Fabrinet: 67% Upside

Fabrinet (FN) is currently priced to destruction with a P/E of 8.8, a P/B of 1.83, and an EV/EBITDA of 6.15 (using ttm EBITDA). FN provides advanced optical packaging and precision optical, along with electro-mechanical, and electronic manufacturing services to original equipment manufacturers (OEMs). I believe FN is positioning itself well for the optical communications market recovery, as telecom companies have been increasing their capital expenditure to keep up with the larger-bandwidth trends as audio and video features in mobile devices become increasingly more prominent.

Business Overview

FN operates under two main segments: optical communications, and industrial lasers and sensors. Optical communications, as a percentage of total revenue, has increased to roughly 70% for fiscal year 2013 from 67% for fiscal year 2012. Optical communications technology has been revolutionary for telecom companies and for the information age. As of recently, telecom companies have increased their capital expenditures to keep up with the higher-bandwidth trends as usage of 40G and 100G ports has increased. FN explains in its most recent 10-K that since 2001, OEMs in the optics industry, have increased their reliance on third-party manufacturers in order to focus on "core" strengths (R&D, marketing, etc.). As also covered in the 10-K, "carrier demand for optical communications network equipment has increased as a direct result of higher network utilization and increased demand for bandwidth capacity. The increase in network traffic volumes have been driven by increasing demand for voice, data, and video services delivered over wired and wireless Internet protocol, or IP, networks."

Industrial lasers and sensors segment makes up 30% of total revenue as of fiscal year 2013, a decline from 32% for fiscal year 2012. Currently, FN is much less focused on this segment, but according to the company's 10-K, the OEMs of the industrial lasers and sensors market are starting to realize the benefits of hiring third-party manufacturers that OEMs in other industries have been able to obtain. The end-markets for this segment are broad: semiconductor processing, biotechnology, metrology and material processing.

Competitive Advantage

While the manufacturing services market is highly competitive, FN has positioned itself very closely with its customers. Because FN manufactures what they call, "low-volume, high mix" products, which is simply code word for "highly complex, specialized products," this implies significant exit costs for the OEMs that FN serves. Furthering the relationship with its customers, FN employs the Factory within a Factory approach: FN sets up its division within its customer's factory, thus increasing efficiency even more so than the Just-In-Time (JIT) approach. FN also makes it one of its top goals to protect its customer's intellectual property, and it achieves this protection with rigorous steps: guarded entries, key-card and biometric-controlled access, as well as fogged observation windows. One of FN's mission-statements is to "never ever compete with its customers."

FN's main optical manufacturing competitors are Sanmina-SCI Corporation (SANM), Celestica Inc. (CLS), Venture Corporation Limited (SGX: V03) and Benchmark Electronics, Inc (BHE). Its customized optics and glass competitors are Browave Corporation, Fujian Castech Crystals, Inc., Research Electro-Optic, Inc., and Photop Technologies, Inc.

	FN	SANM	CLS	BHE
4 yr avg ROIC	11.47%	2.75%	8.20%	5.43%
P/E	8.97	18.2	18.5	20.5
P/B	1.83	1.3	1.3	1.06
EBIT margin	9%	1%	0.06%	1.70%

When comparing FN to its publicly traded competitors, it is obvious that FN is superior by way of profitability, which is due to its phenomenal business model. Yet, even with evidence of FN's superiority, the market is continuing to treat it like a "dead" company. It is also worth noting that the average 4 year return on invested capital (ROIC) includes fiscal year 2012, which had a ROIC of -18.74% due to flooding related expenses of $97 M. If I leave out that unusual charge, the average ROIC comes out to be 20.79%.

Thailand Flooding Incident

In 2011, FN's Chokchai facility was destroyed by severe flooding, and as a result, FN has discontinued production there permanently. Because of this unfortunate incident, FN's 2012 ROIC and operating margin ended up in negative territory due to a charge of $97 M of flood-related charges. Going forward, however, there will be cash flow benefits as FN receives payments from insurance.

(click to enlarge)

As you can see, the stock suffered near the end of 2012, most likely due to the horrible earnings report. The stock has since rebounded from its low of around $9, to its current level of $18 as the market is starting to realize the irrationality of the sell-off. While the stock has gained 100% from its lows, I still see significant upside as FN is still trading as if the company will see no further growth, even though its competitors have much higher multiples of earnings and have significantly smaller ROIC's and EBIT margins.

Management

As covered by some other great articles, the Founder, Chairman and CEO of Fabrinet, David T. Mitchell, has a great track record of success. In 1979, David T. Mitchell founded Seagate Technology, Inc. (STX), a disk drive manufacturing company, which has now become a leader in the data storage devices industry which has had high ROIC and ROE for the past 9 years.

Customers

JDS Uniphase Corporation (JDSU) and Oclaro, Inc. (OCLR) make up 17% and 31% of FN's revenues, respectively (OCLR's 31% is combined with the acquisition of Opnext, Inc.). In JDSU's recent earnings call, the management has also taken note of the increased trends in demand for higher-bandwidth products. According to CEO Waechter:

"We see a healthy demand for our 100G products and are working to increase reduction capacity on these products. We're excited about the early success of our tunable and TrueFlex product lines and pleased with our penetration into the Datacom market with our 10G and 40G products. And as we said, early response to our Gen2 fiber laser has been very positive and we have additional opportunities later in calendar 2014 for the gesture recognition."

Reading through the Q&A session, it is clear that JDSU is also expecting a recovery of growth from China:

Analyst: "And then, Tom, just as a follow-up, I didn't hear you guys talk much about China or maybe I missed it. I would love to get your thoughts, how do we think about the potential opportunity for you in China this year across both your major business segments, CCOP and NSE?"

CEO: "we are encouraged by what we're seeing now in China. They are building out the TD/LTE base stations that's actually happening and we're seeing the associated back -- 100G backbone happening. So we do believe, where it was very lumpy in calendar 2013, we're actually starting to see that flow through. I'll ask Alan to give a little bit more specifics and then David on his business."

Valuation

I used two different methods to value FN: an owner's earnings (Warren Buffett's definition of FCF) model, and a DCF model. For both models I assume FN will continue to achieve a revenue growth rate of 5% for 4 years (well below its average growth of 10%), and a terminal rate of 3%.

For my DCF model I used an EBIT margin of 9%, a tax rate of 4%, depreciation and amortization margin of 10%, a working capital margin of 16%, a capital expenditure margin of 3%, and a discount rate of 15%.

For my owner's earnings model, I assumed an EBITDA margin of 12%, a net income margin (as a percent of EBITDA) of 80%, and the other inputs as used in the DCF model.

The DCF model implies upside of 110%, and the owner's earnings model implies an upside of 120%

Year	0	1	2	3	4	TERM
Sales	654	686.7	721.035	757.0868	794.9411
Y/Y growth rate	5%					3%
EBIT		61.803	64.89315	68.13781	71.5447
EBIT margin	9%
After tax EBIT		59.33088	62.29742	65.4123	68.68291
Tax rate	4%
Add: Depreciation/Amortization		68.67	72.1035	75.70868	79.49411
Depreciation/Amortization margin	10%
Less: capital expenditure		17.8542	18.74691	19.68426	20.66847
capital expenditure margin	3%
Working capital	110	109.872	115.3656	121.1339	127.1906
Working capital margin	16.00%
Less: increases in working capital		-0.128	5.4936	5.76828	6.056694
FCFF		110.2747	110.1604	115.6684	121.4519	1042.462
Discount Rate	15%
Present value of FCFF		95.89103	83.2971	76.05387	69.44049
Shares outstanding	35
Fair value of the company	39.06126

Year	0	1	2	3	4	TERM
Sales	654	686.7	721.035	757.0868	794.9411
EBITDA	75.864	79.6572	83.64006	87.82206	92.21317
EBITDA Margin	12%
Net income		63.72576	66.91205	70.25765	73.77053
Net income margin for EBITDA	80%
Add: Depreciation/Amortization		68.67	72.1035	75.70868	79.49411
Depreciation/Amortization margin	10%
Add/Less: 1 time items
1 time items margin
Less: capital expenditures		20.601	21.63105	22.7126	23.84823
capital expenditures margin	3%
Owner's earnings		111.7948	117.3845	123.2537	129.4164	1110.824
Discount Rate	15%
Present value owner's earnings		97.21283	88.75954	81.04132	73.99425
Shares outstanding	35
Fair value of company		41.48092
growth rate y/y	5%					3%

While I believe the "fair value" of FN to be between $39 and $41, I currently have a target price of $25 which I obtained by estimating EPS to be $1.97 for next year, multiplied by the industry multiple of 12.9. So, in the near term I believe the stock has 34% upside using a conservative multiple and the average revenue growth rate of 10%. I believe, however, that FN's share price should be trading with a multiple of at least 16 (the average of its publicly traded competitors), which then implies a fair value of $31, an upside of 67%.

Conclusion

Fabrinet is the most efficient and profitable company in its industry, yet the market has it currently valued as though the Thailand floods were happening right now! With increased demand in FN's end-markets, the stock should be valued by at least the industry's average multiple of earnings.

Source: Fabrinet: 67% Upside

Disclosure: I am long FN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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