Fabrinet (FN) Q3 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. Welcome to Fabrinet’s Third Quarter Fiscal Year 2016 Financial Results Conference Call. [Operator Instructions] As a reminder, today’s conference is being recorded. I would now like to turn the call over to your host, Garo Toomajanian, Investor Relations.

Thank you, operator and good afternoon everyone. Thank you for joining us on today’s conference call to discuss Fabrinet’s financial and operating results for the third quarter of fiscal 2016 which ended on March 25, 2016. With me on the call today are Tom Mitchell, Chief Executive Officer and Chairman of the Board of Directors of Fabrinet and TS Ng, Fabrinet’s Chief Financial Officer. This call is being webcast and a replay will be available on the investors section of our website located at investor.fabrinet.com. Please refer to our website for important information, including our earnings press release and our non-GAAP to GAAP reconciliation. I would like to remind you that today’s discussion will 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 reflects 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 Risk Factors in our Form 10-Q filed on February 2, 2016. We will begin the call with remarks from Tom and TS, followed by time for questions. I would now like to turn the call over to Fabrinet’s CEO and Chairman, Tom Mitchell. Tom?

Thank you, Garo and good afternoon everyone. We delivered strong performance in the third quarter with revenue and earnings per share that were above guidance. During the third quarter, we benefited from positive trends in the optical industry, which resulted in higher than expected demand from both new programs and programs that have been in production for two or more years. With demand increasing, we are optimistic that we will continue to benefit from strong market trends in the fourth quarter and into fiscal 2017. From a capacity perspective, we are excited that the first building of our new campus in Thailand will be completed by September. This new campus will allow us to continue to meet increasing customer demand and to grow at a healthy pace. Now I will turn the call over to TS for details on the quarter.

Thanks, Tom and good afternoon everyone. I would like to provide you with more details on our performance by end market and our financial results. Total third quarter revenue was $250.9 million, an increase of 32% from a year ago and above the high end of our guidance range. As a reminder, we did not record any consignment revenue in the third quarters of fiscal year ‘15. Our strong performance this quarter was primarily the result of positive trend in the optical communications, which generated demand that was above expectations. Our optical communication business represented 77% of our total revenue, increasing more than 4 percentage points, both from last year and last quarter. Optical revenue increased 41% from a year ago to $192.2 million, while non-optical revenue increased 11% to $58.7 million. While we expect increasing diversification in our business to drive and increase in our mix of non-optical revenue in the long run, over the near-term, very strong optical industry dynamics will likely continue to favor growth from optical revenue. Within optical, the revenue split was 56% from telco market and 44% from datacom market. As year-over-year telecom growth jumped to 29% in Q3 compared to 5% in Q2. At the same time, datacom momentum continues to be very strong with datacom revenue growing 60% from the third quarter of fiscal year 2015, in line with 64% growth in Q2. As you might expect, growth in our optical communications business continues to be driven by 100-gig solution and other advanced components and modules, including QSFP28 transceiver and silicon photonic modules. We continue to see a mix shift towards 100-gig programs, with revenue increased more than 175% from a year ago more than offset revenue decline of approximately 10% from both 10-gig and 40-gig programs from the prior year. In fact, in the third quarter, 100-gig program revenue was more than double the revenue we generated from 10-gig and 40-gig programs and was a meaningful contributor to optical revenue growth in the quarter. Turning to our non-optical communications business. At $58.7 million, revenue from lasers, sensors and other market represent 23% of total revenue. We saw year-over-year growth in each of the lasers, sensors and other revenue categories. Laser, which make up 47% of non-optical revenue, increased 8% from a year ago. Though up 50% from a year ago, non-automotive sensor revenue declined from the second quarter as certain consumer related programs slowed as anticipated. Automotive revenue make up 35% of non-optical revenue and increased 12% from a year ago. New business represented manufacturing programs from new or existing customers that were not in production 2 years ago. Revenue from new business represented 25% of total revenue in the third quarter, up from 17% of revenue in Q3 of fiscal year 2015 and consistent with the second quarter mix. As you look to the near future, we expect that revenue from new business will continue to increase in dollars. However, given strong growth trend from projects and related enhancements to program that were in production more than 2 years ago, the mix of revenue from new programs may not increase as quickly as it did earlier in the year. To be clear, this is more a reflection of acceleration in production of existing customer programs than a change in the performance of revenue from new program from which we expect to see strong growth on a dollar basis. Revenue from our Fabrinet West new product introduction facility continues to grow. In fact, we are already in the process of installing a third production line at Fabrinet West during the fourth quarter, which will support further revenue growth into fiscal 2017. We are making excellent progress with the first building at our new campus in Chonburi Province in Thailand, with approximately 500,000 square feet of manufacturing space. Our first new building in Chonburi will increase our total manufacturing space in Thailand by approximately 50%. Our new campus has space for additional buildings of the same size, which will bring our total manufacturing space in Thailand to approximately 2.5 million square feet compared to approximately 1 million to date. As Tom mentioned, we now expect our first building in Chonburi to be completed by September, with first customer shipment expected to begin in the third quarters of fiscal 2017. Now, turning to the details of our P&L, a reconciliation of GAAP to non-GAAP measures is included in our press release. Non-GAAP gross margin in the third quarter was 12.6%, an increase of 100 basis points from a year ago and up 10 basis points from last quarter primarily due to higher than anticipated revenue. For the fourth quarter, we expect non-GAAP gross margin to be consistent with the third quarter, which is slightly above our targeted range of 12% to 12.5%. Non-GAAP operating income was $21.7 million, operating margins of 8.6%, excluding share-based compensation expenses of $2.0 million and executive separation costs of $0.8 million and income from flat insurance payments of $0.9 million, non-GAAP operating margin improved 120 basis points from a year ago primarily due to higher gross margin this year as both the third quarters of fiscal 2015 and 2016 includes startup cost associated with our Fabrinet West facility in Santa Clara, California. Other income and expenses in the third quarter included a $3.2 million foreign exchange gain, reflecting deliveries of contracted, but against an unrealized loss in the first quarter. Approximately $2.3 million of the remaining underlying loss will be reversed as contracted but is delivered. GAAP taxes in the quarter were net expenses of $2 million and our normalized effective tax rate was 5.8%, which was slightly lower than our expected range of 6% to 7% due to the reversals of income tax expenses related to our U.S. operations. We continue to anticipate that our effective tax rate will be in the range of 6% to 7% of fiscal year 2016. Non-GAAP net income was $20.8 million in the third quarter or $0.56 per diluted share compared to $0.36 in Q3 of fiscal year 2015 and was above the higher end of our guidance. On a GAAP basis, which includes share-based compensation expenses, executive separation costs, flat related income, amortization of debt issuing cost and the unrealized gain from mark-to-market foreign exchange adjustment. Net income for the quarter was $20.8 million or $0.56 per diluted share compared to $10.8 million or $0.30 per diluted share in the third quarter of fiscal 2015. Moving on to the balance sheet and cash flow statements, we ended the quarter with a cash and investment balance of approximately $273 million. This represents an increase of more than $6 million from the end of the second quarter, primarily due to operating cash inflow that were partially offset by CapEx and revolving loan payments. We continue to expect CapEx in fiscal 2016 to be in the range of $60 million to $70 million, with approximately $30 million of debt in maintenance CapEx and the remainder going toward the land purchase and construction of new manufacturing facility in Thailand. I would now like to discuss guidance for the fourth quarter. We expect the strong business momentum we have generated in the third quarter to continue into the fourth quarter. We expect revenue in the fourth quarter to be between $260 million and $264 million, representing growth of 26% to 28% from a year ago. Excluding the impact of $4.6 million in consignment revenue in the fourth quarters of fiscal 2015, this guidance will represent growth of 29% to 31%. We anticipate non-GAAP net income per share in the fourth quarter to be in the range of $0.59 to $0.61 and GAAP net income per share of $0.55 to $0.57 based on approximately $37.2 million fully diluted share outstanding. For the full year fiscal 2016, we expect revenue to be between $960.4 million and $964.4 million, representing growth of approximately 24% to 25% of growth of approximately 27%, excluding the impact of consignment revenue in fiscal 2015. In summary, we delivered a strong performance in the third quarter and are anticipating an even stronger performance in the fourth quarter. We are benefiting from robust industry trends as well as from investments we are better enabling us to attract additional programs from both new and existing customers. With new facility coming online, two to three quarters from now, we are optimistic that we can continue to meet our growing demand into 2017 and beyond. Operator, we will now like to open the call for questions.

Thank you, sir. [Operator Instructions] Thank you. Our first question comes from the line of Alex Henderson of Needham. Your line is open.

Hey, guys. Can you hear me?

Hi, Alex.

Yes, I guess its good being you guys these days.

Seems to be.

Couple of quick questions. One simple one for you, TS, what should we be thinking about the tax rate for fiscal ‘17? Is it going to increase a little bit because of Fabrinet West?

Not necessarily. I will assume 6% to 7% as previously guided. So remember, Chonburi is going to come online and it’s all tax-free over there, so...

So, 6% to 7% of non-GAAP. And could you break out just I think you kind of hit some of it, but it was a little confusing on the breakout on 10-gig, 40-gig and 100-gig, what was the growth rate, what percentage of revenues are coming from those three buckets?

Okay. We said we shipped more 100-gig than 10 and 40 combined. In this case, we are doubling in this case. So in other words, if you look at the total transceiver and modulator, you go by speed, we have two-third shipments in 100-gig and a one-third shipment in 10 and 40-gig so to speak.

Okay. So, a third, two-thirds and is 10-gig and 40-gig declining or what’s the trajectory of those two?

In my prepared remarks, we said it is down about 10%. So, if you compare sequentially down 10%, but it’s make up by the 100-gig.

Great. That’s very helpful. And on Fabrinet West, you are indicating a third line, are we still thinking that by the time we get to the December quarter that you will be producing $5 million to $10 million of quarterly revenue kind of trajectory on that? Is that kind of the ramp on that?

Yes, that’s right in line, Alex.

Perfect. I will see the floor. Thank you.

Thank you, Alex.

Thank you. Our next question comes from the line of Patrick Newton of Stifel. Your line is open.

Yes, thank you, Tom and TS. Congratulations on the great quarter. Three questions on my end. One is just to dovetail off of Alex’s question on MPI facility, how much of a loss was the facility in the March quarter, what’s embedded in the June quarter? And then if we think about the breakeven, you talked about $5 million to $10 million is the right range for December. So, should we think breaking more tech weave [ph], is that the $10 million threshold being either kind of the December, March timeframe?

Yes, I think, Patrick, your data of December is really in line with what we plan and what we anticipate.

And TS, the loss per share?

Yes. So, we don’t break out that, but in the past, we say most of the startup costs is in our operating expense. So, in the past quarter at Q3, we still look at about $2 million to $2.5 million bake into the operating expense. Now bear in mind, the $2.5 million have about $0.5 million sales and marketing is rightfully below the line. So, I am hopeful that when you get to the breakeven level, the $2 million will be fully absorbed into the customer result.

Alright, that’s helpful. And then I guess, shifting to new customer question adjusting its optical suppliers, I think specifically have not outsourced products, it seems like silicon photonics has some of these suppliers revisiting that strategy. So, I guess my question is as you look at new customers and new programs, do you see Japanese optical vendors as representing one-off opportunities for Fabrinet or could these clients potentially become material customers of Fabrinet’s long-term?

This is Tom. As we look at it, we don’t see anyone off. I mean, every one of our Japanese customers today, which we are certainly proud of is a continued customer with the company.

Maybe I asked that incorrectly. I think historically, you have had just a few programs with these guys where part of that fleet just takes on optical communications market share, they could be the size of your leading customer if they were to outsource at the same rate, so maybe to ask differently, do you think there will be an increasing percentage of outsourcing from Japanese customers on a go-forward basis?

I think, I guess, that was incorrect that we are experiencing increased experience in Japanese outsourcing. And our sales efforts and engineering efforts in Japan are quite successful.

Great. And then just one more if I may, two trends that we are monitoring closely is ZTE and Verizon, are they not direct customers, you do have several customers that supply those two parties. So we have a strike at Verizon and then ZTE had some pickups and we have a temporary reprieve from that looks like permanent, I am curious if you have seen any of that solutions in your order flow due to either of those kind of changes in the market over the last month or so?

Patrick, this is TS. I think during the OSG time, we have this scale of ZTE and I believe is kind of behind us right now. Most of – everybody was doing shipping to ZTE. So far from our vantage point, I don’t see any impact after, the big scale. But in terms of Verizon, so far again we had not seen really impact. In the future, I don’t know if there is an impact. I don’t think they are going to slowdown the metro upgrade, maybe just a method of delay little bit in terms of timing. But so far, we have not seen any impact on that.

Great. Thank you for taking my questions. Good luck.

Thank you.

Thank you. Our next question comes from the line of Troy Jensen of Piper. Your question please.

It’s a nice [indiscernible].

Thank you.

Hi Tory.

TS, I would like to start with you, can you just tell us what you are assuming for other income in that $0.59 to $0.61 earnings number for the quarter?

For this quarter, there is really very little, in fact almost none. There is again – we excluded from a non-GAAP reporting. And there is something about interest expense offset interest income and expense. We have a flat income, we again excluded from the non-GAAP. So from a non-GAAP standpoint, I think on expense I will say insignificant.

Okay. So would that imply that your SG&A declined slightly on a sequential basis?

A little bit, not a lot. And again, we will continue to see that. I won’t call SG&A, I will say operating expense will be continuing to decline, a lot dependent on how fast Fabrinet West perform. If you get to the breakeven, then that $10 million will be significantly lower.

Understood. So TS, while I got you – did you say, I am sorry if I missed it, but the number of 10% customers you had on the call?

On the 10% customer, no we haven’t seen anything yet because we normally report once a year. So next quarter, I will have our report who will be the new 10% customer for this year.

Okay. But can you give us if there is a two or three or similar to the filings?

I mean, we are ramping a few customers honestly until the last finishing line. I really cannot tell who will be the winner, so...

Alright. Understood. And then I would like to say last one here for Tom, it sounds like you accelerated the opening of the new building, can you just let us know what was the previous kind of launch date and how much has it changed now?

We have always had the end of September as the opening of that facility and that in fact is going to happen. And as TS said, we probably expect that we will be shipping products out of there in the third quarter, so…

Understood, guys.

Thank you.

Thank you. Our next question comes from the line of Paul Coster of JPMorgan Chase. Your line is open.

Yes. Thanks very much for taking my questions, couple of quick ones. The new business that you re bringing on board, how does it compare with the incumbent business in terms of gross margin and the tenor of the contracts?

Paul, this is TS. Typically, new business as we have discussed before, will come a little bit higher than gross margin because we had room to improve the yield and so on. And with the improvement we share with the customer, so I think for – compared to the legacy product accessing customer, new business generates a little bit higher than the gross margin.

What about the contract, how is it compared to your incumbent existing customers?

Contract, you mean…?

Yes. I mean are there shorter duration contracts initially?

A little bit of background on that. Our customer base is not based on a contract, it’s based on the volume supply agreement. And the volume supply agreement really is what the customer and ourselves agree on, its how we are going to run the business between the two of us. And it’s really not project. It’s not – and in fact it is not project defined, it just includes relationship. And beyond that, it’s all relationship.

Okay, good. Thank you. That helps. And my other question was, as we look to longer term into the next fiscal year, should we make any assumptions around gross margins with respect to labor costs. I mean, how do you see those evolving over the course of the year, what percentage of the overall COGS do they make up and is there any risk there?

Yes. So in terms of volume, as you know the gross margin is pretty much depend on the – is a volume driven. The higher the volume, obviously I get better absorption. Again, in terms of volume, we only have 13-week visibility. So beyond 13-weeks it’s really cloudy. So until I know the volume I really not project gross margin, but we do know that we have pressures on labor cost, obviously you understand that. And we continue to find offset to productivity to material pricing and so on. So I mean cost reduction is ongoing thing in the factory. So I feel 12% to 12.5% we guided all along is achievable. We are comfortable with that level. Beyond that, it’s all dependent on the volume.

Okay, thank you very much.

Thank you, Paul.

Thanks Paul.

Thank you. Our next question comes from Dave Kang of B. Riley. Your line is open.

Thank you. Good afternoon, nice quarter guys. First question is can you just talk about the products that are enjoying strong demand, is that across the board, I mean you talked about 100-gig, but any other products besides 100-gig?

Well, I don’t know about enjoy, but we are ramping QSFP28 also, as I mentioned in the prepared remarks. So 100-gig is the main driver. Obviously, silicon photonic is also ramping nicely, all the advanced components will support 100-gig. So those are the products we see produce strong and a lot of this are in the telecom in the past quarter, so.

What about – you didn’t talk about rodems, how is that demand picture?

Well, we see strong demand there. Again, probably you ask our customer, you might get that insight. So yes, you are right we see pretty strong demand there.

But you haven’t seen kind of a slowdown because of the Verizon strike, have you?

No. I don’t know, Tom, do you see any impact there?

No. We can’t really tell you that we have seen absolutely no effect with that strike.

Got it. And then any revenue you left on the table last quarter as a result of any component bottleneck or maybe your customers being capacity constrained these days?

I think across the board, I think we were able to rise to the occasion and ship as requested throughout the whole quarter.

Got it. And then so you talked about silicon photonics, what is it in terms of revenues, about what 15%, 20% of revenue and how many customers are you involved with silicon photonics at this point?

Dave, we don’t go into that detail here. The only thing I can tell you is that silicon photonics today, I think I have mentioned it before is increasing as a percent of our revenue. Today, it already surpassed 15%, that’s what I can tell you.

Got it, fair enough. And then my last question is from your end, can you tell whether the strength is coming from U.S. or China or both or which is stronger, I guess, that’s what I like to know?

Okay. You are going to see tomorrow when you file the Q, essentially we shipped more to the North America in the past quarter than in other regions. So, that’s in the Q.

Got it, alright. That was it for me. Thank you.

Thank you, Dave.

Thank you.

Thank you. Our next question comes from the line of Tim Savageaux of Northland Capital Management. Your line is open.

Hi, can you guys hear me?

Yes.

Yes.

Alright, great. I can work the mute button. Yes, I want a sort of a question on the guidance also along the product lines and also my congratulations on continued tremendous results. As you look, I guess, TS, last quarter, you mentioned that telecom joined the party as it were in terms of seeing growth resume kind of along the lines you have seen in datacom for the last several quarters. That really seemed to accelerate this quarter with some pretty strong sequential growth. So, I guess as you look at your results and also your outlook, if you can characterize the telecom growth last quarter and maybe what you expect going forward maybe by new and existing programs, where you seem to be indicating that some of your existing stuff has really picked up a bit or on a product basis, I know previous question was on rodems, obviously when you talk – there is a portion of business that’s not allocated by speed, what are you sort of seeing there or if you can give us a little more detail on sort of what was driving telecom in the quarter and how you think that might proceed heading forward assuming you continue to see optical grow as a percent of your overall revenue?

Okay, alright. Let me try my best to answer that. I think if you look at both segments, telecom and datacom both are growing, continuing to grow. And obviously, telecom is accelerating. The growth is accelerating as what we expected. So again, in the case of telecom, a lot of which comes from the existing customers, the legacy product because to support the telecom growth. So, some of which you mentioned that rodems, amplifiers and so on. And those that support the TS said telecom upgrade is here. We are in the cycle right now. We are in the upgrade cycle right now. Now, we see pretty good momentum too. Even though datacom has been growing tremendously in the last couple of quarters, we see the momentum continue. So, like what I say telecom come to the party and continued to accelerate. So, that’s what I can tell. And the new business some of which are supporting both segments too. So, we actually see multiple growth from all segments. Is that helpful?

It is. And if I could follow-up very quickly on that. Well and maybe starting at a higher level, if you think about both your – within your overall revenue base, your optical communications versus industrial or non-communications split and you seem to indicate in your commentary you expect the growth to be continue to be biased toward optical comm, but I guess would you expect any meaningful changes in that sort of split that 77% number. And then within optical comm, the telecom versus the datacom, I would imagine we would expect to see perhaps both of those numbers maybe creep up a bit in terms of telecom percentage and overall optical percentage or no you tell me?

Okay. So, for the op comm versus non-op comm, I will expect that their ratio will probably continue. We saw nice growth, 77% in the past quarter on the optical communications. Non-optical is 23%. I believe the same pattern will probably maintain in the next quarter. Alright? And then within the op comm, I would expect telecom will inch up a little bit compared to datacom. So next quarter, I believe that telecom – I would expect telecom to be a little bit higher than in terms of percentage higher than the past quarter?

Great, thanks. Very helpful. And so too was the kind of granular commentary on the non-communications side as well and congratulations once again.

Thank you, Tim.

Thank you.

Thank you. We have a follow-up question from Alex Henderson of Needham. Your line is open.

Thanks. So, a number of your competitors or number of your customers had said they are experiencing the supply constraints and at least one or two of them have indicated that they are being pressed to deliver expedited orders. Can you talk about whether that’s impacting your business? Are you seeing people trying to expedite orders and talking through premium prices to pull demand in a faster way? Does that reflect down to you guys or is that something that’s somewhat transparent to you guys?

Well, Alex, the one thing that we have never experienced in the industry is the price movement because of the shortage of capacity. And then in this case, the pricing has never been a factor. But with the – and what we are experiencing is that the capacity constraints that exists are primarily capacity constraints on equipment that is furnished or owned by the customer. And so their capital layout only carries to certain capacity, but if the capacity constraints are not the constraints of facilities, bricks and mortar or headcounts or those types of issues. And considering as you well know, we believe we are in the early part of this ramping cycle. And in the ramping cycle, it does have capacity constraints as it moves forward.

So, there was a discussion on the Neophotonics call about another 30,000 units of orders coming in from China in the back half of the summer and you have also got to ramp up above the datacom 25-gig – 10-gig to 25-gig cycle and also ramp up of the metro core cycle. So, do you think that the industry demand picture will outstrip your ability to add capacity and your customers’ ability to add capacity through the year end or do you think that there is more of a chance for some sort of balance or – I mean, how do you see that playing out as we go through? And then if you look at that facility that you are coming on, how much floor space have you already got commitments for?

Well, we have the floor space of about 500,000 square feet and we certainly have made some commitments to that square footage, but I really can’t go through and define – and divulge who that’s been made it to. But back to your other question on I think the industry as we go through this ramping period, which obviously is very good for everybody is rising to the occasion to meet the demand and there are isolated cases of capacity problems, which obviously have resolved in the short period of time.

Okay. Just one last question on the capacity, did you say that you had significant portion of that 500 square foot committed to? Is that what I heard you say? I am just asking what is that?

But what our experience is and since an experience over that the last 15, 16 years is it takes us a new facility, the next larger facility put into balance of the others of about 300,000 square feet. It takes us about 3 years to complete the assignment of all the space and obviously about halfway through that, we started another building, but we certainly have a lot of space to be allocated in the 500,000 square feet.

Okay. I will see the floor. Thanks.

Thank you. At this time, I would like to turn the call over to Tom Mitchell for any closing remarks. Sir?

Yes. We want to say thanks for joining the call and have a good evening.

Thank you, sir and thank you ladies and gentlemen. That does conclude your program. You may disconnect your lines at this time. Have a great day.