Fabrinet (FN) Earnings Call Transcript & Summary

Hi, I'm Samik Chatterjee. I cover some of the IT hardware and networking equipment names at JPMorgan. The next session we are hosting is Fabrinet, and we have the privilege of hosting Seamus Grady, who's the CEO of Fabrinet; and Csaba, CFO of Fabrinet as well. The way we will conduct the session is I'll go through kind of a Q&A format initially, but audience members do have the option of sending in questions as well. So you can use the Q&A feature on Zoom to send in questions and I can ask them on your behalf.

Seamus, Csaba, thank you for joining the conference. Let me just start with kind of what we are asking most companies: to kind of outline just given the COVID-19 supply chain impact that we are seeing, particularly coming out of calendar 1Q as one of the concerns. So maybe just outline for us how has the disruption impacted the way you operate? And how are you thinking about long-term implications on manufacturing productivity?

Thank you, Samik. So obviously, the COVID impact, we first became aware of it in February, at the end of February, from our Casix operation in China. And by the time we got to Chinese New Year, if you like, we had implemented all of the precautions in our Bangkok operation that we were implementing in China. So we were, I suppose, on the case very, very quickly and implemented very strict precautions, including all of the usual precautions that everybody talks about. Now we had those in place early on in the process. We're back up to 100% everywhere. We just announced our, let's say, calendar Q1, which is our fiscal Q3, and we came in within our guidance range on both revenue and EPS. Right now, business is 100% operational everywhere. We're fully ramped up and back up to speed everywhere. We have quite a compact footprint. So some companies, maybe some of our competitors have a very big global footprint and were maybe badly impacted. We've been very fortunate to keep our employees safe and have all of our operations up and running right now. So the day-to-day impact are more to do with the precautions we're taking and the controls and the protocols we have in place. As regards to the impact on the business, it's mostly around the supply chain concerns. We haven't seen, thankfully, we have not seen any large-scale demand destruction or anything like that. We think the demand remains quite robust. So the concerns we've seen are mostly around supply chain. In our fiscal Q3, calendar Q1, the March quarter, we had sized it at the start of the quarter that we felt COVID would impact us to the tune of about $8 million to $10 million in terms of the top line impact. The actual impact came in a little bit higher, about between $12 million and $15 million so a little bit higher. And then this quarter, we sized the impact at between $25 million and $35 million so a bigger range, if you like. And then I would say, if you had to split that between how much of it is supply, how much of it is demand, it's probably mostly, I would say, supply and just kind of caution that we're taking around supply constraints that we've seen again in fiscal Q3 were mostly in China. But of course, in our fiscal Q4, this calendar Q2, they could be anywhere and especially if we get an outbreak somewhere that would require a lockdown in a particular geography.

Got it. So sounds like you're seeing kind of on your own operations, you really don't have much constraints going into fiscal 4Q, but on the supply chain side, you do have some concerns. Kind of can you just dive a bit more into what are the primary drivers there? Which countries are really the bottlenecks? And any more -- any further updates from the time you kind of made some comments about that on the earnings call as to if things are improving? Or are things kind of going in the other direction? That will be helpful.

I think we see things as being, I suppose, stable. The concerns we have are more to do with country lockdowns, if there are additional lockdowns that come into effect. Again, the last few months have been impacts in Malaysia and the Philippines. But it's mostly to do with concerns if there are lockdowns or if suppliers are unable to operate at 100% capacity. And then to a lesser extent, there are some concerns around logistics constraints, commercial flights. Obviously, a lot of the parts we buy, especially if they're high-value, very small form factor components, they would typically fly in on commercial flights or could fly in on commercial flights. And with a lot of commercial flights just not running, it just makes the logistics channels a little bit more of a challenge. So again, Q3 was isolated to China and the Hubei province mostly and Q4 is really across many countries. But no particular one commodity, if you like, or one country. It's just, I suppose, an abundance of caution we're taking this quarter to make sure we don't get surprised.

Let's kind of move to focusing on the demand side then. You did see kind of an inventory correction at one of your customers. But aside from that, I mean, telecom demand seems to have remained relatively robust here. How sustainable do you think that demand is? What are you hearing from your customers in terms of how long is the investment cycle that they are seeing from their end customers in terms of 5G infrastructure equipment? And how long do you think this kind of investment cycle lasts?

So we don't have great visibility into our customers' investment cycle, but I would say the, let's say, the mood music we hear from our customers is quite positive. They do seem to be quite bullish in the main. As you mentioned, we had one customer with an inventory correction and it's on a newer program. We don't see it as indicative of any broader trend. And indeed, we don't see it as indicative of any broader trend with that particular customer, either. We think it is literally just an inventory correction on a newer program. We're involved in a lot of newer programs with our customers. So newer programs can be a little bit more, I would say, volatile than very stable existing products. But the flip side of that is we do get to participate early on when these products are launched, and it can be very, very good for our long-term prospects. So that's really the situation we see with the telecom demand, in particular. It does seem to be quite robust and broad-based, and we don't see the investment cycles as going down anytime soon. We certainly haven't heard anything along those lines.

Got it. Just kind of on the same note, hitting on datacom here and one of the big themes that investors kind of keep asking about is the 400G adoption in data center infrastructure. How are you thinking about the opportunity set there? How is Fabrinet positioned to execute on that? And again, like what do you think in terms of when does this opportunity peak in terms of revenue opportunity for Fabrinet?

So 100G remains strong within the data center but we are seeing quite strong growth in demand for 400G and above in DCI, which we actually categorize that. We report that in our telecom sector, so if it's within the 4 walls of the data center, we count it as datacom. So again, we see 100G quite strong there. And then data center interconnect, we would count 400G in that and we see it as being very strong. We are also seeing strong and growing demand with one of our customers in QSFP56 200G transceivers. So 400G is strong, but again, the way we categorize it, we would count 400G as a telecom product. But I think 100G will persevere for a long time. It's not going anywhere anytime soon.

Telecom, datacom demand strong in both these end markets. You do address a lot of other end markets, although they are kind of a smaller part of your revenues. Any end markets where you're seeing incremental weakness or you're seeing kind of a level of demand that might take longer to recover? Anything on that front?

Yes. So as you say, telecom, datacom remain quite strong, and they represent 75% of our revenue between them. Outside of that, the other 2 main areas we service, automotive represents about 8% of our revenue. Obviously, automotive is quite soft right now. Nobody is buying cars. So let's say, traditional automotive, at least, is we see that being quite flat to down for the foreseeable future, really until the economy recovers. But within that subset of automotive products, we also have some what we call newer automotive type applications, such as laser lighting and other, if you like, LIDAR type applications, which we see as being quite robust and maybe not suffering the same downturn. Because some of those applications, we categorize them in automotive, but several of the applications for LIDAR are actually outside of the automotive world. And then the other one that's quite big for us is laser, the laser world. We service several of the large laser manufacturers. And certainly, we take lasers -- industry lasers could continue to be impacted by some of the longer-term economic downturn. If it's a prolonged economic downturn, we think the laser industry could be flat for a while.

Okay. Given what you're seeing on the demand front, I know you've generally historically managed the business over a very tight range of kind of gross margins. But as the visibility into some of these end markets seems to be a bit lower, there seems to be just that additional variability where lead times are in terms of changing orders, et cetera, the notice times seem to be shorter. What kind of variability does that bring in -- relative to your gross margins? Or kind of what kind of challenges does that present?

So we typically have 13 weeks visibility with our customers and we don't have much visibility beyond that. Sometimes we do but it's more from the point of view of being able to position long lead time components than anything else. So -- but typically, you can -- we have about 13 weeks visibility. But even within that 13 weeks, if the customer decides within that 13-week period that they need to make a change, well, we have to be very flexible and agile and responsive. In other words, just because it's in the 13-week forecast, we can't make the customer take it if they don't need it. So we work with the customers. We're very -- we pride ourselves in being very flexible and agile. And I would say that last quarter and certainly this quarter, there's a huge amount of what we call churn. In other words, one particular SKU or part number or series of part numbers, maybe the demand for that drops off to 0, and it's replaced by demand inside lead time for some other SKU that we might end up shipping the same revenue to that customer. But the mix of what we're shipping ends up being vastly different than we thought it would be at the start of the quarter. And that churn drives a lot of, I would say, a lot of cost and a lot of inefficiency. Some of those costs and inefficiencies, we can pass on to the customer, but some we just can't. Some are just inefficiencies that we have to live with. So it does put a little bit of pressure in terms of our gross margins. We have guided our gross margins down a little bit this quarter. We were typically in the 12% to 12.5% range. This quarter, we've guided to 11.5% to 12%. And that 0.5 point or 50 basis points, that's primarily due to, let's say, the impact of COVID and the inefficiency and that churn that I talked about goes with that. But I want to be clear as well, we're not setting a new expectation that we'll be down at the 11.5% to 12%. The expectation is and the target we have internally is, as quickly as possible and as soon as this situation we all find ourselves in, as soon as that's behind us, that we very quickly get our margins back up above 12% again.

If I can just follow up, I mean, you mentioned there's the variability in kind of the mix that you're supplying to customers. And that seems to have increased from -- your comment, seems to have increased over the last quarter or the last couple of quarters. What do you think is the driver there? I mean what's driving customers to kind of move around in terms of mix a lot more over the last couple of quarters?

I think it's the old adage, forecast accuracy. We'd all love to have perfect forecast accuracy, but a lot of the time the customers' customers, they might think they know what they want, and therefore, our customers will give us a forecast. But in the end, customers change their mind and we have to be flexible and responsive to that. And I just think it's end customers are looking to maybe -- if they believe they need a product A and they end up needing product B, well we have to -- our customers have to be responsive and we have to be responsive to that. So I don't think there's anything that unusual behind it other than companies are trying to make sure they get the equipment that they really need. Forecast accuracy, it varies greatly by customer. It's kind of the bane of the industry, I would say. Anyone will tell you that it's very hard to get perfect forecast accuracy. We would love it if our customers have perfect forecast accuracy but it's just not to be.

Got it. Maybe we can take a bit more of a broader kind of view here. And you've been -- kind of we cover some of these optical system companies as well and you are the contract manufacturer of choice for a lot of them. How would you kind of quantify what the market share position of Fabrinet has as the kind of contract manufacturer in the optical component or system space? And then we've seen over the last kind of 12 months or so, some of these outsourcing wins really accelerate from kind of the system companies we cover. So just wanted to get your thoughts about what do you think is the driver here because we've seen a sudden acceleration in these outsourcing wins.

Yes. So yes, we're the -- we believe we're the leader in outsourced optical -- in the outsourced optical communications business, both components and systems. Of that entire business, we think that roughly 50% of the manufacturing activity is done in-house by the OEMs and about 50% is outsourced. And of the 50% that's outsourced, we believe we have about 50% market share. So we're the leader in outsourced optical contract manufacturing. We value that position greatly. We work very hard to make sure we maintain that and hopefully grow our market share. We have been, I would say, moving up the value curve with our customers. We have a reputation for being very good at manufacturing the most complex, most difficult components. And for us, it's a relatively straightforward step, we believe, to move up to start to integrate the products at a higher level for our customers. And it really, it brings -- you mentioned 2 examples, Infinera and Cisco, that would become significant. Infinera is a really quite significant customer. Cisco is also a customer of ours already. But really the differentiation for us and how we can really add value for those companies and companies like them is we make it a win-win for both of us. Obviously, for us, we get to expand our relationship with these excellent customers. And for the customers, we help them really with their margin stack-up elimination. A lot of the components that go into these systems are manufactured by Fabrinet. And if one of our competitors has to purchase those components from Fabrinet, well, they have to add on a markup and a margin. Whereas if we're using components that we've manufactured ourselves, we can eliminate that margin stack-up because we don't need 2 margins for the same component. So we can really show value to the customer. And really, we've proved ourselves as a very capable supply partner for those type of companies. So we are really targeting to expand our business in that domain.

Got it. Infinera, Cisco, 2 new award wins that you mentioned recently over the last kind of 2, 3 quarters. How should we size the opportunities individually in terms of the new wins with Infinera and Cisco? And more so kind of on the Cisco opportunity, I believe the award win or the total contract value that was taken from Celestica, one of your competitors, was much larger than kind of what you hinted as the opportunity in your recent discussions. So just wanted to see if there's an incremental kind of road -- revenue road map there.

Yes. So we certainly haven't stated publicly what the revenue will be, and we can't really do that because it's really our customers' business that we'd be talking about. The Infinera relationship is, I would say, is already a very strong relationship and an expanding and growing relationship. We were already servicing most parts of Infinera's business. So for us, it was a logical step to become the, if you like, the primary contract manufacturer supporting the Coriant acquisition that they did. That's really what we did there. We helped Infinera to shut down the operation in Berlin, the old Coriant operation, and we moved everything to Bangkok. The Cisco business is early days. Again, we haven't particularly sized it. I think maybe others have inferred what the size of the business will be. And certainly, historically, Cisco has been, I believe, a very large customer for one of our competitors who talked about it on their last earnings call. Celestica mentioned it on their last earnings call, and they indicated that they plan to exit that business by the end of the calendar year, which would be, I would say, quite in line with our thinking. But ultimately, the pace and the speed at which we transfer that business will be set by the customer -- by the end customer, Cisco. Most of that business will be transferring within Thailand so obviously, our operation in Thailand, but also we believe Celestica's operation in Thailand. So it should be straightforward. But the size of that opportunity, we're not really sizing that right now because it wouldn't be appropriate to disclose that.

Okay. You talked about the system opportunity, and I think you mentioned kind of the one of the differentiations being kind of being able to eliminate the margin stack for some of your customers. How should we think about kind of the time line of how quickly this can progress? Because there's definitely value for the customer, but there's a kind of a large-scale change in how they were maybe originally planning to assemble the product or the supply chain that they had planned for the product. So how quickly do these kind of -- how quickly do you see the ramp in that opportunity happening relative to kind of more component-related outsourcing wins?

Yes, it's a really good question. And I think the way we think about it is these opportunities, they don't come along every day. They're very significant in terms of their ability to kind of move the needle versus, let's say, regular growth we get through normal, which we want to. We work very hard to win new customers and to grow them organically. But if you win a new customer and you grow it organically, it takes several years for the customer to become, if you like, meaningful in terms of revenue. Whereas these type of projects like the Berlin, the Infinera Coriant Berlin opportunity, it's one big project that we took and, over a very short period of time, moved it. Similarly, this opportunity with Cisco, it's a big project. Those type of projects don't come along every year, every 6 months or anything like that. I think -- and there's only so many of those type of projects we can handle because they take a huge amount of resources and a huge amount of infrastructure and capacity and everything else. So we have to make sure we can handle it. But I think we would certainly like to add 1 or 2 more. There's a few other, I would say, large opportunities we would like to target. And typically, there needs to be some form of a catalyst for us to, let's say, dislodge a competitor. Unless you go in with a very low price, which we're not -- that's not the way we operate. We don't try and buy the business and we're not interested in buying the business. But if there's some kind of a catalyst like in the case of, let's say, the Infinera business. Infinera had to close the operation in Berlin so that was the catalyst for that. And similarly with the Cisco-Celestica relationship, the separation there was a catalyst. So usually, it's some form of a catalyst, we can do a very, very good job. But to go in and try and, let's say, just convince the customer to move the business. Customers, generally, it's difficult for a customer to move the business once they have it entrenched or an existing supply chain. It's not a simple thing to move the business.

Got it. So if you kind of add all of that together, when you look kind of longer term, and maybe this is more kind of looking back than looking forward, with outsourcing-led wins, how do you think about kind of Fabrinet outperforming the underlying industry? If you think about kind of growth that Fabrinet has demonstrated relative to underlying growth in the optical industry, what do you think that differential could be, just given the share wins through these outsourcing wins?

Yes. We certainly think we should be able to outgrow the industries we serve, and certainly, we should be able to outgrow the EMS industry. Obviously, we only guide 1 quarter at a time and we don't give full year guidance or anything like that because, of course, with only 13-week visibility from our customers, it wouldn't really be credible for us to give full year guidance or anything like that. So we guide 1 quarter at a time. But having said that, the internal goal we set for ourselves is that we want to grow at 2x the industries we serve. That's the target we set for ourselves. We just think that's a good benchmark for us because we're a specialist contract manufacturer, we think we should win more business than the competition because we specialize and because we can really work hard to show our customers the value we can bring. So 2x the industry growth is what we target.

Got it. Let me hit on a couple of industry themes. In the meantime, also, let me remind investors that if you have any questions, you can pop them into the Q&A feature. And so just couple of more industry themes that we kind of get asked about a lot. There has been industry consolidation at your customers, at your customer level, Lumentum acquiring Oclaro, II-VI acquiring Finisar. Now Cisco is looking to acquire Acacia. So when you look at these changes, some of them have been beneficial to you like the Infinera acquisition of Coriant. But as you look at kind of your customers consolidating longer term, how do you think about the implications of that?

Yes. So we've been doing business with, I would say, all of the players involved in the recent consolidations in the industry. And so far, we've not seen any major changes in their outsourcing strategy. From time to time, a company might acquire another company or merge with another company, and they might take a piece of the business and sell it to somebody else. And so in that case, we can pick up a new customer sometimes. But so far, we haven't seen any major negative impact. In fact, if anything, we think the consolidation has been probably positive. Because with fewer players in the optical space, it means that there's a little bit better price stability. Lumentum and II-VI, as you mentioned, they both have internal manufacturing capacity as well. And we're really focused on how we can help them, how we can support them. We don't have a vote in every sourcing decision they make. Sometimes, they decide to build a particular product in-house. Sometimes, they decide to outsource it. But we really just try to do the best we can to service their needs and to be flexible and agile and cost competitive and all of those things. And so far, as I said, the industry consolidation certainly hasn't hurt us. And if anything, I think it's probably helped us a little bit.

Yes. The other industry theme or kind of the topic we get asked about a lot is kind of the U.S. government restrictions or their plans or their kind of intention to tighten the restrictions on Huawei. And you do not directly ship to Huawei but a lot of your customers do. How do you think about the overall impacts, given that Huawei is one of the largest networking equipment companies, and any stoppage there would have, obviously, a ripple effect through the supply chain? How long does it take you, typically, to fast -- change your production lines over and dedicate that capacity to a new customer or a new product of a similar variant? Like just help us think about kind of the implications there, both near term and longer term.

Yes. So a lot of the, let's say, the components that we manufacture that may end up in a system that's going to Huawei, if there were to be a shutdown of a product going to Huawei, well, somebody would still need to make those components. And in all likelihood, they would still come to Fabrinet to have us make those components. So I suppose we're not in any way complacent, we keep in touch with what's going on, keep in tune with what's going on. But we feel, I would say, quite positive about our ability to win business even if something does happen, that capacity has to be retooled. We can -- we're very agile. We're very quick. We can retool very, very quickly if one of our customers was to get knocked out or kicked out of being able to ship to Huawei, what some other company would come along to produce -- to supply, let's say, the systems that Huawei was going to supply. So we feel -- I suppose we feel quite good about that. We also think that because we're in Thailand, Thailand is like the, if you like, the Switzerland of the manufacturing world, quite -- it's neutral. It's an acceptable place to manufacture. We can ship products into the U.S. We can ship products to China. But ultimately, the shipping of the products into, let's say, into China, that responsibility rests with our customers ultimately. We manufacture, we ship FOB, Thailand or, if you like, Ex works. So the actual importer or the exporter of record is actually our customer, not Fabrinet. So I suppose on several fronts, we feel we think we're pretty well covered in that regard.

Okay. On the -- on cash flow and kind of the implications of the demand environment that we're seeing or kind of you're definitely having to run in the short run, maybe some of your facilities below 100% utilization maybe not as a consequence of demand, but more as a consequence of the supply chain constraints that you have. So what kind of impact, given you're -- kind of you are more about manufacturing company, what kind of headwinds does that lead to on the cash flow aspects? And how are you thinking about cash flow for the remainder of the year?

So it's not so much that the churn and the supply chain restrictions, if you like, restrict our ability to operate at 100%. We're actually at 100% utilization, I would say, everywhere. It's more to do with the linearity. So we like to be -- like any manufacturer will tell you, the best way you can make sure you minimize your costs, maximize your margins and generate cash is to produce in as linear a fashion as possible. So ideally, if you're producing 13 million, you want to produce 1 million each week in the quarter and produce in a linear fashion. In the current environment, it's not always possible to do that. We do end up being more back-end loaded than we would like, which has an impact on collections. But that's kind of a 1-quarter impact. We do plan to continue to be generating a fair amount of positive free cash flow. We plan to continue to be generating cash as we go through the cycle, so no change in that front.

You had roughly $500 million of cash on the balance sheet. It doesn't sound like you foresee any major issues with cash flow in the current environment. How are you thinking about kind of relative to using the balance sheet, either be it driving some industry consolidation at the contract manufacturing level yourself or returning the cash to shareholders in the form of buybacks?

Yes. So we had -- last quarter, we started the quarter with $62 million remaining in our share repurchase authorization, and we repurchased about $21 million, a little bit over $21 million worth of shares in the quarter. So we have about $41 million remaining in our share repurchase authorization. We review our capital allocation strategy regularly with the Board. And really, right now, we've been comfortable with our capital allocation strategy. We always look at, okay, what should we do in terms of maybe an accelerated share repurchase or other forms of share repurchase. So we will continue to review that. As regards M&A activity, we do think the current climate, there will be companies who are maybe not in a strong -- we're quite fortunate. We're financially very, very strong. We have a very strong balance sheet. And God forbid, if anything were to happen that the whole industry got shut down, we could ride this out for a very, very long time. So we're in a very fortunate position. But that will cause problems for a lot of other companies, and it will present opportunities for consolidation and also maybe for acquisition of smaller companies who have maybe some unique offerings and capabilities in technologies that we want to acquire. So we'll be doing our homework and doing a lot of research. Historically, we have not been very acquisitive purely because we haven't been able to find a lot of value out there. Some of the companies that are for sale, their expectations of the price that they want to get is not something that we feel represents good value. So we're -- we like to spend our money carefully. But certainly, the areas we would look at as we continue to generate cash, are how can we continue to return the surplus -- some of the surplus cash to the shareholders and also are there acquisition opportunities we should be looking at. And then investing, historically, the best use of our cash has been to grow the company organically. We're able to generate margins of about 12%, call it, 12% to 12.5% historically, which is way higher than the rest of the EMS industry. Our OpEx is less than 3% so we're typically able to generate operating margins of 8.5% to 9%, which is very, very high for EMS world. And then our ROIC is typically 28%, 30%. So the best use of our cash is typically to invest so that we can grow the business organically.

Got it. Maybe just a couple of questions before we wrap it up. You outlined kind of how you think about revenue growth longer term, which is 2x the industry growth. Your margins typically have been around that 12% gross margin level, operating expenses around 3%. So when you put all that together, how do you think about earnings growth or kind of more -- maybe more in a pointed way, how do you really think about margin improvement from here on. Particularly if you have to drive share wins, you have to onboard a lot of new business, which typically has been done historically at kind of lower than corporate level margins and has driven some level of moderation on the margin. So when you take all that into account, how are you really thinking about kind of the drivers of earnings growth beyond just the top line growth?

Yes. I think the majority of it will come from top line growth. Margin expansion, there probably are some opportunities, but it is in that -- we think the, if you like, a sensible range for us is in that 12% to 12.5% range. But then as we grow the company, the operating expenses, the OpEx and SG&A, we would envisage holding relatively flat. We're not planning to add any great cost in our OpEx line. So we would see our operating margin expanding, albeit on gross margins that are still in that 12% to 12.5% range. So that's what we're really targeting to do, is grow the company, grow the revenue, maintain and slightly improve the gross margins, make sure we keep our OpEx under tight control so that we can expand our operating profit and ultimately, our EPS.

Good. Last question. I mean what COVID really kind of data show to a lot of companies, the risk around having a concentrated supply chain in China. Now you've generally been well protected, in some case, in that sense because you have your manufacturing in Thailand. When you look longer term, is there then a kind of thought process of also having a more diversified footprint in your manufacturing just to lower the risk related to having concentrated exposure to one country?

Yes. I mean, we're constantly looking at, okay -- obviously, we're very, very happy with Thailand. We think it's a fantastic location to do business. It's very business-friendly. The workforce is very stable, the costs are predictable and the availability of labor has been just excellent. So we think it's a really good place to do business. But we are always looking to understand, okay, in maybe 5 years from now or 10 years from now, in the future, where should we be and where should we be investing? But for now, we're quite happy to continue to expand in Thailand but with an eye on what other locations are out there for us for sure.

Great. To keep everyone on schedule, I would like to wrap it up there, but thank you both for attending the conference. Thank you for all those very much.

Thank you, Samik. Thank you very much, and thank you, everyone, for listening and watching. Stay safe. Thank you. Bye-bye.

Thank you.