged in for this quarter, 28.5?

We are still buying. We haven't concluded this quarter yet. Usually, we go out and buy almost any rate. We buy enough for the following quarter so.

Okay. Helpful. I have a sense, maybe just want to follow up a little bit more. When you look at the trends that you were talking about, the laser sensors was flat as you said. And when you gave guidance last quarter, is that where you expected it? So was all of the upside in the comm side? Is it...

I wouldn't say that it was all in the comm side. I mean I think that we were roughly expecting that route to be relatively flat and that's the way it came in. So relative to our guidance, there's probably a little bit more upside in comm than we would've expected. But again, I don't think it's anything that was terribly surprising to us given what the ultimate number wound up being.

And again, what was the -- did they come from certain vendors that were stronger than you thought but their orders tailed off? Why isn't the strike that you saw continued in the -- your optimism for next quarter?

Well, again, I mean it was across a few different customers, each one of them was a little bit higher than planned. But I don't think that, that's something that is, again, it's not terribly shocking. It's not like it all came from 1 customer to where I could say, "Boy, that either dropped off or something along those lines."

Were there restarts of certain programs that were still on hold from the floods? Is that -- I'm just trying to -- just a little color. I know you gave some answers, but I'm still trying to correlate why things were stronger and tended to be a little bit better this quarter and yet, you have no confidence to continue into next quarter?

Well, again, I think the reality of it is we came in a little bit better than we had hoped or that we planned for last quarter. And as we're looking at this quarter, we're trying to be conservative in the same way we were last quarter. We haven't seen a sustained sign of an uptick in orders to where we feel overly comfortable giving a -- an aggressive growth target. And so we're being careful here. We're certainly hopeful that the order patterns will turn, but until they do, we're certainly not going to get out in front of our skis.

Okay. And I'm perfectly fine with you staying on your skis, that's a comfortable place to be. The commentary though sounded pretty negative as well though, flattish demand, not seeing a pickup to all kinds of things. That doesn't -- don't sound to be all that in correlation with the other information that you're giving. So I'm just trying to feel as to where we're supposed to be reading into this. Our trends really -- the muted trends that you're seeing this quarter, they weren't as -- weren't quite muted, and it sounds as though there's a possibility that things could get a little bit better, but you're just not totally seeing them yet. Is that one way to characterize it?

I think that's a fair characteristic. I mean, I think when we talked back in February on our earnings call, the whole point, frankly, is that we would start to see a -- some of the early signs that we saw continue to grow. And they didn't, they flatlined out. And I think we're here now, still on that sort of flattish order pattern and we're still hopeful that there could be upside as we continue to move forward through the quarter. But we're not seeing it yet.

Okay. Interesting. One last question on the laser sensor side. You didn't give a split, I believe, between government and commercial types of lasers, saying that government was more flattish, commercial was a bit weaker. Did I get that description correctly?

I mean, I don't think we called it out specifically. Government, I think, continues to be one of the areas in laser that has been under the most strain just given some of the things that have gone on with the sequester, and prior to that, even some of the budget debate that was happening. So that continues to be a marker. I think if you listen to the public commentary from some of our customers, that would certainly reflect that, whereas some of these other end markets, I think, are a little bit more mixed. But to be blunt, my customers can answer that question better than I can.

Our next question is from Paul Coster of JPMorgan. Paul Coster - JP Morgan Chase & Co, Research Division: Did you talk about the 10% customers this quarter? And if not, can you share with us the numbers there?

I would just say that they're the same that we've disclosed in our K historically, and there's no real change to any overall percentage or anything like that, Paul. Paul Coster - JP Morgan Chase & Co, Research Division: Okay. You talked about the auto opportunity. Can you just tell us what exactly the product is inside autos?

So we work with some of the subassembly system vendors. We do a number of programs from antilock brake sensors to airbag deployment sensors to a few others. So we primarily are in the safety and control function. Paul Coster - JP Morgan Chase & Co, Research Division: And why should we be interested in what's happening there?

Well, for us, it represents a real nice opportunity. It takes a long time to get yourself qualified and prove yourself to those types of customers. And once you're sort of designed in with those guys, you tend to have a very long life cycle with them. And so we have opportunities to grow both within those customers. As they look to award new programs, we're certainly able to bid for some of those, as well as we continue to obviously look for ways to expand on the relationships we have today to -- now that we've proved ourselves in that market to bring some new customers in over time. So we think that's, obviously, another diversification avenue for us. It's one that we're certainly hopeful about over the longer term. As we continue to mine for a few others, hopefully, all of those in aggregate can continue to help us diversify our revenue stream. I mean, ultimately, we've stated this before. We'd love to get to a point in some number of years down the road where we're at sort of a 50-50 split between optical and non-optical, if you will. Paul Coster - JP Morgan Chase & Co, Research Division: You say -- in other words, you think the auto segment can be material contributor to total revenues?

Absolutely. Paul Coster - JP Morgan Chase & Co, Research Division: Okay. All right. And then finally, you talked about advanced products being a growing proportion of your network vertical communications business. What are we exactly referring to? And are we talking about the actual revenues or the orders that are coming in now?

No, I mean, I think if you just sort of look at what's going on in the industry right now, there certainly is more of a focus on some of the higher-speed components and modules. Customers are certainly, I think, focused on the 100-gig upgrade cycle and a lot of the pieces of that as they continue to look at their portfolios. And so the comment there was just, I think, really trying to indicate that, that regardless of what the slope of the curve might look like, it's clear that customers are certainly focused on that end of the optical market. Paul Coster - JP Morgan Chase & Co, Research Division: That doesn't have any impact on gross margins and it doesn't seem to be yielding revenue growth through higher ASPs at the moment.

Paul, not really. Because in the past, we say that was a cost-plus model, so yes.

We have a follow-up question from Patrick Newton of Stifel. Patrick M. Newton - Stifel, Nicolaus & Co., Inc., Research Division: I guess just kind of sticking around the FX question, your other income had a $1 million gain on FX. It was about $0.03 net of tax. That kind of nets out the impact of Thai baht through the -- your SG&A. I'm curious, is there something buried in that other income line that is a natural offset or hedge to the Thai baht? Or is that some kind of hedging game -- gain -- or is that something that can continue on a go forward basis?

Okay, Patrick, that's a good catch. Now, we received insurance proceeds in Thai baht, okay? And during the flat, at the time, about 1.5 years ago, the Thai baht was running at THB 31 for U.S. dollar. But all the claim is submitted in U.S. dollars and converts at THB 31, because that was baht converting at that time. So when I received this THB 350 million, which you saw USD 11.6 million, I have to remit that to Cayman Island, because some of these inventory belong to Cayman Island. So when I receive a baht, we book it as whatever, forward rates, P&L rate we use. And then when we send it out because of the baht appreciator, so we tenderize using the spot rate. So that's how you create the gain there. Also, I had foreward contracts, a whole bunch of foreward contracts and a mark-to-market. And at the end of the quarter, Thai baht is appreciating, the trend is appreciating. So mark-to-market, that's how we've created about close to 900K foreign exchange gain there. Patrick M. Newton - Stifel, Nicolaus & Co., Inc., Research Division: So I guess in the June quarter, based on mark-to-market and based on the insurance proceeds, should we see any type of similar benefit? It sounds like not to the level of $908,000, but should we anticipate some type of benefit?

Yes, only the small portion, only the mark-to-market portion might reverse. And again, we don't forecast the foreign exchange going forward. So that might roll out into the P&L, but I think it's not a big significant amount.

And no further questions at this time. We'd like to turn the call over to John Marchetti for any closing remarks.

Great. Well, thank you, everybody, for joining us today. And now, we look forward to speaking with you all soon. Thanks very much.