Fabrinet's (FN) CEO Seamus Grady on Q3 2018 Results - Earnings Call Transcript

Fabrinet (NYSE:FN) Q3 2018 Earnings Conference Call May 7, 2018 5:00 PM ET

Executives

Garo Toomajanian – Investor Relations

Tom Mitchell – Founder and Executive Chairman

Seamus Grady – Chief Executive Officer

TS Ng – Chief Financial Officer

Analysts

Dan Park - Needham & Company

Troy Jensen - Piper Jaffray

Tim Savageaux - Northland Markets

Dave King - B.Riley

Operator

Good day, ladies and gentlemen. Welcome to Fabrinet's Financial Results Conference Call for the Third Quarter of Fiscal Year 2018. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instruction for how to participate will be given at that time. As a reminder, today's call is being recorded.

I would now like to turn the call over to your host, Garo Toomajanian, Investor Relations.

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 third quarter of fiscal year 2018, which ended March 30, 2018. With me on the call today are Tom Mitchell, founder and Executive Chairman; Seamus Grady, Chief Executive Officer; 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 and investor presentation, which includes our GAAP to non-GAAP reconciliation.

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 February 7, 2018.

We will begin the call with remarks from Tom, Seamus and TS, followed by time for questions. I would now like to turn the call over to Fabrinet's Executive Chairman, Tom Mitchell. Tom?

Tom Mitchell

Thank you, Garo, and good afternoon everyone. I am pleased we exceeded our regular expectations for the third quarter and today we are well positioned to benefit from stabilizing demand, current customer growth and new customer opportunities.

I’d like now to turn the call over to Seamus for his remarks.

Seamus Grady

Thank you, Tom, and good afternoon everyone. We're pleased that our third quarter revenue came in above the top end of our guidance range with revenue of $332 million and non-GAAP net income of $0.71 per share including the impact of $0.06 foreign exchange headwinds. This strong profitability is also reflected in cash flows with year-to-date operating cash flow increasing 49% to nearly $90 million and year-to-date free cash flow of $61.5 million compared to a little over $3 million a year ago. We believe that business trends are stabilizing and this is reflected in our expectations for increasing revenue in the fourth quarter as TS will detail later.

As in the second quarter 72% of third quarter revenue came from optical communications programs and 28% for non-communications. Within optical telecom continues to dominate under 64% of optical revenue. Telecom revenue grew 6% on a sequential basis. We anticipate that this stabilization will continue into the fourth quarter in both telecom and datacom programs. We're also optimistic that our non-optical communications business will resume sequential growth in the fourth quarter after a modest decline from record levels in the second quarter. These trends reflect not only market conditions of our customers and their customers, but our ability to attract new customers and new programs.

Our strong position in the markets is driven by our experience and reputation as a technology driven manufacturer for optical communications and other markets that require precision, manufacturing and advanced packaging. Over the years, we have reinforced this focus on optical communications while also leveraging as to enter adjacent markets such as optical sensing, commercial lasers and medical. New business, which again represents a 35% of revenue in the third quarter continues reflect this diversification.

Fabrinet West our new product introduction facilities strategically located in Santa Clara, California has been instrumental in helping us get closer to customers and win new programs serving diverse end markets. While there's only one Silicon Valley, we believe there are a small number of global regions that share similar characteristics of a large concentration of technology companies. One of these locations is Israel, where we already have a number of customers. In March, we made early steps towards establishing a new NPI facility in Israel, where we can continue our proven model of providing local new product introduction services helping our customers with design for manufacturability and then transferring those programs to Thailand for value manufacturing.

While it's still very early days for us in this exciting region, we're confident that in Israel, we can replicate the NPI playbook that we have been successful with in Fabrinet West and Fabrinet UK. Having already established a beachhead in Israel including a new executive vice president to lead the charge, we look forward to sharing our progress with you as we execute on our plans. In summary, we are pleased to have exceeded our revenue expectations in the third quarter. We are enthusiastic about the fourth quarter and beyond with stabilizing our improving trends across the markets we serve and we are excited about the many opportunities ahead.

Now let me turn the call over to TS to discuss the details of our third quarter performance and our outlook. TS?

TS Ng

Thank you, Seamus. Good afternoon everyone. I will provide you with more details on our performance by end market and our financial result for Q3 of fiscal year 2018 as well as our guidance for Q4. Total revenue in the quarter was $332.2 million above the high-end of our guidance range. Non-GAAP net income was $0.71 per share within our guidance range. In the third quarter, we experienced a $2.4 million, or $0.06 per share, foreign exchange headwind compared to $3.7 million or $0.10 headwind in the third quarter of 2017. Excluding the impact of this headwind, non-GAAP EPS would have been above our guidance range.

Looking at the quarter in more detail, revenue from optical communication programs was $241 million compared to $287 million a year ago and $242 million in the second quarter. Non-optical communications programs represented 72% of total revenue consistent with the second quarter. Within optical, telecom represents a 64% of revenue up 4 percentage point from the second quarter. In other words, in the third quarter, telecom revenue increased by 6% from the second quarter to $154 million. Datacom revenue was $87 million or 36% of optical communications.

By 100-gig solution continue to dominate with revenues up $129 million, down slightly from $133 million in the second quarter. Revenue from 400-gig solution was $10 million in the third quarter compared to $16 million in the second quarter. Revenue from QSFP28 transceivers was $37 million in the third quarter compared to $42 million in the second quarter as the transition to lower-cost CWDM4 variance continues with volume not yet high enough to offset lower prices. Silicon photonic revenue was $66 million compared to $74 million in the second quarter.

Turning to non-optical communications. We again had a strong performance, but did not beat our record second quarter performance. Non-optical components and modules represented 28% again in the third quarter at $91 million. Revenue from the industry laser market was again a record at $43 million, up 23% from years ago. Automotive revenue of $21 million was below the records of nearly $26 million in Q2, but up 6% from a year ago. Sensor revenue grew slightly to nearly $5 million from $4 million in the second quarter. Other revenue of $22 million was down slightly from $23 million in Q2. Finally, new business was $116 million or 35% of revenue in the third quarter as it was in the second quarter.

Now turning to the details of our P&L, a reconciliation on GAAP to non-GAAP measures is included in our earnings press release and investor presentation, which you can find on our website. Non-GAAP gross margin in the third quarter was 11.6% consistent with Q2 and below our target range of 12% to 12.5%, primarily due to startup cost related to certain new customer program as well as to the decrease in revenue and a continued strengthening of the Thai baht from the second quarter. We expect gross margin to improve in the fourth quarter, but not enough to put us in the target range for all of FY 2018.

Non-GAAP operating income in the third quarter was $30.1 million and operating margin was 9.1% up slightly from Q2 from cost savings from the reduction in workforce that we make in Q2 as well as approximately $1 million impact from the reverses of management bonus accrued against FY 2018 objectives. Taxes in the quarter were a net expense of $1.5 million and our normal effective tax rate was 6.2% consistent with Q2 and in line with our expected range of 6% to 7%. We continue to anticipate an effective tax rate of 6% to 7% for fiscal year 2018.

Non-GAAP net income was $28.4 million in the third quarter or $0.71 per diluted share compared to $0.72 in Q2 and $0.80 a year ago. On a GAAP basis, which includes share-based compensation expenses and amortizations of debt issuing costs, net income for the third quarter was $21.1 million, or $0.55 per diluted share, compared to $21.7 million, or $0.57 per diluted share in the third quarter of fiscal year 2017. As I mentioned earlier, we experienced a $2.4 million, or $0.06 per share, negative impact from a stronger back Thai baht on our GAAP and non-GAAP bottom line results for the third quarter.

Turning to the balance sheet and cash flow statements. At the end of the third quarter, cash and investments were $315.4 million. This represents an increase of $27.8 million from the end of the second quarter primarily from operating cash flow of $52.7 million, which increased 31% from the second quarter offset by a CapEx of $6.9 million, share repurchases of $12.5 million and repayments of long-term loans from bank of $3.4 million.

Free cash flow, which is operating cash flow less CapEx, was $45.8 million in the third quarter, an increase of 53% from Q2. On a year-to-date basis, operating cash flow was $89.8 million. After subtracting CapEx of $28.3 million, year-to-date free cash flow was $61.5 million reflecting the meaningful decrease in CapEx that we have anticipated for FY 2018. We expect CapEx in FY 2018, all of which is maintenance CapEx, to be approximately $35 million. During the third quarter, we were active in our share repurchase program and bought back approximately 422,000 shares at an average price of $29.58. As of the end of the third quarter, $37.6 million remain in our repurchase authorization.

I’d now like to turn to our guidance for the fourth quarters of fiscal year 2018, which incorporates approximately $7 million negative impact from sanctions on ZTE. As a reminder, we do not have any direct customer in China, but many of our customers do serve Chinese customers. With that background, we anticipate revenue to be in the range of $334 million to $342 million, an increase from the third quarter as Seamus indicated.

From an earnings perspective, we anticipate non-GAAP net income per share in the four quarter to be in the range of $0.73 to $0.77 and GAAP net income per share of $0.55 to $0.59, based on approximately 37.9 million fully diluted shares outstanding. In summary, we are pleased to have delivered revenue in the third quarter that was above our guidance range and are enthusiastic about increasing revenue in the fourth quarter as customer demand across our diverse range of program stabilize or improve. Our position in the market continues to strengthen as customer look us to manufacture the most challenging design.

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

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Alex Anderson with Needham & Company. Your line is now open.

Dan Park

Good afternoon. This is Dan Park on for Alex. Thanks for taking my questions. So, I am just wondering regarding your comment on ZTE and Huawei, have you seen any change in orders relative to ZTE and Huawei? And how much of your silicon photonics [indiscernible] falling off as a result of ZTE?

Seamus Grady

So as we mentioned in our prepared remarks, the – our estimate for Q4 is an impact of about $7 million in our Q4 outlook and that's included in the outlook we get for Q4. That number we arrived at from discussions with our customers. So we feel pretty excited about that number.

Dan Park

Okay, great. And I guess my second question, have you seen reacceleration of demand in the datacom space? And to what extent is the pressure on this business? Have you seen any evidence of demand reaccelerate – reacceleration in demand given some of the issues around the risk of workaround having been resolved and volume changes at Web 3.0 customers?

TS Ng

This is TS. I think the volume is already there in terms of quantity. The thing cloud the whole – the data is a pricing reduction. So and we – in our prepared remarks, we say that the lower prices are not enough to offset the volumes increase. So it will – it’s just be in the two parts. Obviously, volume continues to increase, but again, because of the price reduction, we can’t really tell.

Dan Park

Okay, great. Thank you for taking my questions.

Seamus Grady

Thank you.

TS Ng

Thank you, Dan.

Operator

Thank you. And our next question comes from the line of Troy Jensen with Piper Jaffray. Your line is now open.

Troy Jensen

Hey, gentlemen, congrats on the nice results.

Seamus Grady

Thank you, Troy.

TS Ng

Thanks, Troy.

Troy Jensen

Hey, guys, just a little color on the June guidance, are you expecting both of the datacom and telco to grow? Or are they going to be stable and the laser business grow? Just to be more insight would be helpful?

Seamus Grady

I think we expect both segments to grow moderately and that's why you see it reflected in our total guidance.

Troy Jensen

Okay. I have just a follow up on the silicon photonics question, $66 million this quarter. Can you just talk about customer concentration in there and is it still three big guys? Is it – just any color you can give us just generically on silicon photonics would be great.

Seamus Grady

Yeah, so, essentially we have a new entrant about maybe two or three quarters ago and they start ramping. So there is a new customer we acquire. And other than that, it’s still the same customer profile. One of them has been ramping down. If you listen to their earnings call, they've talked about ramping down temporarily and since their volume is coming back. So if you look at from Q2 to Q3 to Q4, most of the customers are about the same as that we added another new customer and they are ramping very nicely.

Troy Jensen

Okay, all right, perfect. And how about last question for me. Can you just talk I guess an update on the partnership with MACOM?

Seamus Grady

So there is nothing really to update on that. MACOM is a customer of ours are not a 10% customer, so we're not going to go into huge amount of detail, but they remain the customer of ours as a number of programs we’re working on with MACOM. There is no real update since we last discussed it.

Troy Jensen

So I think previously there, I believe that the June quarter we could have some threshold of revenue, so do you feel like you’re still on track for that?

Seamus Grady

We're probably not in a position to really talk about that because it's one of our customers businesses for them to talk about, but we're still working the customer and with the end customer on that program and it's progressing at a pace, but we're not really in the position to get that level of guidance down to [indiscernible] program…

Troy Jensen

Okay, I understood Seamus. So you guys keep up the good work. Thanks.

Seamus Grady

Thanks, Troy.

TS Ng

Thank you.

Operator

Thank you. [Operator Instructions] Our next question comes from the line of Tim Savageaux with Northland Markets. Your line is now open.

Tim Savageaux

Hi, good afternoon. A couple of questions.

Seamus Grady

Hi, Tim.

Tim Savageaux

Hey. So to the extent you reported revenue above the high end of guide. I’d say as you look across your portfolio, where was kind of the upside surprise if you will from your perspective things like telecom sites has pretty been pretty strong I don't know if you had an expected strength there or anything else in particular to call out?

TS Ng

I would say if you look at the number in detail, it’s a telecom sector. And more specifically it’s a non-speed telecom gadgets that you know make the quarter. Those things are on laser, modem, amplifier and so on. That those – we don’t classify them by with 100-gig or 400-gig and so on. So those are pretty strong segment and that’s pretty much endorsed also verified by our customer in the earnings call if you listen to the earnings call.

Seamus Grady

The other one I would just add to that is our optical sensing business is up, was pretty strong last quarter has was a commercial laser business. That business is very strong. So it's across a number of sectors.

Tim Savageaux

Understood and very helpful. And then to follow up, silicon photonics was down a bit in the quarter and that's I imagine prior given the ZTE news was disclosed after the end of the quarter. I imagine the impact there maybe it's not entirely in silicon photonics, but it will be incremental in the June quarter in terms of looking at the March quarter decline, how would you characterize the drivers of the silicon photonics decline in March?

Seamus Grady

So the March decline in silicon photonics, we have a mix of customers in the silicon photonics space, but it is pretty concentrated as we mentioned a moment ago with a few customers with one in particular seeing weakness last quarter and they talked about that in their earnings call, but we do see that actually recovering this quarter. So the ZTE effect is factored into our numbers. That’s not to say that something else couldn’t happen, but based on best information that we have right now there’s about a $7 million impact, some of which is actually that silicon photonics business.

Tim Savageaux

Got it. Thank you. I will pass it on.

Seamus Grady

Thanks, Tim.

TS Ng

Thank you, Tim.

Operator

Thank you. And our next question comes from the line of Dave King with B.Riley. Your line is now open.

Dave King

Thank you. Good afternoon. A couple of questions. First, regarding the $7 million impact from ZTE, is that primarily one customer or can you just characterize that?

Seamus Grady

I know it’s across a number of customers, it’s more than one customer, it’s across the number of customers. As you – actually we don’t ship anything directly to ZTE. We actually don’t ship anything directly to China, all of our product chipsets works, but that $7 million is across the number of customers, who – customers of ours who shipped to ZTE.

Dave King

Got it. And then gross margin and SG&A. First one on gross margin, it was kind of flat. How should we think about fourth quarter and beyond? Can we get back to 12% or how should we think about that? And then also on the SG&A, it was down about a little over $2 million. What drove that and is that kind of sustainable or is that going to pop backup to like over $10 million?

TS Ng

So, Dave, normally we don’t guide our gross margin, but if you check our guidance on the EPS and the revenue and work backwards, and given the knowledge of operating expenses are a little bit low in Q3. I would say – you’d like that the good margins are improving in at Q4. We have implied a better gross margin going to June quarter. And again on the CapEx – operating expenses side, $8.5 million is extremely low. We talked about reverses of some of the management bonus accrual. I was expecting get back to about 10 to 10.5 level, the normal run rate level in the June quarter. So hopefully that’s helpful.

Dave King

Yes. And one more on CapEx, so $35 million this year, how should we think about next fiscal year?

TS Ng

Next fiscal year, a lot depend on the revenue, okay. If we are going to ramp for example last year 45% grow, obviously, we need a lot of CapEx, but assuming normal grow I would say we would still be around – approximately around $35 million to $40 million. We don't commission a second building until I feel maybe at the end of 2018 or maybe in early 2019 calendar year, right Seamus.

Seamus Grady

Yeah, I think if we get to the point where Chonburi is, 70%, 80%, exactly 70% plus percent utilized, we’ll commission the second building. Obviously that will then drive a much bigger CapEx in the year in which we do that. It's a problem we hope to have. But as of right now I think that that $35 million to $40 million is probably a good number for next year.

TS Ng

Yeah, the second building [indiscernible] spend in FY2020, we will commission the construction in FY2019, but I think that the payment will be in 2020.

Dave King

Got it. And one more question and this will be my final question. On the silicon photonics, it was down slightly in third quarter. Is it going to be down or up or maybe flat in fourth quarter? What’s baked into your guidance?

TS Ng

I think we have three or four customers there and a lot depends on their demand posture. One of them doing well, the other one sees a temporary setback and in the earnings call they’re talking about coming back. So hard to tell, but I think if both of them are doing well, obviously we’ll see the number going up.

Dave King

Got it. Thank you very much.

TS Ng

Thank you.

Operator

Thank you. And I am showing no further questions at this time. So I would like to return the call to Mr. Seamus Grady for any closing remarks.

Seamus Grady

Okay, thank you, operator, and thanks for everyone for participating in today's call. We’ll forward to speaking with many of you at the upcoming investor events and we'll talk to everyone when we present our fourth quarter fiscal 2018 results in August. Thanks again and have a great afternoon.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day.