Good day, ladies and gentlemen. Welcome to Fabrinet's financial results conference call for the third quarter of fiscal year 2018. At this time, all participants are in a listen only mode. Later, we will conduct a question and answer session, and instructions on how to participate will be given at that time. As a reminder, today's call is being recorded. I would now like to turn the call over to your host, Garo Toomajanian, Investor Relations.
Thank you, operator, good afternoon, everyone. Thank you for joining us on today's conference call to discuss Fabrinet's financial and operating results for the third quarter of fiscal year 2018, which ended March 30, 2018. With me on the call today are Tom Mitchell, founder and Executive Chairman, Seamus Grady, Chief Executive Officer, and Toh-Seng Ng, Fabrinet's Chief Financial Officer. This call is being webcast and a replay will be available on the investor section of our website, located at investor.fabrinet.com. Please refer to our website for important information, including our earnings press release and investor presentation, which include our GAAP to non-GAAP reconciliation. I would like to remind you that today's discussion will 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, 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-Q filed on February 7, 2018. We will begin the call with remarks from Tom, Seamus, and T.S., followed by time for questions. I would now like to turn the call over to Fabrinet's Executive Chairman, Tom Mitchell. Tom?
Thank you, Garo, good afternoon, everyone. I am pleased we exceeded our revenue expectations for the third quarter, today we are well positioned to benefit from stabilizing demand, current customer growth, and new customer opportunities. I'd like now to turn the call over to Seamus for his remarks.
Thank you, Tom, and good afternoon, everyone. We're pleased that our third quarter revenue came in above the top end of our guidance range with revenue of $332 million and non-GAAP net income of $0.71 per share, including the impact of a $0.06 foreign exchange headwind. This strong profitability is also reflected in cash flows, with year-to-date operating cash flow increasing 49% to nearly $90 million, and year-to-date free cash flow of $61.5 million, compared to a little over $3 million a year ago. We believe that business trends are stabilizing, and this is reflected in our expectations for increasing revenue in the fourth quarter, as T.S. will detail later. As in the second quarter, 72% of third quarter revenue came from optical communications programs, and 28% from non-communications.
Within optical, telecom continues to dominate, and at 64% of optical revenue, telecom revenue grew 6% on a sequential basis. We anticipate that this stabilization will continue into the fourth quarter in both telecom and datacom programs. We're also optimistic that our non-optical communications business will resume sequential growth in the fourth quarter after a modest decline from record levels in the second quarter. These trends reflect not only market conditions of our customers and their customers, but our ability to attract new customers and new programs. Our strong position in the market is driven by our experience and reputation as a technology-driven manufacturer for optical communications and other markets that require precision manufacturing and advanced packaging. Over the years, we have reinforced this focus on optical communications while also leveraging it to enter adjacent markets, such as optical sensing, commercial lasers, and medical.
New business, which again represented 35% of revenue in the third quarter, continued to reflect this diversification. Fabrinet West, our new product introduction facility strategically located in Santa Clara, California, has been instrumental in helping us get closer to customers and win new programs serving diverse end markets. While there's only one Silicon Valley, we believe there are a small number of global regions that share similar characteristics of a large concentration of technology companies. One of these locations is Israel, where we already have a number of customers. In March, we made early steps towards establishing a new NPI facility in Israel, where we can continue our proven model of providing local new product introduction services, helping our customers with design for manufacturability, and then transferring those programs to Thailand for volume manufacturing.
While it's still very early days for us in this exciting region, we're confident that in Israel, we can replicate the NPI playbook that we have been successful with in Fabrinet West and Fabrinet UK. Having already established a beachhead in Israel, including a new executive vice president to lead the charge, we look forward to sharing our progress with you as we execute on our plans. In summary, we are pleased to have exceeded our revenue expectations in the third quarter. We're enthusiastic about the fourth quarter and beyond, with stabilizing or improving trends across the markets we serve, and we are excited about the many opportunities ahead. Now let me turn the call over to T.S. to discuss the details of our third quarter performance and our outlook. T.S.?
Thank you, Seamus. Good afternoon, everyone.
I will provide you with more details on our performance by end market and our financial results for Q3 of FY 2018, as well as our guidance for Q4. Total revenue in the quarter was $332.2 million above the high end of our guidance range. non-GAAP net income was $0.71 per share within our guidance range. In the third quarter, we experienced a $2.4 million of $0.06 per share foreign exchange headwind, compared to a $3.7 million or $0.10 headwind in the third quarters of 2017. Excluding the impact of this headwind, non-GAAP EPS would have been above our guidance range. Looking at the quarter in more detail, revenue from optical communication programs was $241 million, compared to $287 million a year ago and $242 million in the second quarter. non-optical communications programs represented 72% of total revenue, consistent with the second quarter.
Within optical, telecom represented 64% of revenue, up four percentage points from the second quarter. In other words, in Q3, telecom revenue increased by 6% from Q2 to $154 million. datacom revenue was $87 million, or 36% of optical communications. By speed, 100G solution continued to dominate with revenues of $129 million, down slightly from $133 million in Q2. Revenue from 400G solution was $10 million in Q3, compared to $16 million in Q2. Revenue from QSFP28 transceivers was $37 million in Q3, compared to $42 million in Q2 as the transition to lower cost CWDM4 variants continues, with volume not yet high enough to offset lower prices. silicon photonics revenue was $66 million, compared to $74 million in Q2. Turning to non-optical communications. We again had a strong performer but did not beat our record second quarter performance.
non-optical components and module represented 28% again in Q3 at $91 million. Revenue from the industrial laser market was again a record at $43 million, up 23% from a year ago. Automotive revenue of $21 million was below the records of nearly $26 million in Q2, but up 6% from a year ago. Sensor revenue grew slightly to nearly $5 million from $4 million in Q2. Other revenues of $22 million was down slightly from $23 million in Q2. Finally, new business was $116 million, or 35% of revenue in Q3 as it was in Q2. Now turning to the details of our P&L, a reconciliations on GAAP to non-GAAP measures is included in our earnings press release and investor presentation, which you can find on our website.
Non-GAAP gross margin in Q3 was 11.6%, consistent with FQ2 and below our target range of 12%-12.5%, primarily due to start-up costs related to certain new customer program, as well as to the decrease in revenue and a continued strengthening of the Thai baht from Q2. We expect gross margin to improve in Q4, but not enough to put us in the target range for all of FY 2018. Non-GAAP operating income in Q3 was $30.1 million, and operating margin was 9.1%, up slightly from Q2 from cost saving from the reduction in workforce that we made in Q2, as well as approximately $1 million impact from the reversal of management bonus accrue against FY 2018 objective.
Taxes in the quarter were a net expense of $1.5 million, and our normalized effective tax rate was 6.2%, consistent with Q2 and in line with our expected range of 6%-7%. We continue to anticipate an effective tax rate of 6%-7% for fiscal year 2018. Non-GAAP net income was $28.4 million in Q3, or $0.71 per diluted share, compared to $0.72 in Q2 and $0.80 a year ago. On a GAAP basis, which includes share-based compensation expenses and amortizations of debt issuing costs, net income for Q3 was $21.1 million or $0.55 per diluted share, compared to $21.7 million or $0.57 per diluted share in Q3 of fiscal year 2017. As I mentioned earlier, we experienced a $2.4 million or $0.06 per share negative impact from a stronger Thai baht on our GAAP and non-GAAP bottom line results for Q3.
Turning to the balance sheet and cash flow statement. At the end of Q3, cash and investment were $315.4 million. This represents an increase of $27.8 million from the end of the second quarter, primarily from operating cash flow of $52.7 million, which increased 31% from the second quarter, offset by a CapEx of $6.9 million, share repurchases of $12.5 million, and repayments of long-term loans from bank of $3.4 million. Free cash flow, which is operating cash flow less CapEx, was $45.8 million in the third quarter, an increase of 53% from Q2. On a year-to-date basis, operating cash flow was $89.8 million. After subtracting CapEx of $28.3 million, year-to-date free cash flow was $61.5 million, reflecting the meaningful decrease in CapEx that we have anticipated for FY 2018. We expect CapEx in FY 2018, all of which is maintenance CapEx, to be approximate $35 million.
During the third quarter, we were active in our share repurchase program and bought back approximately 422,000 shares at an average price of $29.58. As of the end of the third quarter, $37.6 million remain in our repurchase authorization. I would now like to turn to our guidance for the fourth quarter of fiscal year 2018, which incorporates approximately $7 million negative impact from sanctions on ZTE. As a reminder, we do not have any direct customers in China, but many of our customers do serve Chinese customers. With that background, we anticipate revenue to be in the range of $334 million-$342 million, an increase from the third quarter, as Seamus indicated.
From an earnings perspective, we anticipate non-GAAP net income per share in the fourth quarter to be in the range of $0.73-$0.77, and GAAP net income per share of $0.55-$0.59, based on approximately 37.9 million fully diluted shares outstanding. In summary, we are pleased to have delivered revenue in the third quarter that was above our guidance range and are enthusiastic about increasing revenue in the fourth quarter as customer demand across our diverse range of programs stabilize or improve. Our position in the market continues to strengthen as customers look to us to manufacture their most challenging designs. Operator, we would now like to open the call for questions.
Ladies and gentlemen, if you have a question at this time, please press star and then one on your touch-tone telephone. If your question has been answered, or you wish to remove yourself from the queue, please press the pound key. Our first question comes from the line of Alex Henderson with Needham & Company. Your line is now open.
Hi, good afternoon. This is Dan Park on for Alex. Thanks for taking my questions. Just wondering regarding your comment on ZTE and Huawei, have you seen any change in orders relative to ZTE and Huawei? How much of your silicon photonics business is falling off as a result of ZTE?
As we mentioned in our prepared remarks, our estimate for Q4 is an impact of about $7 million in our Q4 outlook, and that's included in the outlook we gave for Q4. That number we arrived at from discussions with our customers, so we feel pretty solid about that number.
Okay, great. I guess my second question, have you seen a re-acceleration of demand in the datacom space? To what extent is there pressure on this business? Have you seen any evidence of re-acceleration in demand given some of the issues around the Arista workaround having been resolved and volume changes at Web 2.0 customers?
This is T.S. I think the volume is already there in terms of quantity. The thing, Cloud, the whole data is a pricing reduction. In our prepared remarks, we say that the lower prices is not enough to offset the volumes increase. If you split it into two parts, obviously volume continues to increase. Again, because of the price reduction, we can't really tell.
Okay, great. Thanks for taking my questions.
Thank you.
Thank you.
Thank you.
Thank you. Our next question comes from the line of Troy Jensen with Piper Jaffray. Your line is now open.
Hey, gentlemen. Congrats on the nice results.
Thank you.
Thanks, Troy.
Hey, guys, just a little color on the June guidance. Are you expecting both datacom and telco to grow, or are they going to be stable and the laser business grow? Just any more insight would be helpful.
I think we expect both segments to grow moderately, that's why you see how it reflected in our total guidance.
Okay. All right. How about just to follow up on the silicon photonics question, $66 million this quarter. Can you just talk about customer concentration in there, and is it still three big guys? Just any color you can give us just generically on silicon photonics would be great.
Yeah. Essentially we have a new entrant about maybe two or three quarters ago, and they start ramping. There's a new customer we acquire. Other than that, still the same customer profile. One of them has been ramping down. If you listen to their earning call, they're talking of ramping down temporarily, and it seems like their volume is coming back. If you look at from Q2 to Q3 to Q4, most of the customers are about the same, except we added another new customer, and they're ramping very nicely.
Okay. All right, perfect. How about, last question from me. Can you just talk or give us an update on the partnership with MACOM?
There's nothing really to update on that. MACOM is a customer of ours. They're not a 10% customer, so we're not going to go into a huge amount of detail. They remain a customer of ours. There's a number of programs we're working on with MACOM, and there's no real update since we last discussed it.
I think previously there is belief that the June quarter, we could hit some threshold of revenues. Do you feel like you're still on track for that?
We're probably not in a position to really talk about that because it's more of our customer's business for them to talk about. We're still working with the customer and with the end customer on that program, and it's progressing at a pace. We're not really in a position to give that level of guidance down to the program.
Okay. Yep. Understood, Seamus. You guys keep up the good work. Thanks.
Thanks, Troy. Thank you.
Thank you.
Thank you.
Thank you. Once again, ladies and gentlemen, if you'd like to ask a question at this time, please press star and then one on your touchtone telephone. Once again, that is star and then one to ask a question. Our next question comes from the line of Tim Savageaux with Northland Capital Markets. Your line is now open.
Hi, good afternoon. A couple of questions.
Hi, Tim.
Hey. To the extent you reported revenue above the high end of guide, I'd say, as you look across your portfolio, where was kind of the upside surprise, if you will, from your perspective? Looks like telecom side's been pretty strong. I don't know if you had unexpected strength there or anything else in particular to call out.
I would say, if you look at the number in detail, it's the telecom sector. More specifically, it's a non-speed telecom gadget that make the quarter. Those things like Pump laser, EDFA amplifier, and so on. That those, we don't classify them by whether 100 gig or 400 gig and so on. Those are pretty strong segments, and that pretty much endorsed, also verified by our customer in their earnings call, if you listen to their earnings call.
The other one I would just add to that is our optical sensing business is up. Was pretty strong last quarter, as was commercial laser business. That business is very strong.
It's across a number of sectors.
Understood, very helpful. To follow up, silicon photonics was down a bit in the quarter, that's, I imagine, prior, given that ZTE news was disclosed after the end of the quarter, I imagine the impact there, maybe it's not entirely in silicon photonics, but it'll be incremental in the June quarter. In terms of looking at the March quarter decline, how would you characterize the drivers of the silicon photonics decline in March?
The March decline in silicon photonics, we have a mix of customers in the silicon photonics space, but it is pretty concentrated, as we mentioned a moment ago, with a few customers, with one in particular seeing weakness last quarter. They talked about that in their earnings call. We do see that actually recovering this quarter. The ZTE effect is factored into our numbers.
That's not to say that something else couldn't happen, but based on the best information that we have right now, there's about a $7 million impact, some of which is actually that silicon photonics business.
Got it. Thank you. I'll pass it on.
Thank you, Tim.
Thank you, Tim.
Thank you. Our next question comes from the line of Dave Kang with B. Riley. Your line is now open.
Thank you. Good afternoon. A couple of questions. First, regarding the $7 million impact from ZTE. Is that primarily one customer or can you just characterize that?
It's across a number of customers.
Right.
It's more than one customer. It's across a number of customers. As you'd appreciate, we don't ship anything directly to ZTE, and we actually don't ship anything directly to China. All of our product ships ex works. That $7 million is across a number of customers of ours who ship to ZTE.
Got it. Gross margin and SG&A. First one, gross margin. It was kind of flat. How should we think about fourth quarter and beyond? Can we get back to 12%, or how should we think about that? Also on the SG&A, it was down about a little over $2 million. What drove that, and is it kind of sustainable, or is it going to pop back up to over $10 million?
Dave, normally we don't guide a gross margin. If you take our guidance on the EPS and the revenue and work backwards, given the knowledge of operating expenses are a little bit low in Q3, I would say, you will realize that the gross margins were improving in FQ4. We have implied a better gross margin going to June quarter. Again, on the CapEx operating expenses side, $8.5 million is extremely low. We talk about reversals of some of the management bonus accrual. I will expect to get back to about $10 million-$10.5 million level, the normal run rate level, in the June quarter. Hopefully that is helpful.
Yes. One more on CapEx. $35 million this year. How should we think about next fiscal year?
Next fiscal year, a lot depend on the revenue, okay? If we are going to ramp, for example, like last year, 45% growth, obviously we need a lot of CapEx. Assuming normal growth, I would say it will still fluctuate around $35 million-$40 million.
Yeah.
We won't commission a second building until maybe at the end of 2018 or maybe in early 2019 calendar year, right, Seamus?
I think if we get to the point where Chonburi is 70%, 80%, certainly 70-plus % utilized, we'll commission a second building. Obviously, that will then drive a much bigger CapEx-
Yeah
in the year in which we do that. It's a problem we hope to have.
Right.
As of right now, I think that $35 million-$40 million is probably a good number for next year.
The second building will probably spend in FY 2020. We will commission the construction in FY 2019, but I think the payment will be in 2020.
Got it. One more question, and this will be my final question, is that on silicon photonics, it was down slightly in third quarter. Is it going to be down or up or maybe flat in fourth quarter? What's baked into your guidance?
I think there are about three or four customer there. A lot depend on their demand posture. One of them doing well, the other one, see the temporary setback. In their earning call, they're talking about coming back. Hard to tell, but I think if both of them are doing well, obviously we'll see the number going up.
Got it. Thank you very much.
Thank you.
Thank you. I'm showing no further questions at this time, so I'd like to return the call to Mr. Seamus Grady for any closing remarks.
Okay. Thank you, operator, thanks for everyone for participating in today's call. We look forward to speaking with many of you at the upcoming investor events, we'll talk to everyone when we present our fourth quarter fiscal 2018 results in August. Thanks again, have a great afternoon.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, you may all disconnect. Everyone, have a great day.