Fabrinet (FN) Q1 2021 Earnings Call Transcript

Good afternoon. Welcome to Fabrinet's Financial Results Conference Call for the First Quarter of Fiscal Year 2021. 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 first quarter of fiscal year 2021, which ended September 25, 2020. 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. 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-K filed on August 18, 2020. 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.

Thank you, Garo, and good afternoon, everyone. We had an excellent first quarter with results that surpassed our expectations and reinforce our longer-term optimism. Revenue in the first quarter was a record $436.6 million and was above the high end of our guidance range, driven primarily by stronger-than-expected performance in telecom and automotive. With a constant focus on efficiency improvements, gross margins increased to 12%, within our target range. In addition, we continue to effectively manage operating costs. As a result, we also outperformed on the bottom line, delivering non-GAAP net income of $1.05 per diluted share. Our business also produced healthy cash flows, even as we continue to make growth investments. Operating cash flow was $34.5 million, and free cash flow was $21.9 million. Looking at some of the details of the quarter, optical communications revenue was $344 million, up 9% from the fourth quarter. Telecom revenue of $261 million grew faster than anticipated at 14% from the fourth quarter. This sequential increase of more than $30 million in telecom revenue far offset the expected decline in datacom revenue, which was down 4% from the fourth quarter at $83 million. As anticipated, inventory issues that we experienced at one telecom customer now appear to be behind us. We also continue to make progress on the transfer of an optical transport system program at Cisco, which is on track to ramp in the quarters ahead. In fact, we ended the quarter on a very high note when we were awarded Cisco's EMS Partner of the Year at their annual Supplier Appreciation Event. Silicon photonics-based optical communications products represented 25% of total revenue in the first quarter, a historic high, driven primarily by telecom growth. Revenue from QSFP28 and QSFP56 transceivers also continued to grow and was a record $59 million, up 8% from the fourth quarter. As reflected in our strong telecom performance, we continue to see robust growth at faster data rates. Revenue from 100-gig programs was stable at $150 million, while revenue from 400-gig and above grew 62% sequentially to $70 million. Looking at our non-optical communications business, our performance was better than expected, with revenue increasing $3 million sequentially to $93 million. Industrial laser revenue declined as expected and was $34 million, a sequential decrease of 16%, reflecting broader demand trends. This was more than offset by automotive revenue, which increased sequentially to $35 million, a record level. A sequential revenue increase of 28% in automotive was driven by the combination of growth from new automotive programs and by an unanticipated return to growth from traditional auto programs. Sensor revenue was stable at $2 million in the first quarter, and other revenue increased $2 million to $21 million. Looking to the second quarter, we expect to see similar business trends to the first quarter. We anticipate that telecom will continue to grow at a healthy pace, driven by newer programs and faster data rates. This should largely offset a decline that we anticipate in datacom revenue based on current demand signals. In non-optical communications, we expect continued softness in industrial lasers, but are optimistic that automotive revenue growth will continue and largely offset those declines. It's also worth mentioning that this near-term softness in the industrial laser market does not affect our optimism that the industrial laser industry will look to increase outsourcing in the years ahead. In fact, intense competitive pressure could even serve as a catalyst, and we remain very well positioned to benefit when this industry transition begins to take place. We continue to pursue a multifaceted growth strategy. This strategy includes leveraging the growth of the industries we serve, combined with investing in facilities and technologies that enable us to further penetrate existing customers and win new customers, both in the markets we currently serve and in new markets. Our first quarter results demonstrate that we are benefiting from the successful execution of this strategy. While we have no control over broader market trends, we remain focused on what we can control, including investments in next-generation manufacturing technologies and in capacity expansion, as well as capitalizing on our early success pursuing system-level business and exploring opportunities in new markets that our advanced processes can serve. As we execute on our strategy, we believe we are very well positioned to deliver superior returns for all our stakeholders. In summary, we're off to a positive start in fiscal 2021. Our strategy is working as strength from newer programs offset the softness we see in certain markets. We are optimistic that we can continue to leverage our strong reputation in the markets to further advance our position as the leading manufacturer of the most complex products. Now I'd like to turn the call over to Csaba for additional financial details and our guidance for the second quarter of fiscal 2021.

Thank you, Seamus, and good afternoon, everyone. I will provide you with more details on our financial results for the first quarter and our guidance for the second quarter of fiscal year 2021. We were very pleased to deliver financial results that exceeded our guidance ranges for the first quarter. Revenue of $436.6 million was more than $6 million above the high end of our guidance range and a new record. Non-GAAP net income was also a record at $39.3 million or $1.05 per share, $0.05 more than the high end of our guidance range, largely due to our revenue upside and gross margin improvement. On a GAAP basis, net income was $33.1 million or $0.88 per diluted share. Now turning to the details of our P&L. Unless otherwise noted, profitability metrics I refer to will be on a non-GAAP basis. 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. Gross margin was 12%, up from 11.8% in the prior quarter. This improvement was primarily a result of the strong focus on manufacturing efficiencies and continued cost reduction efforts. Operating expense during the quarter was $12.5 million, or 2.9% of revenue. This produced operating income of $39.9 million or 9.1% of revenue. Taxes in the first quarter were $1.7 million, and our normalized effective tax rate was 4.5%. Turning to the balance sheet and cash flow statement. At the end of the first quarter, cash, restricted cash, and investments topped $0.5 billion for the first time at $503.8 million, an increase of $8.3 million from last quarter. Operating cash flow was an inflow of $34.5 million. And with CapEx of $12.6 million, free cash flow was $21.9 million in the first quarter. We did not repurchase shares during the first quarter due to the smaller open window after our year-end blackout period. At the end of the quarter, we had $100 million remaining in our share repurchase program. We expect to implement a 10b5-1 plan in the second quarter that will enable us to repurchase shares even during blackout periods. This program will complement opportunistic open market purchases that remain subject to blackout periods. Our primary capital allocation priorities continue to be risk mitigation, investment in long-term growth, and returning value to shareholders through share repurchases. With our strong balance sheet, we expect to be active in all these areas in fiscal 2021. I would now like to turn to our guidance for the second quarter of fiscal year 2021. We believe the trends we experienced in the first quarter will continue in the second quarter. In optical communications, we expect strong telecom revenue, driven by healthy demand from higher data rate products, combined with our newer program ramps. This should more than offset export restriction-driven headwinds at any end customers of our customers. We expect datacom softness to continue with revenue down sequentially based on current Q2 forecast. Still, we believe that telecom strength will offset this weakness for total optical communications revenue that is roughly flat with Q1. In non-optical communications, we believe the near-term weakness from the industrial laser market will continue in Q2. On the other hand, we anticipate growing demand from new technologies like LIDAR, as well as traditional automotive programs continuing to improve. This automotive trend should offset most, but not all of the softness from the laser industry. Therefore, we anticipate total non-optical communication revenue to be slightly down sequentially. We expect total revenue in the second quarter to be between $420 million to $440 million. From a profitability perspective, we are optimistic that we can drive efficiencies and anticipate that net income will be roughly flat with our record first quarter results. We expect EPS to be in the range of $1 to $1.07 per diluted share. In summary, we are pleased with our execution in the first quarter and our financial results that exceeded our guidance ranges. We are proud of the success of various growth initiatives and our financial performance, and we look forward to continuing to deliver profitable growth as we execute on our strategy. Operator, we are now ready to open the call for questions.

Our first question comes from the line of John Marchetti with Stifel.

Seamus, I was wondering if you could talk a little bit about some of the trends in datacom. Obviously, seeing very good telecom strength here. But just wanted to get your take on maybe where we are in sort of this downtrend on the datacom side? And maybe looking out maybe a little bit longer term, to see what your expectations are for that portion of the business turning around a little bit?

Yes John, unlike maybe some of the prior slowdowns that we saw where a lot of the slowdown previously was driven by pricing, that pricing seems to have stabilized. So that's the good news. The current softness appears to be demand-driven, primarily demand-driven. We do remain optimistic as demand for data bandwidth and capacity will continue to grow. So over the longer term, we remain optimistic. But the downturn we're seeing right now is, let's say, more volume-driven than price-driven. At the same time, our broad portfolio of customer programs in multiple end markets means that the growth in other areas can offset much of the datacom softness we see. So we don't see it as a very significant issue, but it is more volume-driven, I would say, than price-driven.

Okay. Moving on to the guidance for the telecom sector, I’m curious about the various factors we’ve heard from some of your customers and the broader industry. Can you provide any insights into the new program demand you're experiencing now compared to a couple of quarters ago, alongside the underlying demand? We're trying to understand how the telecom business is likely to perform as we look ahead to next calendar year.

We are quite pleased with the progress we are making in the telecom sector and the growth we are experiencing there. In the past, we had a metric for new business that we referred to as revenue from new business, which included new customers since early 2014. However, since many of these programs are now entering their sixth year, we have decided not to emphasize that metric anymore. We are evaluating other measures that may be more relevant. The new business we are observing continues to increase in both dollar amount and as a percentage of total revenue, which includes new business from new customers and new programs from existing customers. Most of our growth, in fact, comes from new business with existing customers. Our pipeline remains strong and robust. As mentioned in previous discussions, we are pursuing both new customers and new programs from existing customers, while also looking to expand vertically into the systems space with customers for whom we currently provide component-level services. We have seen some success in this area, and overall, we feel optimistic about our pipeline and the new business wins we are achieving.

Got it. And then maybe lastly, Csaba, I may have missed it, but did you give any of the 10% customer commentary in the quarter? I was hopping between a couple of calls, so I apologize if I missed that.

John, this is Csaba. Well, we are only providing 10% customers at the end of the year. So we haven't provided that, and we continue to stick to our process and provide that at our year-end.

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

I was hoping we could talk a little bit about the systems companies coming in, if you could give us some sense of where you are on bringing up Cisco, what the time line might be? When do you think that gets to kind of run rate revenues, and to what extent you think you're now at run rate relative to Infinera and where you are on any additional systems companies?

So thanks, Alex. So first of all, yes, we did announce the Cisco. When we announced the Cisco win, let's say, we said that we expected Cisco to be a 10% customer in FY '21. We think we're still on track for that. We remain quite optimistic about that and about the pace of the ramp. We think we should be ramped primarily, I would say, largely ramped at the end of the calendar year, we should be largely at the run rate by the end of the calendar year. Again, the, let's say, the 10% nature of the customer, we will talk at that at the end of the year, but we're quite happy that we feel we're on pace there and should be largely ramped towards the end of the year. Infinera, we did the Berlin transfer with Infinera, that's now behind us. And of course, in prior quarters, Infinera had talked about an inventory correction, which now seems to be in the past, and we're back to the normal run rate. So I would say we're at the run rate right now with Infinera. And then there's other system-level companies we're certainly targeting, but it's too early to talk about at this stage. We're very much targeting, not a huge number of customers, we don't need a huge number of customers. We just need a small number of significant wins like we have been able to accomplish so far with both Infinera and Cisco. So we're very firmly targeting 1 or 2 more of those.

So looking at the Cisco situation, is it fair to say a little bit in the fourth quarter, but not a material number and then ramping gradually in the first quarter and then hitting your kind of run rate as you exit the fourth quarter of fiscal year, but not a full quarter's worth? So the first full quarter would be then the third quarter. Is that the right process?

Yes. I think that would be fair, yes.

It's a bit surprising because the datacom segment has shown strong performance based on recent numbers, and while you don't link directly to any specific data, we've observed good results from other areas at the same time you are reporting. Additionally, there has been positive feedback regarding datacom. Do you think this could be due to a shift in market share among your customers or perhaps related to the delays in the rollout of 5G? What are your thoughts on the reasons behind this weakness?

We think it's probably more program transition-related than share shift. We certainly haven't lost any customers or any programs. Sometimes, there might be some share shift going on, let's say, between our customers to, like you say, programs that we're not necessarily producing, but it's more likely to be program shifts within our customers where they're transitioning from one program to another and maybe ramping down an order program and haven't fully ramped up a newer program. So we...

If I recall it correctly, you had said that, that was going to be the case in the third quarter calendar, but that you thought it would rebound in the fourth quarter. Now you're saying that you expect it to continue to be weak. Is that because of a delay in that ramp and therefore, we should anticipate a nonseasonal benefit as it ramps in the normally seasonally weak March quarter?

Yes, hopefully. We remain optimistic about that. However, the transition we discussed earlier is still ongoing. It seems to be taking a bit longer than we expected and than our customers would prefer, but we are still positive about the long-term outlook.

So any sense of what's driving that transition this differential? Then I'll see the floor.

Alex, this is Csaba. So what we have seen in the last, I would say, 2 quarters that you mentioned, we also had a transition of one of our particular customer. We thought it was going to be done largely this quarter that transition shift. We started to see the higher data rates of transceivers picking up actually. So that could be one of the drivers. While 100G still remains very strong, you started to see QSFP56 is coming up and double the transceivers starting to come in the pipeline. So this might be a knock-on effect of bringing up the new products and then somewhat tapering off the 100G and at the same time, bringing up the higher data rate products. So that's the common denominator we are seeing across many customers rather than any particular share or shift.

Our next question comes from Dave Kang with B. Riley.

This is Danny on for Dave. Going off the question about Cisco and Infinera, I was wondering if you could provide any additional color around the demand and around any ramp from Infinera in addition to Cisco?

I'm sorry, but we can't share any insights on demand from specific customers. We prefer not to speak on behalf of our customers during these calls, so I can't provide that information.

Okay. Got it. That's fair. And well, I guess, an additional question would be, are there any verticals that you're particularly excited about? You mentioned the autos and telecom earlier. What's giving you the confidence in these 2 sectors? And how should we think about that going forward?

Yes, I believe there are several areas of interest. Firstly, traditional automotive has surprisingly rebounded strongly this quarter. More exciting for us is the new automotive sector, particularly LIDAR, where we've achieved solid wins and see significant growth potential. Additionally, the industrial laser business, despite facing challenges in the sector, remains under-penetrated regarding outsourcing, which gives us a positive long-term outlook. Another area is our system business, where we are focused on vertically integrating and enhancing our value to customers. We are selective in this pursuit to ensure we are targeting high-quality revenue from high-quality customers, and we have been fortunate in that respect. Finally, we are optimistic about the broader precision sensors market, which includes our traditional sectors as well as medical and other markets. We believe we have a strong mix of segments that align well for effective service to our customers while providing good diversification. Overall, we remain optimistic about our long-term growth prospects, as demonstrated by our robust growth in recent quarters despite various challenges like COVID and Huawei.

And we have a follow-up question from the line of Alex Henderson with Needham.

I wanted to discuss the industrial laser business. One of your key customers reported this morning and noted a sharp decline in the recent period, but indicated that their numbers are stable sequentially, suggesting they believe the business has hit its lowest point. I understand you have been gaining some market share as well. I'm trying to figure out how to assess the industrial laser business, which usually sees stronger performance in the first half of the next year. Is there something beyond the obvious customer that is experiencing some challenges, which could lead to a cautious outlook for the upcoming quarter?

No. I think it's more about the industry in general. Currently, we don't produce all the products needed for every customer. Therefore, we're really dependent on the market demand for the products we do produce. Our strategy focuses on increasing our outsourcing penetration. We believe that companies that haven't outsourced much will need to do so increasingly. That's where we plan to take advantage. In the short term, we're affected by market conditions, but in the long term, we feel quite optimistic about the industrial laser segment for us. It's a good fit overall. With the customers we currently have in that area, we've performed very well, and we believe we can continue to grow our outsourcing and strengthen our relationships with these companies as they increase their outsourcing.

We have another follow-up question from the line of John Marchetti with Stifel.

Seamus, I know you don't have any direct exposure to Huawei. But with some of the key customers, certainly indicating that, that revenue stream is continuing to weaken as we look out over the next several quarters. How do you think about that market for you or that share that, that represents? Particularly, as we look out into next calendar year, how quickly maybe can some of that get reallocated? Particularly, with your production lines, does it require a tremendous amount of rework to go from Huawei, say, to a different systems-level vendor? And just trying to think of maybe how we think about that as a headwind as we're looking more into calendar '21?

Thank you, John. To address your question, the impact from the last quarter, specifically the recently ended quarter, was minimal. The sanctions were implemented quite late in the quarter, so we were able to fulfill most requirements by September 14. Thus, the impact on Q1 was very minor. For our Q2 guidance, we are anticipating a headwind of approximately $25 million to $30 million due to customers affected by the Huawei sanctions. This expectation is included in our Q2 guidance, meaning that without the sanctions, we would be projecting $25 million to $30 million higher than our current outlook. The impact is substantial, but we have managed to navigate that challenge and still provide an upward guidance. Regarding the speed at which our customers can adjust and how quickly we can modify our production lines, while the changeover is important, it is relatively straightforward. The main factor is that non-Huawei customers need to complete their product qualifications, which can take some time. We do not foresee significant delays on our end, and in fact, some of our customers are proactively increasing their capacity to produce these products. They remain optimistic about their offerings, as they have some excellent products available. We anticipate a transition over the next few quarters as our customers move away from Huawei, and we are prepared to offer any necessary support to ensure their success. However, the primary focus is on the end customer qualifying the products, which is what may take more time. Does that clarify things, John?

Absolutely.

Operator, if you're still on the line.

And I'm sure we have another follow-up question from the line of Alex Henderson with Needham.

So two questions, both on kind of progress front. One is what's going on with your Israel prototyping facility? And second one is, could you give us an update on where you are on the production expansion and plans?

Sure. In Israel, we are currently experiencing a lot of exciting activity. With the facility operational, we've seen a strong level of interest from our customers, both existing ones based in Israel and new clients who are engaging with Fabrinet for the first time. While the revenue from these wins isn't substantial yet, they are crucial for establishing new business and customer relationships. It’s important to note that the primary objective of the new product introduction facility isn't solely focused on revenue generation; rather, it aims to secure new programs and build relationships through quick turnaround times, prototyping, and services at the late-design stage, which act as catalysts for growth. In this context, our ultimate goal remains to drive high-volume manufacturing to Thailand. We are pleased with our progress and the activities happening there, along with the interest we are generating and the business we have secured.

Just before we get off of that, those new customers to Fabrinet altogether?

Some are, yes. Some are new customers to Fabrinet, and they're in the, I would say, in the communication space, but also in other non-communications areas, such as new automotive, medical, defense and aerospace and other segments that are, I would say, new and exciting for Fabrinet. So yes, plenty of opportunity there. It really is a very, very busy hotbed of technology and activity.

Perfect. And on the capacity expansion progress in Thailand?

Yes, we are very happy and excited to have a solution for increasing capacity at our main campus in Pinehurst due to customer demand for expansion. We began the expansion in the fourth quarter, and it will take several quarters to complete. Unlike building a new structure, this process involves a significant amount of rearrangement on an already busy campus before reaching full effectiveness. The project is underway, and simultaneously, we are attracting new customers to the Chonburi campus, where we are seeing significantly increased production volumes and evaluating our next steps for expansion.

And I'm showing no further questions. I will now turn the call back over to CEO, Seamus Grady, for any further remarks.

Thank you, operator. Thank you all for joining our call today. We're pleased to have exceeded our guidance and reported record revenue and net income in the first quarter. Our strategy is working, and we look forward to sharing more success with you as we look ahead, as well as meeting with some of you virtually at the Needham conference in November and the MKM conference in December. Thank you, and goodbye.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating, and you may now disconnect.