Paul Kalivas - Chief Administrative Officer, Executive Vice President, General Counsel and Corporate Secretary David T.

Mitchell - Founder, Chairman and Chief Executive Officer John Marchetti - Chief Strategy Officer and Executive Vice President Toh-Seng Ng - Chief Financial Officer, Executive Vice President, Chief Financial Officer of Fabrinet USA Inc and Executive Vice President of Fabrinet USA Inc.

Patrick M. Newton - Stifel, Nicolaus & Co., Inc., Research Division Sherri Scribner - Deutsche Bank AG, Research Division Alexander B. Henderson - Needham & Company, LLC, Research Division Natarajan Subrahmanyan - The Juda Group, Research Division Paul Coster - JP Morgan Chase & Co, Research Division Troy D.

Jensen - Piper Jaffray Companies, Research Division Mark Sue - RBC Capital Markets, LLC, Research Division.

Good day, ladies and gentlemen, and thank you for standing by, and welcome to the Fabrinet Fiscal First Quarter 2014 Earnings Conference Call. [Operator Instructions] As a reminder, today's conference is being recorded. It is now my pleasure to turn the floor to Paul Kalivas, Chief Administrative Officer and General Counsel. Sir, you may begin..

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 2014, which ended September 28, 2013.

With us on the call today are Tom Mitchell, Chief Executive Officer and Chairman of the Board of Directors of Fabrinet; TS Ng, our Chief Financial Officer; and John Marchetti, our Chief Strategy 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 afternoon's discussion, we will be presenting both GAAP and non-GAAP numbers. Our GAAP results and reconciliation of our GAAP to non-GAAP results are attached to our earnings press release, which is also posted on our website.

I would like to remind you that today's discussion may 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 6, 2013, and our Form 10-Q filed on May 3, 2013. We will begin the call with brief remarks by Tom, John and TS, followed by a time for questions.

I would now like to turn the call over to Fabrinet's CEO and Chairman, Tom Mitchell..

Thank you, Paul, and good afternoon, everyone. Fiscal 2014 is off to a strong start, and I am particularly pleased that our first quarter results demonstrated another strong quarter of revenue, margin and earnings per share growth.

With our strong customer relationships and expanded pipeline of new business, I am confident that we will be able to build on our successful first quarter and deliver a strong year of profitable growth. As always, I want to thank our employees for their hard work and all of our customers for their continued trust and support of Fabrinet.

I will now turn the call over to John Marchetti, Fabrinet's Chief Strategy Officer, for a further discussion of the markets we serve.

John?.

Thanks, Tom. And thanks, everyone, for joining us today. As Tom mentioned, fiscal 1Q was a solid quarter for us with sequential increases in revenue, margin and earnings per share, all of which came in ahead of our expectations.

The primary driver for the upside in the September quarter was an improvement in our Optical Communications business, which increased nearly 12% sequentially. This improvement was seen in both our telecom and datacom end markets, and represents a marked improvement over the prior quarter.

There continues to be a greater focus and effort in some of the more advanced components and modules in our Optical business. We expect these trends to continue and, combined with the recent improvement in demand, gives us confidence that the underlying fundamentals of our Optical business remain strong.

We expect the benefit to our customers as spending on optical equipment accelerates. The laser market, while stable over the last 2 quarters, has yet to show signs of any meaningful re-acceleration.

The weakness that we saw in the government and research markets early in the calendar year appears to be behind us, while the industrial market remains mixed. We expect that over the near term, our Laser business may continue to experience some sluggishness as demands still seem somewhat muted.

But over the longer term, we believe that the laser market represents a significant opportunity for growth, as it is still in the very early stages of outsourcing. Demand and visibility in our Automotive segment remains fairly solid.

But while we did see a modest sequential decline in our September quarter results, we believe the longer term trend in this business is encouraging, and we are excited about the opportunities for growth in the coming quarters. Our results in our non-optical business have not been as strong as we would have liked recently.

We remain confident that our Laser, Sensor and Other segments will be important drivers of our top line growth for the next several years. And as Tom has mentioned on several occasions, we will continue to explore ways to accelerate our growth in these and potentially other new markets.

As we look out into the remainder of fiscal 2014, we're encouraged by the overall growth prospects for our business.

We continue to work closely with our customers to ensure that we are aligning our resources to meet their current and future production needs and believe that our business will accelerate along with our customers as demand trends improve. Our new customer acquisition efforts are a vital part of our overall growth strategy.

And while these new wins always take time to generate meaningful revenue, we believe the pipeline for this new business remains strong. With that, I would now like to turn the call over to TS, our Chief Financial Officer, for a report on our financial results.

TS?.

Thanks, John. Good afternoon, everyone. I'm pleased to report that Fabrinet delivered fiscal Q1 results well above our guidance range as we saw solid demand across the customer sets. I'd like to start with an update on the insurance recovery status, then move on to a review of the results for the first quarter, and end with our outlook for fiscal Q2.

As a reminder, we continue to expect our financial results to be impacted for multiple quarters due to the timings of approval and payment of insurance proceeds. Claims for all losses related to inventory, property and business interruption have been settled and collected, and we continue to work with our insurance syndicate on our equipment claim.

In the first quarter, we received an interim payment toward the inventory claim in the amount of approximately $6.6 million. So far in this process, we have received total payments against our claims in the amount of approximately $36.1 million, and we will continue to aggressively pursue the balance.

We will disclose additional information on the timing and payments of our insurance claims as it becomes available. Now to review the results for the first quarter of fiscal 2014. Please note that all numbers are GAAP, unless stated otherwise.

Our total revenue for the first quarter was $171.6 million, an increase of 7% sequentially, and an increase of 8% compared to the first quarter of fiscal 2013.

On an end-market basis, revenue from Optical Communication was $124.6 million in the first quarter or 73% of total revenue, while Laser, Sensor and Other revenue was $47 million, the remaining 27%. Our share-based compensation expenses for the quarter were $1.6 million, of which roughly $1.3 million was included in SG&A.

Our flood-related item for the quarter was income of $6.6 million, which consists of an interim payment on our inventory claim, offset by additional payments from settlements of all customer claims of $8.3 million. These amounts are included in our results as other income and are excluded from our non-GAAP results.

We intend to book the gains on insurance proceeds in future periods as those amounts become reasonably certain. Our effective tax rate for the quarter was 3.9%, including the effects of flood-related insurance recovery. Without these items, our normalized tax rate would have been 5.8%.

We continue to expect our effective tax rate to remain in the 5% to 6% range through the remainder of the fiscal year.

On a GAAP basis, including flood-related income and share-based compensation expenses, our net income for the first quarter was $19.2 million or $0.55 per diluted share compared to GAAP net income of $16 million or $0.46 per diluted share, in the first quarter of fiscal 2013.

In the near term, we expect that our GAAP results may continue to fluctuate due to the size and timing of our future insurance recoveries.

On a non-GAAP basis, net income totaled $14.2 million for the quarter or $0.40 per diluted share, an increase of 11% compared to non-GAAP net income of $12.8 million or $0.36 per diluted share, in the same period a year ago. Moving onto the balance sheet and cash flow statement. We ended the quarter with a cash balance of approximately $164 million.

Cash increased by approximately $14 million sequentially as the result of proceeds from insurance claims and strong working capital management, partially offset by additional flood-related payment to customers. I would now like to discuss guidance for fiscal 2Q. We expect revenues of between $170 million and $174 million.

GAAP net income per share is expected to be in a range of $1.54 to $1.56 with expected non-GAAP net income per share in the range of $0.40 to $0.42 based on approximately 35 million fully diluted shares. That concludes our prepared remarks. At this point, I would like to turn the call over for questions.

Operator?.

[Operator Instructions] And it looks like our first question in queue will come from the line of Patrick Newton with Stifel..

I guess the first one for Tom or John. Given the sale of Oclaro's amplifier business to II-VI and you had some comments out of II-VI last week on its earnings call that it hopes to eventually integrate its amplifier portfolio. I was hoping you could update us on the size of the business to make sure we understood that.

If you could comment on your relationship with II-VI, and then perhaps discuss whether or not you anticipate you're going to maintain this amplifier business long term?.

Sure. Thanks, Patrick. In terms of where we stand with that today, we continue to work with II-VI. That business just closed. And so we're still working through a lot of the particulars there. I don't really have a great update in terms of exactly where that stands over the longer-term period.

Certainly over the near-term period, operationally, things have not changed really much at all for us. We continue to work through Oclaro for that business, at least on an operational basis, and expect to certainly over the next several months, if not several quarters.

In terms of the size of the overall exposure of that amplifier business, we haven't gone through and broken down product sets for customers in the past, and I'm not going to do it here today. I understand what you're looking for there.

If and when the time comes that we need to really bracket that exposure because we are fearful that it will move away, we'll do that at that time. But until something like that occurs, we're not going to share sort of the byproduct customer revenue with anyone..

Okay. That's understandable. And then, I guess just, John, on the Optical Communication, very solid quarter there. I'd love a little bit if an update on datacom versus telecom. I know you said both grew sequentially.

But is it fair to assume that datacom growth is still outpacing telecom? And then if you could remind us of what that mix is?.

Sure. So the overall mix didn't change much for us, Patrick, this quarter. We're still about 2/3, 1/3, with more exposure to the telco side versus the datacom side. You're right in that the datacom growth still is outpacing the telco growth.

But what was nice for us and, obviously, you can tell by the set of results is that telco result, having that start to really grow again, was very helpful for us. We're -- because of the greater exposure to that side of the Optical business, that's going to have an overall bigger impact for us than on the datacom side..

And then, I guess, specifically on the telecom side, if you could, it is great to see that start to grow, but if you could help us understand linearity in the quarter, did it accelerate as we exited the quarter? Or where did it, kind of, perhaps catch you a little bit by surprise and allowed you to put up the top line that you did? And then you also alluded to modules becoming a more important driver of growth.

If you could help us understand, is this all Coherent technology? And if you have any, I guess, any capacity builds as a result of some of that growth?.

Sure. Let me try to parse that out a little bit. I mean, in terms of what we saw, I mean, the challenge for us whenever we give guidance in August is you're never sure how the customer set is going to come back in September. So we had talked on our last call about seeing a little bit of strength coming into the quarter as we started fiscal 1Q.

But it sort of paused in August, which is absolutely normal, and you're never really quite sure what you're going to step back into in September. And we were very happy to see that order growth and the demand rate, if you will, continue to be very solid right through the month of September.

So linearity in that September quarter is always a little bit strange because the middle month tends to be the weakest. We're generally -- we kind of build nicely through the quarter. But we were pleasantly -- we were very happy with the way customers came back in terms of demand in that month of September.

In terms of modules, Coherent is certainly the biggest driver. We are seeing growth beyond Coherent. But the Coherent portion is still the biggest piece of the module growth right now..

Our next question in the queue will come from the line of Sherri Scribner with Deutsche Bank..

I just want to get a little detail on your expectations for the December quarter. It looks like -- sorry, it looks like you're guiding relatively flat for the September quarter.

I wanted to get some sense of where you think the mix will come from in terms of optical and laser? I would assume that you think the laser business is relatively flat, so that would imply that optical was also flat. So I was hoping to get some detail on that..

Sure, Sherri. I mean we are being a little bit conservative there, to be fair, as is typical with the way we guide. I think you're right in that for the laser and sensor market, hopefully, we'll see a little bit of growth there.

But where we are right now, it wouldn't shock me if we do see flat as we continue to go through the rest of this calendar year. For the optical group, again, with the guidance range we gave, there is a little bit of upside in there. And our hope is, obviously, that will continue to accelerate. We're being a little bit careful.

Last year, we saw some great strength in the month of October only to have it fall off in the second half of November. So we're being a little bit cautious. But I think in general, we're expecting some growth out of that Optical Communications side..

Okay. That's helpful.

And then thinking about the guidance in terms of the EPS guidance, what is your expectation for interest expense? Would you expect it to be about flat? So would you expect margins to be relatively flat? Or do you think that margins are improving?.

Sherri, this is TS. I think the interest expense is very small. We only had about $26 million debt remaining on our balance sheet, so that’s not a significant number. We’ll be flat, I would say that. And in terms of guidance on the gross margin, we normally don't guide the gross margin.

But as you can see, the earnings per share is slightly inched up $0.40 to $0.42. And obviously, John always say that the whole guidance will be consolidated..

Okay. I probably misspoke a little bit there. I meant the net interest expense when I was talking about that. Would you expect it to be flat because that will impact whether your gross margins are better? But it sounds like you expect the margins to be up a slight bit, but not substantially..

Right. That's correct..

Okay. And then also just wanted to quickly clarify in terms of the disconnect between your GAAP guidance and your non-GAAP guidance. It looks like almost more than $1 in terms of the difference.

Is that related to flood recoveries? Can you give us some detail on what you're expecting there? And then also the accounts payable ticked up substantially this quarter. Just wanted to get a sense of why that ticked up..

Okay. Good question, Sherri. So on the GAAP to non-GAAP, essentially there are 2 big ticket items. The first one, of course, is the stock-based compensation, so we accrue that. And the $1.6 million booked in the quarter, $300,000 is in cost of goods sold and then $1.2 million, $1.3 million is in the SG&A. So that's the first piece.

And then the second piece, of course, is the flat income. We accrue that from a non-GAAP, so if you remove the 2 items I just mentioned, it's pretty much a consolidated GAAP number..

Again, I'm sorry. I'm sorry I wasn't very clear. I meant for the guidance.

I think that's for the guidance, the EPS difference between GAAP and non-GAAP, it looks like it was about $1 or more?.

Okay, okay. Yes. So I mentioned in my prepared remarks that we still have the equipment claim to be settled. So the equipment claim, we forecast, we estimate to collect sizable amount. So if you are successful collecting those amounts, those are all going to the GAAP EPS. That's why it's a difference between $1.54 with $0.30, $0.40 we are guiding so....

And do you have a dollar amount that you expect for that?.

Actually, [indiscernible] he said approximately $14 million now..

Okay.

And the accounts payable difference, why that was up?.

Yes, accounts payable, you can see our inventories also see went up quite significantly, and essentially because of -- we are giving up the rent. So anyway, most of these accounts receivables -- excuse me, account payable came from the inventory buildup..

Our next question in the phone queue will come from the line of Alex Henderson with Needham & Company..

So I wanted to press a little bit on the industrial laser piece. It seems pretty clear listening to at least one of the customers that you handle that they're looking at a pretty steep decline in that business.

So is it a situation where you have multiple customers here and a couple of customers are growing nicely, and one of them is under a fair amount of pressure? Or is the -- can you talk a little bit about the mix within that? Because the guidance that they've given is not consistent with the guidance you're giving or the commentary you've given on that.

And then second, can you talk a little bit about your expectations for the auto segment sequentially? I would assume that that's improving given your recent wins..

Sure, Alex. I mean, I think on the laser market, while we do have several sizable customers within that -- or sizable, I should say, for us in terms of what makes up that segment for us -- there's a little bit of movement around in there.

But to be fair, that business, while it hasn't grown as much as we had hoped, it's been fairly stable for us over the last several quarters. So we're not expecting a big, big change on a go-forward basis.

We do build multiple laser types for multiple customers, so there's always a little bit of a mixed shift from quarter-to-quarter in terms of what we might be focusing on from one quarter to the next. But that business has been, certainly over the last 2 or 3 quarters, pretty stable, and we would expect it to be that way going forward.

On the sensor side or on the auto side, we are expecting hopefully that, that will start to tick up a little bit more aggressively even if it's not by, say, the December quarter certainly as we get into calendar '14. As you said, we've had some decent wins there. We continue to get some new programs coming in.

So we're pretty encouraged by the pipeline that we got on that auto side..

Okay. Second question, and this is sort of a bucketing question.

If I were to bucket your Coherent, your OTN, your carrier-grade Ethernet and your datacom businesses on one side and SONET, SDH 10 gig long haul, the multiservice edge stuff in the other bucket, can you give us a relative sizing of those 2 buckets? What -- to what degree we're seeing some shifting between those 2 buckets? And is the acceleration a function of some of those higher growth business accelerating? Or these other stuff becoming -- the stuff that's declining becoming less of a drag?.

Sure, sure. Obviously, if you take the datacom piece, right, that's about 1/3 of the overall exposure. If you layer in some of those faster growing technologies, if you will or some of the newer technologies -- I think that's probably a better way to put it -- we're probably somewhere around 55%, maybe 60% debt total kind of goes that way.

So for that other 40%, I do think it's a little bit of both, Alex. I mean, I do think you've seen a moderation of some of the declines in some of the more legacy type technologies. But we've also -- we still get a fair bit of growth out of 10 gig.

So I think those 2 pieces of that, say, remainder are the biggest sort of drivers that are happening on that more legacy side of the business..

If you look at the accelerating piece, the strong growth there is Coherent OTN, carrier-grade Ethernet and datacom, could you rank order them in terms of what's driving the business?.

Well, I mean, datacom has been strong now for several quarters. I mean, we're starting I think to see more acceleration in Coherent and in some of the others, and that I think is reflected in the uptick that we've seen in our telco business, where that datacom business, quite frankly, has been growing nicely for 2 or 3 quarters now..

Our next phone question will come from Subu Subrahmanyan with The Juda Group..

First, John, really a bigger picture question.

We're now seeing a couple of quarters of growth, and I'm just wondering if, from your customer's perspective, are we starting to get a sense of trajectory of improvement? Is it still kind of one quarter at a time? What kind of dialogue or visibility are you getting from your customers? The second is on gross margin.

We saw some improvement this quarter, a tick up in volumes.

And I'm just wondering with a combination of kind of flattish volumes, I guess, getting into the next quarter and some currency benefit, what directionally do you expect from gross margin?.

Sure. I think to your first question, Subu. I mean, I think customers are still being very prudent about it. I don't think anybody is kind of getting ahead of themselves in terms of trying to sort of outpace what they're getting in from their customers. I think that we've seen our customers be very measured in their approach to this.

But I do believe that in general, they're feeling better about their businesses today than they were feeling a quarter or 2 ago. I think that's certainly the case on the optical side.

In terms of your question about gross margin, I mean, directionally, we can provide a little bit of revenue uplift from where we are, then we should see gross margin tick up as well. I mean, those 2 should generally trend in the right direction even if they're not growing necessarily in the same curve.

But we would expect that as revenue continues to move up, gross margin should move up with it..

Sure. I guess my question, first question is more as a follow-up on that. From September to December last quarter, as you mentioned, we saw an uptick and then it kind of faded. I'm just asking if kind of sentiment-wise it feels broader, more directional or still feels on the quarter-to-quarter basis relatively modest..

Right. And I apologize for not picking up on that the first time around. I do think it feels broader. Part of it last year as well, there was probably a little bit of that demand that we caught that was still somewhat flood-related as either some of our customers were replenishing some inventory or some things along those lines.

So you have this quarter, obviously, with none of those effects really having any impact whatsoever, it does feel a little bit more broader-based than just, say, a one quarter phenomenon..

Our next phone question will come from the line of Paul Coster with JPMorgan..

A few quick ones.

First one, the $40 million of cash that you expect to come in from insurance claims, is it unencumbered? Or does that cash go back out the door to customers?.

No, I think we had settled with all the customers now as we mentioned in the prepared remarks. So Paul, yes, we are done with the customer, so the money comes to our pockets..

Okay. Very good. And you seem to be getting close to pre-flood revenue levels again when gross margins rose 100 basis points or more higher than they are today.

What's the impediment, as we kind of creep back towards that level, from you -- the impediment preventing you from getting back, if there are any impediments, to sort of 12%, 13% range gross margins?.

So Paul, pending the Thai baht exchange against U.S. dollar, assuming they can return back to the previous level, we still believe that 12% to 12.5%, once the revenue get up to about $195 million to $200 million, is achievable.

So we look at the cost structure almost every quarter, and that cost structure will produce 12% to 12.5% gross margin, 9% to 9.5% on the operating margins impact..

Very good.

And then lastly, so what extent are you able to sort of identify seasonality in the Optical Communications business? Specifically, the extent to which there's a December year-end budget flush that you benefit from?.

I mean, Paul, what I would say is that, that is always customer and end-market dependent. I mean, typically, the carriers will spend a little more as they go through each successive quarter of the calendar year, and they spend a little bit more in December.

If you look at some of the CapEx guidance that was given during the most recent set of results from some of the carriers, I certainly don't think most are expecting a big uptick into calendar year-end. So it varies year-to-year.

Typically, December is a little bit stronger, and then you're back down a little bit in the March quarter as budgets get reset and they have to get allocated and released and all those things. But I don't think we're expecting any kind of a huge flush into calendar year-end..

[Operator Instructions] And our next phone question will come from Troy Jensen with Piper Jaffray..

So maybe for TS, can you just help me out with other income? So below the operating line, to get to this $0.40 to $0.42 this quarter, what are you assuming the other income will be?.

Yes, normally, the other income consists of interest income and also the bigger items exchange gain, okay? So we have a whole bunch of forward contract at the end of the quarter. And according to the company standard, you mark-to-market.

So those forward contracts have certain value, and you compare with the quarter end exchange rate at that time, you mark to the market. So in the FQ1 fiscal fourth quarter, we booked about close to $1 million gain on that. Now moving forward on the guidance, we assumed this is 0. Because we can tell how the baht is moving by end of the quarter.

So other than the income interest expense, we basically assume nothing there..

0 other income, so we should be like 8.5% plus operating margins to get to that 40-plus cent range. Okay. That's perfect. And then how about maybe just a quick one for John. Oclaro II-VI, I know you can't say a lot, I get that.

But can you just maybe paint out some worst case scenario? I mean, how long is it before they would potentially try to move the business? Then maybe best case scenario, is there anything that you guys could pick up from II-VI? Is this is an opportunity at all for you guys?.

I think to be fair, Troy, I think both of those options are still very much on the table, right? I mean, it depends ultimately what they want to do, which is best for their business.

For the optical amplifier business, in particular, we think we can make a fairly compelling case to them to keep that business with us, but ultimately that's going to be their decision to make.

Over time, if they do decide that we're the best -- best way to continue to produce that product going forward, then I think it does open up opportunities potentially for other programs with them as we continue to go through that relationship.

If they do decide to move it depending on when they actually make the decision, it would be -- my assumption is that it would be at least a couple of quarters once they make the decision before it actually got moved out of the barn. So you use that as a little bit of a reference.

I think, for the most part, I don't think we're likely to see an impact to the fiscal '14 number either way. But if they really wanted to make that decision very, very quickly, you could potentially, I guess, hit the 4Q number, but certainly not before that..

[Operator Instructions] And it looks like we do have an additional questioner on the queue. It looks like it will come from the line of Mark Sue with RBC Capital Markets..

Gentlemen, I just had a question on what you're seeing from a geographic and demand point of view recognizing a lot of the products do end up in different areas. Perhaps maybe you could give us a sense of just China, LTE, what the pull-in might be from your high-level sense.

And just the strength of the telco trends, the sustainability of that with a lot of the big projects that are going out with data centers in North America..

Sure. Thanks, Mike. It is a little bit difficult for us to really get geographic trends because in a lot of cases, we're shipping to either another contract manufacturer or we're shipping to a customer, maybe not to the carrier directly. We saw a little bit of an uptick again in telco in September.

Is that China-related, specifically? It's hard for me to tell. We saw North America get stronger as we kind of came through the summer months. So that is continuing to be, I think, a relative source of strength as well.

There could've been a little bit of an uptick in the China market, but it wasn't so much, Mark, that we actually -- when China released some of that CapEx, we absolutely saw it flow through immediately..

And presenters, at this time, I'm showing no additional questions on the phone queue. I'd like to turn the program back over to management for any additional or closing remarks..

Thanks very much, and thanks, everybody, for joining us today. We look forward to talking to you soon. Have a great day..

Thank you, presenters, and thank you, ladies and gentlemen. Again, this does conclude today's call. Thank you for your participation, and have a wonderful day. Attendees, you may now all disconnect..