Fabrinet's Management Presents at Morgan Stanley Technology, Media & Telecom Conference (Transcript)

| About: Fabrinet (FN)

Fabrinet (NYSE:FN)

Morgan Stanley Technology, Media & Telecom Conference

February 26, 2013 16:55 ET

Executives

John Marchetti - Chief Strategy Officer

Analysts

Kim Watkins - Morgan Stanley

Kim Watkins - Morgan Stanley

Okay. I think we are on, so I will get started. Welcome to the Fabrinet presentation, here just talking about a car. My name is Kim Watkins; I’m the Communications Equipment Team here at Morgan Stanley headed up by Ehud Gelblum who unfortunately could not be with us here today. So, it’s a great pleasure of welcoming John Marchetti, the Chief Strategy Officer from Fabrinet. And before we get started I need to read some disclosures. Please note that all important disclosures including personal holding disclosures and Morgan Stanley disclosures appear on the Morgan Stanley public website at www.morganstanley.com/research disclosures or are available at the Registration Desk. And so with that I think most of you may know John that John actually joined Fabrinet about a year ago from the Salt Lake.

John Marchetti - Chief Strategy Officer

Yes.

Kim Watkins - Morgan Stanley

Prior to that. So he is intimately familiar with the industry. So just to kick it off John I thought it would be a great way to start to just talk about the different addressable markets that you focus on.

John Marchetti - Chief Strategy Officer

Sure.

Kim Watkins - Morgan Stanley

Clearly it’s the largest piece today is optical but there are opportunities for you in lasers and sensors. Can you just contrast the size of the relative TAMs of those three markets and where we are with respect to outsourcing penetration?

John Marchetti - Chief Strategy Officer

Sure. So obviously the largest market that we serve today is Optical Communications, it’s roughly 70% of our total revenue and when we roll up the COGS of that industry we think we’ve got roughly 25% give or take of that market today. Over time we think that can obviously grow a little bit but we’ve got a fair bit of share there, the largest of the outsourcers within that group, that TAM for us is probably somewhere in the 3 to 3 plus billion maybe or $2 billion to $3 billion range rather. So, that is again the largest piece of our business today.

If you look at our other segments which today to be fair is primarily lasers, industrial lasers and automotive sensors. The laser market I think has an opportunity from a TAM perspective to be in that $1.5 billion to $2 billion range over time and from an outsourcing perspective it’s still very early stages, again doing the same kind of COGS rollup we’ve got mid single digit kind of share in that market today. And as far as we can tell there is no real major player in that group besides us in terms of outsourcing and manufacturing.

The automotive sensor market is or really the sensor market as a whole is a massive market, you are talking 10s of billions of dollars. For us so really trying to carve out a couple of specialty niches within that and focus on customers what we still think we can keep through to our model of being sole-source and being unique in terms of the value chain in terms of production.

That’s again probably $1 billion to maybe $2 billion market depending on how you slice it. So when you roll all that up we think we’ve got about $5 billion to $6 billion TAM that we can address over the next several years. And our challenge as we look out is how do we continue to diversify and accelerate that non-optical revenue portion of our business so that we can smooth out some of the cyclicality that’s inherent in that Optical Communications business.

Kim Watkins - Morgan Stanley

Actually I love to hear more about that. What’s the catalyst for a center, company or even looking back at the automotive business that you have one, what was the catalyst for those companies to even outsource model.

John Marchetti - Chief Strategy Officer

Sure.

Kim Watkins - Morgan Stanley

Even on the laser side?

John Marchetti - Chief Strategy Officer

I mean the key challenge I think for these customers are why they consider coming to somebody like us quite frankly is really they are not manufacturing companies and generally what we do tends to be low volume high mix which even adds more complexity to manufacturing to be able to change over quickly to manage so many additional parts across a supply chain, its easier if you are doing a high volume low mix business where you can order kind of consistently, it’s easier to manage, easier to plan for.

So to specialize in sort of that area of the market ultimately what we bring to the customers is cost savings and really those cost savings are associated with manufacturing excellence is being able to improve the company’s yields which as a result of that lower material cost which is the biggest challenge in terms of cost for most of the customers that we work with. And that’s really what we bring to the table I mean at the end of the day we are a services company. We don’t make our own products, we manufacture for our customers and we ultimately deliver cost, quality and on-time deliver and we have to excel across all three of those metrics in order to A), attract the companies, but B), keep those customers over time.

Kim Watkins - Morgan Stanley

And who are some of the few customers that you can just talk about, how your customers work across that?

John Marchetti - Chief Strategy Officer

Sure, I mean on the optical communication side, yeah our largest customers are guys like JDSU and Oclaro and things like that. Our largest customer today on the industrial laser side is in fact JDSU, there are others within that mix, but JDSU is our largest customer on the laser side as well. So we’ve got a very good relationship with that company. The automotive side, we haven’t really broken out those companies that still sort of early stages for us.

Here we tend to work with the sub-assembly companies who then bid to win, your actual models with the car companies and what have you. But again that is a business where over the last 12 or 18 months it’s finally come to a critical mass enough we’re at more and just, starting to talk about it a little bit more openly. It took us, four plus years to break into that auto market. And that’s, challenge for this business as a whole is, it’s not a business that grows quickly over night. It’s a lot to bring a customer in and prove to them that you can do the manufacturing better than they can. And then getting that product line in and qualifying and getting it audited and then turning it into revenue. So it’s a long tail process to get big new customers in and have them become meaningful revenue over time.

Kim Watkins - Morgan Stanley

So you kind of gave an a little illustration four years, I mean is that how long it takes to get proven to a new customer and add a new product category or is that?

John Marchetti - Chief Strategy Officer

I mean it – I wouldn’t say it has to be that kind of the timeframe, but it is certainly a longer timeframe than it is a shorter one. Again in a lot of cases especially with industries that aren’t has familiar with outsourcing, just getting them comfortable quite frankly with giving up the control takes a fair bit of time. And I think we’ve seen that a fair bit in the laser market.

Automotive was a little bit of a challenge for us, because you have to prove to them that you can produce with zero defects. So you get a small project to prove yourself on, and once you can do that you kind of grow slowly with them from there build out, both internally with them and then externally as the market grows itself. So, it tends to be a more prolonged process than probably any of us would really like, but that’s just kind of the nature of the manufacturing that we choose to do for the customers.

Kim Watkins - Morgan Stanley

Okay. So in terms of looking forward, you talked about optical sounds like you got a much larger share within that market. So, I got the future opportunities for adding new customers are more in the laser and the sensor pieces. What are you most excited about in terms of looking forward in order to add new customers?

John Marchetti - Chief Strategy Officer

Sure, I mean I think the laser opportunity today is certainly were I think we see the most growth potential over the next, call three years. We feel like that market is where optical was four or five years ago in terms of their, as they are looking at outsourcing for the first time, I think we bring a lot of the same skill sets to the laser market as we do to the optical communications market. Lot of instances building a communications laser is very similar to building an industrial laser; you just don’t want to put your hand in front of the industrial laser.

But it takes a lot of the same skill set with the growth now starting to shift a little bit towards fiber laser, we have a lot of experience in fiber handling and alignment and things along those lines again that translates over from our optical communications group. So, we feel like there that sort of a natural fit for us and we started to see, I think some good traction there.

Being on that like I said we’ve started in automotive, we’re hoping to see a couple of other industries whether that’s medical or medical devices, whether its aerospace whether things along those lines were hopefully we can find niches that lend itself again to that same sort of model that we’ve had in optical communications and prove to be pretty successful for us.

Kim Watkins - Morgan Stanley

And that’s primarily for the sensor piece of the business?

John Marchetti - Chief Strategy Officer

For the sensor piece business, correct.

Kim Watkins - Morgan Stanley

Within optical itself, do you have more exposure on the telco side, I mean JDSU is a little bit more Telco-focused, Oclaro has both. So which piece of it is where you’re exposure is in, is there a difference in which piece of the business is more attractive to you?

John Marchetti - Chief Strategy Officer

Right, so it’s varied over time. Today we’re probably roughly 60%, 65% towards telco…

Kim Watkins - Morgan Stanley

Okay.

John Marchetti - Chief Strategy Officer

Over datacom, but like I said we’ve seen that shift back and forth between various levels over the last four or five years. In terms of whether one is better for us or not, need not really to be blunt again it depends on the customer themselves and the products we’re doing for them but ultimately as long as overall industry demand ticks up. We should participate in that along with through our customers I should say. So it’s not a huge difference to us whether one side or the other generally does better I mean today I am more exposed to telecom. So I would like to see telecom grow faster.

Kim Watkins - Morgan Stanley

Yeah.

John Marchetti - Chief Strategy Officer

But ultimately there is not a huge difference was there.

Kim Watkins - Morgan Stanley

Yeah. Well interestingly one of your biggest competitors have seen some fairly pretty good growth in datacom too. So which means into another question which is that there are a couple of companies that are building their own infrastructure Google comes to mind. Do you have any intentions of going directive to offer your services to a Google type?

John Marchetti - Chief Strategy Officer

I think we certainly consider those kinds of opportunities as long as we are not competing against our customers. And what I mean by that is if we have a, an OEM or systems vendor who has there own design and is looking for manufacturing partner then we will absolutely consider that opportunity and we’d happy to build that for those kind of folks. What we won’t do is design our own component or module and try to sell that in competition against one of our, whether it’s for Google or for whomever. So to the extent that these larger OEMs or larger systems vendors start to vertically integrate or bring pieces like that to us as long as they’ve got the design and they are looking for a partner we are happy to do that.

Kim Watkins - Morgan Stanley

Okay. What about your opportunities with existing customers we talked about a little bit moving out of the existing bids but to what extent do you see customers bringing increased levels of business to you adding build opening new lines.

John Marchetti - Chief Strategy Officer

Right, right.

Kim Watkins - Morgan Stanley

In your existing manufacturing footprint?

John Marchetti - Chief Strategy Officer

We have a group that sort of dedicated to do product introduction with our existing customer set. And then each customer that we have that we build for has essentially a general manager that’s assigned to that account. And part of that general manager’s responsibility is working with those actual customers to make sure that new products that are being introduced whether it’s the next generation of existing product we are building or something new that they are bringing to market that where they are to a) be able to be aware of it and work on it with that customer and hopefully b) win it at an early enough stage that we can help for a design for manufacturing phase right along with their true product design.

Right, we tend to work best with existing customers as when we’re in the process early enough that we can help identify potential bottlenecks in the actual manufacturing process for that customer early in the design phase and then if they are doing the beta testing with us right at our facility as soon as that line is qualified and you’ve worked at out that can become a full production line with no additional work. And so from a time to market perspective it really is I think a good partnership for the customer they trust us they know our capabilities but in early we really can help them accelerate that time to market because there is no product transition if you will from either their testing side or something like that back to us. So each GM is responsible for bringing those kinds of new programs from existing customers in-house. So we generally have a pretty healthy pipeline as I look across that spectrum of customers that we have today both within optical as well as outside the optical arena as well.

Kim Watkins - Morgan Stanley

Okay. When you look forward does your growth come from existing customers more or adding new customers?

John Marchetti - Chief Strategy Officer

I think on a longer term view I think it’s going to be fairly well balanced between both of those but I think from a near term perspective getting back to the discussion we had earlier about how long it takes to grow some of these new customers certainly over the near term it’s going to be more growth from customers we have in the factory today and guys that are already up and running and producing revenue for us.

Kim Watkins - Morgan Stanley

Got you. Okay. I wanted to hit on some of the near term trends that you’ve seen these have slowed down in the month of December or it seems like the business have ticked backup a little bit but your guidance is down a 11% sequentially. So clearly some weakness there, the firmness that you saw do you think sustainable and then can you just remind us what the timeline is between when you see the order.

John Marchetti - Chief Strategy Officer

Sure.

Kim Watkins - Morgan Stanley

And when the revenue comes through?

John Marchetti - Chief Strategy Officer

So I think to be clear we are a lagging indicator for the industry the carrier or the ultimate purchaser has to put the order in through the systems vendor that then has to get to the component vendor who is my customer and then filters down to me. So we do tend to be the tail of this dog and so to speak but overall I think we have seen a modest up tick. I think our customers in particular are a little bit more optimistic certainly as they are looking out through the March quarter and into June. But I certainly wouldn’t characterize that as folks being overly optimistic to where we really starting to see orders fly in or anything like that.

I think the industry has gotten itself to a point where it’s very rational about how it build and while folks maybe optimistic they are not certainly not about to build ahead of demand during the anticipation of those orders coming in. So, at this point, I think, we’re in pretty well in a balanced mode, where I think, we’re building through that end market demand. And again, I think a lot of our customers are optimistic that we’re going to start to see this really start to turn up until we start to see that order, order flow come through we’re not going to certainly getup and be overly – overly giddy about where we’re standing today.

Kim Watkins - Morgan Stanley

And then what about the timeframe between when the order, come through to you versus (PCBA).

John Marchetti - Chief Strategy Officer

I mean, early on in the process that may take several weeks to filter its way all the way down. It (azure) sort of in the midst of a demand cycle, you can see that translate into order changes on a weekly basis without too much trouble.

Kim Watkins - Morgan Stanley

Okay. Again the March quarter guidance being down as sharply as it is one thing that strikes me was it’s never was actually a little bit stronger than you expected yes one of your larger customers JSU is going through – went through VMI transition with a number of their customers did that explain a little bit in terms of what you saw in March or this end market return.

John Marchetti - Chief Strategy Officer

I think it’s hard for me to know completely to be fair.

Kim Watkins - Morgan Stanley

Okay.

John Marchetti - Chief Strategy Officer

It maybe a combination of both but I think ultimately just looking at the order of pattern that we had as we came through the December quarter those orders sort of fell off in the month of December and then sort of flat lined and up tick modestly at the end of January. I think it is more demand related than anything else. Most of our customers have guided down for the March quarter and I think while our sequential decline is likely have been larger than theirs. When I look across my customer setting I can see all of them talking about being down sequentially and they will roll all that up that’s kind of where we’re at.

Kim Watkins - Morgan Stanley

Okay, got you. I wanted to talk about so one of the things that we think about when you said you are 65% service provider lot of your customers JDSU grow, they talk about the telecom, annual telecom pricing is coming through. Do you want to sustain that on your top line, do you see that on your gross margin where you see that?

John Marchetti - Chief Strategy Officer

Well I mean to be fair we’re again we’re a services company so we got a cost plus kind of model. So, while the customers certainly come to us and we work with them to take the cost out is not as simple as the past or where if they are giving price declines to their end customers, they turnaround and pass those on directly to us now. Again we’ve only got three metrics to deliver on and cost is obviously a very important one of those three. But we work with the customer to make sure that we can take cost out of the system and not just overall prices sort to speak to match theirs.

And so, ultimately at the end of the day it is a very collaborative process with the customer to work together, to find ways that we can lower even beyond the price concessions that they are giving to their customers to make sure that we’re constantly taking cost out of their product or their production to make sure that they are able obviously recoup up their end.

But it isn’t as simple as every January; we’re in lockstep with that customer in terms of whatever pricing concessions they need to make in the marketplace. Our price negotiations with our customers happened on a more ongoing basis typically quarterly at least and again it’s all based on more of the cost side of the equation than it is on any kind of pricing sort to speak.

Kim Watkins - Morgan Stanley

Okay, got it. So, we’re not seeing that in the guidance a little okay. Oclaro recently a while ago actually added Venture as an outsource manufacturing partner. Did you bid on this business and then longer-term, what impact do you expected to have on margins for you and do you have another negotiating number?

John Marchetti - Chief Strategy Officer

Right. We did not bid on this business. In terms of our policy they change going forward. I think the key at least today for us is what has been transferred to Venture has been transferred to Oclaro’s Shenzhen facility not out of our factory. And so, at least today we don’t see a Venture as an attempt by our customer to setup the second source. There are certainly products that they are transferring their that I think makes sense to be transferred there whether for cost or other reasons. But for us the key for us that makes sense as we look forward that with our customer as to make sure that we’re doing the complex modules and components. And we’re still doing that for that customer.

So I don’t see it having a big impact quite frankly on, on any real aspect of our business as we continue to move forward with that customer. Now that certainly could change over time, they can decide to pull business or move something that we’re not seeing today but at least as we sit here today that relationship is progressed I think the way we hoped it would in terms of their certain pieces of business that absolutely makes sense to go there and the pieces that we wanted to maintain and even a couple of pieces that we were hoping to receive and so far that gone our way.

Kim Watkins - Morgan Stanley

So can you just note down one level of what types of things that you made a lot of sense to go to Venture versus what you want to keep…

John Marchetti - Chief Strategy Officer

Why don’t you take a look at like I said the key to us is making sure we continue to win the complex modules and components?

Kim Watkins - Morgan Stanley

Got it, okay.

John Marchetti - Chief Strategy Officer

From these customers, that is what we have historically done for most of these people. We believe that’s obviously where we have our biggest skill set it’s where we can add the best value and it’s where we think from a customer perspective it’s something that they obviously value from us. True sort of low level of PCB type work or something here, that’s not necessarily something what we’re going to be as price competitive with some others in the industry.

Kim Watkins - Morgan Stanley

Got it, okay. Apart from Venture in Malaysia a while ago or may be a year or two ago (inaudible) was talking about getting into the business in an acquisition there. What do you see on the competitive environment?

John Marchetti - Chief Strategy Officer

I mean not much has changed thankfully over the last couple of years. And I think, I, not to be too strong about it but I think that the competitive question to some extent sort of answered itself through this flood period. We have a little bit different of the model than a lot of traditional contracts manufacturers in that what we tend to build for our customers is custom and so that equipment is provided by the customer to us. And when the flood hit I think that was an opportunity for them to sort of pick up and lock step and move to another contract manufacturer if they felt that that was the best thing for them. And, most of them shows absolutely not to do that.

And so, I, to me I think that validates some of the competitive advantages that we have in the market and I think again there is always the potential for competition will increase will get tougher as we move forward. And I certainly don’t think it will be the last one at some of our businesses but, and we feel pretty good when we say comparatively and I think to some extent the opportunity or the window that the flood open for some of the competitors at least in our minds is now shut and I think we feel pretty good about where we sit today.

Kim Watkins - Morgan Stanley

Okay, so a couple of things on the flood it still continues to impact your business to some extent I guess the first question there you got some or called excess capacity in new building currently, if you have seen a drag on your margins, and do you think margins can get back to where we were before the flood or has something fundamentally changed in the market that, that’s off the table on there?

John Marchetti - Chief Strategy Officer

No I mean, we’re still confident we can get back to that 12% to 12.5% range on the gross margin line. We’ve talked about for a little bit now that if we get back to $190 and above in terms of quarterly revenue already we should be able to do 12% to 12.5% without too much trouble. I mean part of it to your point is we’ve had a little bit of a change that cost structure some of that is flood driven some of that areas isn’t but, so to us it’s really just as this point a revenue issue so that we can absorb some more of those fixed costs. As we continue to move forward I think we’ll continue to march back up towards that 12% to 12.5% without too much trouble.

Kim Watkins - Morgan Stanley

Okay, so sounds like that you commented that is actually revenue.

John Marchetti - Chief Strategy Officer

Yeah.

Kim Watkins - Morgan Stanley

You mentioned. Okay, I’m asking one more question and then open it up for the audience there if we have any questions I’ll come up in just a minute. Oclaro it’s no secret that they’re experiencing some balance sheet issues in the extreme case that they ever go bankrupt although they have to sort up their balance sheet so did not funding for quite a while. What’s your exposure there and how do you think about that?

John Marchetti - Chief Strategy Officer

So I mean Oclaro continues to be more an important and very good customer for us. They are roughly our second largest customer when you look at it by revenue. And, it is obviously in our best interest that they do well in the industry as a result of that. Again I think if some of the signs that we’re seeing on demand horizon are real and it does turn out to be a pretty good year from demand I think Oclaro is going to be just fine. The challenge for us as a management team is to continue to monitor that situation both with the customer and externally and to make sure that we’re taking appropriate measures protect ourselves. And like I said today we had no reason to get overly anxious about that customer they continue to pay on time and to do all the things all of our other customers do and it is I mean it is a risk that we’re going to have to continue to monitor certainly over the next whatever period of time until we see that they consistently seem to be doing better in their own. But again I think certainly some of the things that happened during the flood put them back on their heels a little bit and then we’ll just have to watch out that sort of develops over the next over many quarters it takes to be fair.

Kim Watkins - Morgan Stanley

Yeah, okay. Any questions out there in the audience?

Question-and-Answer Session

Unidentified Analyst

What can you tell us about the insurance situation and how that's being resolved?

John Marchetti

Sure, so form an overall perspective we continue, we started over the last couple of quarters to get some internal payments in from the insurance company. We booked a $97 million gross loss on the income statement. If you look on our balance sheet I think today its either $51 or $54 million there is a third party liability there, that's what we know needs to be paid to customers. The ultimate claim is a little bit above that $97 million once you’re factoring some business interruption and things like that.

So to the extent that we get more than $54 million or $51 million from our insurance carriers that would be additive to our cash balance. On the unlikely scenario we get less then that then we’d have to come out of pocket whatever that is to make the difference up to our customer.

So where we sit today we’re certainly starting I think to see some momentum with the carriers or I should say our insurance syndicate to getting that paid its still probably going to be a few quarters before its all set and done but we’re certainly making progress there and I think for us part of it was just the challenge of putting the claim together quite frankly because as we’re filing on behalf of all these customers we had to make sure we had kind of everybody’s buy and everybody was comfortable with the claim we were filing and things along those buy.

So it took us a fair bit of time quite frankly just to get the claim submitted to the carriers but fortunately we had a balance sheet where we weren’t rushed to accept a lowball offer settlement and I think we’re slowly but surely getting there with the insurance syndicate but ultimately we feel comfortable that the worst case scenario is will be net cash neutral from where we are today but I think there is probably a good likelihood that we’ll be able to add and somewhat more cash back for the balance sheet as a result of the insurance settlements.

Unidentified Analyst

Carrier spending has been relatively depressed since the (inaudible) in ‘09 if the team leads are right and we actually see an increase in and spending like in the summer time given the past what happened is several quarter not a few years tailwinds. How much capacity do you have if we have a nice one or two year starting in the summer?

John Marchetti

Sure so from a, if you look at it from an existing footprint space today our total footprint today is just under about a million square feet that's about 70% occupied from a space perspective and I use that term specifically. You look at our equipment utilization it’s probably running a little bit below that.

So I think there is plenty of room within the existing lines that our customers had setup today could meet that demand and to be fair when you go back into some prior cycles our customers aren’t in a rush to add new CapEx to add a lot of capacity even during an up tick, unless to your point they had a real sense that there is either fundamental shift to demand that would make that last longer. What I truly felt like say one or two product categories they would have enough demand that it would make sense to even add an additional line.

Now I can certainly set that up for any customer who needs it. What I think is probably more likely is just for whatever period of time that you really see that surge, our customers will just run as hot and as hard as they can for that finite period of time until it starts to taper off again and get back to a sort of a more normalized level.

Kim Watkins - Morgan Stanley

Any other is out there, I’ve got a quick one after the floods happened you talked about potentially building a new manufacturing site outside of Thailand is that still in the plans or in the work?

John Marchetti

I would say it’s still something we’re considering. I think the push to do that has lessened quite a bit from our customers. We do have land available to us at our current campus to where if we wanted to we could build our next facility so to speak right next to the one we just put up. So we do already own land large enough to build Building 7 because we’re totally creative with the names of those buildings. Do we need to move geographically I think if we had customers that were adamant enough we have the resources where we could do that but it will be a decision that we make with our customers as suppose to just saying what we need to be in a New Jersey. So it will really be more of a discussion that way and we’ll see how that plays out over time right now we’re not in a rush to build any other building so…

Kim Watkins - Morgan Stanley

Okay.

John Marchetti

We’ll see where the next one goes up.

Kim Watkins - Morgan Stanley

Got it. Okay, with that we are out of time. So thanks very much John for being with us.

John Marchetti - Chief Strategy Officer

Thank you. Thank you.

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