Fabrinet (FN) Earnings Call Transcript & Summary

Good day, ladies and gentlemen. Welcome to Fabrinet's financial results conference call for the second quarter of fiscal year 2020. [Operator Instructions] 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.

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 and fiscal year 2020, which ended December 27, 2019. With me on the call today are Seamus Grady, Chief Executive Officer; TS-Seng, Chief Financial Officer; and Csaba Sverha, Vice President of Operations, Finance and CFO designate. 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 include 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 November 5, 2019. We will begin the call with remarks from Seamus, TS and Csaba, followed by time for questions. I would now like to turn the call over to Fabrinet's CEO, Seamus Grady. Seamus?

Thank you, Garo, and good afternoon, everyone. We had a very strong second quarter with financial results that exceeded all of our guidance metrics, including record quarterly revenue. This performance was driven by sequential growth in nearly all areas of our business. With end-market demand stabilizing, we expect to see continued year-over-year growth in the third quarter. Revenue in the second quarter was $426 million, up 7% from the first quarter and 6% from a year ago. Revenue upside largely fell to the bottom line, with non-GAAP net income of $1 per share, which was also above the top end of our guidance range. Gross margin was 11.9%, and we continue to anticipate non-GAAP gross margins to be within our target range of 12% to 12.5% for the full year. Looking at our business by end markets. Optical communications revenue was $322 million, up 6% from the first quarter. This represented 76% of total revenue, consistent with the first quarter. Within optical communications, telecom revenue was $248 million, up 8% from the first quarter and 20% from a year ago and represented 77% of optical revenue. Our Berlin transfer program with Infinera again contributed to our telecom growth, and the program was fully ramped at the end of the quarter as anticipated. Datacom revenue in the second quarter was $74 million, a slight increase from Q1, which was better than we had anticipated as demand trends for these products continue to stabilize. Datacom represented 23% of optical communications revenue. By technology, silicon photonics-based optical communications revenue increased by 7% from the first quarter to $82 million and represented 26% of optical communications revenue. Revenue from QSFP28 and QSFP56 transceivers was $48 million, up $3 million from the first quarter. By data rate, 100-gig programs represented 49% of optical communications' revenue at $159 million. And products rated at speeds of 400 gig and above continue to see rapid growth, up 31% from the first quarter to $49 million. Looking at our nonoptical communications business, revenue of $104 million was up from $97 million in the first quarter, which was also better than expected. We were pleased to see the demand for industrial lasers improve and as a result, revenue for these products was also better than expected at $46 million compared to $41 million in the first quarter. We remain optimistic that over the longer term, industrial laser manufacturers will increasingly leverage outsourcing to remain globally competitive, and we believe we are uniquely positioned to be a leader in serving this market as the opportunity evolves. Automotive revenue moderated to $21 million, reflecting normal quarter-to-quarter variability from next-generation automotive programs, and which we expect to return to growth in the third quarter. Sensor revenue increased slightly to $3.9 million from $3.5 million. Finally, revenue generated from other nonoptical applications grew 20% sequentially to $33 million, mainly from Fabrinet West. During the quarter, we saw additional programs that had ramped production at Fabrinet West transfer to Bangkok, where we anticipate their volumes will continue to grow. This is another illustration of the success of our new product introduction model, which we will continue to leverage in Santa Clara, and we are gearing up to extend to Israel in the coming months. At the same time, success of our program with Infinera demonstrates our ability to build complete network systems while offering economic advantages to our customers. We believe there could be additional opportunities for us to vertically integrate from the component level up to the system level that can provide additional business to Fabrinet while simplifying the supply chain for our customers, and we have been actively pursuing these opportunities. And today, I'm pleased to announce that after the close of the second quarter, we were awarded a significant new project by Cisco, which will further build on our successful partnership. While it is still early days, we believe that if this program ramps as anticipated, that Cisco could represent 10% of revenue or more for Fabrinet in fiscal 2021. We look forward to sharing more on this program as it progresses. Finally, we also announced today that after more than a year of evaluating internal and external candidates, we are pleased to welcome Csaba Sverha as our new Chief Financial Officer, effective February 17, with TS stepping down from the role nearly 18 months after initially announcing his intention to retire. We are extremely grateful to TS for his contributions over the years to Fabrinet and for his commitment to ensuring a smooth transition. TS will be reporting to me as EVP Special Projects during this transition period. His dedication and positive attitude are a model for us all, and we wish him the best in his well-deserved retirement. Csaba has been Vice President of Operations Finance at Fabrinet for almost 2 years now, and I have had the pleasure of working directly with Csaba in the past. He displays all the characteristics that have had a meaningful hand in Fabrinet's past success, including integrity, collaboration and commitment to success. I am confident that Csaba will play a leading role in helping Fabrinet get to our next level of performance. Before I turn the call over to TS and Csaba, I would like to address the coronavirus outbreak that I'm sure you're all concerned about. While our third quarter results often reflect a small seasonal downtick, guidance that we are providing for the third quarter also includes the anticipated impact from extended shutdowns in China due to the coronavirus outbreak. Specifically, the Lunar New Year week-long shutdown at our Casix facility in Fuzhou, China, which manufactures custom optics components, has been extended from 1 week to 2 weeks ending February 10. In addition, some of our third-party suppliers in China are also impacted by shutdowns. This has a direct impact on our top and bottom line expectations and is considered in the guidance we are providing for the third quarter. News related to the coronavirus is rapidly evolving, and our top priority is to keep our employees safe, and we'll continue to monitor the situation. In summary, we are pleased with our stronger-than-expected performance in the second quarter, and we are excited about our new business activity. While we anticipate that coronavirus outbreak will result in a larger-than-normal sequential revenue decline in the third quarter, I believe we remain well positioned to extend our business success and market leadership as we look ahead. Now let me turn the call over to TS and Csaba to discuss the details of our second quarter performance and our outlook. TS?

Thank you for the kind words, Seamus, and good afternoon, everyone. I would like to congratulate Csaba on his appointment and I am committed to making sure his transition to the CFO position is smooth. Now turning to our results. I will provide you more details on our financial results for the second quarter and then will introduce Csaba to provide our guidance for the third quarter of fiscal year 2020. Total revenue in the second quarter of fiscal year 2020 was $426.2 million, above the upper end of our guidance range and a quarterly record. Non-GAAP net income was $1 per share and was also above our guidance range, even after a foreign exchange headwind of $1 million or approximately $0.03 per share. Now turning to the details of our P&L. A reconciliation of 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 second quarter was 11.9%. We continue to expect gross margin to be within our target range for the year. Non-GAAP operating expense was $12.3 million in the second quarter. As a result, non-GAAP operating income was $38.5 million and non-GAAP operating margin was 9%. Taxes in the quarter were $2 million and our normalized effective tax rate was less than 5%. We continue to expect our effective tax rate to be 5% to 6% for the full year. Non-GAAP net income was above our guidance range at $37.7 million in the second quarter or $1 per diluted share, as I indicated earlier, on a GAAP basis, which includes share-based compensation expenses and amortizations of debt issuing costs. Net income for second quarter was $31.2 million or $0.83 per diluted share, also above the high end of our guidance. Turning to the balance sheet and cash flow statement. At the end of second quarter, cash, restricted cash and investments were $450.5 million compared to $436.4 million at the end of the first quarter. Operating cash flow in the quarter was $50 million, and with CapEx of $9.1 million, free cash flow was $40.9 million in the second quarter. During the quarter, our working capital returned to neutral level as we began consuming the transfer inventory and collecting receivables. We did not repurchase any shares during the quarter. $62.2 million remain in our share repurchase program. We will continue to evaluate market conditions to opportunistically purchase shares when possible. Before I turn the call to Csaba to provide our third quarter guidance, I would like to take this opportunity to thank all our investors on the buy side and our sell side analysts for your support and all the work you have done over the years. I appreciate your professionalism and have enjoyed working with all of you. I wish you all nothing but the best. I will now invite Csaba to give our FQ3 guidance.

Thank you, TS, and good afternoon to those of you listening to our call. I'm looking forward to stepping up as the next CFO at Fabrinet. TS has been a great mentor, and my aim is to maintain the transparent and open level of dialogue with investors that TS has had. I'm looking forward to a smooth transition, including getting to know those of you attending OFC in March or other investor events in the coming months. I would now like to turn to our guidance for the third quarter of fiscal year 2020. After the record quarterly revenue performance in Q2, we expect to maintain our year-over-year growth in the third quarter. We anticipate that third quarter revenue will moderate more than the usual seasonal impact as a result of the coronavirus outbreak in China. For the third quarter, we anticipate revenue to be between $410 million and $418 million. From an EPS perspective, we anticipate non-GAAP net income per share in the third quarter to be in the range of $0.92 to $0.95 and GAAP net income per share of $0.75 to $0.78, based on approximately 37.9 million fully diluted shares outstanding. In conclusion, we are pleased with our strong performance in the quarter. We are excited about our business momentum. And despite a small near-term impact of coronavirus outbreak, we remain optimistic that we can continue to build shareholder value over the longer term. Operator, we are now ready to open the call for questions.

[Operator Instructions] First question comes from Alex Henderson of Needham.

Well, before I get into a question, TS, thank you very much for all the work you've put in with us, and we really appreciate your professionalism and superb job you did running the company's finance operations.

Thank you, Alex.

And welcome to your replacement.

Thank you, Alex.

So the first question I wanted to ask was obviously you hedge forward a quarter. I mean the other side of the corona event was the falloff of tourism in Thailand and the very sharp correction in the baht that has occurred. Obviously, you were expecting some pressure from the strong baht before. Now that it's corrected, are you changing any of your steps in terms of your hedging policies, where you typically hedge 1 quarter fully 2 quarters half I think is the way you do it and then lesser in the back half. Will you lock in these lower rates? Or how do you think you'll handle it?

Yes, Alex, let me try to answer that. Okay. We did not change our policy of hedging, for example, like exactly what you say, 100% for the current quarter, then 50% for the out quarter and then 25% for the out quarter. The only thing we are looking at is to document it as a cash flow hedge. That's what we did for the interest rate swap contract. And so this quarter, all the interest rate are mark-to-market -- interest rate swap mark-to-market is all going to the OCI, the other comprehensive income, net equity, and then you will roll out over time. So we're going to do the same thing for our cash flow hedge. Depends on PWC approval, we might get it done this quarter or maybe next quarter. But for sure, next quarter, we get it done. So in that case, then all the gain and loss, exactly what you advised before, were going to the equity.

So just to be clear, though, I was really talking about the longer-term implications of the exchange rate strength pressuring gross margins and now that pressure has been removed by the correction. Do you plan to lock that in at all, so that you can -- in case the corona issue goes away and we end up with a rebound in the baht?

Yes, the baht has not totally rebound yet. We see a short-term weakening, okay? Right now, the forecast is 30.5%. We've been mark-to-market at 30.2% last quarter. So again, in the long run, we believe that baht will continue to under pressure to be strengthened. So we take proper steps to just make sure that we properly hedge them. And obviously, the best hedge will be natural hedge. If I can sell in Thai baht, that will be perfect. But then the industry won't allow me to do that. So yes, we watch it very closely. Again, if Thai baht continues to strengthen, really nothing much you can do. At some point in time, you've got to bite the bullet, so -- and taking into the OCI will release the immediate pressure a little bit, but in the long run, if baht continues to strengthen, then you had to face the fact that it's increased cost for -- and pressure on the gross margin.

So if I could ask one more question. The comment you made about Cisco, I'm assuming that you're not including the acquisition of Acacia in those numbers. Otherwise, I think you would have been over 10% either way. So I assume this is just Cisco prior to that acquisition going to 10%? And could you quantify that? Is that a doubling of your business with Cisco? Or is it 20% improvement in your business with Cisco? What is this project that you're talking about in terms of scale compared to what you're currently doing? Is it a significant increase, a modest increase? Some characterization.

Thanks, Alex. And I would -- I think first of all, you're correct. The numbers we talked about are Cisco alone. It doesn't include the -- let's say, the Acacia business, which, of course, would be significant on its own. So looking at Cisco, I mean this is a significant -- I would characterize it as a significant new business award for us. It's a very large piece of business. And it's very important for us because it's right in -- I suppose, in our wheelhouse, in our sweet spot, we've talked maybe at some of the investor meetings and the road shows about the importance for us of penetrating some of the system companies from the component level up. We produce a lot of components that go into these products. So to us, it seem to make sense in order to simplify the supply chain for our customers, while at the same time, growing the business ourselves. It seems to make sense for us to go after this type of business. And we've been fortunate with this one. It's a vertical -- what I would call a vertical up deal. So it's from the component level up, like I say, it simplifies and streamlines the supply chain for the customers. Yes, the 10% metric is for Cisco as a whole, which we hope -- we expect when they -- when the deal with Acacia goes through, will be a combination of Cisco and Acacia. But certainly, the business on its own is a significant piece of business.

So is it similar in size to the increase you got off of the systems business from Infinera? Or is it smaller than that? I mean can you give us some -- is it bigger than a red box kind of comment? Can you help us frame it?

I would say it's in a similar kind of range. We don't want to put a number on it right now, but it's a significant piece of business. I mean we win business all the time. We generally don't call out specific programs. So the fact that we're calling it out means it's a significant piece of business. So it will be of a -- I suppose, of a similar scale. And certainly...

Okay. One last question, and I'll see the floor. Can you break out your expectation for datacom and telecom in the upcoming guidance?

In the upcoming guidance?

I think the telecom is down for a couple of reasons. The virus, coronavirus, doesn't help us. But again, we see strength on the datacom. I mean this quarter, past quarter actually too, we expected to be down, but we're kind of flat and up a little bit, and we see the momentum will continue. So I think most of the datacom guys are outside China. Lucky, okay? So most of the China's are mostly telecom. So we expect telecom to be down.

Our next question comes from Troy Jensen of Piper Sandler.

Congrats on the nice results and TS, good luck, we definitely all enjoyed working with you over the years, and I wish you the best.

Thank you so much.

Thank you, Troy.

Could you guys dive in, I mean you hit on the coronavirus. I guess I'm just curious if you could kind of quantify how much of an impact that is? Just being curious, your thoughts too just on the whole China supply chain and how resilient is it right now? And what are your expectations for the virus going forward, so to speak?

So the coronavirus outbreak itself -- the first week of the coronavirus outbreak coincided with the Lunar New Year, which meant that many of the facilities, many of our own facility in China in Casix in Fuzhou was already shut down as were many of our component suppliers. And the impact, it's not a huge impact. If I had to put a number on it, I would say it's in the $8 million to $10 million range for the quarter. And it's largely driven by the fact that government-mandated shutdowns for an additional week. For example, our own operations in the Casix operation in Fuzhou, we had plans to be back on February 3, and that got pushed out by -- because of the government-mandate it's shutdown to February 10. So we lose a week's production and some of our -- several of our suppliers are in the same situation. Like I say, we estimate the impact of this extended shutdown to be about $8 million to $10 million for the quarter. So in effect, our guidance would have been roughly flat sequentially, which would have been in line with or maybe a little bit better than a seasonal Q3 for us, let's say, fiscal Q3, calendar Q1, which would be seasonally down for us. So without this coronavirus impact, we would have been kind of flat to slightly up, I would say. So about -- to answer your direct question, about an $8 million to $10 million impact.

And just thoughts on just like -- just the recent couple of days or a week or so have you gotten more concerned about -- have there been more conversations and just your thoughts on how resilient the supply chain is right now for you guys. How much good visibility do you have on supply?

We think it's pretty resilient, and we think it's -- of course, none of us know when we could find ourselves here a quarter from now, saying we were too conservative and overestimated the impact or we could find ourselves saying we weren't conservative enough and we underestimated the impact. It's really very difficult to say. I think it's -- our working assumption is that all the -- our own operation as well as the suppliers who are affected that they all get back to work a week from today and February 10. If something happens this week, if that changes, then the impact could be greater. Similarly, so I think it's -- we're not -- I mean obviously, our primary concern is for the health and welfare of our employees, and we're taking great precautions to make sure everyone is well both in our operation in Casix, but also in our large campus in Thailand, as you can imagine, we have a lot of visitors who come through. It's a 10,000 person campus. We have a lot of people who come through there. So we're taking great precautions to make sure everyone is safe and well. So that's our first concern. But nevertheless, we think the supply chain is actually quite resilient and if businesses get back to -- back into operation a week from today, we should be okay. But we're going to keep a very, very close eye on it for sure as everyone.

Perfect. Yes. Understood. And just one last question and I'll see the floor. Just your comments on industrial laser strength, curious to know is that existing programs getting better? Or is that some of these new design wins that you guys have been turning in?

It's a combination of both, actually. We continue to penetrate that market and win business there with a number of companies but I would say the strength in the quarter was mostly with existing customers, existing [ business ].

Our next question comes from Samik Chatterjee of JPMorgan.

So you -- I appreciate your comments about telecom and the supply side there. Just wanted to understand how you're thinking about the demand side as well? Because even before the coronavirus impact, I think we saw a couple of industry players kind of signed the warning signs on 5G network deployment in the different geographies, including China. So just wanted to understand beyond kind of the supply constraints, how you're thinking about demand? If there is a slowdown, how long would it take in the supply chain to kind of show up in your demand level or orders? And so any insights on that would be helpful.

Yes. So the demand -- sorry, the telecom demand that TS talked about was more focused on the demand side than the supply side. So we are seeing some softness. But for us, it's nothing, I would say, greater than the normal seasonal softness that we would see in this quarter. We do -- and again, we don't claim to represent the industry or have any great insights, but certainly, from what we see, we don't see any huge change other than what we would normally see as a seasonal slowdown, a little bit of a slowdown this quarter. The other thing is, as many of our customers have not announced yet, we don't to be -- seem to be speaking for them. So -- but I would say -- like I said, I don't -- we don't believe there's anything other than the normal seasonal slowdown. TS, what do you think?

I think well said. Yes. We cannot see beyond 1 or 2 quarters. But for the coming quarter, essentially we -- exactly what Seamus said.

Okay. Got it. And if I can just follow-up on the 400 gig, the growth that you had, which is pretty strong, 31% growth, as you're kind of looking through the end of the year, right now, the growth is off a small base. How you are thinking about -- do you think that kind of growth rate is sustainable on the 400-gig products -- 400 gig and above products?

Yes. So 4 -- we group together 400 gig and above. I mean at some point, we may get a bit more granular with that. But right now, we see that continuing to be quite strong. We don't guide beyond 1 quarter, but we do see demand for that 400 gig and above continuing to certainly outpace the growth of the rest of the business. It's growing quite strongly for us.

[Operator Instructions] Our next question comes from the line of John Marchetti of Stifel.