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Thesis

Fabrinet (FN), as an electronic manufacturing service provider of optical components and lasers is a good name to invest in if one believes in the comeback of telecom equipment capital expenditure. Two of its largest customers, JDS Uniphase Corporation (JDSU) and Oclaro Inc. (OCLR) have talked about business getting stronger in the second half.

The company's focus on specialized and small volume items has helped it to maintain decent margins, and higher production utilization rates can help these margins further. With experienced management at the helm and a strong balance sheet, the company is ready to monetize the rise in optical equipment spending.

Besides the strong cash flow from operations, cash balances can benefit from insurance claims settlement. Investors following GARP (Growth At Reasonable Price) style of investing may like Fabrinet at current levels of 5 times EV/ EBITDA and growing at 10-15% in a flat macro spending environment.

Brief overview of Fabrinet's business

The company provides electronic manufacturing services (EMS) to original equipment manufacturers (OEMs) of optical communications, industrial lasers and sensors. Fabrinet offers the full suite of services including process design and engineering, supply chain management, manufacturing, advanced packaging, integration, final test and assembly. It focuses primarily on low-volume but high complexity products.

The company has sufficient capacity to benefit from the improved order book and improved capacity utilization. It has 1.1 million square feet of manufacturing area including approximately 500 thousand square feet of clean room facilities. During Fiscal 2014, its new Pinehurst 6 facility will be online.

Fabrinet has proven manufacturing industry leaders in its management team. Tom Mitchell is the founder, CEO and chairman of the Board. He is also the founder of Seagate Technology Inc. (NASDAQ:STX). Other senior leaders also have deep expertise of engineering industry.

Even though most of Fabrinet's products are sole sourced, major competitors in broad optical manufacturing space are Sanmina-SCI Corporation (NASDAQ:SANM), Celestica Inc. (NYSE:CLS), Benchmark Electronics (NYSE:BHE) and some small companies such as Browave Corporation and Fujian Castech Crystals Inc.

Fabrinet's focus services are less competitive

Even though the broader EMS sector is highly competitive and offers low margins. Optical EMS space is relatively less competitive due to high value and low volume nature of the products. Some of the optical equipment manufacturers still have in-house production.

The company focuses on supplying what it calls "low-volume, high-mix" products, which are usually advance technology products made in small batch sizes. These "low-volume, high-mix" products offer better margins since company is the sole supplier in majority of these products. Qualification and field-testing for these products take minimum three to six months to complete, so once the company is qualified, they don't have to compete on price.

Besides the telecom equipment, the company also serves end-markets like semiconductor processing, biotechnology, metrology, material processing, automotive, and medical devices.

End markets showing signs of improvement

Various research studies and telecom equipment suppliers are pointing towards improving telecom capital equipment spending after years in a downtrend. This strength is driven by increased data and video usage by smartphones causing the bandwidth constraints. 100G deployments among global tier 1 carriers are ramping up and some carriers are migrating to all optical networks.

For Fabrinet, revenues from optical communication products as a percentage of total revenues are close to 70% and lasers, sensors and other markets make up the rest.

According to the market research reports, global optical component market is expected to grow 300% in next 5-6 years, from $4 Billion currently. High-speed processors and component devices that support increased speed and traffic on the optical networks drive part of this growth.

Fabrinet customers are expecting growth.

The optical communication equipment market is highly concentrated and Fabrinet's customer concentration profile is the same. JDS Uniphase and Oclaro make up close to 50% of Fabrinet's revenue.

JDS Uniphase sees improvement in its business on the back of strong LTE and 100G-products rollout. The CEO had the following comments in its most recent conference call,

"Bookings for Q4 were strong, with book-to-bill ratios above 1 for each of our 3 segments."

JDS Uniphase talked about improving the revenue environment at its most recent analyst day, as shown by the charts below.


(Click to enlarge)

Figure 1Source: JDS Uniphase analyst day presentation

(click to enlarge


(Click to enlarge)

Last year, Oclaro Inc. acquired Opnext Inc. and Fabrinet saw the revenue growth related to the merged entity.

This trend of improving optical equipment demand is expected to stay strong with rising network utilization rates and bandwidth demand. In its most recent conference call, John Marchetti, Chief Strategy Officer of Fabrinet had this to say about optical business.

"Confident that the underlying fundamentals of our Optical business remain strong and expect to benefit through our customers, and spending on optical equipment accelerates."

On the industrial lasers and sensors side of the business, the company is expected to see improved demand from semiconductor processing and material processing among others. The company has been working with automotive manufacturers for last few years and has been selected in a number of models, which are expected to ramp up in the next few quarters. Auto, laser and sensor revenue growth rates would eventually outpace the growth in the optical business. Management has talked about quoting in several programs, in its most recent result call.

John Marchetti, also mentioned the following about lasers and sensors business,

"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."

"Demand and visibility in our Automotive segment remain solid, and we are encouraged that signs point to this continuing."

"Flood money"

In 2011, a flood destroyed Fabrinet's Chokchai facility in Thailand. The company recognized $97.3 million as flood related expense and claimed the same amount from the insurance company. But so far insurance company has only paid $27.2 million on its claims of $29.5 million.

In the latest quarter, the company settled its outstanding liability with all its customers, related to the flood. Now its flood related liability towards them has been satisfied in full and the company has also recognized all charges related to the same.

The rest of the payments from insurance against its total flood related loss of $97.3 million is for the company to keep and may grow its cash balance of $150 million currently.

Better than average margins

Gross Margins

ROA

Rev growth (TTM)

FN

11%

6%

12%

SANM

7%

3%

-4%

CLS

7%

3%

-14.3

BHE

7%

3%

-3.6

Source: Yahoo Finance

As shown by the worksheet above, the strength of the company's product portfolio is visible from its much better margin structure. Usually the higher the percentage of sole sourced products, higher are the margins and higher is the bargaining power of the EMS provider.

Typical of the EMS space, any improvement in the plant utilization rates would help on the gross margins front. Fabrinet's gross margins in 2011 were 13%.

Cheaper than the average EMS player

Stock

Net Cash/ share

P/Book

EV/EBITDA

Rev growth

FN

$15

$4

1.6

7.3

12%

SANM

$16

$(3)

1.3

6.3

-4%

CLS

$11

$3

1.5

6.6

-14.3

BHE

$23

$7

1.1

7.0

-3.6

Source: Yahoo Finance

Relative valuation also confirms Fabrinet's advantage, as a stock, over its EMS peers. The numbers look impressive, even looking at the absolute valuation metrics of the company.

Stock

$15.3

Market Cap ($M)

$528

Cash/ Share

$4

P/ Expected 2013 Earnings

11.3

P/ Book

$1.6

P/ Expected 2014 Earnings

10.2

P/ Sales

0.8

EV/ EBITDA 2014

5

Rev growth

12%

Operating Margins

9%

Gross Margins

11%

Conclusion

This stock is a good way to participate in the telecom equipment upgrade cycle. Company's customers are seeing improving business trends and as an EMS player, company's fate is tied to them. Stock is trading at a decent relative and absolute valuation levels. As the telecom capital expenditure increases, margins would benefit from leverage associated with the better utilization of production capacity and having a fixed price contract structure. The target is $25

Source: Fabrinet Is A Good Way To Participate In The Telecom Spending Comeback