Fabrinet (NYSE: FN) - Introduction

Nov-23

Hi all, today I’ll be sharing on Fabrinet (NYSE: FN). Lots of hype around this name in recent quarters for many good reasons. Expensive today but definitely worth adding to your watchlist.

Company Introduction

Fabrinet is a specialist contract manufacturer based out of Bangkok Thailand where they manufacture other people’s products, products that are of high complexity. Specialist due to their specialization in precision assembly within the optical communication space – microelectronics, optoelectronics, and mechanical. High complexity due to complex products with precision down to submicron level assembly technologies.

What is submicron level assembly

Submicron assembly is like crafting a delicate, intricate sculpture. It requires the hands of a surgeon and the precision of a watchmaker to handle these ultra-small building blocks. The components you're working with are incredibly tiny building blocks, much smaller than a grain of sand. These blocks are so minuscule that you'd need a super-powered microscope just to see them. Just like a master sculptor follows a highly detailed blueprint to create their masterpiece, engineers use precise instructions and advanced technology to position these tiny components exactly where they need to be on a microscale. The end result is like a work of art on a microscale – a tiny, functional device with all its components perfectly aligned and connected, even though you'd need a super-powered microscope to appreciate the precision and beauty of the assembly.

History of Fabrinet

Fabrinet was founded by Tom Mitchell in 1999. Prior to Fabrinet, Tom co-founded Seagate Technology, a disk drive manufacturing company, where he served as President from 1983 to 1991. In 1999, Tom took over the lease of Seagate’s Chokchai, Thailand manufacturing site and established a contract manufacturing business specializing in optical communications.

Tom is considered a pioneer in the establishment of Asia as the pre-eminent manufacturing base for HDDs. According to sources, Tom was never tired of rubbing elbows in the foremost circles of the storage industry. He was described by an analyst as the Darth Vader of the hard drive industry, is known to keep a grenade on his desk and made people work 365 days a year (is that what all revolutionists do lol). A co-founder of 2 publicly listed firms with a combined market cap of more than US$20bn in my view simply exemplifies the meaning of gamechanger. Tom has since stepped down as CEO, but he continues to serve as Fabrinet’s non-employee chairman of the Board.

Fabrinet’s niche in optical communication stemmed primarily from Tom’s experience and discipline in optoelectronics manufacturing. Fabrinet’s strategy was simple, focus on that 3-4 things that they’re very good at, then try to be the best in it. Competitors on the other hand try to compete on all fronts and be a jack of all trades. This “master of one” strategy was and continues to be the fundamental element of differentiation between Fabrinet and other EMS players of the world.

In subsequent segments, I will discuss how this simple strategy evolved into a competitive advantage, extending even to the point of creating a moat.

Back then, Fabrinet was only producing HDD and passive optical components. Over time, as Fabrinet expanded, their services stretched into high and low volume printed circuit board assembly (PCBA), reconfigurable optical add-drop multiplexer (ROADM), custom silicon photonic components and modules, automotive modules, LIDAR systems, and today, 100G, 400G, and 800G (damn this exciting…) telecom and datacom components.

Contract Manufacturing & Business 101

A contract manufacturer (“CM”) is a manufacturer that enters into a contract with a firm to produce components or products for that firm . It is a form of outsourcing. In a contract manufacturing business model, the hiring firm approaches the contract manufacturer with a design or formula. The contract manufacturer will quote the parts based on processes, labour, tooling, and material costs. Typically a hiring firm will request quotes from multiple CMs. After the bidding process is complete, the hiring firm will select a source, and then, for the agreed-upon price, the CM acts as the hiring firm’s factory, producing and shipping units of the design on behalf of the hiring firm.

While Fabrinet is labelled as a contract manufacturer, they do more than just contract manufacturing, supporting their customers from cradle to grave. By de facto, they are the manufacturing arm of their customers. Some of Fabrinet’s core services include circuit board assembly, complex systems manufacturing, IP protection, new product introduction, optical component manufacturing, process develop and prototyping.

The diagram below illustrates a basic level of customer dynamics.

Fabrinet has 4 revenue segments – i) optical communication, ii) automotive, iii) industrial lasers, and iv) others. Optical communication forms the bulk of total sales.

Within optical communication, there are 2 key end markets, datacom and telecom.

Optical communications technology is all about moving photons quickly across short and long distances.

In the telecom end market, optical communication equipment produced and assembled is designed for placement outside of data centers, enabling long-haul transmission. Conversely, for datacom, the equipment is situated within data centers to support short-haul transmission.

The fundamentals of optical communication technology remain largely consistent between the telecom and datacom domains. The primary distinctions lie in the regulatory requirements and the specific applications of these components. Datacom components typically operate in a controlled environment, characterized by dry and cool conditions. In contrast, telecom components must endure more challenging conditions, including fluctuations in temperature and humidity.

Customer Dynamics

Fabrinet has a few customers contributing more than 10% of total sales. Lumentum is the longest serving customer for Fabrinet where they’ve constituted more than 10% of sales since Fabrinet’s IPO in 2010. Other otable long-serving customers includes Cisco and Infinera. Given the impact of AI on data centers driving demand for Infiniband, Nvidia became a new major customer for Fabrinet in FY23 (juicy…)

Given Fabrinet’s exposure to customer concentration risk, a commonly asked question and a long-term concern raised by investors over the years is the impact of customer consolidation and shift in bargaining power on Fabrinet.

According to Grady…

“And so far, we've not seen any major changes in their outsourcing strategy. From time to time, a company might acquire another company or merge with another company, and they might take a piece of the business and sell it to somebody else. And so in that case, we can pick up a new customer sometimes. But so far, we haven't seen any major negative impact. In fact, if anything, we think the consolidation has been probably positive. And so far, as I said, the industry consolidation certainly hasn't hurt us. And if anything, I think it's probably helped us a little bit.”

While I get where Grady is coming from, Fabrinet’s exposure to Infiniband, and plausibly ethernet directly translates into business with giants like Nvidia and Broadcom. These guys play key roles in the data centers and are relentless beasts to both their suppliers and customers. In my opinion, this is an important consideration to keep in mind when looking at Fabrinet for the long run.

Cost Structure

Fabrinet's volume supply agreements with customers typically have a duration of 2 years. Purchase order forecasts provide a 13-week visibility, guiding Fabrinet in making raw material purchases based on the earnings forecast for that period. Consequently, over 80% of Fabrinet’s total costs are variable, originating from bills of material (BOM), while fixed costs constitute only 7% of total sales. This lean and nimble cost structure enables Fabrinet to swiftly adapt to changes in demand. However, it's important to acknowledge that the company remains exposed to cyclicality and potential inventory corrections.

Outsourcing Trends

Broadly speaking, there are 2 camps of OEM today.

The first camp consists of outsourcers. In the optical components space, approximately 50% of OEMs adopt the outsourcing model with either one or multiple contract manufacturers. This approach frees up resources and facilitates more efficient capital allocation into R&D and product marketing, enabling the development of next-gen products.

The other camp comprises in-house manufacturers who handle manufacturing independently, employing a vertically integrated approach. Common reasons for choosing in-house manufacturing over outsourcing include maintaining quality control throughout the product process, protecting intellectual property, and reducing risks associated with supplier dependency. However, challenges such as high fixed costs and the potential to lag behind competitors in product innovation and upgrade cycles present significant hurdles in keeping pace with the competitive intensity of their respective sectors.

The evolution of the semiconductor industry over the last seven decades serves as a compelling case study on the importance of outsourcing in fostering innovation. In the 1950s-70s, most semiconductor players operated on the IDM model, emphasizing vertical integration and participation in all aspects of the value chain, from chip design to fabrication, testing, assembly, and packaging. Over time, industry leaders such as IBM and Intel played pivotal roles in catalyzing disaggregation for specialization.

While the old adage suggests, 'Don't boil the ocean', disruptors introduced the concept of 'seeking the blue ocean.' Nimbleness and ability to innovate in specific areas has been a proven playbook in fighting the conglos. Consequently, we’ve observe a pronounced fragmentation throughout the semicon value chain as seen by the success of players such as Cadence, Nvidia, TSMC, Terradyne… you get the point. Going forward, outsourcing will continue to be a trend for many industries in remaining competitive.

Fabrinet’s Manufacturing Facilities

As of 30-Jun-23, Fabrinet’s manufacturing facilities is sized at 3.7mn sqft – of which, 0.9mn sqft of office space, 1mn sqft of clean room facility manufacturing space, 1.8mn sqft of general manufacturing space. To better appreciate the importance Fabrinet’s manufacturing facilities, I reckon we view it from a NPI vs. Volume Production angle.

Fabrinet has 3 NPI (new product introduction) facilities across US, UK, and Israel. The purpose of NPI facility is to establish new products for customers from inception with quick turnaround (typically 48 hours). Fabrinet support their customers from product design to lifecycle and mass production. As the product ramps to a meaningful volume, which on average takes about 6-9 months, it gets shifted to the volume production facilities in Thailand (for low cost reasons) where it runs on a 2 x 12 hours shift, 6 days a week. Margin from NPI business is significantly higher than that of volume production business – 20% vs. < 12%. Given the context, we can view NPI as a consultancy-ish service that is extremely accretive to Fabrinet’s margin.

“These NPI centers serve as business development arms with an emphasis on new business generation, helping our customers with design for manufacturability and then transferring those programs to Thailand for volume manufacturing.”

Among the NPIs, UK is an exception where a portion of their NPI business does not lead to volume production within Fabrinet. Instead, volume production for UK’s NPI business gets outsourced to someone else in China. This is due to lack of learning curve on Fabrinet’s end with regards to doing business in EU. Nonetheless, accretive to Fabrinet’s margin.

Competitive Advantage

In my opinion, the term "moat" is too liberally used today when, in reality, most firms possess only slight and temporary levels of competitive advantage over their peers. However, in the case of Fabrinet, I would argue that they have earned the right to associate themselves with the term "moat".

Clearly, the numbers speaks for itself. Superior growth on top and bottom line, superior margins. How do you even comprehend a firm that delivers margin at 2x of what the industry is offering… Truly a well-defined case of “best-in-class” and hence the premium valuation over peers. In my view, there are a couple of factors behind Fabrinet’s superiority – i) Deep product knowledge, and ii) a long-term credible track record of executing well, which, over time, led to iii) high switching cost and sticky customer relationships.

Deep Product Knowledge

As mentioned at the start, Fabrinet is a specialist contract manufacturer in precision assembly of high complexity products within the optical communication space. Their product knowledge in optical communication stemmed primarily from Tom’s experience and discipline in optoelectronics manufacturing. This is also a classic case of a player being an early mover into a sector with a small TAM. Due to a small and slow growing TAM (back then), competition is correspondingly less intense.

“One is, we focus on a few key areas. So we're quite specialized. We don't try to do everything. We don't claim to be good at everything, but the things that we focus on, we try to be really excellent in those things. And I think customers come to us because we provide, we believe, really excellent quality delivery service with a main focus on the customer.”

To begin with, CMS is a tough business, margins are razor thin (< 7/4% gross/net). Execution risks from product quality control, relationships with OEMs, and loss of IP, can easily lead to non-renewal of contracts. The nature of the industry thereby shaped the mentality of a spray and pray game for many CMS players where they go after every type of business under the sun. As long as they can secure a contract which offers high volume low mix, they’ll take on the contract in maximizing sales. At the end of the contract period, they’ll go out to bid for new contracts. Scale is what most CMS players would rely on in growing the business.

Fabrinet on the other hand, opted for a different approach. They sacrificed scale for differentiation, only participating in their circle of competence – optical communication, industrial lasers, automotives, and sensors. Naturally, Fabrinet’s TAM is much smaller as seen from their revenue run rate vs. peers. Conversely, products within their operational domain exhibit a high degree of complexity, and it is in this domain that Fabrinet dominates its peers, leveraging a distinct edge in product knowledge.

Evidently, Fabrinet’s mix of clean room vs. general manufacturing space is about 40/60 mix vs. general EMS player with < 20/80 mix.

For context, clean room manufacturing spaces serve the purpose of providing a controlled environment with low levels of pollutants such as dust, airborne microbes, aerosol particles, and chemical vapours. These environments are crucial for industries and processes where maintaining a high level of cleanliness is essential to ensure the quality and reliability of the products being manufactured. Optical communication products such as fiber optic components and devices, often require significantly more clean room manufacturing space compared to general products due to the extreme sensitivity and precision involved in their manufacturing process. These products operate on the principles of light transmission, requiring extremely precise manufacturing to ensure minimal signal loss and optimal performance. Any impurities in the manufacturing process can lead to signal degradation, affecting the overall performance of optical.

Non-clean room environments on the other hand do not adhere to the same stringent standards for cleanliness. While they may still maintain a level of cleanliness suitable for many manufacturing processes, they lack the controlled conditions of a clean room. Non-clean room environments are more common in industries where the presence of certain particles or contaminants does not significantly impact the quality or functionality of the end product.

Product knowledge edge also allowed Fabrinet to climb up the value chain in being heavily involved with their customer’s early stage of product development. Margins are the highest in this stage of manufacturing due to abilities in i) identifying and implementing cost reductions with regards to product design, and ii) fast prototype turnaround. Overall it’s a win-win for Fabrinet and its customers. Simply put, the ability to be involved (stemming from product knowledge edge) in customers product design for time and cost to market accretes their margins over peers.

Switching cost and stickiness a function of solid execution

Upon securing the coveted contract, Fabrinet's customer will handover their manufacturing equipment pertinent to the agreement to Fabrinet. This transition distinctly severs the customer's i) in-house manufacturing capability for the designated product and ii) potential to engage another contract manufacturer, unless the existing contract with Fabrinet is terminated. Successful execution of present contract in turn drives renewal of contract for next-generation products. Should there be contract termination, the switching cost of seeking another CM requires about 1 year of requalification period. It takes about 3 months for prototype testing followed by another 6 to 9 months of ramping to build up sufficient inventory.

Incrementally, I would also allude Fabrinet’s factory-within-a-factory model as a key contributor. This is a model where Fabrinet offers their customers exclusive engineering teams and manufacturing space for IP protection purposes. Each of their customers are given a specific zone within Fabrinet’s manufacturing facilities, walled off with controlled access. Additionally, Fabrinet has no IP themselves and never compete with their customers. This gives customers assurance and security in picking Fabrinet as their vendor over other CMS.

Overall, the inherent dynamics of engaging in outsourcing with CMS creates a sticky relationship with high switching cost, if executed well. In the case of Fabrinet, they’ve proven themselves in the last 13 years with their execution credibility.

Hope you enjoyed this piece. As always, am just a student of the game, here to learn and get better, open to any constructive feedback.