Value Play: Fabrinet (NYSE: FN)

In February 2013, Cisco Systems published a “Global Mobile Data Traffic Forecast Update” and the conclusions were shocking:

• Global mobile data traffic grew 70 percent in 2012 and will increase 13-fold between 2012 and 2017. Mobile data traffic will grow at a compound annual growth rate (CAGR) of 66 percent from 2012 to 2017 with smartphone usage leading the way.
  
  
• Mobile data traffic in 2012  was nearly twelve times the size of the entire global Internet in 2000
  
  
• By the end of 2013, the number of mobile-connected devices will exceed the number of people on earth.
  
  
• Mobile-connected tablets will generate more traffic in 2017 than the entire global mobile network in 2012.

Smartphones and tablets are becoming a way of life for many people, using the Internet for information collection, payments, video entertainment, messaging, and social networking. Only 18% of mobile handsets are smartphones today, but the percentage will grow to 50% by 2017. Since smartphones on average use 50 times more data than a basic-feature cell phone, Internet usage will only become more important (and addictive) in the future. The more Internet-connected devices are used, the more bandwidth capacity must be available from telecommunications networks. According to a 2013 Ericsson study (page 8), the No. 1 complaint of smartphone users is a slow mobile network.

The main way to increase speed is to improve the transmission capacity of telecommunications networks both at the customer-to-cell-tower connection (4G LTE networks) and where the long-haul Internet backbone resides. Fiber-optic technologies such as 100 Gigabyte Ethernet (100G), Wavelength-Division Multiplexing (WDM), and Optical Transport Network (OTN) switching are the means to a faster Internet backbone. 100G and WDM deployments in the U.S. and Europe are exploding and the demand for optical network components is at all-time highs.

Chief beneficiaries of this “need for speed” are the optical component manufacturers and their subcontractors. According to WinterGreen Research, the global optical component market will more than triple between 2013 and 2019, increasing from $3.6 billion to $12.3 billion, and global optical amplifier market will increase from $900 million to $2.8 billion.

Fabrinet Has a Tax Advantage

My choice for gaining exposure to the fiber-optic megatrend is Fabrinet, a contract manufacturer of optical components, lasers, and sensors that is incorporated in the Cayman Islands and has its primary manufacturing facilities in Thailand. The company is a master of legal tax avoidance with an effective tax rate in the third quarter of only 3.9% (page 13) — compare that to the 35% corporate tax rate charged to U.S. corporations! The Cayman Islands exempts corporations like Fabrinet from all tax and the corporate tax rate Fabrinet pays in Thailand and mainland China are only 20% and 15%, respectively (page 43).

The company’s customer base includes the three largest optical communications components companies worldwide in terms of revenue (page S-1), and overall includes EMCORE (EMKR), Finisar (FNSR), Infinera (INFN), JDS Uniphase (JDSU), and Oclaro (OCLR).  The two largest customers are Oclaro (25% of total sales) and JDS Uniphase (22%). Although Oclaro is a money-losing small-cap stock, I’m not worried about its financial viability because Oclaro has significantly improved its balance sheet recently through a series of asset sales yielding $204 million in cash. As for JDS Uniphase, no problems there — it is a profitable $3.1 billion mid-cap stock that has $1.06 billion in cash on its balance sheet and is acquiring businesses.

Optical component manufacturing is Fabrinet’s core business (70% of total sales), which in turn is divided about two-thirds equipment used in telco (i.e., voice) and one-third equipment used for data (i.e., non-voice) transmission. The remaining 30% of sales consists of lasers (Coherent) and sensors (page 46) . Advance technologies (most of datacom, Coherent lasers, OTN, 100-Gig Ethernet) comprise about 60% of total sales and older “legacy” telco and datacom components (SONET/SDH circuit switching and 10-Gig Ethernet) comprise the remaining 40% or so. I say “about” and “or so” because the company is organized as a single business segment and it doesn’t break out most of these numbers in its financial statements, choosing to provide estimates of different revenue streams in the Q&A of its quarterly conference calls (which is a bit annoying).

Thai Flooding Caused 2011 Loss

If you look at a time series of the company’s earnings, you’ll see steady, solid growth except for fiscal year 2012 (ending June 2012) which reported a significant loss. The explanation for this anomaly is the $97.3 million in damages at its Thai manufacturing facilities in late 2011 caused by Thailand’s worst flooding in 50 years. One of Fabrinet’s Thai facilities responsible for about 35% of production (Chokchai) was damaged beyond repair and, while the company was able divert this production to its other Thai facility (Pinehurst), the Thai currency (Baht) has depreciated against the U.S. dollar thanks to a political crisis and consequently Fabrinet has not yet been able to return to the revenue level or gross profit margins it enjoyed in 2011 prior to the flood.

Furthermore, the company is still waiting for its flood insurance claims to be paid in full by its insurers. As of now, Fabrinet has settled all damage claims with its own customers and has received $36.1 million from insurers for its claims. That leaves $61.2 million in claims still not received, but in the November conference call CFO Toh-Seng Ng said the company expects to receive another $40 million in insurance payments during the fiscal second quarter (ending Dec. 2013). Whether it will be able to recoup the remaining $21.2 million in insurance claims in later quarters is uncertain, but the company vows to “continue to aggressively pursue the balance.”

When the company reports Q2 2014 earnings in early February, the $40 million insurance payment is going to make GAAP earnings per share look more than a $1.00 per share higher than normal. Although investors should discount these earnings as one-time in nature, the stock price may get a boost from the headline number nonetheless and I’d rather be in the stock prior to the Q2 earnings announcement to benefit from any positive (if misguided) reaction.

Financials are Healthy

First-quarter earnings were excellent, with revenues up 8.2% and earnings up 10.9% — both figures easily beating analyst estimates. Even better, guidance for the second quarter was also better than analysts were expecting. The big growth driver is the optical business. Although optical networking is a highly-competitive business, Fabrinet is able to maintain good profit margins because it eschews commodity manufacturing and focuses on “low-volume, high-mix products” that are customized to each client and which require manufacturing expertise and command premium pricing. In fact, Fabrinet provides a “factory-within-a-factory” manufacturing environment to protect its customers’ intellectual property by segregating certain key employees and manufacturing space from the resources used for other customers. For a majority of its products, Fabrinet is the sole outsourced supplier.

The lasers and sensors segment reported flat financial results. I’m not worried about the laser/sensor businesses because these are more economically sensitive and economic growth is forecast to be stronger in 2014. As chief strategy officer John Marchetti said in the Q1 conference call:

Over the longer term, the laser market represents a significant opportunity for growth as it is still in the very early stages of outsourcing.

The stock price gapped up 11% on the day following the press release to $19.02 and it is still trading around that level today. Looks like a bullish flag pattern with the stock consolidating temporarily before the next upside breakout.

Strong Management

The founder, Chairman, and CEO of Fabrinet is Tom Mitchell, a former U.S. marine who is an industry legend with more than 34 years of experience in electrical component and semiconductor manufacturing. Mitchell not only founded Fabrinet in 1999, but previously co-founded disk-drive manufacturer Seagate Technology in 1979. I like founder CEOs like Mitchell, although Mitchell is known to be abrasive and was forced out of Seagate in 1991. Steve Jobs of Apple was forced out of the company he founded as well (before being invited back in), so a board ouster should not necessarily stigmatize anyone. Insiders own 7.6% of Fabrinet shares (page 41) – including 6.4% by Mitchell himself – which provides some assurance that management’s financial incentives are aligned with the average shareholder. In addition, private equity firm H&Q Asia Pacific, which controlled Fabrinet before taking it public in June 2010, still retains an 18% ownership stake in Fabrinet which I view as a long-term endorsement of the company’s business prospects. Many private equity firms “dump and run” upon taking one of their companies public, so H&Q’s staying power with Fabrinet says something positive.

Low Valuation

Despite Fabrinet flirting with 52-week highs (all-time high is $32.91 back in Feb. 2011), the stock’s valuation remains inexpensive, with an EV-to-EBITDA ratio under 10 and a P/E ratio of 9.5 that is near the lowest it has been since coming public in 2010.

Profitability is stellar with the company generating a return on equity no lower than 17.2% in seven of the past eight years (the Thai flood year of 2011-12 being the only exception). The company’s low tax rate definitely helps explain some of the high profitability, but there is no reason to believe that this Cayman Island and Thai company will experience higher tax rates anytime soon. Furthermore, the company’s current gross profit margin of 10.7% has room to rise back up to its pre-flood level of 12.5%. If that were to occur, revenue growth would translate into more earnings than otherwise would be the case (i.e., earnings leverage). Over the next five years, Fabrinet’s earnings are projected to grow 12% annually and this figure will prove overly conservative if gross margins improve as I expect. Lastly, Fabrinet’s corporate debt is very low at only 7% of capital, so the risk of financial stress is minimal and is evidence of prudent management.

Bottom line: Fabrinet is run by experienced management, operates in an industry with strong macro tailwinds, promises strong future growth and yet sports a low current valuation with little debt – this is my kind of stock!

Fabrinet is a buy up to $25; I’m also adding the stock to my Value Portfolio.

Momentum Play: CBOE Holdings (Nasdaq: CBOE)

As the chief investment strategist of Jim Fink’s Options for Income, I deal with option exchanges every day. There are plenty to choose from – 12 in total – but in my experience the Chicago Board Options Exchange (CBOE) is the best in terms of liquidity and fill prices. When I want to get filled on an options trade both quickly and at a good price, I manually route my order to the CBOE.

Other traders must agree with me because the CBOE is the options exchange with the highest market share (Slide No. 22) of option trading volume going back at least to 2004. In the just-completed 2013 calendar year, the CBOE was on top again:

Source: Options Clearing Corporation

Whereas stock trading volume is at five-year lows, options are booming. 2013 marked the second-best year ever for option trading volume. CBOE’s press release says it all:

• Second-Best Year for CBOE Holdings Volume

• CBOE Cash Index, SPX and VIX Options Set All-Time Annual Volume Records

• CFE and VIX Futures Set Volume Records for Fourth Straight Year

With 12 options exchanges, pricing competition is ferocious in equity and ETF options. Yet the CBOE continues to generate strong profits and have free cash flow available for stock buybacks and special dividends. The company’s unusual success is due to proprietary option and futures products that can’t be traded anywhere but at the CBOE:

1. S&P Dow Jones indices (the S&P 500 and Dow Jones Industrial Average being the two most important)
   
   
2. S&P 500 Volatility Index (VIX)

Index option transaction fees comprise more than half of the CBOE’s total transaction fees (page 46), which is only possible because of the CBOE’s exclusive license and the resulting higher fees per contract that can be charged index options compared to equity options – more than eight times higher:

Source: CBOE press release

In March 2013, the CBOE exclusive license with S&P Dow Jones Indices – a joint venture between McGraw Hill (73% ownership), CME Group (24.4%), and News Corp. (2.6%) — was extended through 2032. This removed uncertainty about the CBOE’s value and helps explain why its stock has performed so well over the past year, rising 73%.

The other options exchanges (especially the International Securities Exchange) hate this CBOE competitive advantage and have repeatedly filed lawsuits to invalidate the CBOE’s exclusive licenses with S&P Dow Jones Indices. The ISE has sued the CBOE in several courts over the past seven years and lost repeatedly. This past December, a New York federal court judge dismissed ISE’s most recent lawsuit, ruling that the issue has already been decided in favor of the CBOE in Illinois state courts.

The CBOE’s profitability is virtually obscene, with returns on equity routinely above 50%:

A Profit Machine

Source: Morningstar

The company has zero debt and is periodically considered a prime takeover candidate for competitors such as CME Group, InterContinentalExchange, Deutsche Borse, and Nasdaq OMX. The most likely candidate is CME Group, which seriously considered buying the CBOE in 2009 before it went public and may be open to the idea again now that its stock price is high thanks to higher trading volume in its interest-rate futures product.  

UBS  and Macquarie both recently upgraded the stock to buy and raised their price targets to $56 and $57, respectively. These are stand-alone values; I think the stock is worth at least $70 on a takeover.   

CBOE Holdings is a buy up to $60; I’m also adding the stock to my Momentum Portfolio.