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Summary

  • Fabrinet's downside risk: audit, currency fluctuations, customers, executive pay package.
  • Fabrinet has some great metrics when compared with its competitors that will support the upside growth.
  • This is a typical Greenblatt stock (cheap and good), and so it has a large rerating potential.

Business overview

Fabrinet (NYSE:FN) provides optical packaging and precision optical, electro-mechanical, and electronic manufacturing services to manufacturers of optical communication components, modules and sub-systems, and industrial lasers and sensors.

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In essence the business breaks down into two main segments.

Year ended

FY 2014 (est.)

FY 2013

FY 2012

FY 011

% of revenue

Optical communications

70%

70%

68%

77%

Lasers, sensors, and other

30%

30%

32%

23%

The below is a graphical representation of Fabrinet's revenue segments.

Source: Fabrinet Annual Statement and conference calls.

Fabrinet offers a highly specialized mix of optical packaging with a low-volume production. Something it calls "low-volume, high-mix" (however, when required, Fabrinet is also capable to accommodate a high-volume production).

Fabrinet tailors specific applications for its customers. It has long lead times to production that can last up to six months, or longer, during which time qualification testing takes places for compliance with the customer's specification and as specified by an industry standards organization, such as Telcordia. Fabrinet tests for reliability, quality, consistency, return loss, etc. During this time Fabrinet develops a close relationship with its customers that allows Fabrinet to stabilize production yields and focus on cost and quality optimization. Fabrinet believes these long lead times are a barrier of entry to new competitors.

This article will review the following:

  1. Downside risk to investing in Fabrinet.
  2. Fabrinet's financial health.
  3. Valuation analysis on an absolute and relative basis.
  4. Expected price target.

1. Downside risk

Recent internal audit: Fabrinet announced that during the fourth quarter of the fiscal year ended 2014, accounting issues were discovered by management, which prompted the Audit Committee to commence an internal investigation. The Audit Committee is investigating whether there were any violations of the company's accounting policies and therefore have postponed its fourth quarter and fiscal year 2014 earnings release. The announcement initially caused the share price to drop (although it has now partially recovered).

Generally, these investigations turn up minor accounting errors and nothing significant comes out of it. Fabrinet's auditors are PricewaterhouseCoopers, so it's reasonable to believe this auditing firm is adequately proficient to have spotted any serious fraud. Further, if there was any chance of fraud the SEC would have suspended Fabrinet from trading pending the investigation. However, while the investigations are taking place a certain amount of uncertainty remains, causing the stock price to remain depressed.

Currency fluctuations: Fabrinet is exposed to foreign exchange risk arising from currency exposure to the Thai baht, as a substantial portion of its payroll expenses are incurred and paid in Thai baht. Although the Thai baht has been somewhat stable, there is still significant exposure to changes in the exchange rate between the Thai baht and the U.S. dollar (the results are adversely impacted when the U.S. dollar depreciates relative to the Thai baht).

Customers: Fabrinet has a very concentrated number of customers, as the table below shows.

Year Ended

2013

2012

2011

JDS Uniphase Corporation (JDSU)

22%

25%

21%

Oclaro, Inc. (OCLR)

25

12

17

Finisar Corporation (FNSR)

*

10

10

Opnext, Inc. (OPXT)

*

*

10

Source: Fabrinet annual report.

* Less than 10% of total revenues in the period.

Fabrinet's customer concentration increases its concentration of accounts receivable and its exposure to default by any of its key customers.

Executive pay: a brief summary of the compensation package of Fabrinet's executive staff is shown in the table below:

Salary

All bonus, stock awards and other compensation

Total

Name and Principal Position

$

$

$

David T. Mitchell

450,000

2,518,338

2,968,337

Dr. Harpal S. Gill

575,000

1,755,198

2,330,198

Paul Kalivas

323,812

599,680

923,492

John Marchetti

375,000

687,610

1,062,610

Toh-Seng Ng

325,000

929,897

1,254,897

Total executive pay

2,048,812

6,490,723

8,539,535

Source: Fabrinet Proxy Statement (2013)

The executives are paid handsomely for a company with a mediocre performance (this should certainly raise a few eyebrows). In addition, it is worth mentioning that insiders only own about 2% of the company, so one could argue that executive's interests are only partially aligned with that of its shareholders.

It's also worth mentioning that Mr. Mitchel, the CEO, is active in selling and disposing of his shares (on the other hand, he is 72 years old and this action is understandable). Likewise, the main institutional shareholder (Asia Pacific Fund) has also been an active seller of late.

Additionally, I find it particularly extravagant when a CEO's automobile and transport costs add up to more than $10K a year and with Mr. Mitchell, it adds up to more than $17K (not including airfare) - and he is not the worst offender amongst the Fabrinet's executives.

2. Financials health

Balance sheet: one of Fabrinet's strongest aspects is its balance sheet, as the tables below shows.

Q3 2014

Q2 2014

Q1 2014

FY 2013

FY 2012

Cash and cash equivalents *

$ 233,664

$ 180,058

$ 163,860

$149,716

$115,507

Trade accounts receivable, net

118,500

121,772

125,876

118,475

128,253

Inventory, net

107,826

96,705

94,528

88,962

103,223

Source: Fabrinet annual report (2013)

* With cash equivalents consisting of deposits with maturities of less than 3 months.

As of Q3 2014, no more income/expenditure related to the 2011 flooding. This makes the liquid assets available for business growth. This review will only lightly comment on the 2011 flood as it's mostly no longer pertinent.

Leverage: Fabrinet has been active in reducing its leverage -its latest quarter debt/equity ratio is below 3%. (The additional leverage was incurred during the 2011 flood, and was used to replace the damaged equipment).

Q3 2014

Q2 2014

Q1 2014

FY 2013

FY 2012

Loans, current portion

$ 9,660

$ 9,668

$ 9,668

$ 9,668

$ 9,668

Loans, non-current portion

12,000

14,409

16,826

19,243

28,911

Total loans

$ 21,660

$ 24,077

$ 26,494

$ 28,911

$ 38,579

Fabrinet, also has available undrawn credit facilities totaling $5.5 million.

Inventory: As the table below shows, Fabrinet is doing a great job of keeping its inventory lean. More specifically, reducing the volume of raw materials it stocks in spite of seeking incremental growth.

FY 2013

FY 2012

Raw materials

$ 34,572

$ 45,309

Work in progress

43,806

43,879

Finished goods

7,342

8,760

Goods in transit

5,359

7,976

91,079

105,924

Less: Inventory obsolescence

-2,117

-2,701

Inventory, net

$ 88,962

$ 103,223

However, Fabrinet computes its inventory on a first-in-first-out basis. Meaning that costs of the earliest materials purchased are assigned to cost of goods sold. In other words, the cost of goods sold are calculated at the more aggressive style of accounting. This leads to paying higher taxes, as higher profits are recorded. On the other hand, this is not a problem for Fabrinet as it domiciled in the Cayman Islands - the Cayman Islands have a favorable tax regime; this allows Fabrinet to have annual income tax within 5%-6% range.

Revenue growth:

FY 2014 (est.)

2014 Q4 (est.)

2014 Q3

2014 Q2

2014 Q1

FY 2013

FY 2012

FY 2011

FY 2010

FY 2009

FY 2008

Average

Revenue USD Mil

690

171

168

179

172

642

565

744

506

441

511

YoY growth

7%

14%

-24%

47%

15%

-14%

8%

EPS GAAP

2.59

0.3

1.33

0.41

0.55

1.98

-1.64

1.87

1.41

1

1.33

YoY growth

31% *

14%

-24%

47%

15%

-14%

11%

* Without Fabrinet's insurance income throughout 2014, its average EPS YoY growth is 8%.

Margins: as the table below demonstrates, Fabrinet has good and stable gross margins for a business that has its primary revenue stream in the highly competitive and cyclical telecom industry.

FY 2014 (est.) *

FY 2013

FY 2012

FY 2011

FY 2010

FY 2009

FY 2008

Average

Gross Margin %

11

10.8

11

12.7

12.7

13.2

13.4

12

* The FY 2014 gross margin is from Fabrinet's own guidance on the conference call.

Share dilution: There is some share dilution that investors need should be aware of (shown below).

2014 Q3

2014 Q2

2014 Q1

FY 2013

FY 2012

FY 2011

FY 2010

Shares dilution

0.6%

1.3%

0.8%

1.3%

-0.1%

8.8%

0.6%

Bad debt allowance: In all likelihood this is carries no significant importance, but as Fabrinet works closely with startups (with big risks of bankruptcy - as highlighted on the conference call), it's worth noting that Fabrinet does not carry any allowance for bad debt. To Fabrinet's credit, in the past, this lean approach has worked in Fabrinet's favor.

Geographical breakdown of revenue:

2013

2012

2011

North America

46.70%

48.30%

43.60%

Asia-Pacific

34.00

33.50

37.30

Europe

19.30

18.20

19.10

100.00%

100.00%

100.00%

As of late, Fabrinet is seeking to gain additional market from outside of North America. It is too early to tell whether this will be successful.

3. Valuation

Valuation on an absolute basis:

With cash and cash equivalents of $234 million in its most recently reported quarter, Fabrinet trades at approximately 2.5 times cash and cash equivalents. In addition, Fabrinet has a current ratio of 3.4, so there is little danger of bankruptcy in the near term.

As Fabrinet's main customers (JDSU and Oclaro) invest heavily in capital expenditure in the second wave of the telecom cycle (post dot.com boom/bust era), this stock offers investors a means to participate in this telecom boom cycle with a cheap price tag and so at significant margin of safety to intrinsic value.

Dividend: Nil.

Valuation on a relative basis: When comparing Fabrinet's stock with that of its competitors, Farbinet offers investors good value.

Valuation Measures

Fabrinet

Celestica Inc. (CLS)

Sanmina Corporation (SANM)

Benchmark Electronics Inc. (BHE)

Market Cap:

562.72M

1.95B

1.92B

1.31B

Enterprise Value (Aug 29, 2014):

350.73M

1.43B

2.07B

920.18M

Trailing P/E:

5.88

14

19.8

11.21

Enterprise Value/EBITDA :

6.06

6.74

7.07

6.3

Return on Equity

27%

11%

10%

11%

Source: Yahoo Finance

In the same style as Mr. Greenblatt (who is one of the institutional investors in Fabrinet and holds Fabrinet stock in no less than 3 of his funds); I also aim to invest in good (high ROE) and cheap (low P/E) companies (although I am no Greenblatt, I have previously argued its merits here).

Gross margin: As can be seen in the table below, Fabrinet's gross margin perform well against its competitors.

Gross margin (%)

FY 2013

FY 2012

FY 2011

Average

Fabrinet

10.8

11.0

12.7

11.5

Celestica Inc.

6.7

6.7

6.8

6.7

Sanmina-SCI Corporation

7.2

7.2

7.7

7.4

Benchmark Electronics, Inc.

7.4

7.2

6.2

6.9

Source: Morningstar.com

4. Price target

When Fabrinet releases its conclusion from the audit and its annual results, a lot of uncertainty regarding this stock will be lifted.

The following points should cause the market to rerate this stock:

  • robust balance sheet;
  • expected long-term annual growth in the 8-10% range;
  • its ability to participate in telecom's latest boom cycle with its peer leading gross margins;
  • Natural competitive strengths (such as highly specialized products and long lead times to production).

With the above in mind, the stock should revalue to a higher P/E of at least 10-12 (reasonable when compared with S/P's current P/E of 18). Based on this analysis, the intrinsic value price target is $25 (EPS $2.59 FY 2014). This allows a significant margin of safety in this investment.

Conclusion

This stock has a margin of safety at the current share price of $16. There is plenty of room for the Fabrinet's price to revalue on a higher P/E multiple (as it's currently depressed). Even without any exceptional growth, as it stands, Fabrinet's stock is undervalued and has scope to increase based on a higher P/E ratio to the target of $25.

Source: Fabrinet: An Opportunity You Might Have Missed