Fabrinet (FN) Q1 2019 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. Welcome to Fabrinet's financial results conference call for the first quarter of fiscal year 2019. [Operator Instructions] As a reminder, today's call is being recorded. I would now like to turn the call - conference over to your host, Garo Toomajanian, Investor Relations. Please go ahead.

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 first quarter of fiscal year 2019, which ended September 28, 2018. With me on the call today are Seamus Grady, Chief Executive Officer; and TS Ng, 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 investor presentation, which include our GAAP to non-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 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 SEC filings, in particular, the section captioned Risk Factors in our Form 10-K filed on August 22, 2018. We will begin the call with remarks from Seamus and TS, followed by time for questions. I would now like to turn the call over to Fabrinet's CEO, Seamus Grady. Seamus?

Thank you, Garo, and good afternoon, everyone. Revenue in the first quarter came in well above the high end of our guidance range at $377 million, an all-time record for quarterly revenue. Strong revenue, combined with the foreign exchange gain, produced non-GAAP net income of $0.92 per share, which was also above the high end of our guidance. This earnings performance also helps drive strong cash flows with operating cash flow of nearly $35 million in the first quarter and free cash flow of $29 million. We have anticipated that our modest sequential growth in the fourth quarter would continue into the first quarter, and our actual performance was considerably better than we had anticipated. And as TS will detail in a moment, we expect fiscal Q2 to represent another quarter of sequential growth. With increasing demand, we continued to see components constrained during the first quarter. We were again able to successfully mitigate these shortage risks during the quarter, and we will continue to take appropriate steps to manage these supply challenges going forward. In the last several months, there have been a lot of discussions related to tariffs on products coming to the U.S. from China. I can report that we have not seen any negative impact from these tariffs, and we don't anticipate that we will in the future. With the vast majority of our manufacturing in Thailand, we could actually benefit from tariffs on products being manufactured in China if components and equipment makers look for suppliers in other countries. Looking at our first quarter performance by end markets. Both optical communications and nonoptical communications business grew from a year ago. Optical communications revenue of $281 million was up 2% from a year ago and up 16% from the fourth quarter with revenue for both telecom and datacom products growing double digits from the fourth quarter. Telecom revenue was $179 million, an increase of 14% from the fourth quarter, and datacom revenue was $102 million, up 19% from the fourth quarter. By technology, silicon photonics-based optical communications revenue was $83 million, up 19% from the fourth quarter. Variance of the QSFP28 form factor, which can be both silicon photonics and non-silicon photonics-based, generated revenue of $45 million, which was up marginally from a strong Q4 which saw 20% sequential growth. By data rates, 100G programs continue to dominate optical communications production and grew slightly faster than optical communications overall to $155 million or 41% of total revenue. Speed rate of products at 400G and faster data rates represented lower than 4% of total revenue. Turning now to nonoptical communications. Revenue was $96 million compared to the record $103 million we generated in the fourth quarter. Still, quarterly revenue for nonoptical communications was the second-highest in our history with industrial lasers again delivering a strong performance with revenue of over $49 million. Automotive revenue declined slightly from a record fourth quarter to $22 million. Revenue from sensors and from other products were both up from a year ago, but down from the fourth quarter with sensors at $4 million and other revenue at $21 million, representing normal quarter-to-quarter variability. While this variability is likely to continue especially when newer programs ramp, we remain optimistic about our long-term growth opportunities in our nonoptical communications business. Revenue from new business reached nearly $138 million, up 10% from $125 million in the fourth quarter. Our new product introduction, or NPI, services continued to be an important driver of new business as these services can turn into long-term programs, generating significant revenue over several years. As we have mentioned previously, we are in the process of looking to establish a new product introduction facility in Israel to support our existing customers there as well as to develop new customers. This would enable us to replicate the success we have seen in Fabrinet West and Fabrinet U.K. We are working closely with our existing customers in Israel to determine the best approach going forward. In summary, we are off to a strong start in fiscal 2019 with first quarter revenue and earnings above our guidance ranges. Moreover, with strong momentum across our business, we are forecasting continued growth in the second quarter, which TS will detail in a moment. Now let me turn the call over to TS to discuss the details of our first quarter performance and our outlook. TS?

Thank you, Seamus, and good afternoon, everyone. I will provide you with more details on our performance by end market and our financial results for Q1 as well as our guidance for Q2 of fiscal year 2019. Total revenue in the first quarter of fiscal year 2019 was $377.2 million, which was $22 million above the high end of our guidance range. Non-GAAP net income was $0.92 per share and was also above our guidance range. Net income in the first quarter benefited by $0.08 per share from a mark-to-market foreign exchange gain. Excluding this impact, non-GAAP net income was still slightly above the top of our guidance range. Note that as of the first quarter of fiscal year 2019, these results are being reported under ASC 606, though the change had an immaterial impact on our results. Under the previous accounting standard, ASC 605, our revenue would have been $300,000 less or a difference of less than 0.1%, and net income would have been a negligible $30,000 less. Looking at the first quarter in more detail. As Seamus mentioned, we saw strong sequential growth from optical communication programs in first quarter with a pause in the sequential growth of nonoptical program after a record fourth quarter. Optical communication increased to 74% of revenue, the highest level in a year with nonoptical communication representing 26% of revenue. Now turning to the details of our P&L. A reconciliation on GAAP to non-GAAP measures is included in our earnings press release and investor presentation, which you can find on our website. Non-GAAP gross margin in the first quarter was 11.2%, reflecting an anticipated sequential decline in gross margin that we previously discussed as we absorb the impact of annual merit increase that take effect in the first quarter. During the quarter, as Seamus noted earlier, we are able to overcome industry-wide component supply challenges which help us exceed our revenue guidance for the quarter. Notwithstanding this, these component supply challenges caused some operating inefficiency and less favorable material pricing that negatively impacted our gross margin for the quarter. We remain optimistic, however, in our target range for non-GAAP gross margin between 12% to 12.5%, and we expect to return to this range on a quarterly basis during fiscal year 2019. Non-GAAP operating expense was $10.2 million in the first quarter, down slightly both year-over-year and from the fourth quarter. As a result, non-GAAP operating income was $32 million, an increase from the fourth quarter and a year ago, and non-GAAP operating margin was 8.5% compared to 8.6% in the fourth quarter. Taxes in the quarter were $1.9 million, and our normalized effective tax rate was 6.7%. We continue to anticipate an effective tax rate of 6% to 7% for the fiscal year. Non-GAAP net income was $34.1 million in the first quarter or $0.92 per diluted share, up from $0.81 in the fourth quarter and $0.75 a year ago. On a GAAP basis, which includes share-based compensation expenses and amortization of debt issuance costs, net income for the first quarter was $27.9 million or $0.75 per diluted share, a record performance. Turning to the balance sheet and cash flow statement. At the end of the first quarter, cash and investments were $352.4 million. This represents an increase of $16.7 million from the end of the fourth quarter primarily from operating cash flow of $34.6 million offset by CapEx of $5.4 million, withholding tax related to net share settlement of RSUs of $8.9 million, the release of $3.5 million in the restricted escrows related to our Exception U.K. acquisition and repayment of long-term bank loans of $0.8 million. Free cash flow, which is operating cash flow less CapEx, was $29.2 million in the first quarter. We did not repurchase any shares during the first quarter. As such, as of the end of the quarter, $17.6 million remains in our repurchase authorization. Management will continue to evaluate the buyback program based on stock market condition and our cash position each quarter. I would now like to turn to our guidance for the second quarter of fiscal year 2019. While we are now reporting under ASC 606, this guidance is based on ASC 605, and we will provide a reconciliation with our second quarter results. With continued demand in the optical communications market and ongoing momentum in the varieties of nonoptical communications program, we are optimistic that our sequential growth will extend into the second quarter. For the second quarter of fiscal year 2019, we anticipate revenue in the range of $380 million to $388 million. From an earnings perspective, we anticipate non-GAAP net income per share in the second quarter to be in the range of $0.91 to $0.94 and GAAP net income per share of $0.77 to $0.80 based on approximately 37.6 million fully diluted shares outstanding. In summary, we are off to a good start in fiscal 2019 with financial results that exceeded our expectations. We are enthusiastic about our momentum, which we expect to continue into the second quarter. Operator, we would now like to open the call for questions.

[Operator Instructions] Our first question comes from Troy Jensen with Piper Jaffray.

Seamus, maybe I'll start with you. I guess, you had a little bit more time now to kind of look at options for Fabrinet. Just would love to get an update on your - maybe your M&A strategy and whether or not you think 2019 will be a bigger year kind of for strategic moves for the company.

Yes. So we continue to evaluate M&A opportunities that come our way. As we've mentioned previously, we're being very, I suppose, selective and very deliberate in our approach, and I think it's fair to say we're being picky. We do want to add capabilities not just revenue, so we continue to look. We're looking for complementary businesses that will contribute to our profitability that we can acquire at a reasonable price. And we don't have anything to report at this point, but we continue to evaluate several opportunities. And it still remains a key part of our strategy, and we look at it once we have some news. But as you can appreciate, Troy, it's not the type of topic we give, unfortunately, until we have some news. But we continue to look at a lot of opportunities that come our way.

Perfect. Maybe just for TS. Could you talk about the - I understand why the margins kind of get hit here this quarter in September. What do you think they look like maybe over the next 2 quarters? And how quickly do we get back to this 12% to 12.5% range?

So in our prepared remarks, we still anticipate a return back to the 12% sometime in this fiscal year. So if you look at the guidance we provided, again, if you work backwards, it's pretty close to that level.

It is. Okay. All right. Perfect update. And how about just maybe last question from me. I guess I'd be curious to know how the automotive business is. TS, I think you gave a revenue number but I didn't get it. If you could repeat that, and would love just to get an update and your thoughts there.

Yes. The automotive is $22 million, down from $26 million. Again, $26 million is kind of really high. I wouldn't say all-time high, but it's one of the historical highs.

Troy, this is Seamus. Our automotive business is made up of, as we've talked about previously, traditional automotive and some of the newer technologies, newer programs we're working on. And the traditional automotive, last quarter, continues to be very stable. New programs tend to be more variable though as the programs ramp. So the decline we saw last quarter in the overall automotive revenue, as TS said, Q4 was a record quarter for us in automotive. And at the time, we said not to expect automotive to grow, if you like, in a straight line since the new programs, you can see variability as they ramp. And that's really what we saw going on last quarter was variability on the new programs because the new programs, sometimes quite new technology. So there's a little bit more choppiness than with the traditional automotive. So that's really what we saw last quarter. We didn't lose any programs. We didn't lose any customers. We actually gained a few programs, but the overall revenue did decline. But it's, like I said, it's more choppiness on newer programs than any overall trends.

[Operator Instructions] Our next question comes from Alex Henderson with Needham.

Clearly, that's a pretty steep sequential improvement in gross margins off of the 11.2%. I assume that some of that is related to the - an improvement in the component supply chain where you're getting some of the issues resolved on supply constraints. Is that an accurate guess what's causing that improvement?

I think so, Alex. I think that's a fairly good assessment. I mean, really, we had a couple of, if you like, gross margin headwinds last - this past quarter. One was the merit increase, which we have talked about previously, but the other one then was the component shortage situation. We did manage to exceed our revenue but at a little bit of a cost. And the way we look at it is one of the key reasons customers outsource to us is our ability to deliver on time including, and maybe especially, in tight supply situations. When the components that we source are in short supply, we really do everything we can to make sure we get those components and meet our customers' commitments. And this is something we're actually very proud of, that our customers ultimately award us for with more business. In previous quarters when we saw the potential for component charges, and again in Q1, we acted very quickly to secure the supply, and sometimes that means overlooking volume discounts or other arrangements to make sure we get the parts. We want to make sure we get the parts for the customers so that they can make their revenue. And while it did create near-term drag on gross margins, we really believe it's absolutely the right thing to do to drive revenue and strong customer relationships. So that component shortage headwind, if you like, it manifested itself really in 2 ways. One was the, as I mentioned, maybe giving up a little bit on volume discounts and paying a little bit more for components. And also, frankly, we also probably carried some operating inefficiency due to some idle capacity. If you have all the parts except for that last component, if the last component doesn't come in on time, we still incur most of the operating costs. So that's really what drove that this past quarter. We do see the situation improving over the next couple of quarters, but that was the primary driver this past quarter.

So would it be reasonable to think that at the lower end of your revenue guidance, that your gross margins might be a little higher and at the higher end, that it, ironically, it might be a little lower as a result of pushing on that envelope again as we go through the December quarter?

I think it really depends - it really comes down to the mix. It's hard to say - unfortunately, Alex, it's not quite that straightforward because a lot of it just come down to the mix. As you can imagine, while the average gross margin last quarter came out to 11.2%, within that, there's a fairly wide range. So it really does come down to the mix at the end of the day, but we do feel we're targeting to get back to that 12% this year. And as TS said, if you reverse engineer the EPS guidance we've given, we're there or thereabouts this quarter, we think.

Yes.

The second - the other line of question I wanted to address is can you talk a little bit about the uptake of floor space in your new facility? It sounds - seems like that's coming on faster than you might have thought. Is that a function of people moving - trying to move at an expedited rate out of China? What's driving that? And what is - what kind of floor space metrics can you provide us in terms of how much of it's taken up at this point? And then finally, along the same lines, at what juncture would you be considering starting up the process for the next 550,000 square-foot facility?

So a couple of points there, I think. Yes, the uptake is pretty strong on the new building. Right now we're above 50%, I would say late 50s, heading towards 60% in terms of a combination of occupied and spoken for in the new building. Once we get to probably 70%, 75%, we'll pull the trigger on the next building. We do believe - so we've started the process of getting the permits in place. Timing wise, we think in all likelihood, we feel we probably will start that process rolling this fiscal year. It really does depend on how quickly some of the new programs ramp and some of the uptake happens. As we said in our prepared remarks, the tariffs in China, they're certainly not a headwind for us. We do think they could be a tailwind. And while we're not building our business plan based on tariffs, it does - it hopefully blows some business in our direction as customers who are producing in China come our way. So we are seeing a little bit of that, but it is quite slow. As you can imagine, Alex, even when customers in China come our way and ask us to look at building products for them, the qualification process can be quite long. So you could be looking at a kind of a 4 to 6 months qualification process for that to take hold. And again, the tariff situation could change quickly and that could be no longer a tailwind for us. So like I said, we're not building our business based on that, but it does certainly help us, we think.

One last question and then I'll cede the floor. The industrial laser business sounded a little bit stronger than we had anticipated. There's been a number of other companies in the space that have suggested some weakness mainly driven off of the semi equipment market slowdown. Can you talk about your mix relative to semi equipment versus fiber laser and if that's something that differentiates you from the rest of the market and what you're thinking there?

Alex, this is TS. I think your observation is very accurate. We see most of - in fact, we have 5 or 6 customers there. We are gaining market share, so I can tell you that. One of the customers, we continue to gain more program. But the rest are pretty flat, okay, so to speak. So because of the gain in market share in one customer, that's why we show $2 million growth, from $47 million last quarter to $49 million in Q1. But moving forward, we believe that the 1 or 2 customers we gain market share will continue to grow. And the rest, we'll just - we'll see what happens with the marketplace on semiconductor.

[Operator Instructions] And Mr. Henderson, your line is back open.

Could you give us some granularity on what you're thinking relative to the optical and the datacom piece in the guidance? So you talked a little bit about the mix in the current quarter, but didn't really specify how you see that playing out sequentially.

So Alex, the telecom is pretty strong, as you know. We grew 23% - $23 million quarter-over-quarter, $156 million to $179 million. Although we don't break down guidance for Q2, but we still anticipate continued double-digit growth in the coming quarter, December quarter. For datacom, also grew very nicely, 19% quarter-over-quarter. Moving forward, the number in front of me is flat to slightly up a bit. So is that helpful?

That's very helpful. And I would assume that the mix towards silicon photonics is also accelerating into the upcoming quarter. Can you give us any thoughts on how that looks on a perspective basis?

Yes. We have a very nice growth, up $13 million. Silicon photonics sequentially grew 19 - $13 million, excuse me, 19%. And moving forward, we anticipate continue to grow. With the program we have with the customer, we will continue to grow the technology.

So do you think it's growing faster than your overall optical business at this point as we look forward?

I would say close, close to that same level.

And with that, I'll turn the conference back over to Mr. Grady for closing remarks.

Okay. Well, thank you for joining our call today. We appreciate the interest in our company. We're excited to deliver strong results and a positive outlook as we continue to position the company for continued growth and diversification over the longer term. We look forward to speaking with you again soon. Thank you, and goodbye.

Thank you. Ladies and gentlemen, that concludes today's conference. Thank you very much for your participation. You may all disconnect. Have a wonderful day.