Fabrinet (FN) Earnings Call Transcript & Summary

Good afternoon. Welcome to Fabrinet's Financial Results Conference Call for the Second Quarter of Fiscal Year 2023. [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, Vice President of Investor Relations. You may begin.

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 year 2023, which ended December 30, 2022. With me on the call today are Seamus Grady, Chief Executive Officer; and Csaba Sverha, 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. During this call, we will present both GAAP and non-GAAP financial measures. Please refer to the Investors section of our website for important information, including our earnings press release and investor presentation, which include our GAAP to non-GAAP reconciliation. In addition, 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 8, 2022. We will begin the call with remarks from Seamus 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. Good afternoon, everyone, and thank you for joining us on our call today. We had a strong second quarter with revenue above our guidance range at $668.7 million. This new quarterly record was an increase of 18% from a year ago and 2% from the first quarter. After adjusting for the 14-week period in Q1, revenue would have grown 5% sequentially. Supply constraints continue to act as a revenue headwind. While we continue to see pockets of relief in some areas, we have also seen increasing supply constraints in other areas. In aggregates, the revenue impact of supply constraints during the second quarter was approximately $20 million, a little smaller than anticipated. That said, we continue to face supply issues with certain commodity components. While these supply constraints could worsen before they get better, we continue to anticipate a better supply environment later this calendar year. Our team executed very well in the second quarter, delivering non-GAAP operating margins of 10.9%, setting a new quarterly performance record. Including the impact of an $0.11 foreign currency loss, non-GAAP EPS of $1.90 was in the upper end of our guidance and would have been well above the range were it not for the foreign exchange impact. Looking at the quarter in more detail, both optical and nonoptical communications saw quarterly and year-over-year revenue increases to new record levels. Within optical communications, telecom demand continues to be strong, but revenue decreased slightly sequentially, primarily due to recent component shortages. On the other hand, in datacom, we reached a new quarterly revenue record and also experienced our fastest sequential growth in 10 years. Turning to nonoptical communications. We had another record quarter for automotive revenue as supply improvements from the first quarter continued driving strong growth in newer automotive programs. This growth in automotive more than offset declines in industrial laser revenue in the quarter. Investing in our long-term growth remains a top priority for Fabrinet. As you know, our recently opened Building 9 provides us with significant capacity to continue to scale our business over the next several years, and we continue to ramp new programs for our customers in this state-of-the-art 1 million square foot facility. Looking ahead to the third quarter, we remain optimistic that the industries we serve can remain relatively resilient despite broader global economic trends and this is reflected in healthy demand trends that we continue to see across our business. As I noted earlier, the supply environment is still challenging. Even though we continue to successfully mitigate the impact of supply shortages, we do expect greater revenue impact from supply headwinds in the third quarter than in Q2, and this is reflected in the guidance that Csaba will detail in a moment. Our business model remains very agile, flexible, and resilient. Over the years, our ability to respond quickly to changing market dynamics has helped us to optimize our business in the face of changes in supply or demand. As such, we're confident that we can continue to operate very effectively in a dynamic global environment to the benefit of all our stakeholders. In summary, we delivered strong second quarter results with revenue above guidance and record operating margins. While the supply environment remains volatile, our demonstrated ability to execute, reinforces our optimism that we remain well positioned to continue producing strong financial results as we look ahead. Now I'd like to turn the call over to Csaba for additional financial details on our second quarter and our guidance for the third quarter of fiscal 2023. Csaba?

Thank you, Seamus, and good afternoon, everyone. We delivered record revenue in the second quarter that was above our guidance. Revenue was $668.7 million, which was up 18% from a year ago and up 2% from the first quarter, which you will recall was a 14-week quarter with an extra $20 million revenue contribution. Adjusting for this extra week, sequential revenue growth would have been 5%. After delivering record operating margin in Q1, we again reached a new high point with non-GAAP operating margin of 10.9% in the second quarter. Our foreign currency hedging program continues to dampen the impact of FX fluctuation on operating margins, but our bottom line results were negatively impacted by foreign exchange revaluation loss of $3.9 million or $0.11 per share in the second quarter. As a result, non-GAAP earnings per share was $1.90 in the upper half of our guidance range. Without this $0.11 foreign exchange loss, non-GAAP EPS would have been well above our guidance. Looking at the revenue in more detail. Optical communications revenue was $506.1 million, up both sequentially and from a year ago to a new record. Within optical, telecom revenue was $392.9 million, which was up 11% from a year ago, but a decline of 3% from the first quarter, primarily due to increased supply constraints for certain commodity semiconductors used in these products. Datacom revenue, on the other hand, was very strong at $113.2 million. This record datacom revenue was up 15% from a year ago and 22% from Q1 due to a combination of continued positive demand trends and better component availability for these products. By technology, silicon photonics revenue was $123.4 million, an 11% sequential decrease due to the same supply constraints that impacted telecom revenue. The impacted telecom products were also primarily newer, faster speed rated products, and as a result, revenue from products rated at 400 gig or more also declined 11% sequentially to $173.6 million. I want to emphasize that we believe demand for this product remains robust and that this decline was primarily supply related. Revenue from 100 gig products, on the other hand, was the highest we have seen in over 2 years at $153.4 million, up 10%, both from a year ago and from Q1. Nonoptical communications revenue was also another record at $162.6 million and represented 24% of total revenue. As in Q1, growth in nonoptical communications was driven primarily by automotive revenue, which was a record $94.8 million, more than doubled from a year ago and up 9% from Q1. In addition to a better supply environment for these products, they also benefited from continued demand trends for newer automotive products. Industrial laser revenue was $30.9 million, down 13% sequentially. Other nonoptical Communications revenue increased from a year ago and from last quarter to $36.8 million. As I discussed the details of our P&L, expense and profitability metrics provided are on a non-GAAP basis, unless otherwise noted. A reconciliation of GAAP to non-GAAP measures is included in our earnings press release and investor presentation, which you can find in the Investor Relations section of our website. Our execution was very strong in the second quarter as reflected in our gross margins, which tied our prior record of 13%. Tailwinds from foreign exchange hedges contributed approximately 20 basis points to this performance. And based on current FX levels, we anticipate that these tailwinds could turn into mild headwinds over the next few quarters. Operating expenses in the quarter were $13.7 million or 2.1% of revenue. This produced record operating income of $73.1 million or 10.9% of revenue. As I indicated in my introduction, a strong Thai baht and weaker U.S. dollar resulted in a foreign exchange loss of $3.9 million, $0.11 per share, primarily due to asset and liability revaluations at the end of the quarter. Thanks to our strong balance sheet, we continue to benefit from a higher interest rate environment, with net interest income of $2 million or approximately $0.05 per diluted share, which partially offset FX losses. Non-GAAP net income was $70 million or $1.90 per diluted share. On a GAAP basis, net income was $1.71 per diluted share. Effective tax rate was 1.7% in the second quarter, and we continue to anticipate an effective tax rate in the low to mid-single digits for the year. Turning to the balance sheet and cash flow statements. At the end of the second quarter, cash, cash equivalents, restricted cash and short-term investments were $527.6 million, up $27.7 million from the end of the first quarter. Operating cash flow was $44.5 million, with CapEx of $13.4 million, free cash flow was $31.1 million. We will continue to execute on our plan to return surplus cash to shareholders, though buyback activity was low during the quarter. Approximately $94.9 million remains in our share repurchase authorization. On an operational note, earlier in the third quarter, we made the decision to exit our business in the U.K. Unlike our new product introduction facilities at Fabrinet West and Fabrinet Israel, our U.K. operation has not become a meaningful or ramp the volume manufacturing in Thailand. Since the U.K. facility also operates at a relatively small scale, serving mostly local customers, we estimate that the impact on non-GAAP financial results will be immaterial. We expect the ramp down to be substantially completed by the end of the fiscal year, during which we will help ensure a smooth transition for our customers. We expect to incur restructuring costs of approximately $3.5 million, which will be excluded from our non-GAAP results. Now I will turn to our guidance for the third quarter. We remain optimistic about the long-term demand trends across our business and our ability to manage supply constraints as effectively as possible. At the same time, our general supply environment has improved, the availability of certain components worsened in Q2, impacting telecom revenue. From what we are currently seeing, we expect these constraints to be even tighter in Q3. Therefore, our guidance assumes a supply chain headwind of $30 million to $35 million, which is about $10 million to $15 million greater than what we saw in Q2. With these incremental supply constraints and typical Q3 seasonality in mind, we anticipate revenue in the range of $640 million to $660 million. We anticipate non-GAAP net income to be in the range of $1.86 to $1.93 per diluted share. In summary, we had a strong second quarter performance with record revenue and margins. While the supply environment is gradually improving, a small number of components continue to constrain our ability to meet customer demand. Nevertheless, we remain confident in our ability to continue to execute value in Q3 and over the long term. Operator, we are now ready to open the call for questions.

[Operator Instructions] Our first question comes from the line of Samik Chatterjee with JPMorgan.

I have a couple. Maybe if we can start with the telecom and the supply constraints you're seeing there. Wondering if you can give us a bit more details about the kind of components you're seeing sort of the more worsening constraints on, because it seems like it's a bit countered to what investor expectations are at this point for a more broader sort of easing of the supply chain. So definitely, we would be curious about sort of where you're seeing these incremental constraints? And is it more about not really buying from those sort of broker market? Or just sort of not -- the part not being available or the supply and not being able to ship to it? And I have a follow-up.

Yes, Samik. Yes, it's an unusual situation. I mean, overall, we're seeing the supply situation begin to improve in certain areas with certain suppliers who have been, let's say, problematic historically for the last several quarters. But we've also seen some new suppliers pop up and because the majority of our business is telecom, it's about 75% telecom, 25% datacom, the shortages that we're seeing are in about the same proportion. The devices, the specific devices or components that we see in short supply, they also support very specific products used in certain telecom transceivers where demand continues to be healthy, but we still have a couple of outlier components. So I know it's a bit of a mixed message. Overall, we see things improving, and we especially see things improving, as we said before, in the second half of this year. But last quarter, we did have some and this quarter, again, we continue to have some component shortages that are specific to telecom.

For my follow-up, maybe you can spend a bit more time on the datacom side. I understand you're still supply constrained there, but we've seen a lot more sort of pullback in the big customers in their CapEx sort of their overall spending plan. So when you think about sort of the current sort of pipeline there, are you seeing any softening of the pipeline outside of the supply constraints that you are still sort of navigating when you sort of look 3 to 6 months out? Are you seeing any softening of the demand pipeline?

So, I mean, as you know, Samik, we guide 1 quarter at a time, so we don't comment really on 6 months out in our guidance. While we -- we haven't seen any particular softening. We're still primarily supply constrained on the datacom side. Obviously, we grew very nicely in the quarter, and our datacom business remains quite strong. So we're primarily a supply constraint on the datacom side. And our business there continues to grow nicely. We had some good strong results for 100-gig products. So 400 gig remains strong, again, somewhat supply constrained. But the demand remains strong for -- across the product categories that we serve in the datacom side of the business.

Our next question comes from the line of Alex Henderson with Needham & Company.

I'm definitely equally puzzled on the supply side because we had expected it to improve, not erode here. There's clearly a semiconductor company or two from the United States that are cited frequently as the source of a lot of the consternation in the supply chain. Is it that typical source that is now improving and we're seeing a shift to a different geography, perhaps the COVID lockdowns or other issues shifting it to a different geography? Is that -- where is the -- where is the nexus of this particular supply chain located?

It's really twofold. Some of it is, again, we've called out a slightly higher supply headwind number in Q3. I think we've called it $30 million, $35 million versus $20 million of about actual in Q2. Some of that is -- it's a combination of really 2 areas. One is supply constraints that are COVID related, I would say, in China. So some of the suppliers who had gone through some lockdowns and whatnot in China, we are seeing a slight, not huge, but a slight headwind due to component-related supply constraints coming out of China this quarter. And then secondly, we have a couple of -- some of the -- and again, I really don't want to get into naming specific suppliers, but some of the component manufacturers who historically, certainly for the last several quarters have been problematic have really improved, and we are actually back to more normal lead times with many of the suppliers who historically were problematic. But unfortunately, 1 or 2 new ones have popped up. And I think they'll go through the same cycle as the other ones. They'll increase capacity, they'll improve output, and they'll get things improved, but we are seeing that supply headwind this quarter. So I understand, Alex, it's a kind of a confusing message. On the one hand, we have -- we have certain commodities where things have improved, things have stabilized and we're back to more normal lead times. But unfortunately, we have, as I say, some of these new component suppliers who have cropped up as problematic, coupled with a certain amount of supply headwind coming out of China because of COVID.

So if I'm looking at the guide for the upcoming quarter, could you give us any granularity on the assumptions between datacom and telecom sequential or year-over-year growth or sequentially any way you want to phrase it?

Do you mean in terms of the component headwinds or...

No, in terms of the aggregate, what are you assuming in terms of the revenue growth by segment?

Yes, go ahead, Csaba.

Alex, we typically don't break this out in our guidance. But as you can see, we are calling out slight downward trends on a quarter-on-quarter basis. So the headwind is primarily supply related as we have discussed. So we will expect telecom to be moderating slightly and also datacom while -- has been very strong in the last quarter, it's going to probably moderate slightly quarter-on-quarter basis. But both segments are -- continue to be strong from a demand perspective. Nevertheless, the incremental headwinds are mostly concentrated around these 2 segments. Overall demand side seems to be strong and robust, but our ability to fill that demand is really constrained around the material. So in both cases, I think we would expect a slight moderation or flat quarter-on-quarter in these 2 segments.

The $30 million to $35 million, is that all in the optical piece? And is it evenly split between the 2 categories?

Yes. It's primarily around optical communication. Our automotive and laser segment have been somewhat stable in the last 2 quarters. There has been significant improvement on the supply side in those segments. The $30 million to $35 million is mostly around optical communication and split around as a proportion of the range, probably 75% is telecom, about 25% is datacom-related.

Our next question comes from the line of Fahad Najam with Loop Capital.