Fabrinet Stock: A Key Enabler Of The AI Revolution (NYSE:FN)

Summary

Fabrinet is a key player within the data center ecosystem and is well-positioned for future growth as AI continues to grow. It has a strong balance sheet, good profitability metrics, and reliable EPS generation. While it does command a premium valuation, I believe such a valuation is justified and I have a Buy recommendation on the company.

Background

Most data including Cable TV, Internet, and other telecommunications travels at the speed of light through cables that exist all around us. But who helps facilitate such light-based speeds to enable the digital world?

One of those companies is Fabrinet (NYSE:FN), who makes optical sensors, transmitters, receivers, lasers and more for many different industries as showcased below. According to their 10K Fabrinet provides “advanced optical packaging and precision optical, electro-mechanical and electronic manufacturing services to OEMs of complex products such as optical communication components, modules, and sub-systems, industrial lasers, automotive components, medical devices and sensors.”

While they are involved in many industries, the key driver of Fabrinet’s recent success has been their Datacom business, which involves creating fiber-optic cable within data centers—a key cog that allows communication to happen within the data center, and thus within the cloud.

According to their Q1 2024 Investor Presentation, in just 2 years, their Datacom revenue has grown from $88.8 million per quarter to $242.0 million in the most recent quarter, an astonishing total growth of 146%.

According to the same Q1 2024 Investor Presentation, two years ago, Fabrinet’s Datacom business made up 16.35% of its total revenue. In the most recent quarter, Datacom made up 35% of Fabrinet’s revenue.

The next logical question to ask is how has Fabrinet been able to grow their Datacom business at such an astonishing rate?

Relationship with Nvidia

The answer lies in a major partner and one of Fabrinet’s biggest customers: Nvidia (NVDA). Nvidia has chosen Fabrinet as its Datacom partner meaning that Fabrinet helps with manufacturing, optical-based connections, networking cables and other services for use in the data center. This is evident in Fabrinet’s 10K which shows Nvidia as its 3rd biggest customer over the past year. Before that Nvidia was not a top 5 customer, which suggests the partnership is a recent one, but is quickly growing.

Thus, Fabrinet is a key enabler for the AI and data center transformation working with the most important company in that arena. While I am not an expert on the technology and exact specifics, the partnership can be seen when one compares Nvidia’s revenue growth over the past 2 years to the revenue growth within Fabrinet’s Datacom unit.

Since Q1 2022, Nvidia has grown its revenue 156% from $7.1 billion to $18.2 billion in the most recent quarter (data from Seeking Alpha).

Since Q1 2022, Fabrinet’s Datacom business has grown its revenue 172% from $88.8 million to $242 million in the most recent quarter (data from Fabrinet Q1 2024 Investor Presentation).

Fabrinet’s other businesses are quite cyclical as can be seen from their total revenue breakdown below:

Valuation

As Datacom has driven much of Fabrinet’s success over the past several years, and because much of Fabrinet’s other businesses are cyclical, I believe continued growth in Datacom is integral to Fabrinet’s future success and valuation.

If we assume that over the next 2 years, Telecom, Industrial laser, and Other revenue can return to their F1Q22 levels of $338.6 million, $37.5 million, and $30.3 million respectively while Automotive stays put at $88.4 million, Fabrinet’s total revenue not including datacom would be $493.5 million. As Fabrinet is cyclical and is currently in the middle of a downcycle within these non-Datacom segments, it is reasonable to assume a new up-cycle would see them recover much of the loss in revenue. Therefore, my projections represent a return to revenue levels of 2 years ago (Q1 2022) and these values are derived from Fabrinet’s Q1 2024 presentation.

Now, because we have determined that Fabrinet’s Datacom growth tracks very strongly with Nvidia’s revenue growth we can use Nvidia’s expected revenue growth of 51% over the next 2 years to correlate with Datacom growing at 51%. This would mean the Datacom business can grow to $365 million over the next 2 years.

Added together, Fabrinet’s total quarterly revenue may grow to $859 million by 2026. If we multiply by 4 that means Fabrinet’s annual revenue could reach about $3.44 billion by 2026.

According to their most recent ER, Fabrinet believes they can maintain their recent margins of about 12% gross margin and about 9% net margin. This would mean Fabrinet could produce $77.3 million net income per quarter or $309 million of net income annually. If we put a 22x multiple on that (which is similar to its 5 yr average multiple) and add the $670 million of net cash on the balance sheet that would mean Fabrinet should be worth at least $7.5 billion or about $202 per share.

Additionally, the net cash can produce about another $27 million a year in income or $0.72 a share per year if it yields 4%. Note that my calculations assume little additional growth in Fabrinet’s non-Datacom businesses. Also, if Datacom grows faster than expected my calculation could undervalue the company.

On the other hand, if Datacom growth does not shape out as expected, or if its other businesses decline, Fabrinet may prove overvalued and underperform.

Peer analysis

According to the 10K, Fabrinet lists their main competitors as Benchmark Electronics (BHE), Celestica (CLS), Sanmina-SCI (SANM), and Jabil (JBL). As you can see below, Fabrinet is significantly more expensive than all 4 competitors on both a P/E basis, and EV/EBITDA basis.

However, a higher valuation is often justified for superior growth metrics and as can be seen below, Fabrinet is growing revenue faster than all of its peers over the past 5 years.

EPS has grown the strongest of its competitors as well and Fabrinet has the best net income margin.

Additionally, Fabrinet has the best balance sheet with the least debt. This insulates Fabrinet from interest rate risk and means that further interest rate hikes would not be a threat to its balance sheet, although they could affect its customers spending habits. The superior balance sheet also allows Fabrinet to earn some interest income.

Because of its superior growth metrics, strong margins, and fortress balance sheet I believe Fabrinet’s premium valuation is deserved.

Risks

Customer Concentration

One of Fabrinet’s risks is their concentration on only a few customers for a majority of their revenue. According to the 10K, 4 customers contribute at least 10% of their revenue meaning that just 4 customers make up over 40% of Fabrinet’s revenue.

Those customers are Cisco (CSCO) (15.6%), Lumentum (LITE) (15.4%), Nvidia (12.5%) and Infinera corporation (INFN) (12.4%) and they make up about 56% of Fabrinet’s revenue. If any of those customers cuts back or falls on financial trouble, Fabrinet’s revenue is at risk.

And with Datacom primarily driven by Nvidia, the thesis I have laid out relies heavily on Nvidia’s continued partnership with Fabrinet.

Israel Risk

Fabrinet has significant ties with Israel as listed in its 10K. the Asia-Pacific region (APC) makes up about 42% of Fabrinet’s revenue. Israel is the largest contributor to the APC segment at $341 million, which represents about 12.9% of Fabrinet’s Revenue. Fabrinet also has a small facility in Israel. Any geopolitical escalation in Israel may adversely affect Fabrinet’s business.

Conclusion

Fabrinet is a key part of the AI revolution and has a privileged position as a preferred supplier for Nvidia. Fabrinet’s strong growth, strong margins, and pristine balance sheet position it well for continued outperformance over the long term. And while it does command a rich valuation, I believe this valuation is justified, and Fabrinet will continue to reward shareholders with strong gains over the years ahead.

Key risks to my thesis include geopolitical risk and customer concentration risk. If Fabrinet loses Nvidia as its partner, the business and stock price may be significantly affected.