2023-05-25 21:28:07 ET
Summary
- Fabrinet has been a strong grower over the past 5 years with steady increases in revenue and operating margins.
- The company has recently ran into issues with revenue growth, but margins are holding in strong at all-time highs.
- The company is trading at a discount to its historical norms, which will prove to be a long-term value opportunity.
Fabrinet ( FN ) has been the most consistent performer among its peers in the optical component industry in the past 5 years. They have outperformed their sector throughout the recent bull run, through strong execution and growth in their core markets. Fabrinet takes outsourced work from original equipment manufacturers which means they have a lower margin than their other peers. However, this outsourcing has become more common and allowed them to outgrow their industries as a key partner even during down cycles. They have added significant capacity in automotive applications in particular over the past few years, getting to 20-25% non-optical revenue. The optical sector is quite volatile with customers continuously pushing out orders or having large inventory corrections. This has created stocks that are good to trade but are very hard to predict in the short term. Fabrinet has been much more consistent however, especially compared to its two closest peers Coherent ( COHR ) and Lumentum ( LITE ). It has also been able to grow its margins nicely over time, allowing for strong earnings and cash generation. After the recent earnings smash by Nvidia ( NVDA ) powered by data center AI applications, investors are taking a second look at data center beneficiaries for a potential bullish run.
FN Q1 presentation (Fabrinet IR)
Consistent Execution
Fabrinet has been extremely consistent with its performance over the past 3 years, which should give investors confidence of a stock rebound over time. The non-optical communication revenue is less cyclical than the optical revenue, and it has climbed from $90.0m in mid 2020 to over $160 million the past two quarters. The compound growth rate of 22% in the non-optical area has helped diversify the revenue and smooth out any potential optical corrections like FN is experiencing in 2023. The company is essentially debt free with a strong horde of cash for acquisitions and buybacks. The company has $537 million in cash now, but hasn't done a significant acquisition or buyback in recent years. A change to that in the coming year could be a positive catalyst for shares to move higher as the company could add additional capabilities in adjacent areas. Hopefully the current dip in the stock price has management buying shares aggressively here. A dividend isn't out of the question either long term, but FN has no issues with organic growth making that less likely in the next few years.
In Q3 the company put up $665.3 million in revenue, up nearly 18% y/y. Even more importantly costs were held relatively in check, with operating income increasing to $61.8m. This is with a head of 30 to 35 million on revenue due to component shortages - a common theme the past 2 years for equipment manufacturers. This is going to subside in the coming months and hopefully by year end will be completely gone. Higher speed products of 400 Gigs/second are now the standard with $221 million in revenue versus $112.3 million at 100gigs/s. 800 gigabyte per second speed will be next to ramp over the coming few years, as increased speed is necessary for artificial intelligence applications. Management called this out as something to be excited about as average selling price and margins would be higher for Fabrinet. Automotive revenue is a serious driver for FN now, with $94.1 million in revenue up 77% y/y due to continued increases in chip density in vehicles. Self-driving capable vehicles are becoming the norm even though the software may not be yet ready for a fully self-driving car. Car companies want to have future proof vehicles on the road, allowing them to upsell the FSD feature to customers when it becomes available. This area will be a continued growth driver for them for years to come, with Q2 of this year expected to be at record revenue levels above the $94.1 level above.
Gross margins were 13.1% up from 11.3% in first quarter of 2020, or a nearly 2% improvement over the past 3 years. FN expects that recent tailwinds from foreign exchange relating to the Thai Baht currency will disappear and become a small headwind. However, the gross margin rate can stabilize at these high levels near 13% and provide strong operating income. Operating income has moved from 7.4% to 9.4% since Q1 of 2020, or a full 200 basis point increase. This led to strong $1.94 earnings in Q3 2023 with a 29% y/y increase with potential increases when component availability improves. Their new facility (building 9) in Thailand which is just starting to ramp, allowing for more long term margin gains. The building is 1 million square feet, giving significant growth potential for the coming years as it gets filled.
Sector outperformer
Below you can see that Fabrinet has been a consistent performer while its optical peers have struggled. FN has a solid 3 year total return of 55% as Coherent (formerly II-VI) and Lumentum have had poor results. Issues with margins, debt and volatile growth have led to outperformance for Fabrinet. Fabrinet has consistently improved both revenue and margins, while II-VI took on a good amount of debt to buy Coherent at the end of the cycle. Long term FN will continue to outperform as companies look to outsource manufacturing to them, and the non-optical part of FN's business allows more consistent results. As you can see below, FN stock trades at just 10.3x EV to EBITDA, while the other two are in the mid-teen range. Note that this is below its longer run average in the mid-teens as well. The fact it doesn't pay a large interest expense on its debt also means it has stronger earnings conversion from its operating income. Despite trading at this discount, Fabrinet has consistently increased operating income over time, while the chart below shows operating margin weakness has sent the other two down. FN continues to be the best option for those looking for long-term share appreciation and growth, while the other two may have good upside when the next boom cycle in optics happens. However, that isn't now as we continue to wait for the communications equipment cycle to begin anew.
Conclusion
The entire hardware technology sector is significantly off its highs and has experienced a significant bear market. Fabrinet was the strongest performer, continuing to trend up until several months ago at the start of 2023. The fundamentals haven't changed and FN trades at a very attractive valuation for its long term prospects. FN is a strong buy under $100 per share and I have been adding to positions for long term in this area. The company is a beneficiary of the continued push to higher speed transfers and the coming push for generative AI capabilities. Now is the time to pick up some of the pick-and-shovel companies that will help propel the data center industry in the long term.
For further details see:
Buy Fabrinet On Discounted Valuation