Earnings Call Transcript - FN Q1 2022

Operator, Operator

Good afternoon. Welcome to Fabrinet's Results conference call for the first quarter of fiscal year 2022. As a reminder, today's call is being recorded. I would now like to turn the call over to your host, Garo Toomajanian, Investor Relations.

Garo Toomajanian, 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 2022, which ended September 24, 2021. 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-K filed on August 17, 2021. 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 Grady, CEO

Thank you, Garo. Good afternoon, everyone, and thank you for joining us on today's conference call. We had a strong start to fiscal 2022 with top and bottom line results for the first quarter that exceeded our expectations. Demand trends remain robust across our business, which contributed to revenue reaching $543.3 million, more than $13 million above the high end of our guidance. We continue to execute very effectively with revenue upside falling to the bottom line as reflected in our non-GAAP net income of $1.45 per share, which was also above our guidance range. From a revenue perspective, we had a particularly strong quarter for optical communications, which grew 10% from the fourth quarter and 24% from a year ago. As Csaba will detail in a moment, strong optical communications demand was evident in both telecom and datacom. We continued to execute well despite the component supply constraints that we and many others continue to experience. During our last call, we estimated that we would see a $25 million to $30 million revenue headwind in the first quarter from these constraints. We are pleased to report that the actual impact was at the lower end of that range. Our ability to overcome many of these component challenges was most evident in our record optical communications results. Component shortages in the automotive markets' extremely lean supply chain resulted in a moderate decline in automotive revenue from the fourth quarter. As we look to the second quarter, we are optimistic about continued strong demand across our business and are anticipating healthy overall growth despite persisting supply chain headwinds. Operationally, I'm very happy to announce that our COVID-19 vaccination program for employees in Thailand has been a great success and that, at this point, 99% or virtually all of our employees in Thailand are now fully vaccinated. I'm also pleased that we were successful in delivering first quarter margins within our target ranges despite these additional COVID-19 related costs in the quarter. At our Chonburi campus, construction of our second building is progressing well. This building will add approximately 1 million square feet or 50% to our global footprint, substantially increasing our manufacturing capacity. We are on track for construction to be completed around the end of the fiscal year. This schedule is extremely timely since based on continued customer demand, we now anticipate that our first building in Chonburi will be effectively fully occupied when our second Chonburi building opens for business. In summary, after a very strong first quarter, we are optimistic that Q2 will represent another strong quarter for revenue and profitability. Demand trends remain strong, and we are excited that our second building in Chonburi will be coming online just at the right time to enable us to continue meeting anticipated demand and extend our business momentum in the years ahead. Now I'd like to turn the call over to Csaba for additional financial details on our first quarter and our guidance for the second quarter of fiscal 2022.

Csaba Sverha, CFO

Thank you, Seamus, and good afternoon, everyone. We are off to a great start for the fiscal year with record revenue and non-GAAP profitability in the first quarter. Revenue of $543.3 million was well above our guidance and represented an increase of 7% from the fourth quarter and 24% from a year ago. As we continue to execute very efficiently, our top line outperformance fell to the bottom line, with non-GAAP earnings of $1.45 per diluted share, which also exceeded our guidance. This result includes approximately $0.05 per share in foreign exchange gains, offsetting the expenses related to our vaccination program that we incurred in Q1. Looking at the quarter in more detail, optical communications revenue was $427.3 million, up 10% from the fourth quarter and made up 79% of total revenue. Within optical communications, telecom revenue increased 9% from the last quarter to $338.6 million, a new record, and datacom revenue of $88.7 million increased 15% from Q4. By technology, silicon photonics products reached a record $135.1 million or 25% of total revenue and were up 23% from the fourth quarter. Revenue from products rated at speeds of 400 gig or higher was $173.3 million, up 30% from the fourth quarter and 149% from a year ago. Revenue from 100 gig products increased modestly from Q4 to $135.6 million. Based on continued strong demand, we are expecting to see strong sequential growth in optical communications in the second quarter. Non-optical communications revenue was $116 million or 21% of total revenue, representing a 25% increase from a year ago but a decrease of 5% from the fourth quarter. While, as Seamus noted, the overall impact of component shortages was at the lower end of our expectations for the quarter, these constraints were more apparent for non-optical products, especially in automotive. With the majority of our sensor revenues serving automotive applications, we are now reclassifying automotive revenue and other non-optical communications revenue to include historical sensor revenue, which has represented less than 1% of quarterly revenue for the past two years. On this combined basis, automotive revenue was $48.2 million, a decrease of 8% from last quarter. While we don't intend to break this out in the future, for a more direct comparison purposes, automotive revenue, excluding sensors, declined 8% sequentially. Industrial laser revenue was $37.5 million, a decline of 9% from Q4 but stable when viewed on a trailing 12-month basis. Other non-optical communications revenue was $30.3 million, up 7% from the fourth quarter. This category now includes a portion of revenue that was previously classified as sensors. Now turning to the details of our P&L. Unless otherwise noted, profitability metrics are 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 12.1%, down 20 basis points from Q4, consistent with our expectation, considering the expenses related to our vaccination program and annual merit increases. Operating expenses in the quarter were $13.2 million or 2.4% of revenue, resulting in operating income of $52.5 million or 9.7% of revenue. The effective tax rate was 1.2% in the first quarter, and we continue to anticipate that our tax rate in fiscal year 2022 will be approximately 3%. Non-GAAP net income was a record at $54.2 million or $1.45 per diluted share. On a GAAP basis, net income was $1.20 per diluted share. Turning to the balance sheet and cash flow statement. At the end of the first quarter, cash, restricted cash, and investments were $528.6 million, compared to $548.1 million at the end of the fourth quarter. Operating cash flow was $39 million. With CapEx of $34.6 million, free cash flow was $4.4 million in the quarter. We did not repurchase any shares during the first quarter. We remain committed to returning surplus cash to shareholders through a 10b5-1 share repurchase plan, combined with opportunistic open market share buybacks. Currently, we have $81.2 million in our share repurchase authorization. Now I would like to turn to our guidance for the second quarter of fiscal year 2022. After a strong start to the year, we are optimistic that our momentum will continue in the second quarter. We expect strong top line growth despite similar revenue headwinds from component shortages that we experienced in the first quarter. We estimate that the ongoing supply cost changes will again impact our second quarter revenue by approximately $25 million to $30 million. With that backdrop, for the second quarter, we anticipate revenue in the range of $540 million to $560 million. From a profitability perspective, we anticipate non-GAAP net income to be in the range of $1.42 to $1.49 per diluted share. In summary, we are off to a great start to the year, and we are optimistic that strong demand trends and execution will combine again to produce even stronger results in the second quarter.

Operator, Operator

Thank you. Our first question comes from Alex Henderson of Needham. Your line is open.

Alex Henderson, Analyst

Thanks. Can you hear me OK?

Seamus Grady, CEO

Yes, we hear you fine, Alex.

Alex Henderson, Analyst

Perfect. Congratulations. Nice quarter. Outstanding results in a tough environment. There's been a very strong order rate across almost every company that has reported results so far that has any hardware or systems and related characteristics to it. So I assume that you're getting an extension of the visibility well beyond the current quarter and well beyond traditional metrics. Can you talk to whether that's, in fact, the case? And if so, what kind of commentary are you hearing from these companies?

Seamus Grady, CEO

Yes. So we see the demand continuing to be quite strong. I would say, longer visibility than normal. Normally, we have about a 13-week rolling forecast. Obviously, we have much longer visibility, much further out these days with the component supply constraints that we're all experiencing. So we do have visibility further out. We still just guide one quarter at a time, Alex, but the demand signals we're seeing remain quite strong across our business.

Alex Henderson, Analyst

Is your visibility extending multiple quarters into next year at this point? I'm not looking for guidance, just your perspective on visibility. I just came from Arista's call, and they mentioned increasing their orders by a $2 billion commitment, which is four times their previous order rate and they have visibility through 2022. I assume you are noticing similar trends. Is that correct?

Seamus Grady, CEO

Yes. It depends on the customers and the specific commodities within the customer. I mean, in some cases, we have visibility out, I would say, close to a year at this stage. But it's really for the purpose of positioning component supply. We're not using it to forecast revenue or anything like that. But certainly, for the purpose of securing component supply, we have visibility out to three, four quarters, which we normally would not have.

Alex Henderson, Analyst

In the Q2 guide, can you give us any more granularity on the revenue growth expectation for telecom versus datacom? What's going on in that context?

Csaba Sverha, CFO

Alex, this is Csaba. We are anticipating telecom and datacom to continue to be strong. So again, sequentially, we are guiding up at midpoint at about $550 million. So we do anticipate strong telecom and datacom to continue.

Alex Henderson, Analyst

So no granularity between the two or any difference between the rates of growth?

Csaba Sverha, CFO

We are usually not providing guidance and breaking that down from a guidance perspective, but we do anticipate both of them to continue to grow.

Alex Henderson, Analyst

Okay. And then I wanted to talk a little bit about the BOT. I'm looking at a chart of it that is at almost five-year lows. I think the last time it was at this level was back in July of 2017, which is a long time ago. Obviously, it's come off very hard since February, almost in a straight line. So how does that impact your numbers? Obviously, in the current quarter, it's a benefit. But I would think that given your costs are entirely BOT, that should help your competitive position considerably or help your margins. How are you planning on benefiting from that?

Csaba Sverha, CFO

So yes. As I mentioned in the prepared remarks, we had a $0.05 per share gain in the current quarter. That's the sheer fact of the revaluation of the balance sheet items. So as you know, we are continuing with our FX and currency hedging programs. So we usually hedge out three quarters ahead. We are entering the quarter with a 100% hedge position and then next quarter with 50% and 25% ahead. So obviously, if BOT stays at the current levels, we will see benefits in our Q3 and Q4, and definitely a tailwind that makes our position more competitive as most of our cost base is in Thailand and BOT. We do anticipate a tailwind from this assuming the curve stays the same.

Alex Henderson, Analyst

And clearly, Csaba, I'm not asking what your hedging policy is, hedging policy hasn't changed. My question is, if we have the exchange rates stay at this level for an extended period of time, which is yes, nobody wants to forecast currency. So we're assuming it flat at this level. How will you handle that benefit? Will it be something that you use to go after competitive wins? And in this environment where things are sold out, will you use it to allow yourself some more pricing power on buying supplies and therefore drive share gains? Or alternatively, will you feed some of it back into the margins? How should we think about your strategy relative to this level of BOT?

Csaba Sverha, CFO

So first of all, most of our material spending is still in U.S. dollars. So our labor and overhead spending is predominantly in BOT. So there's not much you can leverage there ahead. Obviously, we are not going to increase pay ahead just to offset. So basically, what you should anticipate is some of this will obviously fall to the bottom line as we are realizing gains from these forward contracts in the next couple of quarters. So that's definitely something you should anticipate in the gross margins and it falling to the bottom line.

Alex Henderson, Analyst

Perfect. And one last question. Could you talk about the facility coming online? I think you made some comments that it was coming online at the end of the year. Can you remind us what portion of capacity is coming on?

Seamus Grady, CEO

Yes. The current new building is finished and is ramping up and will be, I would say, fully occupied by the end of the fiscal year, at which point the new building, Building 9 will be coming online, and that's about 1 million square feet, just over a million square feet of space. So timing-wise, we think we've got it right. I think a little bit of good planning and a lot of luck on our part. Building 8 has been filling up maybe a little bit ahead of our expectations, which is great news, and Building 9 will be coming online just at the right time. So about the end of the fiscal year, so middle of the calendar year next year, we should be up and running in Building 9 and effectively at or about full capacity in building 8.

Alex Henderson, Analyst

Okay. One last question, then I'll cede the floor. Can you talk a little bit about systems? I'm not asking about any particular customer. But broadly, are you winning additional new systems customers? What does the pipeline look like? How should we be thinking about systems performance in the current period and current environment? Thanks.

Seamus Grady, CEO

Yes. We've had some success in that area, especially where we already have a lot of the content. Our most effective approach is through bottom-up vertical integration, where the content system develops on its own. A lack of content isn't very appealing to us. However, when we do have the content, it becomes very compelling for both us and our target customers. We are currently in discussions with a few more network system companies, but there's nothing to announce right now. The pipeline remains strong, and the challenge is transforming that pipeline into reality. As we've experienced before, achieving success in the complete network systems space can significantly impact our revenue. We are continuing to work with a few additional companies, but we have no updates to share at this moment.

Alex Henderson, Analyst

Great. Thanks for the great quarter.

Seamus Grady, CEO

Thanks, Alex. Appreciate it.

Operator, Operator

Our next question comes from Samik Chatterjee of JPMorgan. Your line is open.

Unidentified Analyst, Analyst

Great. This is Angela Jen on for Samik Chatterjee. Congratulations on the strong quarter. Great to see.

Seamus Grady, CEO

Thank you.

Unidentified Analyst, Analyst

So I have first question more on the supply chain. So we would really appreciate any details you could provide about where the exact bottleneck might be? I know you mentioned the component costs were rising, but could you drill down a little bit more into that? I would appreciate any color. Thanks.

Seamus Grady, CEO

So the component constraints are pretty pervasive. It's not any one commodity in particular, it's pretty pervasive across the supply base. From our perspective, costs go up as we pass those costs on to our customers. Unfortunately, our customers have to bear the cost of the unfavorable variances. And we are seeing some sizable variances coming through from the supply base. But again, we have to pass those costs on to our customers. But it's not only one commodity, Angela, it's spread across several commodities and it's also across all industries. If anything, I think maybe optical is a little bit less prone to it than automotive. We have a small amount of automotive business, let's call it traditional automotive business. That supply chain tends to run quite lean anyway. So maybe here's a little bit worse on the automotive side with maybe a little bit more bigger room in the optical space. But it's still affecting every customer, every product. And I'm afraid I don't have any great wisdom or any great insight as to when it's going to improve. We see it continuing for the foreseeable future. And it's certainly, from our perspective, we have not seen it improve. It's continuing, there about $25 million, I think we sized it last quarter, about $25 million to $30 million in potential headwinds for the quarter. It came in at the low end of that range. And I think we've baked in about the same headwind, $25 million to $30 million headwind into this quarter. So it's continuing, and it's maybe stabilized a little bit, but it certainly has not improved.

Unidentified Analyst, Analyst

Great. I appreciate the commentary. And then just last question. On the optical communications side, I mean, these are really impressive numbers. Would love to hear more about what exactly might have driven that? And if you see those trends continuing? I mean, I can see like the 400G ramp in silicon photonics must be driving part of it, but any additional detail there would be appreciated. Thank you.

Seamus Grady, CEO

Yes. I think you kind of hit the nail on the head. The 400G silicon photonics and also the 400ZR starting to take off, we certainly feel very good about the optical communications business, and again, both across telecom and datacom. But yes, it's a good time right now with that transition from, let's say, 100 and 200 gig to 400 gig. We're right in the middle of that. And 100 gig remains strong as well. So we have 400 gig ramping, 100 gig remains strong, and then 400ZR is starting to come on as well. So overall, the demand segments we're seeing are quite strong, and we're quite optimistic about that.

Unidentified Analyst, Analyst

Great. Thank you.

Seamus Grady, CEO

Thank you.

Operator, Operator

Our next question comes from Fahad Najam of MKM Partners. Your line is open.

Fahad Najam, Analyst

Thank you for taking my call. I apologize, I missed much of your prepared remarks. A couple of earnings going on today. So if I'm asking you repeat, I apologize. But can you help us understand in terms of the strength you saw in the quarter and the trends you're seeing in intra data center silicon photonics versus telecom and silicon photonics? And then I have a follow-up on 400ZR.

Seamus Grady, CEO

So we classify, let's say, intra data center silicon photonics in our telecom revenue. It's not in our datacom number. Now within our telecom number, we don't really break out, let's say, traditional telecom versus silicon photonics-based intra data center products. So we don't really break that out. What I would say is, overall, the demand trends we're seeing are quite strong across the board in both telecom and datacom. And it is encouraging as we look out, it is encouraging to see those demands. But further granularity or breaking out between, let's say, traditional telecom and silicon-based intra data center products. We don't really break that out.

Fahad Najam, Analyst

Got it. And then on the 400 gig ZR, I'm not sure if it is still material for you to call it out individually. But if it is, I would love to hear what 400-gig ZR revenue is looking like. But if you can't answer that, can you just answer us: are you seeing more than one supplier for 400 gig ZR? Or are there more than one customer now beginning to deploy 400-gig ZR? Is it still predominantly a single vendor story?

Seamus Grady, CEO

No, we have multiple vendors involved. While we aren’t detailing the 400ZR at this moment, we are beginning to observe some promising activity with a few customers, who are at different stages of ramping production. Overall, the numbers are still relatively small and not significant yet. However, the performance projections we’re seeing are encouraging, and we’re hopeful that the 400ZR will continue to grow and become more substantial over time. We have about three or four customers in the 400ZR space, although one of them might be lagging a bit in their development. Still, we have three strong customers showing solid demand, with a fourth one also emerging. So, yes, we have multiple customers in that area.

Fahad Najam, Analyst

Got it. Seamus, can you talk about the revenue opportunity related to the next-generation 1.2 terabit product announced by one of your major customers, which is expected to ship at the end of '22 or early '23? It features a unique CMI 8 pluggable. How significant do you see this as an incremental growth opportunity for your business with this large customer?

Seamus Grady, CEO

I'm not sure which customer or product you're referring to, Fahad.

Fahad Najam, Analyst

Cisco introduced a new pluggable form factor called CMI 8, and I am curious about the potential incremental upside that this new form factor might bring. How should we view the introduction of new form factors in relation to revenue opportunities? Is this expected to provide an incremental benefit, beyond just enhanced speed and capacity?

Seamus Grady, CEO

Yes. Pluggables are a significant part of our business. We are form factor agnostic, meaning we are open to whatever form factor is utilized. Our main focus is on the content and technology within the pluggable and ensuring we are producing as much of that content as possible. While I cannot discuss specific customers until they have made official announcements, any shift toward new form factors that increases demand for pluggables is something we always look forward to. However, I cannot provide further details on the particular example you mentioned.

Fahad Najam, Analyst

Appreciate the answers. Thank you.

Seamus Grady, CEO

No problem. Thank you, Fahad.

Operator, Operator

Thank you. I'm showing no further questions at this time. I'll turn the call back over to Seamus Grady for his closing remarks.

Seamus Grady, CEO

Thank you, operator. We're pleased with our excellent start to the fiscal year with results that exceeded our guidance ranges. We're optimistic that we'll be able to deliver another strong quarter in Q2, and we look forward to speaking with you again. Thank you, and goodbye.

Operator, Operator

Thank you. Ladies and gentlemen, this does conclude today's conference. Thank you all for participating. You may now disconnect. Have a great day.