Fabrinet's (FN) CEO Tom Mitchell on Q2 2017 Results - Earnings Call Transcript

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Fabrinet (NYSE:FN) Q2 2017 Earnings Conference Call February 6, 2017 5:00 PM ET

Executives

Garo Toomajanian - Investor Relations

Tom Mitchell - Chairman & Chief Executive Officer

Toh-Seng Ng - Executive Vice President & Chief Financial Officer

Analysts

Alex Henderson - Needham & Company

Paul Coster - JPMorgan

Patrick Newton - Stifel Nicolaus

Troy Jensen - Piper Jaffray

Tim Savageaux - Northland Capital Markets

Operator

Good day, ladies and gentlemen, and welcome to Fabrinet’s Financial Results Conference Call for the Second Quarter of Fiscal 2017. At this time, all participants are in a listen-only mode. Later, we’ll conduct a question-and-answer session and instructions on how to participate will be given at that time. As a reminder, this conference is being recorded.

I would now like to hand the conference over to your host, Garo Toomajanian, Investor Relations. Please go ahead, sir.

Garo Toomajanian

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 second quarter of fiscal 2017 ended December 30, 2016. With me on the call today are Tom Mitchell, Chief Executive Officer and Chairman of the Board 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, which includes GAAP to non-GAAP reconciliations.

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 recent SEC filings, in particular, the section captioned Risk Factors in our Form 10-Q filed on November 9, 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?

Tom Mitchell

Thank you, Garo, and good afternoon, everyone. We delivered a strong second quarter with revenue and profitability that were above our guidance range. Revenue increased over 50% from a year ago, as we benefited from growth in new programs, as well as from existing customer programs. We expect these strong trends to continue into the third quarter.

On a personal note, at my request, our Board of Directors has initiated a CEO succession plan. I intend to continue to play a leadership role in the company after we appoint a new CEO. We have not put a timeline on this process.

I will now turn the call over to TS for more details on the second quarter and our outlook. TS?

Toh-Seng Ng

I would like to provide you with more details on our performance by end market and our financial results. Total revenue in the second quarter was $331.2 million, an increase of 51% from a year ago and above the high-end of our guidance range. Non-GAAP earnings were $0.91 per share and were also above the high-end of guidance, due primarily to our revenue upside.

Please note that included in a $0.91, non-GAAP EPS were $0.05 foreign exchange gain due to the nonrecurring weakenings of the Thai baht towards the end of the quarter. This result included a revenue contribution from our Exception EMS acquisition that was immaterial, but slightly better than expectations. Exception did not materially impact non-GAAP earnings per share.

Our growth is the result of strong optical communications demand, continuous growth in non-optical, and new customer programs. Revenue from new business or new programs that we started tracking in Q1 for fiscal 2014 represented 35% of revenue in the second quarter compared to 35% a year-ago.

Looking at our revenue breakdown in more detail. Optical communications represented 78% of our total revenue, or $274.2 million, an increase of 53% from a year ago. Non-optical revenue represented 32% of total revenue, or $76.9 million, an increase of 30% from a year ago, including a small contribution from Exception.

Within optical, the revenue split was 63% from Telco application and 33% from Datacom application. Both Telecom and Datacom continue to see some year-over-year growth at 58% for telecom and 54% for Datacom. By technologies, 100-gig solutions continued to nominate and represented 45% of total revenue and 58% of optical revenue, or approximately $160 million, an increase of over 130% from a year ago.

Revenue from 10-gig and 40-gig solutions decreased year-over-year consistent with shipping demand – market demand. Also, consistent with recent trend, we continued to see strong demand for Silicon photonic modules. In the second quarter, Silicon photonic revenue grew 137% from a year ago to over $34 million, or 31% of total revenue and 27% of optical revenue.

As I mentioned, non-optical communications represented 32% of revenue in the second quarter. Within non-optical communications, laser revenue increased 39% from a year ago to $35.5 million. Automotive product grew 8% from a year ago to $31.6 million, and sensors and other revenue increased 19% to $19.8 million.

Fabrinet West, our new product introduction facility in Santa Clara continues to ramp. We continue to operate three manufacturing lines there. While we operate in one segment and don’t breakout revenue by facility, we’re enthusiastic about the contribution that this facility will make towards our results.

In fact, we have already seen the transfers of program for Fabrinet West to Thailand consistent with our strategy to leverage NPI facility in Santa Clara and the UK to drive volume production. The transfers of NPI programs to volume production will also help utilize capacity at our new facility in Chonburi, Thailand. This 500,000 of square foot facility is already 10% occupied with more than 25% of manufacturing space already spoken for. In fact, we continue to expect a small amount of revenue from this facility in the March quarter with a continuing ramp as we look ahead.

Now turning to the details of our P&L, our reconciliations on GAAP to non-GAAP measures is included in our press release. Non-GAAP gross margin in the second quarter was 12.7%, a small increase on 12.5% a year ago. Even though start-up manufacturing costs associated with Fabrinet West were included in cost of revenue in the second quarter of fiscal year 2017, but not yet in fiscal 2016.

For the third quarter, we expect non-GAAP gross margin to increase slightly over the second quarter, as we benefit from increased scale. Non-GAAP operating income in the second quarter was $34.3 million, resulting in an operating margins of 9.8%, the highest level we have seen in over five years.

Non-GAAP operating income excludes share-based compensation expenses of $8.6 million. Non-GAAP operating margin improved 190 basis points from a year ago, primarily due to higher margin and leverage to operating expenses with growing revenue. Non-GAAP second quarter results include the impacts of $1.9 million foreign exchange gain due to weakenings of the Thai baht during the second quarter.

Taxes in the quarter were a net expense of $2.0 million and our normalized effective tax rate was 6.8%, which was within our expected range of 6% to 7%. Non-GAAP net income was $34.5 million in the second quarter, or $0.91 per diluted share compared to $18.2 million, or $0.50 per diluted share in Q2 of fiscal year 2016.

On a GAAP basis, which include share-based compensation expenses and amortizations of debt issuing cost, net income for the second quarter was $35.3 million, or $0.67 per diluted share, compared to $19.8 million, or $0.54 per diluted share in the second quarter of fiscal year 2016.

Moving on to the balance sheet and cash flow statement. We ended the second quarter with a cash and investment balance of approximately $259.3 million, compared to $256.9 million at the end of the first quarter.

Cash balance at the end of second quarter included the impacts of $20.8 million in operating cash flow, offset by $17.3 million in CapEx for machine and equipment and $4.9 million for long-term loan repayment. Additionally, $2.2 million in proceed from loan draw down was to support Chonburi construction payment.

After the end of the quarter, we made a 20% deposit towards the $5.6 million purchase of an additional 25 acres of land adjacent to our new facility in Chonburi Thailand. For fiscal year 2017, we continue to expect CapEx to be in the range of $60 million to $70 million, with approximately $30 million to $40 million of debt in maintenance CapEx and the remainder going towards the final construction and equipment for our new manufacturing facility in Chonburi, Thailand.

I would now like to discuss guidance for the third quarter. We expect the strong momentum we’re experiencing to continue into the third quarter. We anticipate revenue in the third quarter to be between $360 million and $364 million, representing growth of 43% to 45% from a years ago.

We anticipate non-GAAP net income per share in the third quarter to be in the range of $0.87 to $0.89, and GAAP net income per share of $0.66 to $0.68, based on approximately $38 million fully diluted shares outstanding.

In summary, we are enthusiastic about our continued business momentum, driven by ongoing strength in the optical market and new customer programs. We’re also excited to see the beginning of the transfers of programs from Fabrinet West to Thailand and believe our growing NPI pipeline will support our growth in the years ahead.

Operator, we would now like to open the call for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our fist question comes from the line of Alex Henderson from Needham & Company.

Alex Henderson

Hey, guys, nice quarter, and thanks for the guide. I wasn’t not sure I got the Datacom, Telecom split correctly, can you give us what the percentages were there on that split?

Toh-Seng Ng

Yes. Hey, Alex, this is TS. I think I make a boo boo there. I think the split is – Telecom is 62% and Datacom is 37%, not 33%, yes, I realized that…

Alex Henderson

37%, 63%?

Toh-Seng Ng

Right.

Alex Henderson

And that’s of optical, right?

Toh-Seng Ng

Yes, within optical.

Alex Henderson

So looking at the new customers as a percentage of sales of 35%, how much of that is coming from FN UK and FN West?

Toh-Seng Ng

Well, we don’t breakout, okay. In the past, you – we talk sort of a number like $10 million. And UK, I believe that we mentioned about $5 million for the last few quarters. Moving forward, we are not going to breakdown the segment, no.

Alex Henderson

Yes, it’s just that’s – it’s an important number relative to how fast you’re adding customers and to the extent that, it’s acquisition-driven, it’s is a little bit different than it’s – if it’s a standard accretion of new customers?

Toh-Seng Ng

In the past, we mentioned that both UK and most of the Fabrinet West are non-optical communications.

Alex Henderson

Right. Okay, I got it. Looking at the laser business, that was the other area that I think I got the numbers a little bit off on. Could you just go over the lasers that was about 39% growth, is that what you said?

Toh-Seng Ng

No, I didn’t say 39% growth. I think we say maybe laser represents 39% of the total, right, yes.

Alex Henderson

Of total, that’s what it was.

Toh-Seng Ng

Yes.

Alex Henderson

Okay, great. That’s what I needed. Thank you.

Toh-Seng Ng

Okay.

Operator

Thank you. And our next question comes from the line of Paul Coster from JPMorgan.

Paul Coster

Yes. Thanks very much, appreciate your time.

Toh-Seng Ng

Hi, Paul.

Paul Coster

I think you’ve talked to 10% of the new Thai facility being occupied. And I think I heard you say that 90% of the space is spoken for, did I get that correct?

Toh-Seng Ng

No, we say about – more than 25% of the space is spoken for.

Paul Coster

More than 25%, is that correct.

Toh-Seng Ng

Yes, that’s correct.

Paul Coster

Okay, got it. And then the business that is coming back from Fabrinet West to Thailand, as you said is non-optical. Is it a larger share of the – or is it the largest share of the new facility that is being deployed on sensors and lasers?

Toh-Seng Ng

Not necessarily. We were saying that Fabrinet West, as I mentioned, optical and non-optical majority today. Today, as the business unfolds, it’s mostly non-optical. We also have optical communication. Remember, Fabrinet West is a new product introduction facility. We try to capture the product at the inception stages.

Paul Coster

Why have you committed to a land purchase at this time?

Toh-Seng Ng

Well, we have the 50 acres of land and one building is already built, already completed. And there’s land adjacent to the 50 acres is available. So we thought for the future growth, we would to secure the land and also provide another access, just in case, either there’s a heavy traffic jam on one access, we have another alternate route to get into that campus.

Paul Coster

Okay. Was there any split that – a significant change in customer concentration this quarter?

Toh-Seng Ng

Not really. We don’t normally talk about 10% customer until the end of the year.

Paul Coster

Okay. And then my last question really for Tom, I suppose is, can you just give us a little bit of a sense of what your strategic stance is in readiness for whatever changes come about as a result of the tax reform proposals that are being considered here in the United States?

Toh-Seng Ng

So, Paul, as you probably follow our story, you know that, over the year, Fabrinet expanded the global footprint quite significantly. We now have Fabrinet West. We also have another manufacturing site in New Jersey. We are in UK now. We are always in China and in Thailand.

So, right now the policy is not clear. It depend on which version you want to follow. So, as the policy become clearer, we will be able to react, because today with our global footprint, we should be able to react whatever it come.

Paul Coster

I think that’s the most I could ask for at the moment. Thank you so much.

Toh-Seng Ng

Thank you.

Operator

Thank you. And our next question comes from the line of Patrick Newton from Stifel.

Patrick Newton

Hey, good afternoon, Tom and TS. Thank you for taking my question. I guess just first starting on the CEO search, Tom, should we think of the hiring of a search firm implicit that you’re looking at external candidates only? And also just, as we think about acquisition of assets similar to Exception, with the pace of acquisitions slow as you’re transitioning to a new CEO?

Tom Mitchell

Well, the first – to answer the first question, as the – the CEOs search is really brought about by the succession planning responsibilities on the – of the Board, and then we really don’t have a timeline on it. So that the – and so I don’t – we don’t foresee in the near future any change at all except the – it is responsibility of the Board to report that. So this was our method of doing that.

Patrick Newton

And no changes to the pace of acquisitions it sounds like?

Tom Mitchell

No, I think, the M&A activity continues. There’s not going to be a change. There’s really no change at all.

Patrick Newton

Okay.

Toh-Seng Ng

So I think if you look at that press release, it talk about, Tom will continue to involve with the business. He will continue to take on a leadership role as soon as we appoint a CEO.

Patrick Newton

And then, I guess, as you’re sitting here thinking about the change of the CEO level, can you comment, I have no tactful way to pose this question. But was there also comment at the Board level about potentially strategic alternatives, or other changes given the reduced role of the founder?

Tom Mitchell

No, I don’t think so, for sure, the search firm is – it looks at internal candidates, it looks at external candidates. And then, obviously, the – what we’re doing is, we’re trying to bring somebody to be the candidates to come will be – have a proven ability to take the company to the next levels of growth and profitability.

Patrick Newton

Okay. So no consideration at all of potentially selling the business, given this transition?

Tom Mitchell

That has not been put on the table at all.

Patrick Newton

Okay. Shifting to the NPI facility, TS, I understand, you don’t want to give explicit revenue generation. But is the – is Fabrinet West break-even currently?

Toh-Seng Ng

We actually don’t talk about that. But obviously, we have a – we have very good prospect on the business. Especially right now, they’re transferring the program – some of the mass production program to Chonburi. So, sometimes you ask me for the revenues, it’s hard for me to quantify, because some of which they may get over there with their existing three line andthe rest they transfer to Thailand. And again, when you look at profitability, it’s also hard to – for me to quantify. But we’re very happy with the acquisition, not acquisition, the greenfield, and we’ll continue to look for opportunity there.

Patrick Newton

Okay. And then maybe without – I understand the break-even in revenue can be a little bit harder, but is the margin profile of the revenue that’s flowing through Fabrinet West still helpfully accretive to the corporate average?

Toh-Seng Ng

Well, if you look at this quarter, it was at 12.7%, and right now Fabrinet West is 100% in the cost of revenue. So you can even draw the conclusion from there.

Patrick Newton

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

Toh-Seng Ng

Thank you, Patrick.

Operator

Thank you. And our next question comes from the line of Troy Jensen of Piper.

Troy Jensen

Hey, congrats on the nice quarter, and Tom congrats on a pending retirement here, it’s well overdue.

Tom Mitchell

Well, I don’t think a retirement for me in the program right now. But we have to – we did have to report this succession planning program.

Troy Jensen

All right, understood. Can’t let go, I understand. A couple of quick questions, TS, I just want to make it clear that you said you only had one 10% customer in the quarter, is that correct?

Toh-Seng Ng

No, I didn’t say that, I said we only report the 10% customer towards the end of the year – fiscal year. So, obviously, with all the things going on, we’re aware of that. We – I do hope that, I had more than one 10% customer.

Troy Jensen

Yes, I understand. Okay, how about quickly on – this maybe premature, but you guys – have you thought about breaking ground on the next building yet, or is that still your plus out, like your timeline, I guess, you won’t start yet, but a timeline?

Tom Mitchell

All right. I believe we would start breaking ground only for another two years.

Troy Jensen

All right, understood. And how about…

Tom Mitchell

This is a 550,000 square foot plant…

Troy Jensen

Yes, it’s a big…

Tom Mitchell

That we just – that we opened in October. And I think the groundbreaking for the next plant will be somewhere between 12 and 18 months.

Troy Jensen

Okay, understood. And then TS, just in your guidance, are you expecting lasers and sensors to grow sequentially in the March quarter?

Toh-Seng Ng

For sensor, yes….

Troy Jensen

Non-optical?

Toh-Seng Ng

I believe so, yes. Laser, honestly, I don’t know, because it’s really the forecast, so hard to tell.

Troy Jensen

All right. And just could you guys give any color on maybe specific products? Is QSFP28 becoming a bigger piece of the revenues, or anything material yet? And I’d love to hear if you could at all on growth in ROADMs?

Toh-Seng Ng

I think we talk about silicon photonic become a very nice piece of business we have currently about 21% of our total revenue. We don’t have a QSFP28, but we’re ramping. We have all favor LR4, SR4. So we have four or five table on that. Other than that 100-gig is very strong. We continue to enjoy the 100-gig growth so…

Troy Jensen

Thanks, guys. Well, good luck this year.

Toh-Seng Ng

Thank you.

Tom Mitchell

Thanks.

Operator

Thank you. And our next question comes from the line of Tim Savageaux from Northland Capital.

Tim Savageaux

Hi, good afternoon, and congratulations on a nice quarter. I want to maybe focus back on that guidance question. So it sounds like, given your comments on non-optical that you expect most of the sequential growth to remain coming on the optical communication side, as we look into the March quarter, is that fair to say?

Toh-Seng Ng

Yes, Tim, yes, I think that’s a good observation.

Tim Savageaux

Okay, great. And then I wanted to maybe try and get a sense of how much the new capacity that you mentioned came online late last year contributed to either the upside in the quarter, or the sequential guidance. And I want to follow-up on a few metrics, you mentioned 25% occupied, but if there’s any color you can give us on the revenue contribution of this new facility on either results or guidance, that would be helpful?

Toh-Seng Ng

Okay. So if you follow our story, Tim, we – essentially, we say Pinehurst the old campus. In terms of space, we’re almost there. We’re pretty much are fully occupied. On the equipment, equipment capacity depend whether six-day or seven-day. We still have a little bit of capacity there. For example, if you’re willing to run seven-day, we’re able to hire people to stagger them to run seven days a week. Our equipment utilization is about 70% to 75% only. So we still have room even in old campus – Pinehurst campus.

For the new campus, we mentioned in our prepared script that, in March, we have some revenue contribution from the new campus – Chonburi campus, but it’s not significant. We’re still helping the customer to qualify to –at present time, based on their requirement. Is that helpful?

Tim Savageaux

It is. And I guess, I’m trying to put it in context of some of your past land acquisitions just sort of current announcement we just made. I believe at that time, we bought the land that you got the buildings on now, and I think there was about 50 acres, and I believe at the time, you talked about adding a 150% of your current capacity over a period of time. I guess, as we stand here now when you referenced the 550,000 square feet, I guess, how much of that is of the original 150% addition? I mean, I think it’s somewhere like a third?

Toh-Seng Ng

Yes.

Tim Savageaux

But as you think of this new land, how should we think about with regards to the size of the capacity expansion on top of that?

Toh-Seng Ng

Okay. So unless you have land, you can’t even build building. So and that’s a strategy behind that. So we have a land currently 50 acres. We have one building already completed. We have room for two more buildings. So each building you can see – you can just assume that it’s a 500,000 square foot.

So for three buildings, it’s $1.5 million. Currently, in Pinehurst, we have $1 million manufacturing space, so 150% on the current Pinehurst capacity. Now, the new land is 25 acres roughly speaking. Half of the existing land we bought about one year, two years ago. So you can figure out that another 50% of the 150% if you try to build another building out there. Is that helpful?

Tim Savageaux

It is. What would be more helpful is to understand what sort of demand indications or growth that you’re seeing that would have you move further on another capacity increase when you’re a third of the way through the current one, I think that’s pretty extraordinary? I’d love you to share your planning assumptions on them?

Tom Mitchell

Yes. Maybe I can help a little bit on that. The thing is, we work on a 10-year plan and we don’t want to get land locked by having all our capacity in 50 acres and then there isn’t any more land available in that area. So we have to go and relocate again in another area. We’re very pleased with that area. Every indication is that, it’s going to work really great for us and and buying the 20 and then – and buying the 25 acres, which is adjacent to the existing 50, exactly a great and really, I believe it’s really a strategic decision to go forward, so we always have the option of increasing in that campus.

Toh-Seng Ng

It doesn’t mean that we have land, we definitely want to build the building today. I mean, we will build the building in concept with the market demand and condition.

Tim Savageaux

Understood. So you’re being a little opportunistic there. One more for me back on the product side. It does look like you saw strength here at a 100-gig, both across Telecom and Datacom in Silicon photonics, and I would assume in QSFP28, you haven’t talked much about the ROADM side. It seems like, as I look through my numbers, you might have seen some flattening out there. I wonder if you can kind of readdress that sort of a ROADM market and anymore color about the strength in a 100-gig, whether you expect that to continue as you move forward to be the primary source of growth on the optical comm side?

Toh-Seng Ng

Okay, very good question, Tim. Tom Mitchell always coached me, don’t get into the customer territory. So Lumentum is going to report I think tomorrow. You probably can hear what they say about ROADM. I believe the December or January. January finish out about WSS and ROADM, they talk about Chinese is going to adopt ROADM. If you listen to their earnings call, I mean, nothing in the pipeline to tell me that, on the – such as ROADMs on the product side is going to slowdown. But again tomorrow, you can hear from Lumentum and see what they say.

Tim Savageaux

Got it. Thanks. Thanks, guys.

Toh-Seng Ng

All right. Thank you, Tim.

Operator

Thank you. And our next question is a follow-up from the line of Alex Henderson of Needham & Company.

Alex Henderson

Thanks. Did you give out the geographic breakout and growth rates in the quarter?

Toh-Seng Ng

Is it – it would be in the Q on the View2 about 50% to North America and the rest is between Asia and Europe. And actually, Alex, I went further one step and look at that is View2 right in the Q, but shipped to. Suffice to say that, today we only have less than 20% ship in the USA. So majority is outside USA. So we build the product outside U.S. and then about 20% ship back to the U.S. My customer import them back to the U.S. For Fabrinet, we have FOV Bangkok [indiscernible]

Alex Henderson

And going back to the capacity utilization of Pinehurst versus Chonburi, it’s my understanding that you moved some of the common equipment that you share between the vendors to Chonburi from Pinehurst, did that open up some space and Pinehurst allow you to get a little bit more available space to offer to your customers?

Tom Mitchell

We didn’t move any equipment out of Pinehurst to Chonburi. Everything in Chonburi is all new.

Toh-Seng Ng

New, yes.

Alex Henderson

Well, let me say it differently then. My understanding is, you brought up a line to – that’s more of a shared line in Chonburi that and shutdown an old line at Pinehurst, which opens up some space at Pinehurst, is that accurate?

Toh-Seng Ng

Yes, in due course, yes, but not right away. We bought two brand new line, we saw in Chonburi and then we’re trying to go to product by product, customer by customer to transfer them. And yes, you’re right, in due course, if we have some space. In fact, as we see, we create a space in almost everyday because of more consolidated rationalized production, move warehouse, consolidate warehouse, consolidate offices and so on. So we create space almost every quarter, every month.

Alex Henderson

All right. I’ll cede the floor. Thanks.

Toh-Seng Ng

Thank you, Alex.

Operator

Thank you. And that concludes our question-and-answer session. I would like to turn the conference back over to Fabrinet for any closing comments.

Tom Mitchell

Well, this is Tom and I thank you for your attendance and we’ll speak to your again in our next call.

Toh-Seng Ng

Thank you.

Tom Mitchell

Good afternoon.

Operator

Thank you. Ladies and gentlemen, thank you for your participation in today’s conference. This does conclude the program and you may now disconnect. Everyone have a good day.

Toh-Seng Ng

Thank you.

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