Fabrinet (NYSE:FN) Q2 2023 Earnings Conference Call February 6, 2023 5:00 PM ET
Company Participants
Garo Toomajanian – Vice President of Investor Relations
Seamus Grady – Chief Executive Officer
Csaba Sverha – Chief Financial Officer
Conference Call Participants
Samik Chatterjee – J.P. Morgan
Alex Henderson – Needham & Company
Fahad Najam – Loop Capital
Tim Savageaux – Northland Capital Markets
Operator
Good afternoon. Welcome to Fabrinet’s Financial Results Conference Call for the Second Quarter of Fiscal Year 2023. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions on how to participate will be provided at that time. 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.
Garo Toomajanian
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?
Seamus Grady
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 increase in 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 or it not for the foreign exchange impact.
Looking at the quarter in more detail, both optical and non-optical 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 charges. 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 non-optical 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 for supply headwinds in the third quarter than in Q2. And this is reflective 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?
Csaba Sverha
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 to 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 [evolutional] (ph) 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 most 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 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 constraint that impacted telecom revenue. The impacted telecom products are 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 two years at $153.4 million, up 10% both from a year ago and from Q1.
Non-optical communications revenue was also another record at $162.6 million and represented 24% of total revenue. As in Q1, growth in non-optical communication was driven primarily by automotive revenue, which was a record $94.8 million more than double from a year ago and up 9% from Q1.
In addition to a better supply environment for these products, we also benefit as from continued demand strength for newer automotive products. Industrial laser revenue was $30.9 million, down 13% sequentially. Other non-optical communications revenue increased from a year ago and from last quarter to $36.8 million.
As I discuss 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 [Indiscernible] 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 tieback and weaker U.S. dollar resulted in a foreign exchange loss of $3.9 million or $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 a 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 meaning program to 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 cost 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 this 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.
Question-and-Answer Session
Operator
Thank you. [Operator Instructions] Our first question comes from the line of Samik Chatterjee with J.P. Morgan. Your line is open.
Samik Chatterjee
Hi, everyone, thanks for taking the question. 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 which kind of components, you’re seeing sort of the more worsening constraints on because it seems like it’s a bit counter to what investor expectations are at this point for a more broad or 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 supplier not being able to ship to it? And I have a follow-up. Thank you.
Seamus Grady
Yes. Hi, 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 of 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 are components that we see in short supply. There’s a 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 in this quarter. Again, we continue to have some component charges that are specific to telecom.
Samik Chatterjee
Okay. For my follow-up, maybe if you can spend a bit time on the datacom side, I understand you’re self-supply constraint there, but we’ve seen a lot more sort of pullback in the big customers and 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 on the pipeline outside of the supply constraints that you still sort of navigating when you sort of look three to six months out? Are you seeing any softening of the demand pipeline?
Seamus Grady
So, I mean, there’s some quick guide one quarter at a time, so we don’t comment really on six month out in our guidance. But 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.
Samik Chatterjee
Okay. Thank you. Thanks a lot.
Seamus Grady
Thank you, Samik.
Operator
Thank you. Please standby for our next question. Our next question comes from the line of Alex Henderson with Needham & Company. Your line is open.
Alex Henderson
Great, thanks. 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’s the nexus of this particular supply chain located?
Seamus Grady
It’s really two-fold. Some of it is, again, we called out a slightly higher supply headwind number in Q3. I think we’ve called that $30 million, $35 million versus $20 million of about actual in Q2. Some of that is — it’s a combination of really two 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 read, I 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 aren’t actually back to more normal lead times with many of the suppliers, who historically were problematic. But unfortunately, one or two new ones have popped up. And I think they’ll go through the same cycle as the other ones, they’ll increase capacity, then improve output, and then get things improved, but we are seeing that supply headwind this quarter. So I understand Alex, it’s kind of a confusing message.
On the one hand, 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 components, suppliers who have popped up as problematic, coupled with a certain amount of supply headwind coming out of China, because of COVID.
Q – Alex Henderson
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?
Seamus Grady
Do you mean in terms of the component headwinds or?
Alex Henderson
No, in terms of the aggregate, what are you assuming in terms of the revenue growth by segment?
Seamus Grady
Yes. Go ahead, Csaba.
Csaba Sverha
Hi, Alex. We typically don’t break this out in our guidance, but as you can see, we are calling out slight downward trends on quarter-on-quarter basis. So there has been this primarily supply related as we have discussed. So we will expect telecom to be moderating slightly and also datacom while have been very strong in the last quarter. It’s going to probably moderate a slightly quarter-on-quarter basis. But both segments are continuing to be strong from demand perspective. Nevertheless, the incremental headwinds are mostly concentrated around these two segments.
Overall demand side seems to be strong and robust, but our ability to feel 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 this two segments.
Alex Henderson
The $30 million to $35 million is that all in the optical piece? And is it evenly split between the two categories?
Seamus Grady
Yes, it’s primarily around optical communication. Our automotive and laser segment have been somewhat stable in the last two quarters. There has been significant improvement on the supply side in those segments. The 30% to 35% is mostly around optical communication and split around proportion of the range, probably 75% is telecom, about 25% in the datacom-related.
Alex Henderson
Great. Thank you so much. I’ll see the floor.
Seamus Grady
Thanks, Alex.
Csaba Sverha
Thanks, Alex.
Operator
Thank you. Please stand by for our next question. Our next question comes from the line of Fahad Najam with Loop Capital. Your line is open.
Fahad Najam
Hey, thanks for taking my question. So for the needling or specifics on the headwind component. If I look at your sub-100 gig revenue, it’s growing pretty nicely in the quarter even 100 gig. So is the 75% of the $30 million headwind mostly of 400 gig and above speed?
Csaba Sverha
That is correct, Fahad. In the last quarter, it was mostly in the higher data rates. [Technical Difficulty]
Fahad Najam
I don’t know if it was my end, but I couldn’t make out what you said, Csaba. Can you please repeat again?
Csaba Sverha
I’m sorry, so yes, the impact was in last quarter and this quarter mostly in our 400 gig and above product segments in the higher data rate segments. So both in Q2 and Q3, the expected headwinds are mostly going to be in that area, in that space. Again, these are very specific components impacting a couple of handful of products in that range.
Fahad Najam
All right. My next question was, I know in the past you’ve said that 400 gig ZR was at the high-single-digit percent of your revenue. One, does this component headwind impact 400 ZR modules versus line card or systems? And second is, can you also update us on the 400 ZR revenue [Indiscernible]
Seamus Grady
So Fahad, yes, 400 ZR, we’re quite happy with the progress we’ve made there. We think we’re a leader in our industry in supporting 400 ZR. So we’re very happy with, let’s say, our penetration rate in 400 ZR and our ability to grow our business with our customers in 400 ZR. Yes, the shortages we talked about, as Csaba said, they break out approximately. So first of all, let’s say the automotive and the laser business, I don’t want to say the shortages are behind us, because it’s too early to take a victory, but certainly they’ve been difficult much more predictable and the improvements we made especially in automotive in the prior quarter seems to have continued in Q3.
So the shortages we’ve called out in Q3 are primarily related to optical communications. And that breaks out 75% telecom, approximately 25% datacom. 400 ZR depending on the application and a lot of our 400 ZR business is categorized in our telecom number. So yes, 400 ZR would be impacted. But again, we wouldn’t be quite — we wouldn’t be prepared to break out the split between 400 ZR and other types of products that we make. But again for the DCI, Data Center Interconnect products would be categorized in our telecom business. So they would be included in that 75% number.
Fahad Najam
Got it. If I could also ask you, you had previously mentioned that you had one prominent customer for 400 gig ZR, I think you most recently said it was true. Any color on how many customers are now ramping 400 gig ZR volume?
Seamus Grady
We have more than two. We have two who are, I would say, ramping nicely. We have another couple of customers, who are still in the earlier stages, new product introductions stages. But we have more than more than two customers, I would say, more than two, less than five. But it’s — we feel we have a very good price of selection of customers there and we’re very happy with the growth in that business.
Fahad Najam
Appreciate the answers. Thank you.
Seamus Grady
Thank you, Fahad.
Operator
Thank you. Please standby for our next question. Our next question comes from the line of Tim Savageaux with Northland Capital Markets. Your line is open.
Tim Savageaux
Hi, good afternoon and a nice quarter. A question on your, kind of, non-speed rated portion of your business, which is at least the way I’m looking at the numbers up pretty nicely, both sequentially and year-over-year, something like 45% year-over-year. And I think historically, we might associate that with kind of optical telecom, rhodium and amplifiers. But currently, I think you’ve got something else to add to the mix in terms of the PON business. So that’s a long way for me of looking for an update on the recent relationship with the DZS to what extent was that a major contributor to that growth in non-speed rated business or sub-100 gig however you want to call it?
And what is your current assessment there in terms of getting up to, kind of, an initial full run rate? And has your perception of the opportunity at DZS changed at all over the last little while? Thanks.
Seamus Grady
So Tim, I’ll let Csaba go through the specifics in a moment. But overall, in relation to DZS, we’re very happy with the relationship, very happy with the pace at which the business is moving and we’re just looking forward to doing a very good job for these guests. They’re a great company and we’re very happy to be participating in their supply chain.
Certainly, in terms of transfer activity, we’re nicely along and we’ve completed the bulk of the transfers, I would say, and we’re really looking to start ramping to volume now. So we’re probably a little bit ahead of even though the total revenue, let’s say last quarter, was not so huge from DZS, but we’re happy with the progress we’re making on the transfers and really looking forward to ramping that over the next few quarters. As you rightly point out, the non-speed rated business, it’s an attractive mix of several type of products and maybe I’ll let Csaba talk to the details of that.
Csaba Sverha
Hi, Tim. This is Csaba. Again, on the non-speed rated business, we don’t break it out. So it is a combination of lower than 100 gig products and non-speed data rate Amplifier ROADM type of business. I mean, also have some other category there. So what we have seen, particularly on year-on-year basis, I think, is mostly a supply related situation have improved significantly, if you look at year-on-year basis. So the growth is really in the amplifier space that I would say if I look back a year ago probably that area was clearly [Technical Difficulty] year ago.
And since then, I think the supply situation has significantly improved in that space. So again, the growth is indeed coming from — on the ROADM and Amplifier space. And the other category as a below sub-100 products remains stable. That’s pretty much the color I can offer in this area.
Tim Savageaux
Well, if I can follow-up on that briefly since you kind of pointed to the year-on-year compare as being driven by ROADM and Amplifiers. Does that imply that there’s some other driver of the sequential compare? I’ll leave it there. Thanks.
Seamus Grady
I think it’s the — on the — what we see is really the supply environment have been again, I think it’s overall, the team has been over the last year. This business has been probably a harder hit in the early part of the last couple of quarters. So the situation has been somewhat improving. But I wouldn’t want to speak on behalf of our customers how this business breaks out on a sequential basis. We do see the pipeline change improving and the demand seems to be robust again both sequentially and year-on-year basis?
Tim Savageaux
Okay, thanks.
Seamus Grady
Thank you, Tim.
Operator
Thank you. Please standby for our next question. We have a follow-up from the line of Fahad Najam. Your line is open.
Fahad Najam
Thanks for taking my question again. I wanted to clarify because a number of investors couldn’t understand the response to my earlier question. So more explicitly the telecom component shortages that you’re seeing on the 400 gig, are they more on the ZR side versus on ZR can you clarify?
Seamus Grady
No, I think, Fahad, what I said was we’re not going to break that out any further than we have already. We’re not going to specify whether it’s ZR or other products. It’s in 70 — approximately of the $30 million to $35 million we called out approximately 75% of that is telecom products. And I was just pointing out that telecom includes obviously pure telecom products, but also our DCI or data center interconnect products, which would include 400 ZR.
Fahad Najam
Got it. Thank you for the clarification.
Seamus Grady
Thank you, Fahad.
Operator
Thank you. I’m showing no further questions in the queue. I would now like to turn the call back over to Seamus for closing remarks.
Seamus Grady
Thank you. Thank you for joining our call today. We delivered strong second quarter results. As we look ahead, we remain confident that we can continue to perform well based on strong broad-based demand and our demonstrated ability to execute through all kinds of market conditions. We look forward to speaking with you again soon and seeing those of you who will be attending the Overseas Conference in San Diego next month. Goodbye.
Operator
Ladies and gentlemen, this concludes today’s conference call. Thank you for your participation. You may now disconnect.
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