Fabrinet - Quarter Report: 2014 December (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended December 26, 2014

OR

Commission File Number: 001-34775

FABRINET

(Exact name of registrant as specified in its charter)

+66 2-524-9600

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”) during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    ¨  Yes    x  No

As of January 23, 2015, the registrant had 35,400,195 ordinary shares, $0.01 par value, outstanding.

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FABRINET

FORM 10-Q

QUARTER ENDED DECEMBER 26, 2014

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PART I: FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

FABRINET

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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FABRINET

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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FABRINET

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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FABRINET

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands of U.S. dollars unless otherwise noted)

General

Fabrinet (“Fabrinet” or the “Parent Company”) was incorporated on August 12, 1999, and commenced operations on January 1, 2000. The Parent Company is an exempted company incorporated in the Cayman Islands, British West Indies. “We”, “us”, “our” and the “Company” refer to Fabrinet and its subsidiaries as a group.

The Company provides advanced optical packaging and precision optical, electro-mechanical and electronic manufacturing services to original equipment manufacturers (OEMs) of complex products, such as optical communication components, modules and sub-systems, industrial lasers and sensors. The Company offers a broad range of advanced optical and electro-mechanical capabilities across the entire manufacturing process, including process design and engineering, supply chain management, manufacturing, advanced packaging, integration, final assembly and test. The Company focuses primarily on the production of low-volume, high-mix products. The subsidiaries of Fabrinet include Fabrinet Co., Ltd. (“Fabrinet Thailand”), Fabrinet USA, Inc., FBN New Jersey Manufacturing, Inc., Fabrinet China Holdings, Casix, Inc. (“Casix”), and Fabrinet Pte., Ltd.

Basis of presentation

The condensed consolidated financial statements of Fabrinet included herein have been prepared on a basis consistent with the June 27, 2014 audited consolidated financial statements and include all material adjustments, consisting of normal recurring adjustments, necessary to fairly present the information set forth therein. These condensed consolidated financial statements should be read in conjunction with the June 27, 2014 audited consolidated financial statements and notes thereto. The year-end condensed balance sheet data was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States (“U.S. GAAP”).

The preparation of the Company’s condensed consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements, and the reported amount of total revenues and expense during the year. The Company bases estimates on historical experience and various assumptions about the future that are believed to be reasonable based on available information. The Company’s reported financial position or results of operations may be materially different under different conditions or when using different estimates and assumptions, particularly with respect to significant accounting policies, which are discussed below. Significant assumptions are used in accounting for share-based compensation, allowance for doubtful accounts, income taxes, and inventory obsolescence, among others. Due to the inherent uncertainty involved in making estimates, actual results reported in future periods may be different from these estimates. In the event that estimates or assumptions prove to differ from actual results, adjustments will be made in subsequent periods to reflect more current information.

Fiscal years

The Company utilizes a 52-53 week fiscal year ending on the Friday in June closest to June 30. The three months ended December 26, 2014 and December 27, 2013 each consisted of 13 weeks. The six months ended December 26, 2014 and December 27, 2013 each consisted of 26 weeks. Fiscal year 2015 will be comprised of 52 weeks and will end on June 26, 2015.

Concentration of credit risk

Financial instruments that potentially subject the Company to concentrations of credit risk consist of cash and cash equivalents, marketable securities, derivatives and accounts receivable.

Cash, cash equivalents and marketable securities are maintained with several financial institutions. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and are maintained with financial institutions with reputable credit and therefore bear minimal credit risk. The Company seeks to mitigate its credit risks by spreading such risks across multiple counterparties and monitoring the risk profiles of these counterparties. The Company limits its investments in marketable securities to securities with a maturity not in excess of three years, and all marketable securities that the Company invests in are rated A1, P-1, F1, or better.

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The Company performs ongoing credit evaluations for credit worthiness of its customers and usually does not require collateral from its customers. Management has implemented a program to closely monitor near term cash collection and credit exposures to mitigate any material losses.

Revenue recognition

Certain customers may request the Company to store finished products on their behalf. In these situations revenue is only recognized when the goods are completed and ready for shipment, and title and risk of loss have passed to the customer. The Company receives a written request from the customer asking the Company to hold the inventory at the Company warehouse, and the ordered goods are segregated in the Company warehouse from other inventory and cannot be used to fulfill other customer orders.

New Accounting Pronouncements – not yet adopted by the Company

In January 2015, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) No. 2015-01, “Income Statement – Extraordinary and Unusual Items (Subtopic 225-20): Simplifying Income Statement presentation by Eliminating the Concept of Extraordinary Items”. The objective of this amendments are to reduce the complexity of extraordinary items concept by the concept of extraordinary items, subtopic 225-20. Presently, an event or transaction is presumed to be an ordinary and usual activity of the reporting entity unless evidence clearly supports its classification as an extraordinary item. The criteria that must both be met for extraordinary classification: (a) unusual nature with high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to the ordinary and typical activities of the entity; and (b) infrequency of occurrence of the event which should not reasonably be expected to recur in the foreseeable future. This amendments are effective for fiscal years and interim periods beginning after December 15, 2015. Early adoption is permitted provided that the guidance is applied from the beginning of the fiscal year of adoption. The Company does not expect that the adoption of this update will have an effect on its consolidated financial statements.

In August 2014, the FASB issued ASU No. 2014-15, “Presentation of Financial Statements – Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern”. The amendments require management to evaluate, for each annual and interim reporting period, an entity’s ability to continue as a going concern when relevant conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations that become due within one year after the date that the financial statements are issued (or available to be issued). This ASU is effective for annual periods and interim reporting periods beginning after December 15, 2016. The Company does not expect that the adoption of this update will have an effect on its consolidated financial statements.

In June 2014, the FASB issued ASU No. 2014-12, “Compensation – Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved After the Requisite Service Period”. This ASU requires that a performance target that affects vesting, and that could be achieved after the requisite service period, be treated as a performance condition. As such, the performance target should not be reflected in estimating the grant date fair value of the award. This update further clarifies that compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. This update is required to be adopted by all public companies for annual periods and interim reporting periods beginning after December 15, 2015. Early adoption of this ASU is permitted. The Company is currently evaluating the impact of adoption of this update on its consolidated financial statements.

In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers (Topic 606), issued as a new Topic, Accounting Standards Codification”. The core principle of this amendment is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This ASU is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period, with earlier adoption not being permitted. This ASU can be adopted either retrospectively to each prior reporting period presented or as a cumulative-effect adjustment as of the date of adoption. The Company is currently evaluating the impact of adoption of this update on its consolidated financial statements.

Recently Adopted Accounting Pronouncements

In July 2013, the FASB issued ASU No. 2013-11, “Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists”. This ASU provides guidance for netting of unrecognized tax benefits (UTBs) against a deferred tax asset for a loss or other carryforward that would apply in settlement of the uncertain tax positions. Under this new guidance, UTBs will be netted against all available same-jurisdiction loss or other tax carryforwards that would be utilized, rather than only against carryforwards that are created by the UTBs. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The Company adopted this ASU in the first quarter of fiscal year 2015. Adoption of this guidance did not have a material impact on the Company’s unaudited condensed consolidated financial statements.

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In April 2013, the FASB issued ASU No. 2013-07, “Presentation of Financial Statements (Topic 205): Liquidation Basis of Accounting”. The amendments require an entity to prepare its financial statements using the liquidation basis of accounting when liquidation is imminent. The amendments require financial statements prepared using the liquidation basis of accounting to present relevant information about an entity’s expected resources in liquidation by measuring and presenting assets at the amount of the expected cash proceeds from liquidation. This guidance is effective for entities that determine liquidation is imminent during annual reporting periods beginning after December 15, 2013 and interim reporting periods therein. The Company adopted this ASU in the first quarter of fiscal year 2015. Adoption of this guidance did not have a material impact on the Company’s unaudited condensed consolidated financial statements.

In March 2013, the FASB issued ASU No. 2013-05, “Foreign Currency Matters (Topic 830): Parents’ Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity”. This ASU permits an entity to release cumulative translation adjustments into net income when a reporting entity (parent) ceases to have a controlling financial interest in a subsidiary or group of assets that is a business within a foreign entity. Accordingly, the cumulative translation adjustment should be released into net income only if the sale or transfer results in the complete or substantially complete liquidation of the foreign entity in which the subsidiary or group of assets had resided, or, if a controlling financial interest is no longer held. The guidance is effective for fiscal years beginning after December 15, 2013, with early adoption being permitted. The Company adopted this ASU in the first quarter of fiscal year 2015. Adoption of this guidance did not have a material impact on the Company’s unaudited condensed consolidated financial statements.

In February 2013, the FASB issued ASU No. 2013-04, “Liabilities (Topic 405): Obligations Resulting from Joint and Several Liability Arrangements for which the Total Amount of the Obligation is Fixed at the Reporting Date”. The guidance in this update requires an entity to measure obligations resulting from joint and several liability arrangements for which the total amount of the obligation within the scope of this guidance is fixed at the reporting date, as the sum of the following: (a) the amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors, and (b) any additional amount the reporting entity expects to pay on behalf of its co-obligors. The guidance also requires an entity to disclose the nature and amount of the obligation as well as other information about those obligations. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The Company adopted this ASU in the first quarter of fiscal year 2015. Adoption of this guidance did not have a material impact on the Company’s unaudited condensed consolidated financial statements.

Basic earnings per ordinary share is computed by dividing reported net income by the weighted average number of ordinary shares outstanding during each period. Diluted earnings per ordinary share is computed by dividing reported net income by the weighted average number of ordinary shares and dilutive ordinary equivalent shares outstanding during each period. Dilutive ordinary equivalent shares consist of share options and restricted share units. The earnings per ordinary share was calculated as follows:

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The Company’s cash, cash equivalents, and available-for-sale securities can be analyzed as follows:

All highly liquid investments with original maturities of three months or less at the date of purchase are classified as cash equivalents. The Company’s marketable securities investments have been classified and accounted for as available-for-sale. Management determines the appropriate classification of its investments at the time of purchase and reevaluates the designations at each balance sheet date. The Company may sell certain of its marketable securities prior to their stated maturities for strategic reasons including, but not limited to, anticipation of credit deterioration and duration management. The maturities of the Company’s marketable securities generally range from three months to three years.

The following table summarizes the cost and estimated fair value of fixed income securities classified as available-for-sale securities based on stated effective maturities as of December 26, 2014:

The Company’s investments in available-for-sale securities are reported at fair value. Unrealized gains and losses related to changes in the fair value of securities are recognized in accumulated other comprehensive income, net of tax, in the Company’s condensed consolidated balance sheets. Changes in the fair value of available-for-sale securities impact the Company’s net income only when such securities are sold or other-than-temporary impairment is recognized. Realized gains and losses on the sale of securities are determined by specific identification of each security’s cost basis. During the three and six months ended December 26, 2014, the net realized loss recognized by the Company was $0.01 million and $0.01 million, respectively.

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The Company reviews its available-for-sale securities on a regular basis to evaluate whether or not any security has experienced an other-than-temporary decline in fair value. The Company considers factors such as the length of time and extent to which the market value has been less than the cost, the financial condition and near-term prospects of the issue and the Company’s intent to sell, or whether it is more likely than not the Company will be required to sell the investment before recovery of the investment’s amortized cost basis. If the Company believes that an other-than-temporary decline exists in one of these securities, the Company will write down these investments to fair value.

As of December 26, 2014, the Company considered the declines in market value of its available-for-sale securities investment portfolio to be temporary in nature and did not consider any of its securities other-than-temporarily impaired. The Company typically invests in highly-rated securities, and its investment policy generally limits the amount of credit exposure to any one issuer. The policy requires investments generally to be investment grade, with the primary objective of minimizing the potential risk of principal loss. Fair values were determined for each individual security in the investment portfolio. When evaluating an investment for other-than-temporary impairment, the Company reviews factors such as the length of time and extent to which fair value has been below its cost basis, the financial condition of the issuer and any changes thereto, changes in market interest rates, and the Company’s intent to sell, or whether it is more likely than not it will be required to sell, the investment before recovery of the investment’s cost basis. No impairment losses were recorded for the three and six months ended December 26, 2014.

As of December 26, 2014, cash, cash equivalents, and marketable securities include bank deposits of $40.0 million held in various financial institutions located in the United States in order to support the availability of the Facility Agreement and comply with covenants. Under the terms and conditions of the Facility Agreement, the Company shall maintain cash, cash equivalents and/or marketable securities in an aggregate amount not less than $40.0 million in unencumbered deposits and/or securities in accounts located in the United States at all times during the term of the Facility Agreement. As discussed in Note 9, the Company must comply with this covenant from and after the effective date of the Facility Agreement.

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. A fair value hierarchy is established which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs for the valuation of an asset or liability as of measurement date. The three levels of inputs that may be used to measure fair value are defined as follows:

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities.

Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for assets or liabilities, either directly or indirectly. If the assets or liabilities have a specified (contractual) term, Level 2 inputs must be observable for substantially the full term of assets or liabilities.

Level 3 inputs are unobservable inputs for assets or liabilities, which require the reporting entity to develop its own valuation techniques and assumptions.

The Company utilizes the market approach to measure fair value for its financial assets and liabilities. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities.

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The following table provides details of the financial instruments measured at fair value on a recurring basis, including:

Derivative Financial Instruments

The Company uses foreign currency contracts to manage the foreign exchange risk associated with certain foreign currency-denominated assets and liabilities. As a result of foreign currency fluctuations, the U.S. dollar equivalent values of its foreign currency-denominated assets and liabilities change. The Company has not designated such foreign currency contracts as hedging instruments under the accounting standard for derivatives and hedging. The forward exchange contracts and option contracts outstanding as of December 26, 2014 and June 27, 2014 had a maturity in one to six months duration. The Company minimizes the credit risk in derivative instruments by limiting its exposure to any single counterparty and by entering into derivative instruments only with counterparties that meet the Company’s minimum credit quality standard.

The derivative assets and liabilities are classified in other current assets and accrued expenses, respectively, on the condensed consolidated balance sheets. The change in the fair value of the derivatives is recorded in foreign exchange gain (loss) on the condensed consolidated statements of operations and comprehensive income.

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The activities and balances for allowance for doubtful accounts were as follows:

The following tables present details of the Company’s intangibles:

The Company recorded amortization expense relating to intangibles of $0.02 million and $0.02 million for the three months ended December 26, 2014 and December 27, 2013, respectively, and $0.04 million and $0.05 million for the six months ended December 26, 2014 and December 27, 2013, respectively.

Based on the carrying amount of intangibles as of December 26, 2014, and assuming no future impairment of the underlying assets, the estimated future amortization at the end of each fiscal year in June is as follows:

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Bank borrowing and long-term debt was comprised of the following:

On April 25, 2014, a subsidiary entered into an amendment to the bank borrowing agreement. Under the amendment of the contract, the long-term loan is secured by certain property, plant and equipment. The carrying amount of assets secured and pledged as collateral as of December 26, 2014 and June 27, 2014 was $51.1 million and $52.3 million, respectively. This subsidiary is also required to comply with the maximum ratios of debt to equity and minimum levels of debt service coverage ratios and Fabrinet must maintain effective shareholding ratio. The carrying amounts of bank borrowings approximate their fair value.

As of December 26, 2014 and June 27, 2014, the Company was in compliance with its long-term bank borrowing agreement. In addition to financial ratios, certain of the Company’s credit facilities include customary events of default.

The movements of long-term loans were as follows for the six months ended December 26, 2014 and December 27, 2013:

As of December 26, 2014, future maturities of long-term debt were as follows at the end of each fiscal year below:

Credit facilities:

Fabrinet entered into a syndicated senior credit facility agreement (the “Facility Agreement”) with a consortium of banks on May 22, 2014. The Facility Agreement, led by Bank of America, provides for a $200.0 million credit line, comprised of a $150.0 million revolving loan facility and a $50.0 million delayed draw term loan facility. The revolving loan facility contains an accordion feature permitting Fabrinet to request an increase in the facility up to $100.0 million subject to customary terms and conditions and provided that no default or event of default exists at the time of request. The revolving loan facility terminates and all amounts outstanding are due and payable in full on May 22, 2019. The principal amount of any drawn term loans must be repaid according to the scheduled quarterly amortization payments, with final payment of all amounts outstanding, plus accrued interest, being due May 22, 2019. As of December 26, 2014, no amounts were outstanding under the Facility Agreement.

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Loans under the Facility Agreement bear interest, at Fabrinet’s option, at a rate per annum equal to a LIBOR rate plus a spread of 1.75% to 2.50%, or a base rate, determined in accordance with the Facility Agreement, plus a spread of 0.75% to 1.50%, in each case with such spread determined based on Fabrinet’s consolidated total leverage ratio for the preceding four fiscal quarter period. Interest is due and payable quarterly in arrears for loans bearing interest at the base rate and at the end of an interest period (or at each three-month interval in the case of loans with interest periods greater than three months) in the case of loans bearing interest at the LIBOR rate.

Fabrinet’s obligations under the Facility Agreement are guaranteed by certain of its existing and future direct material subsidiaries. In addition, the Facility Agreement is secured by Fabrinet’s present and future accounts receivable, deposit accounts and cash, and a pledge of the capital stock of certain of Fabrinet’s direct subsidiaries. Fabrinet is required to maintain at least $40.0 million of cash, cash equivalents, and marketable securities at financial institutions located in the United States. Further, Fabrinet is required to maintain any of its deposits accounts or securities accounts with balances in excess of $10.0 million in a jurisdiction where a control agreement, or the equivalent under the local law, can be effected. The Facility Agreement contains customary affirmative and negative covenants. Negative covenants include, among other things, limitations on liens, indebtedness, investments, mergers, sales of assets, changes in the nature of the business, dividends and distributions, affiliate transactions and capital expenditures. The Facility Agreement contains financial covenants requiring Fabrinet to maintain: (i) a minimum tangible net worth of not less than $200.0 million plus 50% of quarterly net income, exclusive of quarterly losses; (ii) a minimum debt service coverage ratio of not less than 1.50:1.00; (iii) a maximum senior leverage ratio of not more than 2.50:1.00; and (iv) a minimum quick ratio of not less than 1.10:1.00. Each of these financial covenants is calculated on a consolidated basis for the consecutive four fiscal quarter period then ended. As of December 26, 2014, the Company was in compliance with all covenants under the Facility Agreement.

The Facility Agreement also contains customary events of default including, among other things, payment defaults, breaches of covenants or representations and warranties, cross-defaults with certain other indebtedness, bankruptcy and insolvency events and change in control of Fabrinet, subject to grace periods in certain instances. Upon an event of default, the lenders may terminate their commitments, declare all or a portion of the outstanding obligations payable by Fabrinet to be immediately due and payable and exercise other rights and remedies provided for under the Facility Agreement. The undrawn credit facility of $200.0 million became available on July 15, 2014.

Fabrinet intends to use the proceeds of the credit line to finance its future manufacturing building in Thailand, and for general corporate purposes including mergers and acquisitions of complementary manufacturing businesses or technology, although Fabrinet has no current commitments with respect to any such acquisitions.

Undrawn available credit facilities as of December 26, 2014 and June 27, 2014 were as follows:

As of December 26, 2014 and June 27, 2014, the liability for uncertain tax positions including accrued interest and penalties was $1.2 million and $0.9 million, respectively. The Company expects the estimated amount of liability associated with its uncertain tax positions to decrease within the next 12 months due to the lapse of the applicable statute of limitations in foreign tax jurisdictions.

The Company files income tax returns in the U.S. and foreign tax jurisdictions. The tax years from 2010 to 2014 remain open to examination by U.S. federal and state tax authorities, and foreign tax authorities. The Company’s income tax is recognized based on the best estimate of the expected annual effective tax rate for the full financial year of each entity in the Company, adjusted for discrete items arising in that quarter. If the Company’s estimated annual effective tax rate changes, the Company makes a cumulative adjustment in that quarter.

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The effective tax rate for the Company for the three months ended December 26, 2014 and December 27, 2013 was 10.5% and (10.4)% of net income, respectively. The increase in the effective tax rate for the three months ended December 26, 2014 was primarily due to the reversal of liabilities for uncertain tax positions, including accrued interest of $1.5 million in the three months ended December 27, 2013 and an increase in deferred tax assets of $0.6 million from the increase in the income tax rate of the Company’s subsidiary in China from 15% in the three months ended December 27, 2013 to 25% in the three months ended December 26, 2014 due to the expiration of a tax privilege.

The effective tax rate for the Company for the six months ended December 26, 2014 and December 27, 2013 was 9.2% and (1.8)% of net income, respectively. The increase in the effective tax rate for the six months ended December 26, 2014 was primarily due to the reversal of liabilities for uncertain tax positions, including accrued interest of $1.5 million in the six months ended December 27, 2013 and an increase in deferred tax assets of $0.6 million from the increase in the income tax rate of the Company’s subsidiary in China from 15% in the six months ended December 27, 2013 to 25% in the six months ended December 26, 2014 due to the expiration of a tax privilege, as well as the fact that the Company had lower net income during the six months ended December 26, 2014 from income related to flooding of $6.6 million which was recognized during the six months ended December 27, 2013 that was not subject to income tax.

Share-based compensation

In determining the grant date fair value of equity awards, the Company is required to make estimates of the fair value of Fabrinet’s ordinary shares, expected dividends to be issued, expected volatility of Fabrinet’s ordinary shares, expected forfeitures of the awards, risk free interest rates for the expected term of the awards, expected terms of the awards, and the vesting period of the respective awards. Forfeitures are estimated at the time of grant and revised if necessary in subsequent periods if actual forfeitures differ from those estimates.

The effect of recording share-based compensation expense for the three and six months ended December 26, 2014 and December 27, 2013 was as follows:

Share-based compensation expense was recorded in the condensed consolidated statements of operations and comprehensive income as follows:

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The Company did not capitalize any share-based compensation expense as part of any asset costs during the three and six months ended December 26, 2014 and December 27, 2013.

Share-based award activity

Share options have been granted to directors and employees. As of December 26, 2014, there were 11,865 share options outstanding under Fabrinet’s Amended and Restated 1999 Share Option Plan (the “1999 Plan”). Additional option grants may not be made under the 1999 Plan.

As of December 26, 2014, there were an aggregate of 820,023 share options outstanding, 1,097,604 restricted share units outstanding, and 3,008,074 ordinary shares available for future grant under Fabrinet’s 2010 Performance Incentive Plan (the “2010 Plan”). The 1999 Plan and 2010 Plan are collectively referred to as the “Share Option Plans”.

Share options

Fabrinet’s board of directors has the authority to determine the type of option and the number of shares subject to an option. Options generally vest and become exercisable over four years and expire, if not exercised, within seven years of the grant date. In the case of a grantee’s first grant, 25 percent of the underlying shares subject to an option vest 12 months after the vesting commencement date and 1/48 of the underlying shares vest monthly over each of the subsequent 36 months. In the case of any additional grants to a grantee, 1/48 of the underlying shares subject to an option vest monthly over four years, commencing one month after the vesting commencement date.

The following summarizes share option activity:

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The following summarizes information for share options outstanding as of December 26, 2014 under the Share Option Plans:

As of December 26, 2014, there was $0.1 million of unrecognized compensation expense related to share options under the Share Option Plans that is expected to be recognized over a weighted-average period of 0.82 years.

Restricted share units

Restricted share units are one type of share-based award that may be granted under the 2010 Plan. Restricted share units granted to non-employee directors generally cliff vest 100% on the first of January, approximately one year from the grant date, provided the director continues to serve through such date. Restricted share units granted to employees generally vest in four equal installments over four years on each anniversary of the vesting commencement date.

The following summarizes restricted share unit activity under the 2010 Plan:

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As of December 26, 2014, there was $10.8 million of unrecognized share-based compensation expense related to restricted share units under the 2010 Plan that is expected to be recorded over a weighted-average period of 3.12 years.

For the six months ended December 26, 2014 and December 27, 2013, the Company withheld an aggregate of 16,399 shares and 10,242 shares, respectively, upon the vesting of restricted share units, based upon the closing share price on the vesting date to settle the employees’ minimum statutory obligation for the applicable income and other employment taxes. For the six months ended December 26, 2014 and December 27, 2013, the Company then remitted cash of $0.3 million and $0.2 million, respectively, to the appropriate taxing authorities, and presented it in a financing activity within the condensed consolidated statements of cash flows. The payment had the effect on shares issued by the Company as it reduced the number of shares that would have been issued on the vesting date and was recorded as a reduction of additional paid-in capital.

Share capital

Fabrinet’s authorized share capital is 500,000,000 ordinary shares, par value of $0.01 per ordinary share, and 5,000,000 preferred shares, par value of $0.01 per preferred share.

For the six months ended December 26, 2014, Fabrinet issued 26,677 ordinary shares upon the exercise of options, for cash consideration at a weighted average exercise price of $15.58 per share, and 192,437 ordinary shares upon the vesting of restricted share units, net of shares withheld.

For the six months ended December 27, 2013, Fabrinet issued 276,711 ordinary shares upon the exercise of options, for cash consideration at a weighted average exercise price of $12.78 per share, and 122,503 ordinary shares upon the vesting of restricted share units, net of shares withheld.

All such issued shares are fully paid.

The Company’s accumulated other comprehensive loss consists of the accumulated net unrealized losses on available-for-sale securities. For the six months ended December 26, 2014, the changes in accumulated other comprehensive loss, net of tax were as follows:

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Bank guarantees

As of December 26, 2014 and June 27, 2014, there were outstanding bank guarantees given by banks on behalf of Fabrinet Thailand for electricity usage and other normal business amounting to $0.8 million and $0.3 million, respectively.

Operating lease commitments

The Company leases a portion of its capital equipment and certain land and buildings for its facilities in China and New Jersey under operating lease arrangements that expire in various calendar years through 2020. Rental expense under these operating leases amounted to $0.5 million and $0.4 million for the six months ended December 26, 2014 and December 27, 2013, respectively.

As of December 26, 2014, the future minimum lease payments due under non-cancelable leases are as follows at the end of each fiscal year below:

Purchase obligations

Purchase obligations represent legally-binding commitments to purchase inventory and other commitments made in the normal course of business to meet operational requirements. Although open purchase orders are considered enforceable and legally binding, their terms generally give the Company the option to cancel, reschedule and/or adjust its requirements based on its business needs prior to the delivery of goods or performance of services. Obligations to purchase inventory and other commitments are generally expected to be fulfilled within one year.

As of December 26, 2014, the Company had an outstanding commitment to third parties of $5.9 million.

Indemnification of directors and officers

Cayman Islands law does not limit the extent to which a company’s memorandum and articles of association may provide for indemnification of directors and officers, except to the extent any such provision may be held by the Cayman Islands courts to be contrary to public policy, such as to provide indemnification against civil fraud or the consequences of committing a crime. Fabrinet’s amended and restated memorandum and articles of association provide for indemnification of directors and officers for actions, costs, charges, losses, damages and expenses incurred in their capacities as such, except that such indemnification does not extend to any matter in respect of any fraud or dishonesty that may attach to any of them.

In accordance with Fabrinet’s form of indemnification agreement for its directors and officers, Fabrinet has agreed to indemnify its directors and officers against certain liabilities and expenses incurred by such persons in connection with claims by reason of their being such a director or officer. Fabrinet maintains a director and officer liability insurance policy that may enable it to recover a portion of any future amounts paid under the indemnification agreements.

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Operating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision maker is Fabrinet’s chief executive officer. As of December 26, 2014 and December 27, 2013, the Company operated and internally managed a single operating segment. Accordingly, the Company does not accumulate discrete information with respect to separate product lines and does not have separate reportable segments.

Total revenues are attributed to a particular geographic area based on the bill-to-location of the customers. The Company operates primarily in three geographic regions: North America, Asia-Pacific and Europe. The following table presents total revenues by geographic regions:

As of December 26, 2014 and December 27, 2013, the Company had approximately $0.3 million and $0.3 million of long-lived assets based in North America, with the substantial remainder of assets based in Asia-Pacific.

Significant customers

The Company had two customers that each contributed to 10% or more of its total account receivable as of December 26, 2014 and June 27, 2014, respectively.

The Company suspended production at all of its manufacturing facilities in Thailand from October 17, 2011 through November 14, 2011 due to severe flooding in Thailand. The Company never resumed, and has permanently ceased, production at its Chokchai facility. The Company submitted claims for losses to its insurance companies, all of which have been settled as of the end of fiscal year 2014.

In the three months ended December 27, 2013, the Company did not recognize any income related to flooding. In the six months ended December 27, 2013, the Company received from its insurers an interim payment of $6.6 million against its claim for owned and customer-owned inventory losses, which the Company recognized as income related to flooding.

During the six months ended December 27, 2013, the Company fulfilled its obligations to a customer in accordance with a settlement agreement entered into during the third quarter of fiscal 2013 by making a final cash payment to such customer of $3.7 million and by transferring equipment, with an aggregate value of $2.3 million, to such customer. Also, the Company fulfilled its obligations to a customer’s insurers in accordance with a settlement agreement entered into during the fourth quarter of fiscal 2013 by making a final payment of $2.2 million. The Company also entered into other flood-related settlements of $0.1 million during the six months ended December 27, 2013.

As part of the Company’s ongoing efforts to achieve greater efficiencies in all areas of its business, during the six months ended December 26, 2014, the Company implemented a reduction in workforce and incurred expenses of approximately $1.2 million, which represented severance and benefits costs incurred for the termination of approximately 100 employees in accordance with contractual obligations and local regulations.

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As disclosed, the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 27, 2014, the Company determined that certain finished goods sales recognized in each of the first three quarterly reporting periods in the fiscal year ended June 27, 2014 did not qualify for revenue recognition in the period in which they were recorded. The Company evaluated the impact of the errors and determined that the errors did not have a material impact to the consolidated financial statements for the fiscal year ended June 27, 2014, or the interim consolidated financial statements for each of the quarters within fiscal 2014. Accordingly, the Company has not made any adjustments to the unaudited condensed consolidated financial statements for the three and six months ended December 27, 2013.

Had adjustments been made in the three and six months ended December 27, 2013, to reflect revenues and cost of revenues that were inappropriately recorded, revenues, cost of revenues, and net income for the three months ended December 27, 2013, would have been $6.4 million, $5.7 million, and $0.6 million lower, respectively, and for the six months ended December 27, 2013, would have been $3.6 million, $3.3 million, and $0.4 million lower, respectively.

New subsidiaries

On January 6, 2015 the Company incorporated Fabrilink SEZC, a 100% wholly owned subsidiary, in the Cayman Islands. On January 16, 2015, the Company incorporated Fabrinet West, Inc. and Fabritek, Inc., 100% wholly owned subsidiaries, in California, United States.

Lease commitment

On January 26, 2015, the Company entered into a commercial lease agreement for a period of five years for office space of approximately 1,730 square feet at Cayman Enterprise City, HSBC House, 68 West Bay Road, Grand Cayman KY1-1003, Cayman Islands. Monthly service fee of the premises is $14,475 per month.

Capital expenditure commitment

On January 20, 2015, the Company entered into a building remodel project contract for a facility in Thailand of approximately $3.7 million.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements relate to future events or to our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. Forward-looking statements include, but are not limited to, statements about:

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These forward-looking statements are subject to certain risks and uncertainties that could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Quarterly Report on Form 10-Q, in particular, the risks discussed under the heading “Risk Factors” in Part II, Item 1A as well as those discussed in other documents we file with the Securities and Exchange Commission. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

Overview

We provide advanced optical packaging and precision optical, electro-mechanical and electronic manufacturing services to original equipment manufacturers (OEMs) of complex products such as optical communication components, modules and sub-systems, industrial lasers and sensors. We offer a broad range of advanced optical and electro-mechanical capabilities across the entire manufacturing process, including process design and engineering, supply chain management, manufacturing, advanced packaging, integration, final assembly and test. Although, we focus primarily on low-volume production of a wide variety of high complexity products, which we refer to as “low-volume, high-mix”, we also have the capability to accommodate high-volume production. Based on our experience with, and positive feedback we have received from our customers, we believe we are a global leader in providing these services to the optical communications, industrial lasers, automotive, and sensors markets.

Our customer base includes companies in complex industries that require advanced precision manufacturing capabilities such as optical communications, industrial lasers, automotive, and sensors. The products that we manufacture for our OEM customers include selective switching products; tunable transponders and transceivers; active optical cables; solid state, diode-pumped, gas and fiber lasers; and sensors. In many cases, we are the sole outsourced manufacturing partner used by our customers for the products that we produce for them.

We also design and fabricate application-specific crystals; prisms; mirrors; laser components; substrates, and other custom and standard borosilicate, clear fused quartz, and synthetic fused silica glass products. We incorporate our customized optics and glass into many of the products we manufacture for our OEM customers, and we also sell customized optics and glass in the merchant market.

Audit Committee Investigation

During the fourth quarter of our fiscal year 2014, the Company identified violations of our policies and procedures relating to finished goods held in our warehouse on behalf of our customers (the Company refers to finished goods held in our warehouse on behalf of our customers as consignment goods or consignment inventory and when the finished goods are sold the Company refers to the related revenue as consignment revenue). Specifically, the Company identified violations related to certain employees in one business unit colluding to cause the improper recognition of revenues for certain goods by recording consignment revenues on goods before such goods were finished.

In connection with the above, the Audit Committee of our Board of Directors initiated an investigation concerning various accounting cut-off issues in fiscal year 2014, specifically the transfer of unfinished goods to consignment inventory and other inventory cut-off considerations. The investigation found certain process weaknesses concerning the potential to invoice unfinished goods held under consignment arrangements and the need for certain remedial measures.

The Company is working to complete the following recommended remedial measures that were identified through the investigation:

The investigation did not find executive officer involvement in the identified violations.

Impact of the Findings of the Investigation on the Financial Statements and Internal Control

Based on an analysis prepared by the Company, it was determined that the potential exposure relating to the control deficiencies identified during the investigation was not material to our consolidated financial statements for the fiscal year 2014. Further, the Company assessed these control deficiencies to be significant deficiencies rather than material weaknesses on the basis that there was no executive officer involvement in the violations, the potential misstatements were not material to the consolidated financial statements and the Audit Committee was actively involved in the investigation.

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Consignment Revenue Recognition

Subsequent to completion of the Audit Committee’s investigation, the Company evaluated its accounting practices surrounding consignment inventory and consignment revenue. Based on that evaluation, the Company determined that for certain volume supply agreements with our customers not all of the revenue recognition criteria prescribed by U.S. GAAP and Staff Accounting Bulletin No. 104 had been met at the time revenue was recorded. Specifically, the Company misapplied the guidance when assessing the terms of these agreements with respect to when title and risk of loss transfers to our customers. As a result, the Company determined that certain sales previously recognized did not qualify for revenue recognition in the periods in which they were recognized. The Company has evaluated the impact of the errors on both a quantitative and qualitative basis under the guidance of ASC 250 – Accounting Changes and Error Corrections and determined that the errors did not have a material impact to the previously issued consolidated financial statements. The Company has assessed the control implications and concluded that the deficiency constituted a material weakness in internal control over financial reporting (refer to Part I, Item 4 for additional information).

Had adjustments in the prior period been made to reflect revenues that were inappropriately recorded in the three and six months ended December 27, 2013, revenues for the three and six months ended December 27, 2013 would have been $6.4 million and $3.6 million lower, respectively.

During the three months ended December 26, 2014, we amended certain volume supply agreements such that under certain conditions the Company recognizes revenue upon product being delivered to our warehouse. We refer to such revenue as “consignment revenue.” Specifically, we recognize consignment revenue when the goods are completed, ready for shipment, and title and risk of loss have passed to the customer. As a result, in the three months ended December 26, 2014, we recorded revenue of $ 8.0 million with $0.8 million gross profit from these amended volume supply agreements.

Thailand Flooding