Fabrinet: Optical Communications Industry Underpriced Due To Unjustified Pessimistic Outlook

Summary

• The optical communications industry continues to increase in size and demand for external manufacturing is becoming more common.
• The market maintains its pessimistic outlook of the optical communications industry due to China’s 2017 anti-dumping policies, and so the industry is currently undervalued.
• PCR’s new five-year plan will boost its domestic market growth, which will boost Fabrinet’s production within China and Thailand.

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PCR’s Policies

Fabrinet (NYSE:NYSE:FN) and the optical communications industry continue to be undervalued due to a pessimistic outlook that will eventually correct itself. On August 18, 2017, the optical communications industry took a hit due to China’s Ministry of Commerce. After conducting a yearlong expiry review on optical imports, China imposed tariffs and restrictions on imports from the US and Japan in order to promote its domestic production.

These anti-dumping measures made Fabrinet’s stock plummet from $44.01 to $36.03 in August alone due to additional costs and reduced revenue Fabrinet would be expected to suffer due to these tariffs. The Chinese policy affected Fabrinet’s long-term expected revenue, with the stock’s price continuing to drop for the following months. Not only Fabrinet, but the entire industry took a significant hit due to this, since China represents the fastest-growing optical communications market.

Currently, China’s new five-year plan aims to create a domestic optical components industry, which will drastically increase the domestic demand for said components. PCR's policies intend to boost Chinese optics companies in order for them to reach 30% of the global market share by 2022. Demand for optical components will continue to rise as China expands its efforts to erect 5G wireless and data centers. While China will continue to promote the growth of domestic companies in this industry, it is likely that the domestic supply will not be able to sustain the growth in demand.

The industry as a whole will experience a rebound as a race to export optical components and product to China begins. The market, however, remains pessimistic, given that the industry's stocks have yet to recover from their dips in 2017. Fabrinet, for example, dropped from $45.71 to $24.05 within a month, and has only recovered to $29.74. The lack of correction in the market makes these stocks extremely attractive as the market lags in adjusting for PCR’s policies that will net benefit the optical communications industry.

Fabrinet, in particular, will overwhelmingly benefit from the increase in expected revenue as the Chinese optical communications market expands. A majority of its production takes place in Thailand, allowing Fabrinet to avoid most of China’s anti-dumping policies that are imposed to Japan and the US. More importantly, Fabrinet already manufactures within China in Fuzhou. As China’s market expands, Fabrinet will be able to respond faster to demand compared to companies such as NeoPhotonics (NPTN) and Finisar (FNSR), which simply export to China. Fabrinet, therefore, will overwhelmingly benefit as domestic demand increases due to PCR’s new policies.

Valuation

Given how the pessimistic outlook appears to underestimate revenue growth in the industry, a discounted cash flow valuation that adjusts for the increase in revenue growth is the most appropriate to correctly value Fabrinet. According to the proforma used, Fabrinet’s price would be justified with an average perpetual growth rate of 2.4% and a discount rate of 9.47%

Source: Bloomberg Terminal

The equity risk premium was calculated by assigning the market risk premium of 5%, 8.4%, and 6.33% to Fabrinet’s revenue in North America, Asia-Pacific, and Europe, respectively. This resulted in an equity risk premium of 6.5%

Source: Country Default Spreads and Risk Premiums

Source: Bloomberg Terminal

Given Fabrinet’s low debt financing as a proportion of its capital structure, its estimated implied cost of debt hovers around 4.11%, according to the proforma used. Due to its current capital structure, Fabrinet’s appropriate WACC is estimated to be 9.47%. Given the market’s pessimistic outlook, a revenue growth of 2.4% justifies Fabrinet’s current price.

PCR’s five-year plan, however, will boost Fabrinet’s revenue growth for remainder four years of PCR’s current policies to an estimated 3.0%, after which Fabrinet is expected to return to its normal revenue growth, given no change in PCR’s policies. High revenue growth for Fabrinet for the next few years is likely due to the growth in demand within China and because of Fabrinet’s financial ability to increase its production as it takes new customers.

Fabrinet's 3.0% growth is a conservative estimate applicable if China is able to achieve its minimum domestic market share growth target. As long as Fabrinet is able to grow at this market share growth for its Asian Pacific division, 3.0% is a most conservative estimate for Fabrinet's potential overall revenue growth. This, of course, if without taking into account Fabrinet's ability and willingness to expand its market share.

Source: Bloomberg Terminal

As of last quarter, Fabrinet has only utilized 22.13% of $150 M worth of debt as a revolving credit facility, as well as an additional $50 M in the form of delayed draw term loan. Therefore, as demand rises within China, Fabrinet will be able to increase its operations by accessing this form of debt financing. Assuming Fabrinet’s operating expenses over revenue remains around 89%, Fabrinet’s intrinsic value is $32.22, with a 1-year target of $38.73, according to the proforma used.

Conclusion

The optical communications industry suffered a large blow in mid-2017 by PCR’s government, but its new 5-year plan is likely to boost overall demand in the industry. Fabrinet’s CEO has been vocal about his desire to scale up the company’s operations both organically and through acquisitions. Fabrinet’s low debt/capital and access to over $150M of financing will allow it to expand at a faster rate than its competitors, boosting its revenue for the next few years as China’s demand for optical communications manufacturing is increasing.

Given the thin volume of the stock, Fabrinet is currently slightly underpriced at $29.74 versus its intrinsic value of $32.22. With a 1-year target price of $38.75, potential returns (given the most conservative of estimates of 3% revenue growth) could be as high as 33.5%.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.